As the economy continues to experience daily turmoil in the wake of the COVID-19 crisis, it becomes increasingly likely that some companies will feel the need to enter into dilutive financings and downside exits.
This new reality poses heightened challenges for boards and increases the likelihood of litigation, as has occurred in past downturns.
For those not looking to repeat history, here’s a look-back at some of the mis-steps that boards of financially distressed companies have made when seeking financing or considering downside exits while in distress, together with some lessons learned about how boards can get it right during these difficult circumstances.
In each of these situations, insiders came to the rescue of a struggling company. At the time, these insiders thought they were stretching to provide support where no one else would tread.
These insiders viewed themselves as courageously taking on risk to save a bad situation from getting worse. But in hindsight, after the turnarounds had occurred, all that the other equity holders and the courts were able to see were flawed board processes.
In some of these situations, the courts even observed that these transactions were made at fair valuations. But, in all of these situations, there was a failure to adhere to best practices in the board room and, therefore, the consequences for the insiders and the directors were embarrassing at best and in some cases quite costly.
In re Loral Space Communications (2008) – unfair process; unfair price; not entirely fair
Loral Space and Communications Inc., a satellite manufacturer, emerged from bankruptcy with a large stockholder, MHR Fund Management LLC (“MHR”). MHR soon used its influence to install one of its advisors as Loral’s CEO.
Once in position, the newly minted CEO from MHR determined that Loral had a capital shortage, hindering plans to grow the business, and proposed that MHR make an investment of $300m into Loral.
Loral ultimately entered into a $300m convertible preferred stock transaction with MHR, the terms of which provided MHR with extremely favorable economic and governance rights.
In subsequent derivative and class action litigation filed in the Delaware Court of Chancery, certain minority stockholders alleged that the deal constituted an unfair, conflicted transaction that was tainted by a flawed special committee process.
In light of MHR’s 35.9 percent ownership of common stock and because five of the nine Loral directors were directors of, or otherwise affiliated with, MHR, then-Vice Chancellor Strine reviewed the transaction under entire fairness, concluding that the special committee failed to conduct an adequate process and that the financial terms of the deal were unfair to Loral.
The court determined that the process was unfair for four key reasons:
- Interested and apathetical special committee members – although the Loral board did establish a special committee, the committee was composed of just two directors, one of whom was a classmate and long-time friend of Loral’s Chairman and the co-founder of MHR who also solicited MHR to invest in his company during the pendency of the negotiation. The other special committee member was a retired CPA, who, in the court’s view, was characterized by inertia and took a month-long camping trip during the negotiation at a remote lake that did not have phone service.
- Inexperienced financial advisor – despite considering some well-known Wall Street investment banks, the special committee engaged a financial advisor that was not familiar with the convertible securities that were being considered and misinformed the committee that it would consult with an expert. In Strine’s words, the advisor was “not ready to swim in the deep end” or to “match wits” with MHR’s advisors at Deutsche Bank.
- Special committee not fully empowered – the Loral board initially established the special committee to “evaluate and negotiate” the proposed transaction with MHR; it was not empowered to consider alternate sources of financing or conduct a market check until a subsequent board meeting when its mandate was amended at the behest of its lawyers. Even then, the committee failed to take reasonable steps to investigate alternatives or to otherwise create a more competitive process.
- Ineffective special committee – in addition to the failure to conduct an appropriate market check, the court found that the special committee did not function effectively, simply accepting the advice of its inexperienced advisor on the economic terms and once the economic terms were agreed, largely deferring to management in the negotiation of the rest of the deal terms.
After determining there had been an unfair process to reach a deal, the court further held that the economic and other terms of the financing were unfair to Loral.
The convertible preferred stock issued to MHR had a 7.5 percent coupon and a 12 percent conversion premium over Loral’s stock price, while other unsolicited bidders offered closer to a 5 percent coupon and a 20 percent conversion premium.
The court also viewed the structural provisions to ensure MHR never had more than 39.99 percent of the voting power with skepticism, and a bald attempt by the board to avoid so-called Revlon duties (which would have required the board to take reasonable steps to obtain the best price reasonably available).
Lastly, the court was very critical of a broad unilateral veto right granted to MHR over any strategic transaction involving Loral.
Upon finding that the financing was not entirely fair, the Court of Chancery—as a court of equity—determined that the most equitable remedy would be to convert MHR’s preferred stock into non-voting common stock at a conversion price set by the court, leaving MHR with 57 percent of Loral’s outstanding equity but only 35.9 percent of its voting power, while eliminating MHR’s unilateral veto power over strategic transactions.
Whether MHR’s actions contributed to the inadequacy of the board process (and the ultimate result) may be debatable, but there is no arguing that MHR was left holding the bag. The transaction was not rescinded.
