In re Nine Systems: Court Finds Breach of Fiduciary Duty Despite Fair Price
In In re Nine Systems Corporation Shareholders Litigation, Consol. C.A. No. 3940-VCN., 2014 BL 245208 (Del. Ch. Sept. 4, 2014), the Court of Chancery of Delaware considered a challenge to a recapitalization brought against, among others, a controlling group of shareholders and four directors of Nine Systems (collectively “Defendants”). The court determined Defendants breached their fiduciary duties by engaging in a recapitalization that was not entirely fair due to the “grossly inadequate process.” The court, however, found Plaintiffs received a “fair price” and were therefore not entitled to monetary damages. Nonetheless, the court granted leave to submit a petition for attorneys’ fees and costs.
Plaintiffs’ claims turned on the 2002 recapitalization (the “Recapitalization”) of a start-up company—Streaming Media Corporation, later known as Nine Systems Corporation (the “Company”). During the Recapitalization, the controlling shareholders increased their equity through the acquisition of convertible preferred shares, resulting in the dilution of Plaintiffs’ ownership percentage from 26% to 2%. In November 2006, Akamai Technologies, Inc. (“Akamai”) purchased the Company for approximately $175 million. Plaintiffs argued the Recapitalization was unfair and sought over $130 million in damages.
In order for Plaintiffs to have standing to challenge the recapitalization as a direct claim, they needed to establish the presence of a control group—the functional equivalent of a controlling shareholder. Collectively, a group of shareholders may be considered a controlling shareholder. Plaintiffs had the burden of showing the group of shareholders were connected in a significant way and were working together towards a mutual goal. The court found that the circumstances surrounding a “right to invest” provided to an investor prior to the recapitalization demonstrated the presence of a control group. The court stated: “Particularly in light of Catalyst’s earlier comments in the Catalyst Memo, this conduct here demonstrates an agreement, arrangement, and legally significant relationship among Wren, Javva, and Catalyst—who together owned a majority of the Company’s stock—to accomplish the Recapitalization. Thus, as controlling shareholders, they owed fiduciary duties to the other shareholders in the Company.
As an alternative ground, the court examined whether Plaintiffs had standing to challenge the Recapitalization under the theory that the majority of the directors were impermissibly conflicted. The court acknowledged that, “while reasonable minds disagree,” plaintiffs could also “establish standing by proving that a majority of the Board was conflicted—here, meaning interested or not independent—when it approved and implemented the Recapitalization.” Analysis of independence must occur on a director-by-director basis. Plaintiffs established that four of the directors had a fiduciary relationship with their respective entities and therefore faced a potential conflict of interests in any given transaction with the Company. The court found that it was “undisputed” that two of the directors had an incentive “to maximize the value of their investment, while the stockholders who did not participate in the Recapitalization—including the Plaintiffs—would seek to act in the best interests of the Company.” The court determined a third director also faced a “dual fiduciary problem” although not as readily apparent as the others. As a result, the Plaintiffs had “direct standing to challenge the Board’s conduct in the Recapitalization.”
In examining the recapitalization, the court found an absence of “fair process.” Dwyer, the majority owner of one of the shareholders, “alone calculated” the value of the Company. The Board apparently had no significant role in the process. And “[n]o independent valuation was solicited.” Moreover, the terms of the Recapitalization changed between board approval and implementation, something that “compound[ed] the evidence leading to a conclusion of unfair dealing.” Stockholders were notified of the Recapitalization, but “that document was materially misleading.”
Although finding unfair dealing, the court nonetheless concluded the price paid in the Recapitalization was fair. Expert testimony showed that the Company’s equity had no value before the Recapitalization. Thus, the court concluded that the Recapitalization approved by a majority of conflicted directors was nonetheless at a fair price.
Although fair, the court determined that the absence of adequate process resulted in a violation of fiduciary duties. In awarding damages, the court concluded that it would be inappropriate to award disgorgement, recessionary, or other monetary damages to Plaintiffs because the “unfair Recapitalization” was effected at a fair price and any damages would be speculative in nature. The court, however, granted Plaintiffs leave to petition the court for an award of attorneys’ fees and costs.
The primary materials for this case may be found on the DU Corporate Governance website