In re Nine Systems Corp. S'holders Litig., Consol. C.A. No. 3940-VCN (Del. Ch. Sept. 4, 2014) (Noble, V.C.)
In this 146-page post-trial opinion addressing claims challenging a 2002 recapitalization of Nine Systems Corporation (“Nine Systems”), the Court of Chancery held that a conflicted transaction resulting in a fair price nonetheless failed to satisfy the entire fairness standard of review because of a “grossly unfair” process. Although also holding that monetary damages for lost opportunities resulting from the flawed process would by unduly speculative and therefore inappropriate, the Court determined that fee-shifting could be the appropriate remedy for stockholders otherwise left without adequate recourse.
In 2002, Nine Systems, then known as Streaming Media Corporation, was a two-year-old start-up in the streaming media industry. Three investment groups collectively owned approximately 54% of the company’s outstanding stock and over 90% of its senior debt: Wren Holdings, LLC (“Wren”); Javva Partners, LLC (“Javva”); and Catalyst Investors, L.P. (“Catalyst”). Each had a designated representative on the company’s five-person Board of Directors. The other two members of the Board included defendant Troy Snyder, Nine Systems’ CEO, and non-party Abrahim Biderman, the representative of a group of minority stockholders. Plaintiffs collectively owned approximately 26% of Nine Systems’ stock.
Pursuant to the challenged recapitalization, which was undertaken by the Board to fund two strategic acquisitions, Wren and Javva invested additional capital in the company in exchange for convertible preferred stock, while Catalyst received a 90-day option to participate on the same terms as Wren and Javva. During the process leading up to the recapitalization, the Board failed to obtain an independent valuation of Nine Systems or either of its acquisition targets. Instead, the only person who performed any type of valuation was Andrew Dwyer, who owned just under half of Wren. Dwyer, whose valuation consisted of little more than a series of handwritten guesstimates scribbled on a single piece of paper, was also most responsible for determining the relative values of the company and its acquisitions, as well as the accompanying conversion rates for the convertible preferred stock, in connection with the recapitalization. During the time between the Board’s January 2002 approval of the recapitalization and Nine Systems’ subsequent issuance of convertible preferred stock in August 2002, several of the terms changed in favor of Wren and Javva. Although the Board provided stockholders with a general notice concerning the recapitalization, the specific details about its key terms (including who would receive the convertible preferred stock and on what terms) were withheld from the minority stockholders.
Over the next four years, Nine Systems maintained only sporadic communications with most of its stockholders. In 2006, Nine Systems sold itself to Akamai Technologies, Inc. (“Akamai”) in a $175 million merger transaction. As a result of the merger, each stockholder received consideration worth approximately $13.00 per share. Although many stockholders profited on their initial investment, Wren and Javva benefitted substantially more than others in light of their investments in the recapitalization.
Upon discovering additional details regarding the recapitalization, several of the company’s minority stockholders initiated this class action. Plaintiffs contended that the recapitalization was a conflicted transaction that was not entirely fair because Defendants, who collectively owned a majority of the company’s stock, expropriated the minority stockholders’ right to participate in the recapitalization and, therefore, diluted payouts the minority stockholders would have received from the Akamai merger. Plaintiffs argued, first, that Wren, Javva, and Catalyst constituted a control group and, second, that their Board representatives and the CEO, Snyder, were conflicted when they approved and implemented the recapitalization based on the unique benefits that they (or the entities that they represented on the Board) received. Plaintiffs also asserted that Dwyer, Wren, Javva, and Catalyst aided and abetted the conflicted directors’ breaches.
