Recently, the Delaware Court of Chancery issued another ruling regarding the sale of Authentix Acquisition Company, Inc. (“Authentix”) to Blue Water Energy LLP (“Blue Water”), which was approved in 2017 by Authentix’s Board of Directors (the “Board”) and its controlling stockholders. The June 3, 2022 decision (Manti Holdings, LLC v. Carlyle Group Inc., C.A. No. 2020-0657-SG, 2022 WL 1815759 (Del. Ch. June 3, 2022)) denied in part a motion to dismiss and held that the gravamen of the plaintiffs’ post-closing money damages complaint—allegations that the defendants breached fiduciary duties regarding the sale—sufficiently stated claims upon which relief could be granted. The ruling underscores the need for heightened care by target companies and their equity sponsors when contemplating a transaction supported by an equity sponsor, including in their communications (or lack of communications) with management and other shareholders.
In 2015, Authentix’s Board began to explore a potential sale of the company, which provides authentication solutions for governments, central banks, and commercial products. Plaintiffs alleged that three of the Board’s five members, including Authentix’s CEO, were affiliated with Authentix’s controlling stockholders (collectively, the “Sponsor”), and that they were encouraged by the Sponsor to push through a sale of Authentix, even if such transaction was unfavorable to common stockholders. According to plaintiffs, the Sponsor-related directors expressed numerous times during meetings that the Sponsor wanted to sell the company quickly and monetize its investment. For example, plaintiffs alleged one of the Sponsor-affiliated directors stated during sale negotiations that he was “under pressure to sell Authentix because it was one of the last investments still open in the applicable fund, and it was time for” the Sponsor to “monetize and close” its investment. Plaintiffs further alleged that another director, Authentix’s CEO, stated during sale negotiations that he worked for the Sponsor, whose instructions were to execute and memorialize a sale (plus, as noted below, the CEO had a significant “success” bonus tied to the transaction). As a result, plaintiffs alleged, the directors sought to consummate expediently a sale favorable to the preferred equity holders (to the detriment of the other stockholders).
Plaintiffs further alleged that during most of the sale process, Authentix faced uncertainty regarding the renewal of several customer contracts. They alleged these uncertainties were borne out in a handful of indications of interest the company received from prospective suitors, reflecting prices contingent on the company’s successful renewal of the contracts at issue.
In June 2017, the Board voted, over the objection of a director affiliated with one of the plaintiff stockholders, to proceed with a sale to Blue Water. Blue Water submitted an offer of $77.5 million in guaranteed consideration, all payable at closing, with an additional $27.5 million after closing if certain receivables were timely paid and if Authentix met certain financial metrics the following year. The plaintiff-affiliated director expressed disapproval of a sale at the time, due to prior estimates from financial advisors that the value of the company would be greater if certain customer contracts were successfully renewed. Thereafter, according to plaintiffs, the other Authentix directors stopped providing him updates on the sales process.
In August 2017, Authentix successfully renewed two key customer contracts. According to plaintiffs, the Board directed the company to continue proceeding with Blue Water negotiations, notwithstanding the company’s favorable change in value as a result of the contract renewals. The following month, the Board voted 4-to-1, again over the objection of the plaintiff-affiliated director, to approve the sale to Blue Water.
Central to this story were the terms of a Stockholders’ Agreement entered into in 2008 by all Authentix stockholders to encourage a new and significant investment in the company from the then-new lead equity Sponsor. That agreement made the equity Sponsor the majority owner of the company (and with preferred-tier stock), and also provided to the Sponsor “drag-along” rights, which required minority shareholders to “consent to and raise no objections against” any transaction approved by the Board and a majority of outstanding stockholders, and limited minority stockholders from exercising appraisal rights in connection with a such a transaction. See 8 Del. C. § 218(c) (“An agreement between 2 or more stockholders, if in writing and signed by the parties thereto, may provide that in exercising any voting rights, the shares held by them shall be voted as provided by the agreement, or as the parties may agree, or as determined in accordance with a procedure agreed upon by them.”). Following the Board’s approval of the sale to Blue Water, stockholders were notified of the Board vote and that the Sponsor had executed a written consent that bound all equity to the sale pursuant to the Stockholders’ Agreement. Accordingly, the sale was not put to a stockholder vote. At the time of the sale, Authentix’s capital structure comprised (i) preferred stock (including that held by the Sponsor), which was entitled to be paid the first $70 million of any sale consideration, and (ii) common stock, the holders of which were entitled to receive any distributions in excess of that amount. In addition, the director CEO’s employment agreement with Authentix entitled him to a maximum cash bonus of $3 million in the event Authentix was sold for a price between $50 and $80 million. The sale to Blue Water entitled the director CEO to the maximum bonus.
