May.13.2020
During economic downturns, private technology companies often seek emergency funding from existing VC and growth equity investors. These financings, sometimes called “inside rounds,” create conflicts of interest for boards because certain directors are often affiliated with and appointed by the investors participating in the round. This article gives investors practical tools to protect directors and reduce claims against key stakeholders.
Directors owe fiduciary duties of care and loyalty to all stockholders. Typically, director decisions are reviewed under the deferential business judgment rule, which allows directors to make good faith, informed decisions guided by any rational business purpose. However, transactions involving conflicts of interest are reviewed under the more onerous entire fairness standard. An entire fairness review means that the court will evaluate the fairness of both the process and the substance of the transaction.
Two important Delaware Supreme Court cases, Kahn v. M&F Worldwide Corp., 88 A.3d 634 (Del. 2014) (“MFW”) and Corwin v. KKR Financial Holdings LLC, 125 A.3d 304 (Del. 2015) (“Corwin”), outline steps to take so that board decisions regarding inside rounds will be reviewed under the deferential business judgment rule instead of entire fairness review. In MFW, the court held that a transaction involving an interested controlling stockholder will be reviewed under the business judgment rule if both: (1) the company established a special committee of independent directors armed with the power to review, negotiate and approve or reject the transaction at the onset of negotiations, and such committee met its duty of care in negotiating a fair price; and (2) a majority of disinterested stockholders approved the transaction through an uncoerced and fully informed vote. In Corwin, the court found that a transaction involving an interested non-controlling stockholder will receive business judgment rule review if it is approved by a majority of disinterested stockholders through an uncoerced and fully informed vote.
Boards and special committees, especially those established under the MFW framework to negotiate a fair price as required under the duty of care, should strongly consider retaining advisors, reviewing financial statements and market conditions and comparing the proposed transaction against alternatives. In the context of public company M&A and in contentious private M&A transactions, boards and special committees can bolster their approval by obtaining a valuation or fairness opinion. Companies can help ensure that stockholder votes under MFW or Corwin are (a) “uncoerced” by giving stockholders sufficient time to review disclosures and not penalizing them for rejecting or abstaining from the transaction and (b) “fully informed” by providing all material information about the transaction, including a detailed explanation of conflicts of interest, in an information statement or similar disclosure document.
In addition, investors should consider offering all stockholders the opportunity to participate in an inside round pro rata through a rights offering. This further reduces the risk that minority stockholders will later claim they are being treated unfairly and will be easy to implement if the company is already seeking a broad stockholder vote under the MFW or Corwin procedures.
There is no bright-line test to determine whether a minority stockholder is “controlling,” so a close examination of governance rights is required to determine whether the MFW or Corwin procedures should apply. It is also critical to implement these procedures at the onset of negotiations, not after key terms have already been negotiated by conflicted directors and stockholders.
As discussed in more detail in this article, investors should ensure that their director appointee’s personal liability is (1) eliminated for certain claims through an exculpation provision in the charter, (2) further mitigated through indemnification and advancement provisions in the charter, bylaws and a separate indemnification agreement and (3) properly backstopped through a D&O insurance policy. Investors, especially those leading an inside round, should also consider requiring the company to enhance D&O coverage before the financing and determine whether to bear some or all of the related costs.
In conclusion, although inside rounds are frequently executed on compressed timeframes, investors should carefully consider the foregoing issues to help protect directors and reduce claims.