Many startup and growth-stage companies are in urgent need of funding, compelling majority shareholders to finance a "down round" to protect their investment. However, because this funding might decrease minority shareholders' likelihood of realizing meaningful investment returns, counsel should examine whether majority shareholders who provide such financing owe any duty under Delaware corporate law to the minority shareholders of either the company or their class.
By David A. Scherl|March 13, 2002 at 12:00 AM
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As a result of the current economic climate, many startup and growth-stage companies are faced with liquidity problems and find themselves in urgent need of funding. Funding under these circumstances typically takes the form of the issuance of the company’s equity at valuations lower than that of prior financing rounds. Often times, the only practical source of such “down round” financing may be the company’s majority shareholders — they are motivated to protect their existing investment in the company. Typically, they are institutional or otherwise financially secure investors with access to available funds, and have extensive knowledge of the company and its prospects. Notwithstanding that majority shareholders may be the logical, and sometimes only, alternative for such financing, the minority shareholders may have a different perspective. While minority shareholders may be content to stand on the sidelines as the majority shareholders bear the risks associated with funding a company facing a liquidity crisis in uncertain economic times, the terms of the new funding might be such that the likelihood of the minority shareholders realizing a meaningful return on their investment may be greatly diminished as a result of such down round financing. Combine this prospect with the minority shareholders’ frustration over the existing decline in the value of their investment, and the possibility that minority shareholders might want to make a claim against the majority shareholders becomes more than an insubstantial risk. The question is, what claims might be available to the disgruntled minority shareholders. This article examines whether majority or controlling shareholders (holding either a majority of a company’s stock, or a majority of a particular class of a company’s stock) who provide down round financing to a company owe any duty under Delaware corporate law to the minority shareholders of either the company or their class. DELAWARE CASE LAW Although there is a significant body of Delaware case law regarding majority shareholders’ duties to minority shareholders, it appears that the Delaware courts have not addressed this issue either in the context of down round financings or in the context of duties owed by holders of a majority of a class of stock to the minority holders of that class. Moreover, Delaware case law is extremely fact specific regarding majority shareholders’ duties to minority shareholders. Accordingly, our analysis is an extrapolation of existing case law. Existing Delaware case law holds that majority shareholders’ actions must be measured by the “entire fairness” standard (rather than the more deferential “business judgment rule” commonly applicable to directors’ actions). This means that the burden of proving entire fairness shifts, at least initially, to the majority shareholders. [FOOTNOTE 1] The analyses applied in these cases (which often involve shareholder-challenged mergers) support the proposition that the entire fairness standard would be the legal standard applicable to majority shareholder financiers in the context of down round financings. Delaware courts have widely held that a plaintiff may invoke the “entire fairness” standard by demonstrating self-interest or a lack of independence on the part of a majority of the directors approving a transaction. [FOOTNOTE 2] Delaware case law also clearly holds that where a controlling shareholder stands on both sides of a transaction, the controlling shareholder (and the directors who are subject to that control) will bear the burden of proving the entire fairness of the transaction. [FOOTNOTE 3] Accordingly, it appears that the entire fairness standard would apply to down round financings by majority shareholders, since the majority shareholder is generally on both sides of the deal: having directors on the board and/or otherwise controlling the approval of the transaction, as well as providing the financing. The same reasoning and standards may be extended to a shareholder who — while not a majority shareholder — is nevertheless the holder of a majority of a class of a corporation’s securities, and who is also purchasing the class of “down round” securities. If protective provisions have been written into the charter or a shareholders’ agreement, another risk is that courts may find that any such majority class holder has a duty of good faith and fair dealing vis-�-vis the other class holders, based on their contractual relationship. It should be noted that the action brought by a class member would be against the majority class holder as well as the company. Assuming that the entire fairness standard would apply to a down round financing by a controlling shareholder (or a controlling shareholder of a class), controlling shareholders can take certain steps to protect themselves. First, Delaware courts have held that the burden of proof shifts back to the minority