Court Finds Conflict of Interest Due to Private Equity Fund’s Need to Sell Portfolio Company and Wind Up Investment Fund
In a recent case, the Delaware Court of Chancery upheld claims that a private equity fund had a conflict of interest in selling a portfolio company because it needed to wind up an associated investment fund. The claim, brought by minority investors in the portfolio company, alleged that the private equity fund had extracted a “unique benefit” by selling the company to facilitate the fund’s closing. Having found the allegations supported the inference of a conflict of interest, the court held that the sale was subject to the stringent entire fairness standard of review.
Background
Typically, the sale of a controlled company is subject to the deferential business judgment rule if the controller and minority stockholders are treated equally (e.g., they receive the same price per share in the transaction). In certain cases, however, courts have held that a controller can have a conflict of interest when it has an urgent need to sell the company. Prior cases have suggested a high pleading threshold showing the controller had an “immediate need for liquidity” that involved “a crisis, fire sale where the controller, in order to satisfy an exigent need (such as a margin call or default in a larger investment) agreed to a sale of the corporation without any effort to make logical buyers aware of the chance to sell, give them a chance to do due diligence, and to raise the financing necessary to make a bid that would reflect the genuine fair market value of the corporation.”1 More recent cases, however, have suggested a somewhat lower barrier to making these claims.2
Court’s Ruling
In this most recent case,3 the court acknowledged that typically the stockholders’ interests are aligned in maximizing the sale price. It noted, however, that “rational economic actors sometimes do place greater value on being able to access their wealth than on accumulating their wealth.”4 To that end, the plaintiffs alleged that the private equity fund’s representatives had made specific statements about their need to wind up the investment fund, which required selling the portfolio company. Also of note, the private equity fund also held preferred shares in the corporation, which “received the bulk of the… guaranteed Sale consideration,” and thus received an additional, non-ratable benefit relative to the common stockholders. In terms of process, the plaintiff alleged that the sale was made an inopportune time due to uncertainty surrounding the company’s commercial contracts and was not approved by independent directors or disinterested stockholders. In light of these allegations, the court held that the transaction was subject to entire fairness review.
The court also upheld individual loyalty claims against the directors affiliated with the private equity fund. These individuals were “dual fiduciaries” in that they owed duties both to the fund and the portfolio company. The court also upheld claims against the portfolio company’s CEO, finding that he lacked independence from the controlling stockholder. The court observed that “senior corporate officers generally lack independence for purposes of evaluating matters that implicate the interests of a controller.” The court also found persuasive allegations in the complaint that the CEO had said he “had been told to sell the company” and “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 fund] to monetize and close the fund so the money could be returned to investors.”5
It bears noting that the controlling stockholder exercised a contractual “drag-along” right that barred the minority stockholders from objecting and seeking appraisal rights. The court previously held, however, that the stockholders agreement did not bar the minority stockholders from suing the directors and controller for breach of fiduciary duty.6
Take-Aways
- Typically, large stockholders are not deemed to be conflicted if all stockholders are treated equally in a transaction. Delaware “generally presumes” large stockholders are rationally motivated to maximize stockholder value.7
- Nevertheless, even if a controller does not “stand on both sides of the transaction,” it can have a conflict of interest if 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.”8
- Private equity funds and other large stockholders should be careful about suggesting they have sale motivations other than maximizing value – particularly with respect to remaining portfolio companies during the end stages of the life cycle of a fund. From the perspective of private equity board representatives, they should be cognizant of their “dual fiduciary” role, educated on their fiduciary duties, and ensure that they have adequate indemnification and advancement rights.
- Although not the primary focus of the court’s opinion, there can also be a conflict of interest where the controller holds preferred stock that will receive the bulk of the sale proceeds.9
- When a controller is conflicted and entire fairness is triggered, “fair dealing” can be evidenced through a special committee process and/or a majority-of-the-minority stockholder approval condition. Although these safeguards have become fairly common in public company M&A transactions and, when used together, can result in business judgment rule protection,[10] they are used less often in private company transactions because controllers are reluctant to cede such power to minority investors or other classes of securities.
- Private equity investments structured as limited liability companies can avoid many of these issues by disclaiming fiduciary duties or agreeing to other sale-related procedures.
1 In re Synthes, Inc. S’holder Litig., 50 A.3d 1022, 1036 (Del. Ch. 2012).
2 See In re Mindbody, Inc., 2020 Del. Ch. LEXIS 307, at *39-40 (Del. Ch. Oct. 2, 2020) (“The court’s hyperbolic language in Synthes is best read in the context in which it was issued, where then-Chancellor Strine was reacting to a particularly poorly drafted complaint ‘strikingly devoid of pled facts to support’ the alleged liquidity-driven conflict.”); Firefighters’ Pension Sys. v. Presidio, Inc., 251 A.3d 212, 256 (Del. Ch. 2021) (agreeing with Mindbody but concluding that the plaintiff failed to plead that a large stockholder had a divergent interest).
3 Manti Holdings, LLC v. The Carlyle Group Inc., C.A. No. 2020-0657-SG, mem. op. (Del. Ch. June 3, 2022).
4 Id. at 24.
5 Id. at 23, 30.
6 Manti Holdings, LLC v. The Carlyle Group Inc., C.A. No. 2020-0657-SG, mem. op. (Del. Ch. Feb. 14, 2022).
7 Manti Holdings, LLC v. The Carlyle Group Inc., C.A. No. 2020-0657-SG, mem. op. at 24 (Del. Ch. June 3, 2022).
8 Id. at 22-23.
9 See, e.g., In re Trados Inc. S’holder Litig., C.A. No. 1512-CC (July 24, 2009).
10 See Kahn v. M&F Worldwide Corp., 88 A.3d 635 (Del. 2014).