Ross Holding and Mgmt. Co. v. Advance Realty Group, LLC, C.A. No. 4113-VCN (Del. Ch. Sept. 4, 2014) (Noble, V.C.)
In this post-trial memorandum opinion, the Court of Chancery evaluated a reorganization under the entire fairness standard, and held that, although plaintiffs received a fair price, the unfair process infected the entire fairness of the transaction. Since plaintiffs received a fair price, however, the Court held that damages would be an inappropriate remedy and invited the parties to address other remedies through subsequent briefing.
Plaintiffs are minority unitholders and former managers of defendant Advance Realty Group, LLC (the “Company”), a Delaware-formed real estate investment and development firm. When it formed, the Company partnered with defendant Five Arrows Realty Securities, III (“FARS”) for startup capital. FARS loaned the Company $60 million with a maturity date of August 6, 2008. The promissory note FARS received allowed it to convert a portion of its debt into Class A units of the Company at a conversion price of $16.65 per unit. FARS also had the right to designate two of the four members of the Company’s Board of Managers (the “Board”).
In 2005, the Company began exploring options to assist FARS in liquidating its investment in the Company. After a private placement fell through, the Company received a proposed recapitalization of a portion of its portfolio through a $107.5 million mezzanine loan (the “Loan Proposal”). This would have allowed the Company to pay FARS $90 million, the alleged value of its notes at that time. Plaintiffs alleged the Loan Proposal would have provided needed liquidity and capital reserves without diluting the unitholders. Defendants submitted, however, that the Loan Proposal would have put the Company underwater. At the Board’s July 2006 meeting, plaintiffs claim the defendant members of the Board would not accept the Loan Proposal because it was not good for them or, possibly, their affiliated entities. Ultimately, the Company did not accept the Loan Proposal. To address the Company’s cash needs, defendant Peter Cocoziello, a member of the Board and the Company’s President and CEO, invested $10 million through defendant Advance Capital Partners, LLC (“ACP”), a company owned by Cocoziello’s family. The investment was made on the same terms as the FARS loan, including the $16.65 per unit strike price convertible into 600,600 units. As the Court described, the pari passu treatment ACP received effectively diluted the other unitholders.
Knowing that FARS’ notes would mature on August 6, 2008, and because of the adverse consequences that would ensue if the Company did not timely pay on these notes, the Board decided to effectuate the reorganization at issue (the “Reorganization”). The Reorganization spun off the Company’s developmental properties subsidiary, defendant Advance Realty Development (“ARD”), to ACP, gave control of its revenue-generating properties to FARS, and sought to cash out plaintiffs at an allegedly discounted price. The Reorganization would help FARS liquidate its investment and allow Cocoziello, through ACP, to continue managing the Company’s assets. Specifically, FARS, which valued its convertible debentures at $25 per unit (or $90 million), would convert about $10 million of its debt at the $16.65 strike price into about 600,000 units of the Company, giving FARS majority control of the Company. FARS’ remaining debt would be converted into $80 million worth of notes in the reorganized Company. Also through the Reorganization, ACP would receive a majority equity interest in ARD and promissory notes from the Company. The Board valued ACP’s units at $25 per unit, and structured ACP’s conversion to realize this value. Lastly, the minority unitholders would be cashed out at a price of $21.68 per unit. Notably, in negotiating the Reorganization’s structure, the Board did not seek a fairness opinion and, according to the Court, the minority interests appeared to be an afterthought.
In September 2008, the Company approved the Reorganization and sent a memorandum to its unitholders explaining the transaction and offering two options: (1) exchange their Class A Units for ARD common units on the same terms as those accepted by ACP or (2) receive $21.68 per unit. The memorandum explained that, if unitholders elected not to redeem their units, the Company would liquidate its remaining properties, resulting in potentially adverse tax consequences for the remaining unitholders. The memorandum did not contain information regarding how the properties were valued or divided between the Company and ARD. Plaintiffs requested $25 per unit, rather than the offered $21.68 and, when the Company and plaintiffs could not agree, plaintiffs refused to redeem their units. Shortly after the Reorganization, the Company experienced financial difficulties due to the economic recession, and plaintiffs’ units became valueless.
Plaintiffs asserted the following claims: (1) breach of fiduciary duty; (2) breaches of the implied covenant of good faith and fair dealing; (3) fraudulent inducement; (4) civil conspiracy; and (5) aiding and abetting breaches of fiduciary duty. Plaintiffs also requested for the appointment of a receiver. Defendants, in turn, asserted counterclaims against plaintiffs for breaches of fiduciary duty in connection with plaintiffs’ failure to disclose the joint venture proposal.
