It Took Seven Years But PE Firm Proves No Conflict In Sale Transaction

In 2022, the Defendants in Manti Holdings, LLC v. The Carlyle Group Inc. lost a battle—the Delaware Court of Chancery denied their motion to dismiss claims of breaches of fiduciary duties in connection with the 2017 sale of Authentix Acquisition Company, which had been majority-owned by affiliates of a private equity firm.  Earlier this month, following a week-long trial, they won the war when the court ruled for them on the remaining claims in the case.

The Plaintiff-stockholders had alleged that the sale was a conflicted controller transaction.  They alleged that the final sale price was much lower than initial estimates and that the controller was motivated to sell quickly to provide liquidity to its investors, avoid clawback, and realize on its preferred shares, rather than to maximize value for all Authentix stockholders.

Some seven years after the transaction, the court found after trial that the Plaintiffs had not demonstrated any conflicts of interest and that, although the private equity fund and its affiliates controlled the company and, therefore, the sales process, they were motivated by the same considerations as other stockholders—maximizing share price and limiting further decline in company revenue.  The business judgment rule thus applied and no breaches could be proven.

Manti Holdings serves as an important reminder that a decision on a pleading motion is not the end of the story.  Fiduciary defendants with the means and ability to litigate the merits of a case retain the opportunity to avail themselves of Delaware’s deferential business judgment rule in the absence of facts—and not just allegations—demonstrating disabling conflicts.  By the same token, defendants should continue to press trial courts to probe beneath conclusory allegations before forcing parties down a years-long litigation path to resolve such cases.

Background

In 2008, the fund purchased a $40 million stake in Authentix.  Although the fund’s stated term ran until September 30, 2017, the term could be extended and, in any event, the fund was not required to sell portfolio companies by that date.  By 2013, the fund had accumulated a $60.3 million stake in Authentix, representing 70 percent of Authentix’s preferred stock and 52 percent of its common stock.

Authentix’s Board began preparing for the sale process as early as autumn 2015.  The company had recently escaped a period of financial hardship, and it was hoping for even better news in May 2016, when Saudi Aramco was expected to renew a two-year contract.  But rather than renewing, Aramco surprised Authentix with new, unfavorable terms and required it to compete with other companies to win new bids.  Before the renegotiation, Authentix’s valuation was between $200 and $275 million.  After, it dropped to between $120 and $177 million, with one outlier at a maximum of $248 million.

Authentix’s valuation continued to drop throughout the sale process.  By April 2017, Authentix was negotiating with two buyers, both of whom indicated a $115 million valuation.  After due diligence, one buyer required $30 million of this to be contingent, so Authentix granted exclusivity to the other—Blue Water Energy LLP.  BWE’s price, too, came down after due diligence—to between $60 and $70 million.

But then, during BWE’s due diligence, Authentix won a rebidding competition with Aramco, allowing the Board to approve an Aramco bid and renegotiate with BWE.  Following the renegotiation, the Board (voting 4-0) approved a sale to BWE, for less than $90 million up front.  One director did not appear for the vote, but communicated his disapproval: he noted Authentix’s recent achievements and urged that a 12-month delay would increase value.

The deal closed on September 13, 2017—17 days before the end of the 10-year term of the fund that held the majority stake.

The Complaint

On August 7, 2020, a group of Authentix stockholders sued the private equity fund and certain affiliates, along with three of the four directors who approved the sale.  Plaintiffs argued that the Court of Chancery should review the sale under the onerous “entire fairness” standard because, they claimed, the controlling stockholder had extracted a unique benefit from the transaction.  Their theory was that the fund’s business model compelled it to sell at that time, regardless of price.

The Post-Trial Decision

To demonstrate conflicts, the Plaintiffs sought to prove that the controller competed with the other common stockholders for consideration by receiving something “uniquely valuable” in the sale.  Namely, Plaintiffs argued the controller faced two potential conflicts: first, liquidity-based pressures resulting from the controller’s private equity fund structure; and, second, the allegedly non-ratable benefit that the controller received for its preferred shares.

Plaintiffs’ first liquidity-based argument centered around their allegation that Authentix was the last “needle moving deal” in the private equity fund at issue, which they contended supported their view that the controller was pressured to sell.  The court rejected this argument.  As Authentix’s largest shareholder, the court explained, the controller was driven by the same incentive as the other stockholders: to sell Authentix for as much as possible.  Further, the court found that the fund was not required to sell its portfolio assets by 2017, nor was Authentix the last remaining asset in the fund.  The court also noted that, if the controller were facing a liquidity crunch, it would not have drawn out the sale over a full year, entertaining more than 120 potential buyers.

The court also found Plaintiffs’ evidence of investor pressure to be insufficient.  No emails between investors and the fund or sponsor, for example, demonstrated that investors were pushing for a sale.  And the court held that the testimony of one of Plaintiffs’ experts—that the general industry expectation is a “timely” return on private equity investments—demonstrated simply that a term limit “indicates an intent to exit investments, profitably, on that general time-frame” but provided no basis to conclude that this fund’s investors’ expectations “caused the Board to run a fire sale.”

The court also rejected Plaintiffs’ second liquidity-based argument, based on the fund’s clawback provision, which kicked in if the fund could not meet a 7 percent preferred return on the capital outstanding in Authentix prior to a sale.  The court explained that the possibility of a clawback incentivized the controller to “sell portfolio companies that are more likely to decline than grow in proceeds,” which aligned with all stockholders’ interests.

Last, the court rejected Plaintiffs’ argument that the controller was conflicted because it received non-ratable consideration for its preferred shares.  The first $70 million of the sale went to preferred stockholders.  Since the fund held 70 percent of the preferred shares, this meant it received around $48.6 million for those shares.  But the court explained that the controller would always receive the same percent of the first $70 million for its preferred shares: its 52 percent stake in common stock, on the other hand, incentivized it to seek the highest possible sale price.

Thus, the court found “that Plaintiffs … failed to rebut the business judgment rule because there [was] no conflicted controller transaction.”  Applying the rule, the court declined to review the “entire fairness” of the transaction and found for the Defendants on all remaining counts.

Conclusion

Manti Holdings is, first and foremost, a reminder to fiduciaries and their counsel that, even in the face of a lost motion to dismiss, litigating a case to final judgment can be worthwhile in the right cases.  It is often the case, as here, that an early decision on the pleadings is not reflective of the merits and the ultimate outcome.  It may be relatively easy to allege disabling conflicts, particularly if courts do not closely scrutinize conclusions disguised as factual allegations.

Of course, the tradeoff to litigating to final judgment is the protracted distraction and significant economic cost.  Although development of the law based on a full record, rather than mere allegations, may well be a benefit to society (or at least the community that cares about such things), this likely provides cold comfort to the parties paying the bill.  As such, defendants understandably would prefer that trial courts take a more exacting look at complaints.  In Manti Holdings, for example, on both the motion to dismiss and post-trial, the court noted that the controller would have earned the same amount on its preferred shares regardless of Authentix’s sale price (so long as it was over $70 million), but only in its ruling on the motion to dismiss did the court characterize the benefit the controller derived from its preferred stock as non-ratable.  Trial hindsight and the plaintiff friendly Rule 12(b)(6) standard make it difficult to compare these rulings, but a closer examination of conclusory allegations would provide more certainty to market participants and practitioners.

This post is as of the posting date stated above. Sidley Austin LLP assumes no duty to update this post or post about any subsequent developments having a bearing on this post.