Loral got to retain MHR’s $293.3m in cash and MHR was left with non-voting common stock that would likely trade at a meaningful discount to Loral’s voting common stock. Caveat emptor, as they say.
In re Trados Incorporated (2013) – unfair process; fair price; entirely fair
Trados, a translation software company with VC-backing, agreed to merge with SDL plc after a period of economic difficulties.
While the Trados preferred stockholders, who also designated a majority of the directors on the board, and Trados management, in part due to a favorable management incentive plan adopted to promote a sale, each received a portion of the $60m sale price, the common stockholders received nothing.
The common stockholders brought suit alleging that the board breached its fiduciary duties by agreeing to a transaction that allowed the preferred stockholders to get paid their liquidation preference and for management to receive a payout under the incentive plan, while the common stockholders received no consideration for their shares.
Given that preferred stockholders designated a majority of the board, the Delaware Court of Chancery applied the entire fairness standard, finding that the board’s process was inadequate, but that the price was ultimately fair.
The court found that six out of seven directors who approved the transaction were not disinterested or independent because they:
- were management directors that benefited from the management incentive plan;
- represented the venture capital firms that were preferred stockholders; or
- had meaningful connections to preferred stockholders, including one of the supposed independent directors who had deep professional ties to the VC investors.
Central to this conclusion was the reality that the waterfall to distribute proceeds in connection with a liquidation event, such as a change of control transaction, inherently produced a tension between the preferred stockholders (sitting at the top of the waterfall) and the common stockholders (sitting at the bottom of the waterfall).
It did not help the board that evidently there had been little consideration given to the interests of the common stockholders in the record.
The court also found it troubling that the management incentive plan was structured in such a way so as to prioritize management over the common stockholders.
Depositions suggested that certain of the directors failed to appreciate these conflicts, which may explain why the board failed to put in place any procedural protections, such as a special committee or majority-of-the-minority stockholder vote.
Although the court noted that such procedures are not necessarily required, the court concluded that the process was unfair given the other deficiencies.
In light of the overall valuation of the company however, the court determined that the common holders could not expect to receive anything given the preference of the preferred holders, and therefore, the price was fair.
The case is an important reminder that in certain circumstances, and notwithstanding an unfair process, a fair price may result in the court permitting the directors to escape liability.
Facts similar to Trados played out more recently in Blackberry’s 2015 acquisition of Good Technology.
In that situation, former common stockholders of Good Technology sued certain directors of Good Technology affiliated with VC firms that had invested in preferred stock of Good Technology, claiming the directors approved an underpriced sale to Blackberry that provided little value to common stockholders, all as a result of the VC funds’ self-interest in monetizing their investment rather than waiting for the optimal time for a liquidity event.
The directors ultimately settled claims for breach of their fiduciary duties for $17m.
In re Nine Systems Corporate Shareholders Litigation (2014) – unfair process; fair price; not entirely fair
In 2002, Nine Systems Corporations (f/k/a Streaming Media Corporation) (“Nine Systems”), a struggling VC-backed streaming media company, turned to its three largest investors, who collectively owned approximately 54 percent of the company’s outstanding stock and over 90 percent of its senior debt, for a cash infusion in order to acquire two strategic targets.
Each investor had a designated director on the board. The deal was structured as a recapitalization in which certain secured debt held by the investors was converted into a new class of preferred stock and a new class of preferred stock was issued in exchanged for new cash from two of the investors to finance the acquisitions ("the recapitalization”), the specific details of which (and conflicts related thereto) were not disclosed to all stockholders. (The third investor was promised the right to invest on the same terms within 90 days of the recapitalization.)
Instead of obtaining an independent financial analysis of Nine Systems and the two targets, the board relied on a back-of-the-envelope analysis provided by one of the three defendant stockholders involved in the recapitalization.
The recapitalization resulted in the three defendant stockholders’ fully diluted ownership increasing from approximately 54 percent to approximately 80 percent, while the plaintiff stockholders’ fully-diluted ownership decreased from approximately 26 percent to approximately 2 percent.
The two acquisitions were completed and several years later, in 2006, Nine Systems sold itself to Akamai for $175m, with $150m going to the three defendant stockholders and $3m going to the plaintiff stockholders.
Upon disclosure of the additional details surrounding the recapitalization in connection with the Akamai sale, minority stockholders filed suit in Delaware arguing that the investors constituted a control group and the board was conflicted when it approved the transaction.
The Delaware Court of Chancery applied entire fairness, finding that the majority of the board was conflicted when it approved the recapitalization.
The court wasn’t shy in characterizing the board’s process for approval of the recapitalization as “grossly inadequate”.