Determining first that the Company’s operating agreement did not restrict or modify the traditional fiduciary duties applicable to corporations, the Court applied the traditional fiduciary duties of care and loyalty. The Court found that, in negotiating the Reorganization, Cocoziello (as a representative of ACP) and FARS were concerned more with getting the best deal for the entities they represented than getting the best deal for the Company’s unitholders. Since Cocoziello and FARS held three out of four Board seats, and Cocoziello effectively controlled the fourth seat, the Court determined that a the majority of the Board was conflicted. The Court also found that ACP and FARS received benefits unavailable to other unitholders, such as the opportunity to convert their equity into debt as part of the Reorganization. Accordingly, the Court held that plaintiffs rebutted the presumption of the business judgment rule, and that the Reorganization would be subject to the entire fairness standard of review. Because the Reorganization was neither negotiated and approved by a well-functioning committee of independent directors nor ratified by an informed minority vote, defendants bore the burden of proving entire fairness—i.e., that the transaction was both the product of a fair process and accomplished at a fair price.
In applying fair process prong of the entire fairness standard, the Court held that defendants did not deal fairly with plaintiffs. The Court determined that defendants controlled the timing and structure of the Reorganization and appeared to have capitulated to FARS’ desire to cash out its investment at the price demanded by FARS. According to the Court, the Board considered only the Reorganization for more than a year and made little effort to consider the minority unitholders’ interests. The Court also indicated that, in executing the Reorganization without notice to the plaintiffs, and failing to provide sufficient information to allow plaintiffs to value their holdings, defendants improperly kept plaintiffs uninformed about the Reorganization. More specifically, defendants provided little information about plaintiffs’ right to remain with the Company, and when defendants did inform plaintiffs of this right, they indicated that the Company would potentially suffer adverse tax consequences if plaintiffs continued to hold their units. This, among other factors, led the Court to conclude that plaintiffs were given no choice but to redeem their units. Furthermore, the Court determined that FARS and ACP improperly granted themselves two benefits not offered to the minority—they valued their units at a premium ($25 per unit) and they had priority over the other equity holders through their interest-bearing loans.
In applying the fair price prong of the entire fairness standard, however, the Court found that plaintiffs received fair value for their units. In reaching this determination, the Court compared the pre-Reorganization unit value to the post-Reorganization value, concluding that the unit value nominally increased by the Reorganization. The Court largely relied on defendants’ expert’s valuation to support this conclusion, particularly because the expert valued the Company as a going concern. Defendants’ expert opined that the unit value was $25.96 pre-Reorganization, and $30.28 after the Reorganization. The expert also indicated that each unit would be worth $27.66 post-Reorganization if the majority of the minority remained with the Company. The expert ultimately opined that the consideration ACP and FARS received was fair.
Plaintiffs largely conceded defendants’ expert’s approach but argued that the pre-Reorganization value should either be compared to the $21.68 price plaintiffs were offered but did not accept, or should reflect the present value of their units today—zero. The Court rejected both proposed valuations. First, the Court rejected plaintiffs’ argument that their units were unfairly redeemed for $21.68 because plaintiffs never redeemed at this price. Instead, plaintiffs elected to remain with the Company. The Court determined that even under a set of assumptions most favorable to plaintiffs, the value plaintiffs received appeared to be a close estimation of the value they had prior to the Reorganization. The Court rejected plaintiffs’ second proposed valuation, zero, which the Court found failed to value the company as a going concern as of the time of the Reorganization. The Court emphasized that the valuation should focus on the acts of the fiduciaries separately from other events that likely caused the units since to become worthless (namely, the economic recession). Despite receiving a fair price, the Court held that the Reorganization was not entirely fair in light of the flawed process. In fashioning a remedy for defendants’ breach of fiduciary duty, however, the Court held that monetary damages were not appropriate because plaintiffs received a fair price and nominally benefitted from the Reorganization, which was accretive to plaintiffs.
The Court determined that the more appropriate remedy would be rescission. According to the Court, however, because the minority units were now without value, unwinding the transaction to set plaintiffs, FARS, and ACP shoulder-to-shoulder in the Company might be meaningless and thus unnecessary. The Court therefore invited the parties to address the consequences of rescission, as well as the possible award of attorneys’ fees.
The Court dismissed each of plaintiffs’ remaining claims, including the request to appoint a receiver, along with defendants’ counterclaims.