In a related action discussed previously on this Blog, a group of common stockholders challenged the provisions of the Stockholders’ Agreement and petitioned the Court of Chancery for an appraisal under Section 262. The appraisal action was dismissed, and the Delaware Supreme Court affirmed, concluding “Section 262 does not prohibit sophisticated and informed stockholders, who were represented by counsel and had bargaining power, from voluntarily agreeing to waive their appraisal rights in exchange for valuable consideration.” Manti Holdings, LLC v. Authentix Acquisition Co., 261 A.D.3d 1199, 1204 (Del. 2021).
A group of minority stockholder plaintiffs brought an action in the Court of Chancery, alleging the Sponsor-affiliated directors and the controlling Sponsor breached fiduciary duties to Authentix stockholders by approving the sale to Blue Water for less-than-favorable consideration. Plaintiffs also pursued ancillary aiding and abetting and conspiracy claims against the Sponsor and director defendants, and unjust enrichment claims against the Sponsor and the director CEO. Defendants moved to dismiss under Rule 12(b)(6), for failure to state a claim. The Court of Chancery dismissed the ancillary claims as duplicative, but declined to dismiss the fiduciary duty and unjust enrichment claims. In a memorandum opinion, Vice Chancellor Sam Glasscock III concluded that the entire fairness standard of review applied to the sale and that the Sponsor and director defendants must demonstrate fair dealing and fair price with respect thereto. The Court explained:
Delaware Courts have identified two categories of conflicted controller transactions that implicate the entire fairness standard: (a) transactions where the controller stands on both sides; and (b) transactions where the controller competes with the common stockholders for consideration. . . . Under the second category, a controller competes with common stockholders for consideration when it (i) receives greater monetary consideration for its shares than the minority stockholders, (ii) takes a different form of consideration than the minority stockholders, or (iii) extracts something uniquely valuable to the controller, even if the controller nominally receives the same consideration as all other stockholders.
Assuming plaintiffs’ allegations as true for the purposes of the defendants’ motion, the Court concluded that it was reasonably conceivable that the Sponsor received a “unique benefit” from the sale because, pursuant to the company’s capital structure and the terms of the Stockholders’ Agreement, preferred stockholders were entitled to receive the first $70 million of the $77.5 million in guaranteed sale consideration before common stockholders were entitled to receive anything. The Court further credited the plaintiffs’ allegations that: (i) uncertainties regarding the renewal of key customer contracts, which informed sale negotiations, had been resolved shortly before the Board approved the sale, but the Board did not revisit the terms of the anticipated sale or reengage other prospective bidders following this development; (ii) the directors had been encouraged by the Sponsor to facilitate a sale for the benefit of the Sponsor; (iii) three of the target company’s five directors were either affiliated with or not completely independent of the Sponsor; and (iv) the Board ceased to keep the plaintiff-affiliated director apprised of the sale process during the final stage of negotiations, after he expressed disapproval of the contemplated transaction.
The Court also concluded—again, accepting plaintiffs’ allegations as true for the purposes of the defendants’ motion—that the three director defendants in question could not be presumed to have acted independently of the Sponsor’s interests. First, it concluded the plaintiffs had sufficiently alleged that two of the three directors were dual fiduciaries, serving as directors of Authentix and managing directors and officers of Sponsor-related entities. The Court thus concluded that the alleged divergence of interests between the Sponsor and Authentix’s common shareholders rendered these two directors conflicted. Second, the Court found that the third director, Authentix’s CEO, also lacked independence from the Sponsor due to plaintiffs’ allegations, assumed true, that the director CEO stated during sale negotiations that he worked for the Sponsor and “had been told to sell the company.”
The Manti decision provides an occasion for reminding target boards exploring a sale of a private equity or venture capital-controlled entity of their obligation to conduct board business and processes with sufficient formalities to lessen the risk of a contested dispute. The Court of Chancery relied heavily on plaintiffs’ allegations regarding discussions among the Sponsor-affiliated directors, which were not held during formal board meetings, as well as the alleged exclusion of the dissident director from Board discussions concerning the sale process. Such allegations, accepted as true at the pleadings stage, gave rise to colorable fiduciary duty and unjust enrichment claims against the defendants.
Of course, target boards should always, and thoroughly, consider the interests of all equity stockholders when examining the efficacy of a significant transaction. To insulate legitimate board conduct from “he said, she said” allegations—which, in connection with other allegations, might give rise to a reasonably conceivable fiduciary claim—board business should, to the extent possible, occur in formal meetings and be memorialized in minutes that reflect clearly what was discussed, including comprehensive reflections regarding the decision-making process. Side discussions, like those alleged in Manti, should be avoided to the extent possible. In addition, board business should be conducted with proper notice to all directors, and should include all directors.
Moreover, it is prudent for target boards to consider, and utilize when appropriate, an independent special committee to analyze a prospective transaction, particularly where sponsor appointees or other affiliates serve in board or senior management roles. As the Court of Chancery explained in Manti, “[u]nder the great weight of Delaware precedent, senior corporate officers generally lack independence for purposes of evaluating matters that implicate the interests of a controller.”
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