In its opinion, the Court first addressed the issue of standing. Defendants argued that Plaintiffs’ claims were derivative in nature and that the Akamai merger had extinguished Plaintiffs’ status as Nine Systems stockholders, thereby depriving them of the right to assert derivative claims. The Court rejected this defense, concluding instead that Plaintiffs’ claims, alleging wrongful expropriation of value by a controlling group of stockholders (Wren, Javva, and Catalyst), could be asserted directly against the defendant Board members and stockholders. Alternatively, the Court concluded that Plaintiffs had standing because a majority of the Board (Wren, Javva, and Catalyst’s three representatives) were conflicted when they approved and implemented the recapitalization in light of the fiduciary duties they owed to the entities receiving benefits from the recapitalization that were not shared with the other stockholders.
Next applying the entire fairness standard of review, requiring both fair dealing on behalf of the Board and a fair price, the Court determined that, based on a litany of factors, the process undertaken to implement the recapitalization was not fair. Among other things, the Court concluded that Defendants could not rely on Biderman’s eventual approval of the transaction as evidence of fair dealing because the majority of the Board excluded Biderman from many Board communications and meetings. When Biderman was included in such discussions, his objections to the transaction were trivialized. Further, only Catalyst received an option to invest in the recapitalization (which fact was not disclosed to Biderman), a critical factor in Catalyst’s and its Board representative’s decision to approve the transaction. Catalyst’s 90-day option to participate also undercut Defendants’ position that they did not extend the option to participate in the recapitalization to other stockholders because of an allegedly urgent need to raise capital quickly. Finally, the lack of any independent valuations, coupled with Dwyer’s cursory valuation and the changing terms of the transaction, further established the Board’s failure to employ a fair process.
In contrast to their failure to establish fair dealing, Defendants demonstrated that the recapitalization was accomplished at a fair price. In so ruling, the Court rejected the valuation presented by Plaintiffs’ expert, which relied principally on company projections presented to the Board in the January 2002 Board meeting, which the Court determined were not reliable (among other things, the projections grossly overestimated revenues). Agreeing instead with Defendants’ expert, the Court determined that, because the company had no earnings or positive cash flow as of the January 2002 approval of the recapitalization, the best method to value the company, without reliable projections, was to use the last twelve-month revenue multiples for comparable companies. Accepting also the application of a private company discount, the Court credited Defendants’ expert and concluded that the equity value in the company prior to the recapitalization was $0.
In reaching its conclusion that, because the company’s equity had no value, the transaction was accomplished at a “fair price,” the Court dismissed the proposition that In re Trados Inc. Shareholder Litigation, 73 A.3d 17 (Del. Ch. 2013), prohibited it from deeming a transaction not entirely fair when accomplished at a fair price. Instead, the Court interpreted Trados as reinforcing the principle that a court’s conclusion must be contextual. In the context of this case, the Court concluded that the finding of fair price could not save the recapitalization from the grossly inadequate process. Specifically, “a grossly unfair process can render an otherwise fair price, even when a company’s common stock has no value, not entirely fair.” The Court thus determined that the defendant directors and controlling stockholders breached their fiduciary duties, and that Dwyer was liable for aiding and abetting the directors’ fiduciary breaches.
Because Nine Systems’ charter included a Section 102(b)(7) provision, Snyder was exculpated from liability based on the lack of evidence that he breached his duty of loyalty. The provision did not, however, shield the remaining directors from liability for their loyalty breaches (or, with respect to Dwyer, for aiding and abetting the directors’ breaches). In considering the question of damages for the fiduciary breach and aiding and abetting claims, the Court concluded, in its discretion, that calculating damages for the minority stockholders’ lost opportunity to invest in the recapitalization was too speculative based on the facts and circumstances of this case. Relying on Saliba v. William Penn Partnership, 2010 WL 1641139 (Del. Ch.), aff’d, 13 A.3d 749 (Del. 2011), the Court held that a transaction conducted unfairly, even though accomplished at a fair price, may justify shifting certain of the litigation costs to the defendants who breached their fiduciary duties. Because the parties had not briefed the issue of fee-shifting, the Court authorized Plaintiffs to petition for an award of attorneys’ fees and costs.