Encite, LLC v. Soni, C.A. No. 2476-VCG (Del. Ch. Nov. 28, 2011) (Glasscock, V.C.)

This case involves claims for breach of fiduciary duty against four former directors of now-defunct technology startup Integrated Fuel Cell Technologies, Inc. (the “Company”), in connection with their conduct of an allegedly unfair and disloyal auction of the Company’s assets, in which they approved a sale to affiliates of Echelon Ventures, L.P. (“Echelon”), the majority preferred stockholder who appointed two of them to the board.  Stockholders filed a derivative suit challenging the sale before it could be completed and as a result of the suit, the directors resigned, leaving Stephen Marsh (“Marsh”), the Company’s founder and fifth director, as the sole board member.  Marsh promptly abandoned the auction and entered the Company into bankruptcy where plaintiff Encite LLC (“Encite”), an entity formed by Marsh and a losing bidder in the auction, prevailed over Echelon and acquired the Company’s assets in the bankruptcy sale.  Vice Chancellor Glasscock assumed that the assets Encite purchased in the bankruptcy included derivative claims against the former directors for causing a decrease in the value of the Company’s assets.

Marsh founded the Company in 1999 to develop micro fuel cell technology that, if perfected, could replace batteries in devices such as cell phones and laptops.  The Company failed to develop the technology into a viable commercial product or generate a consistent stream of revenue.  After exhausting its initial financing, then-CEO Marsh solicited investment from Echelon, first in the form of a bridge loan that converted into preferred stock, then through the issuance of Series B preferred stock in 2003.  In purchasing a majority of the Series B preferred stock, Echelon negotiated a liquidation preference as well as the rights to appoint two directors, pre-approve any new secured debt, and approve any sale of all the Company’s assets.  Also as part of the Series B stock issuance, the board was expanded to include a Marsh designee, two Echelon designees (defendants James Dow and Franklin Weigold), the CEO, and an independent director elected by all stockholders (defendant Rob Soni).   Soni would later purchase shares of Series B preferred stock.  The board hired Richard Hess in October 2004 to replace Marsh as CEO.  Hess also became a director.

In 2005, unable to secure additional financing on terms acceptable to Marsh (who held voting power sufficient to block any financing transaction that would dilute the junior classes of stock), the board decided to terminate all employees except defendant Hess, cease operations and solicit a buyer for the Company’s assets (primarily intellectual property).  To finance the sale process, the Company solicited a bridge loan, secured by its intellectual property assets, from a group of Series B stockholders led by Echelon (the “Noteholders”).  Before the board approved the bridge loan, Marsh and another former director submitted the first bid to acquire the Company’s assets at a price of approximately $440,000 plus a 1% royalty on gross revenues up to $25 million.  Other responses to the board’s solicitation of offers were less than enthusiastic.  Plaintiff attributes the response to defendants’ failure to conduct an entirely fair process and respond to interested parties.  Defendants attribute the response to Marsh’s refusal to participate, as the Company’s founder and the inventor of its key technology, in discussions with interested parties.  The board did not hire financial advisors but managed to solicit interest in addition to an Echelon-backed bid and a Marsh-backed bid.  Plaintiff alleged that the Echelon affiliated directors favored their own bid and bids that included repayment of their affiliate bridge loan.  Marsh on the other hand was receiving confidential information from a “mole” which he used to adjust his bids.

Ultimately, the board approved the Echelon-backed bid and began the process of soliciting shareholder approval for the proposed sale.  Marsh’s mole leaked a draft of the consent solicitation to Marsh, which Marsh emailed to all shareholders along with a message advising that the board was conflicted and had ignored better offers.  One of the shareholders brought a derivative suit to enjoin the transaction and attached the draft consent solicitation to his complaint. In response, the director defendants withdrew the consent solicitation and resigned from the board.  As the sole remaining director, Marsh abandoned the auction and entered the Company into bankruptcy, where his affiliate, Encite, purchased the Company’s assets and brought this derivative action.

The director defendants conceded that the claims against them would be subject to evaluation under the entire fairness standard of review, but sought summary judgment that they conducted an entirely fair bidding process, that plaintiff could not demonstrate any damages and that plaintiff was barred from recovery pursuant to the doctrine of unclean hands.  Defendant Echelon also sought summary judgment that it did not aid and abet a breach of fiduciary duty.  Marsh sought summary judgment on Echelon’s third-party claims for contribution and tortious interference with Echelon’s business relationship with the Company. The Court denied summary judgment on each of these issues because of unresolved disputes of material fact.

With respect to the fiduciary duty claims, the Court found that because the complained-of transaction was never consummated and there was no specific transaction to evaluate, it must determine whether the director defendants squandered an opportunity to realize the true value of the Company’s assets by refusing to consider and negotiate available offers and attempting to force through an inferior transaction.  It could not do so based solely on the record and defendants’ conclusory allegations.  The Court explained that defendants could not satisfy their substantial burden by pointing to non-specified advice of counsel and statements that there is no single blueprint for fair dealing because reliance on counsel is a factor, but not conclusive evidence of fair dealing, and because directors must demonstrate sufficient “procedural safeguards” to simulate arm’s-length bargaining.  Likewise, the director defendants could not demonstrate fair price given the uncertain and speculative value of a company that never generated a consistent revenue stream, particularly without expert testimony.

Next, the Court expressed doubts about plaintiff’s proffered damages theory and their ability to demonstrate damages at trial, given the Court’s determination that the proper measure of damages would be the difference between the Company’s value before the directors’ resignation and the value “achievable” by Marsh afterward.   Finding that Marsh was not required to abandon the auction or cause the Company to enter bankruptcy, and thus could have sold the assets for more than he obtained in the bankruptcy sale, the Court rejected Encite’s argument that the measure of damages should be the difference between the value “achieved” in the bankruptcy sale and the assets’ highest value during the bidding process.  Nonetheless, because the burden of showing damages once a breach of fiduciary duty has been established is “light” and does not require specific or substantial evidence, but merely some basis for estimation, the Court denied summary judgment.

The Court denied summary judgment on defendants’ unclean hands defense because the wrongs alleged required a finding as to Marsh’s intentions, which should be based on credibility determinations at trial.  Similarly, the Court denied summary judgment on the aiding and abetting, tortious interference and contribution claims because each required a fact-intensive inquiry best saved for a trial.

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