Its holding was based upon several damaging facts, including that:
- the board failed to be adequately informed about the valuation of Nine Systems and the two targets;
- the board did not understand or appreciate the methodology the director used to value the company for purposes of the recapitalization;
- the board sidelined and took steps to marginalize the sole independent director who initially opposed the recapitalization and
- the board withheld material terms from stockholders in its initial disclosure at the time of the recapitalization, including by failing to identify which stockholders were participating in the recapitalization and their favorable terms. (It was not until the Akamai sale years later that stockholders learned of these terms.)
Notwithstanding those fundamental process deficiencies, the court found that the transaction was consummated at a fair price because it estimated that Nine System’s common stock had no value at the time of the recapitalization.
Accordingly, and similar to the fact pattern in Trados, the dilution of the minority stockholders wasn’t necessarily unfair because they received a substantially equivalent amount in value as they had prior to the recapitalization.
In contrast to Trados however, the court—despite finding the price was fair—determined that the recapitalization was not entirely fair because the process was so grossly unfair.
The court then distinguished the result in Trados, stating that entire fairness review is principally contextual—in the present case, "a price that…was more than fair does not ameliorate a process that was beyond unfair."
Unfortunately for the plaintiffs, because of that fair price, they were not entitled to damages other than an award of attorneys’ fees.
As evidenced by these decisions, the boards in Loral, Trados and Nine Systems each made several missteps in the lead-up to approving these transactions.
And while a fair price allowed the directors in two of these cases to escape either a finding of liability or significant damages, each can still fairly be considered an embarrassing failure of the board under the circumstances.
Any board considering a down-round financing or downside exit in the current environment should consider the following takeaways from these past mis-steps.
Involve and empower independent directors
Disabling conflicts will taint the best process.
Boards need to foster a culture of full disclosure of conflicts, both by directors and by their advisors. Any director with serious conflicts should recuse himself or herself or, if a majority of the board is sufficiently conflicted, a special committee should be formed.
Any such committee should be appropriately constituted and empowered to select and engage its own advisors, to seek out alternative transactions, and to say “no” if necessary.
Consider a majority-of-the-minority vote
In the context of a downside exit, the board or special committee may determine to condition the deal on the affirmative vote of the disinterested stockholders as a means of limiting their litigation risk in accepting a proposal that will result in the company being sold for a lower valuation.
This may result in the creation of “holdup” or execution risk but that may be in the buyer’s interest to avoid issues post-closing.
The buyer may want to require the preferred holders to agree to recut the waterfall to avoid another Trados type situation.
A majority-of-the-minority vote is more difficult in the context of a down-round financing, as many of these transactions will be structured to avoid a stockholder vote and the time required to obtain it altogether but, in theory, the board could, if it were so inclined, condition a down-round on receipt of a majority-of-the-minority vote.
Conduct (some form of) market check
Before accepting an investor’s proposal at a lower valuation, companies should consider testing the market to determine if there’s a better deal.
There’s no one right way to do this. Companies should consider checking quietly with the usual suspects—strategic companies in the same space with the resources to pull off such a deal and an appropriate mix of financial investors that focus on that industry.
Other companies may even issue a public statement that the company is looking for funding or considering its strategic alternatives.
The Loral case perfectly showcases the problem with doing nothing.
At the same time, boards should be realistic about the existing rights that some stockholders may have that might frustrate such a market check, such as vetoing an issuance or exercising a right of first refusal or preemptive rights, and attempt to design the process to manage around these rights as best they can.
Keep the business plan up to date
The board in Nine Systems was lucky that the back-of-the-envelope valuation in that case turned out to be fairly accurate. The next board may not be so lucky.
These cases demonstrate that the courts will give some deference to boards putting in the hard work of revisiting and pressure testing their internal projections with management.
This can be a difficult exercise; valuing a company that hasn’t achieved profitability (or even monthly recurring revenue) can be a shot in the dark, particularly in light of the current market volatility caused by the COVID-19 crisis. But just shrugging isn’t the answer either.
Boards need to periodically test and revisit the company’s short- and long-term strategy and forecasts in order to make informed decisions about the company’s future.
Boards should also consider obtaining from a reputable financial advisor an opinion about the financial fairness, or at least a supportive financial analysis, of the consideration received.
Is now the right time to sell or conduct a financing?
Timing matters. As demonstrated in Nine Systems, a company worth $4m could be worth $175m in as little as four years.
Given the inherent tensions between common and preferred holders and between stockholders, management and founders, boards considering a down-round or downside exit would be well-counseled to deliberate on why it makes sense to sell or conduct the financing now.
This will often be a unique mix of a company’s prospects, liquidity and strategic alternatives particular to that company. It is worth directors having that debate and getting it into the record.
With the litany of challenges boards of financially distressed companies are confronting today in the face of down-round financings and downside exits, it is imperative to keep the ultimate goal in mind—to do right by the company and its stockholders.
By learning from the past and implementing reasonable processes, even in less than ideal circumstances, boards can withstand the inevitable heightened scrutiny of their actions while also serving as good gatekeepers.