In Re Trados - Important Lessons For Directors On Fiduciary Duties To Common Stockholders

Overview

In a ruling issued August 16, 2013, the Delaware Court of Chancery applied the entire fairness test—the court's most stringent standard of review for evaluating director conduct—when considering whether directors of a corporation breached their fiduciary duties to common stockholders in approving a change of control transaction in which the common stockholders received no consideration. The dispute in In re Trados Inc. Shareholder Litigation1, arose from the sale of a venture-backed Delaware corporation, Trados, Inc., in which senior management received a portion of the merger consideration pursuant to a management incentive plan ("MIP") put in place when the company began looking for strategic exits, and preferred stockholders received gains on their investments (but less than their total liquidation preference), but common stockholders received nothing.

A Trados stockholder sued first to have his shares of common stock appraised and later sued the corporation's directors for breaching their fiduciary duties by approving the merger. Under the two-prong entire fairness standard of review, the court found that (a) the defendant directors had failed to implement a fair process but (b) the Trados common stockholders had received a fair price in the acquisition because the common stock had no economic value prior to the merger.

Notwithstanding the defendants' avoiding liability in Trados, the court's application of the entire fairness standard of review raises significant implications for venture capital-backed companies given what are often commonplace facts for startup companies: directors affiliated with VC investors, questions of independence regarding board directors in a closely-knit technology and business community, management incentive carve-out plans and transactions where preferred stockholders and common stockholders have divergent interests.

Background

As is typical with many technology startups, Trados had obtained several rounds of venture capital funding to finance a growth strategy that could lead to an initial public offering or other successful exit. Though the company's business was trending upwards under a new CEO, the record before the court indicated its VC backers, including their affiliates who were members of the Trados board, were dissatisfied and sought potential exit strategies. To that end, Trados' board put into place the MIP in 2004 to incentivize the management's pursuit of strategic exits.

In 2005, Trados was sold to SDL plc for approximately $60 million in cash and stock. In the sale, senior management, pursuant to the MIP, received the initial $7.8 million of merger...