shareholders (or, in some cases, that the standard of review reverts back to the business judgment rule) if the transaction was approved by either (i) an independent committee of directors “who have real bargaining power that can be exerted in dealings with a majority shareholder” or (ii) a fully informed vote of a majority of the minority shareholders. [FOOTNOTE 4] Accordingly, to the extent possible, taking one, and preferably both, of these steps is recommended. Obtaining a vote appears to offer the strongest protection to majority shareholders, as such a vote in effect constitutes a waiver by the minority shareholders of their right to protest the financing. Any such vote, however, must be truly based on full and accurate disclosure to be effective. Where the issue relates to class holders, obtaining such a minority vote may be the only means of protection, since — if the majority shareholders are found to owe a contractually based duty to the minority shareholders — action by a committee of independent directors may not satisfy this duty. Nevertheless, such a committee should protect the majority class holders if the makeup of the defendant committee and the content of the deliberations were such as to protect the class (as well as, or as opposed to, the interests of the company as a whole). Recent court cases have reaffirmed the effectiveness of an independent committee’s negotiation and approval of a transaction to either shift the burden of proof back to the plaintiff or reinstate the business judgment standard. [FOOTNOTE 5] It should be noted that the steps delineated above merely shift the burden or alter the standard of review, rather than preclude a finding against the majority shareholder. They do, however, significantly decrease the likelihood of such a finding. In the event that it is impracticable to obtain the foregoing approvals, a majority shareholder or class holder should be prepared to defend the transaction as fair under the “entire fairness” standard. Entire fairness is consistently defined under Delaware law as comprised of two basic aspects: fair dealing (how the transaction was timed, initiated, structured, negotiated, disclosed and approved) and fair price (all elements of the intrinsic or inherent value of a company’s stock, including assets, market value, earnings, future prospects). [FOOTNOTE 6] Accordingly, taking some or all of the following steps would be helpful in establishing the transaction’s fairness to a court: � Obtaining independent legal and financial advice on the proposed financing and other options for the company, including an assessment of the market value of the down round shares; � Shopping the deal; � Offering the opportunity to participate on the same terms to the minority shareholders or class holders; � Engaging in a thorough, documented analysis of the financing’s advantages and disadvantages, evaluating business purpose, consistency with past practice, strategic alternatives, etc.; and � Providing full disclosure to minority shareholders or class holders of all aspects, and at all stages, of the proposed financing. [FOOTNOTE 7] Some Delaware courts have not engaged in an in-depth analysis of fairness in applying the entire fairness standard, but rather have relied on the premise that minority shareholders negotiated their protections at the time of investment and are not entitled to additional court-imposed protections. In Nixon v. Blackwell, 626 A.2d 1366 (Del. 1992), the court, holding that it is well established that shareholders need not always be treated equally for all purposes, [FOOTNOTE 8] stated: “The tools of good corporate practice are designed to give a purchasing minority shareholder the opportunity to bargain for protection before parting with consideration. It would do violence to normal corporate practice and our corporation law to fashion an ad hoc ruling which would result in a court-imposed shareholder buy-out for which the parties had not contracted.” [FOOTNOTE 9] This argument is more compellingly applied to private companies with few shareholders, who do have a real opportunity for negotiation. However, as discussed above, courts may imply a duty of fairness by majority class holders based on this very contractual relationship where, in fact, protective provisions were bargained for, but then lost by virtue of such majority class holder’s action. In any event, the Nixon holding should be relied upon with caution; it is invoked only in a minority of the cases addressing majority shareholders’ duties, most of which involve outcome determinative facts that appear easily distinguishable from down round financings. CONCLUSION Although current case law does not offer a definitive resolution of the extent of majority shareholder or class holder duties in the context of down round financings, majority shareholders and class holders involved are well advised to take as many of the steps above as practicable, especially securing the vote of a majority of the minority shareholders and/or approval of the financing by a truly independent committee of directors. To the extent that they are not able to secure such vote or approval, they should be well prepared to defend the fairness of the financing under the entire fairness standard. David A. Scherl is a partner with Morrison Cohen Singer & Weinstein in New York. Loree M. Jacquet, an associate at the firm, assisted in preparing this article.
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