Controller’s Breach of Fiduciary Duties Leads To Novel Remedy
Vice Chancellor Laster’s opinion in In re Dura Medic Holdings, Inc. is a helpful reminder of potentially bespoke equitable remedies available for breaches of fiduciary duties. The case involved claims brought by a co-founder of Dura Medic, Inc. (“Dura Medic” or “Company”) against affiliates of Comvest, a private equity backer that acquired Dura Medic in 2018 through subsidiary affiliates. The claims focused in particular on Comvest’s subsequent extension of debt and equity financing to the Company without approval by disinterested and independent decisionmakers. Ultimately, the Delaware Court of Chancery held that these controller-interested transactions implicated the entire fairness standard, that Comvest failed to satisfy it (and therefore breached fiduciary duties as a controlling stockholder). This led the Court to hold that Comvest’s financings were equitably subordinated to the Seller Note.
The factual circumstances that led to this remedy warrant closer examination:
In May 2018, Comvest took a controlling stake in Dura Medic, a durable medical equipment supplier. Under the agreement, the selling stockholders, including the co-founder, received $18 million in cash consideration, and a $12 million Seller Note. At the time of the acquisition, Dura Medic faced significant financial distress because of administrative hurdles inherent to submitting claims for reimbursement from Medicare. Following the acquisition, those challenges became worse, as regulatory scrutiny of the Company’s claim submissions increased.
Dura Medic needed cash while new management sought to right the ship, so Comvest, which was then the controlling stockholder of the Company, injected additional funds over four financings. Two of the financings were structured as debt, and two were structured as preferred equity.
The financings provided for a 15% interest rate and, notably, were structurally senior in priority to the co-founder’s Seller Note: the financings were at the operating company level whereas the Seller Note was a debt of the operating company’s parent entity. The Court observed that no outreach to third party sources of financing was conducted, and no market analysis of the terms of the financings was performed before the financings closed.
The co-founder challenged the Comvest financings as a breach of Comvest’s fiduciary duty to the Company. The Court of Chancery applied the exacting entire fairness standard of review because Comvest was the controlling shareholder, and Dura Medic’s board lacked an independent and disinterested majority.
Entire fairness of course requires evaluation of both procedural and substantive fairness, and the burden is on the defendant to prove fairness.
The Court noted that indicia of fair process include:
- Negotiations by a majority of disinterested and independent directors;
- Appointment of a special committee;
- Actual negotiation over price;
- Obtaining stockholder approval;
- Receiving guidance from qualified advisors; and
- Testing the market.
And indicia of fair substance include:
- Contemporaneous market evidence;
- Expert analysis; and
- Contemporaneous financial analyses.
The Vice Chancellor held that Comvest failed to prove that the financings were fair because “none of the traditional indicia of fairness were present” for the process or the pricing. Comvest neither adequately searched for other investors, nor provided evidence that the interest rate on the loan was consistent with market rates or otherwise justified the 15% interest rate.
Comvest tried to assuage the Court of Chancery’s concerns by arguing it had offered the minority stockholders, including the co-founder-plaintiff, the right to participate in the financings. But the Court held that such an offer was insufficient to show fairness in this case where the controlling stockholder led the financing: “when a controller leads the financing, minority investors face the risk that by participating, they will open themselves to greater exploitation.” Additionally, the relationships among the parties had already become strained, and the Court concluded that the co-founder should not have been expected to provide more financing that the co-founder thought would be misused.
To remedy the breach, the Court of Chancery equitably subordinated the challenged financings to be junior to the Seller Note. Equitable subordination, while not a common remedy, may be ordered where a creditor’s inequitable conduct has a detrimental effect on other creditors. It can be a powerful remedy in a distressed entity where subordinated claims may have a greater risk of going unpaid.
In re Dura Medic Holdings, Inc. is a reminder that both publicly traded and privately held companies are best served to consider best practices—substantive and procedural—in related-party transactions. When parties fail to do so, unique equitable remedies may result.
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.
