Delaware Court Allows Challenge to Venture Capital Preferred Financings

Editor’s Note: Allen M. Terrell, Jr. is a director at Richards, Layton & Finger. This post is based on a Richards, Layton & Finger publication, and is part of the Delaware law series, which is co-sponsored by the Forum and Corporation Service Company; links to other posts in the series are available here.

In Carsanaro v. Bloodhound Technologies, Inc., 2013 WL 1104901 (Del. Ch. Mar. 15, 2013), Vice Chancellor Laster of the Court of Chancery denied defendants’ motion to dismiss a complaint alleging breaches of fiduciary duties and statutory violations, among other things, in connection with several rounds of venture capital financings for a start-up healthcare technology company (“Bloodhound” or the “Company”).

In the late 1990s, Bloodhound began developing a web-based software application to monitor healthcare claims for fraud. From 1999 to 2002, the Company issued five series of preferred stock, designated Series A through Series E. Plaintiffs, former common stockholders of Bloodhound, alleged that in the Series D and Series E capital raises, the venture capital firms investing in the Company used their control over the Company’s board of directors to approve financings that unfairly diluted the common stock, undervalued the Company, and improperly benefited the venture capital firms and management. Plaintiffs also challenged a 1-for-10 reverse stock split of the common stock carried out in connection with the Series E refinancing in 2002. In addition to their challenges to transactions in 2001 and 2002, plaintiffs alleged that the board had acted wrongfully in 2011 when it agreed to sell the Company to a third party for $82.5 million, and approved a management incentive plan (“MIP”) that allocated $15 million, or about 19 percent of the merger proceeds, to the Company’s management. Plaintiffs alleged that, as a result of the dilutive financings and the MIP, they received only approximately $36,000 for their common shares in the merger.

As an initial matter, certain venture capital defendants argued that, as non-Delaware entities, the Court lacked personal jurisdiction over them. The Court disagreed, stating that “[s]ophisticated investors should reasonably expect to face suit in Delaware when they place their employees or principals on the board of directors of a Delaware corporation, then allegedly use those representatives to channel benefits to themselves through self-dealing transactions that require acts in Delaware for their implementation.” In this case, the “acts” in Delaware were filings made by the Company with the Delaware Secretary of State in connection with the preferred stock issuances, the reverse stock split and the merger.

On the substantive fiduciary duty claims, the Court held that the allegations relating to the Series D and Series E financings and the MIP stated claims that were subject to entire fairness review. The Court further held that the claims relating to the 2001 and 2002 refinancing transactions were not barred by laches. The Court also rejected an argument that Section 124 of the Delaware General Corporation Law (“DGCL”) barred plaintiffs’ claims. Section 124 provides that “[n]o act of a corporation . . . shall be invalid by reason of the fact that corporation was without capacity or power to do such act” except in certain limited situations. Defendants argued that because none of the limited situations enumerated in Section 124 applied, Section 124 barred plaintiffs’ claims that the reverse stock split and Series E preferred issuance were null and void due to alleged failure to comply with the statutory requirements relevant to those transactions.

After examining the historical context of Section 124 and the broadly enabling nature of the DGCL, the Court held that Section 124 has a narrow purpose: mostly abolishing the application of the ultra vires doctrine as way to challenge a Delaware corporation’s capacity to act. That is, Section 124 significantly restricts when a corporate act can be challenged based on a lack of capacity. Section 124, however, does not address whether a given action was in fact undertaken in compliance with applicable law (such as other sections of the DGCL) or common law fiduciary duties. Because plaintiffs’ claims rested on, among other things, an allegation that the reverse stock split and the Series E preferred issuance were not enacted in compliance with Section 242 of the DGCL—and not a claim that the Company lacked the ability (i.e., capacity) to undertake the challenged actions—the Court held that Section 124 did not bar plaintiffs’ claims.

Finally, the Court addressed defendants’ argument that plaintiffs lacked standing because they sought to assert derivative claims after the merger had closed. In relation to plaintiffs’ challenges to the Series D and Series E preferred stock issuances, the Court acknowledged that a claim that a company issued stock at a below-market valuation (and hence was underpaid for a corporate asset) is a classic derivative claim. Nonetheless, the Court held that plaintiffs stated a direct claim for “wrongful expropriation” under the rationale of Gentile v. Rossette, 906 A.2d 91 (Del. 2006). The Court reasoned that a dilutive stock issuance at an unfair price harms both the company (because it receives too little compensation) and stockholders (because their proportional rights to vote and receive dividends are reduced). The Delaware Supreme Court has previously held that dilutive stock issuances benefiting controlling stockholders may give rise to both derivative and direct claims. In this opinion, the Court of Chancery stated that “[s]tanding will exist if a controlling stockholder stood on both sides of the transaction. Standing will also exist if the board that effectuated the transaction lacked a disinterested and independent majority.” Accordingly, because the various venture capital investors allegedly constituted a control group, the Court concluded that the complaint pleaded a direct claim.

With regard to the 2011 merger, the Court reasoned that plaintiffs’ primary challenge was to the amount of merger consideration awarded to management through the MIP and the allocation of the bulk of the transaction consideration to the preferred stockholders. The Court, citing case law on when “side deals” or payments to management may be challenged on a direct, and not derivative, basis, held that the size of the MIP payments (almost 19 percent of the total proceeds) was facially material and that the plaintiffs could therefore assert a direct challenge to the fairness of the merger based on the allegedly excessive MIP.

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