Fair Price Does Not Overcome Unfair Process, Delaware Chancery Court Rules

By Michael Greene

Sept. 10— A recapitalization is not “entirely fair” even when it is approved and implemented at a fair price if it results from grossly unfair dealings, the Delaware Court of Chancery ruled Sept. 4.

In a memorandum opinion, Vice Chancellor John W. Noble wrote “a price that, based on the only reliable valuation methodologies, was more than fair does not ameliorate a process that was beyond unfair. At least doctrinally, stockholders may be entitled to more than merely a fair price, but the difficulty arises in quantifying the value of that additional entitlement.”

In addressing that challenging question of what damages a stockholder plaintiff may receive in such a scenario, Vice Chancellor Noble determined that the court under its inherent equitable powers could shift the attorneys' fees and costs.

Because the matter was not addressed in post-trial briefing in this case, the court granted plaintiffs leave to petition the court for this purpose.

Recapitalization

This case involves a 2002 recapitalization of a start-up streaming media company eventually known as Nine Systems Corporation. Before the recapitalization, three investors—Wren Holdings, LLC, Javva Partners, LLC and Catalyst Investors, LP—constituted “a control group” of stockholders. They combined to own approximately 54 percent of the company's stock and more than 90 percent of its senior debt.

Despite being well-positioned in a growing industry, the company continuously suffered “cash flow problems that threatened its continued existence.”

In 2001, the representatives of the company's control group decided that company needed a “restart” of its capital structure.

As a result, a recapitalization plan was sketched out, including a determination that the company was valued at $4 million. This valuation was the result of calculations that were performed by one stakeholder who was not a director, and the calculations were only documented by his “handwritten scribbles.”

Additionally, no other member of the board was able to testify as to how exactly the valuation was calculated.

Believing the company would fail without additional capital, Wren and Javva agreed to provide additional investments in the company in exchange for convertible preferred stock.

In August 2002, the recapitalization was implemented and afterward the control group held approximately 80 percent of the company's stock.

Four years later, the company sold itself to Akamai Technologies, Inc. for $175 million. As result of the Akamai merger, various minority shareholders filed the instant lawsuit against the control group and their representatives on the board.

The plaintiffs contended that the recapitalization was not entirely fair because it expropriated their economic and voting rights in the company. They alleged claims for breach of fiduciary duty, aiding and abetting, and unjust enrichment.

Unfair Process

The court explained that under Delaware law, “entire fairness” of a transaction has two components: “fair dealing” and “fair price.”

Although acknowledging that their “process was not perfect,” defendants claimed the process they used was fair in light of the company's immediate need for cash.

Cognizant of Nine Systems's situation at the time of the restructure, the court still rejected this premise, opining that: “The general initiation of the Recapitalization was fair. … But, the specific sequence of events undertaken by the Defendants to implement the Recapitalization was not fair.”

Instead, looking at a variety of factors, Vice Chancellor Noble determined that there was unfair dealing in the recapitalization process.

In particular, evidence of the unfair process included: the fiduciary defendants' attempts to marginalize the one independent director; the fiduciaries' failure to recognize objections to the recapitalization; the lack of attempt on the part of the directors to become adequately informed on how the $4 million valuation was derived; and the failure to disclose material information to minority shareholders.

Fair Price

Despite this unfair process, the court still found the $4 million valuation of the company for purposes of the recapitalization was a fair price. In making this determination, the court factored that the company had no value in equity before the recapitalization.

“Regardless of how much the Plaintiffs may have been diluted in the Recapitalization, because their common stock had no value that could have been diluted, the Plaintiffs necessarily ‘received the substantial equivalent in value of what they had before.'”

But Not an Entirely Fair Transaction

However, the court refused to conclude that the recapitalization was an entirely fair transaction because of “the grossly inadequate process employed by the Defendants.”

According to Vice Chancellor Noble, “it must hold true that a grossly unfair process can render an otherwise fair price, even when a company's common stock has no value, not entirely fair.”

Damages

Here, the court nonetheless declined to award the plaintiffs monetary damages because it found any harm based upon the alleged lost opportunity to invest was too speculative.

However, the court noted generally that “[e]ven where a transaction was conducted at a fair price, a finding that the transaction was not entirely fair may justify shifting certain of the plaintiffs' attorneys' fees and costs to the defendants who breached their fiduciary duties.”

The court granted plaintiffs leave to petition the court for this purpose.

To contact the reporter on this story: Michael Greene in Washington at mgreene@bna.com

To contact the editor responsible for this story: Ryan Tuck at rtuck@bna.com

The opinion is available at http://www.bloomberglaw.com/public/document/In_re_Nine_Sys_Corp_Sholders_Litig_Consol_CA_No_3940VCN_2014_BL_2.