D&O Fiduciary Duties to Multiple Classes of Stockholders

Lessons From In re Trados Inc andpresents Lessons From In re Trados Inc. and Other Recent Delaware Decisions

presents

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Michael D. DiSanto, Partner, Reed Smith, Palo Alto, Calif.

Wednesday, January 27, 2010

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Fiduciary Duties & M&A Practice 2010 _____

Lessons From Recent Delaware Decisions

Strafford CLE TeleconferenceJanuary 27 2010January 27, 2010

Michael Di Santo Mark A. Morton Trevor NorwitzReed Smith Potter Anderson &

Corroon LLPWachtell, Lipton, Rosen

& Katz

New Rules of the Road for 2010?

◦ Companies with Controlling Stockholders: Will recent judicial guidance change the way third party deals are done?judicial guidance change the way third party deals are done?

◦ Distressed M&A: When can you sell and who calls the shots?

◦ Running a Sales Process after Lyondell: What did we learn from the Supreme Court’s decision and what does the future hold?

◦ The Duties of Corporate Officers: Business as usual or a new focus?

◦ Raising the Stakes in Bid Jumping Situations: New Rules, New Risks?

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Controlling Stockholders: Has Hammons Hotelschanged the rules?changed the rules?

◦ Kahn v. Lynch mandates entire fairness review for squeeze out mergers by controlling stockholders

h ld h h d h i i f i◦ Court held that Kahn does not, however, require entire fairness review for every merger in which a controlling stockholder is present

• Business judgment standard of review may apply if the t lli t kh ld d t t d “ b th id ” d th controlling stockholder does not stand “on both sides” and the

minority stockholders’ interests are adequately protected (by special committee and non-waivable majority of the minority vote condition))

• The nature of procedural protections matters – if a special committee or a majority of minority vote condition, then only a burden shift (i.e., plaintiff must prove unfairness)

◦ Take away

• Will sellers trade dollars for less scrutiny?

• Will a “non waivable” majority/minority condition hurt deal 3

• Will a non-waivable majority/minority condition hurt deal value?

Distressed M&A: When can you sell and who gets to call the shots?to call the shots?

◦ “Antagonistic” interests: contract rights vs. residual owners

◦ Key questions for the Board (after Trados)y q

• Why sell the company now?

• How was the merger consideration allocated?

• Are alternatives available that preserve value for the common stockholders?

• Is the Board conflicted? If so, how is that conflict addressed?

• Is insolvency a risk? (Gheewalla)

◦ Liability exposure/threat of injunctive relief◦ Liability exposure/threat of injunctive relief

◦ Best Practices

• Considering “option” value

4 • Fostering leverage/structuring solutions

Running a Sale: Dissecting Lyondell

◦ Lyondell

◦ Revlon 2.0

• If the board is disinterested and independent (and exculpated from due care breach), then sole basis for li bili i b d f i h liability is bad faith

• Bad faith exists only where there is an “utter failure to attempt” to obtain best price

• Doctrinal “high bar” to a damage remedy

◦ Netsmart

• Absent jumping bidder or disclosure violations, injunctions Absent jumping bidder or disclosure violations, injunctions are disfavored

• Practical “high bar” to an injunctive remedy

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Running a Sale: Practice Pointers

◦ Is there an analytical disconnect in the law?

A li ti f i ht t d d i ti t t• Application of oversight standard in an action context

• Acknowledges duties are contextually specific, but then says no single failure ever will be consequential

◦ Does the new standard create a judicial null set?

• If “bad faith” requires an “utter failure to attempt” to secure the best price, is it possible to “act” in “bad faith”?

◦ Do buyers have greater negotiating leverage?

◦ Has Revlon’s disciplining effect been eroded?

◦ The danger in overreachingThe danger in overreaching

• Reading the judicial tea leaves (Bernal)

• Equity is never without a remedy (Loral)

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The Duties of Corporate Officers: Business as usual or a new focususual or a new focus

◦ The Court of Chancery has held, and the parties do not dispute, that corporate officers owe fiduciary duties that are identical to those owned by corporate directors. That issue – whether or not officers owe fiduciary duties identical to those of directors – has been characterized as a matter of first impression for this Court. In the

h i li d h ffi f lpast, we have implied that officers of Delaware corporations, like directors, owe fiduciary duties of care and loyalty, and that the fiduciary duties of officers are the

h f di W li i l h ldsame as those of directors. We now explicitly so hold.Gantler v. Stephens, 965 A.2d 695, 708-09 and n.37 (Del. 2009)

◦ Questions/issues raised:• Who is an officer?• Defining an officer’s responsibilities (by bylaw and/or

contract) vs. the officer’s fiduciary duties (“identical”)

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• Do officers and directors have the same protections?

New Risks and Rules for Overbidderse s s a d u es o O e b dde s

◦ Nacco Industries v. Applica Inc.

◦ Merger contracts matter!• Chancery reaffirms utility and enforceability of “no-shop”

and similar deal protection clausesand similar deal protection clauses• Practical implications and litigation consequences• Tortious interference with contract

◦ Raising the Stakes for Section 13(d) compliance• New risks when state law intersects with federal law• Clarity (or confusion) on overbidder “intent”

◦ What’s next for deal jumpers? Best practices for targets?

I li i f lli kh ld i8

◦ Implications for controlling stockholder transactions

Teleconference Faculty

Michael DiSantoMark A. Morton

P tt A d & C LLP Trevor NorwitzMichael DiSantoReed Smith, LLP

1510 Page Mill RoadPalo Alto, CA 94304

(650) 352-0532

Potter Anderson & Corroon LLPHercules Plaza, 6th Floor1313 North Market Street

Wilmington, DE 19801 (302) 984 6078

Trevor NorwitzWachtell, Lipton, Rosen & Katz

51 west 52nd StreetNew York, NY 10019

(212) 403-1333(650) 352 0532Email: mdisanto@reedsmith.com

www.reedsmith.com

(302) 984-6078Email: mmorton@potteranderson.com

www.potteranderson.com

(212) 403 1333Email: TSNorwitz@WLRK.com

www.wlrk.com

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International Arbitration

Client Alert 09-264

September 2009

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If you have questions or would like additional information on the material covered in this Alert, please contact one the authors:

Michael D. DiSanto Partner, Silicon Valley +1 650 352 0532 mdisanto@reedsmith.com

Richard Scudellari Partner, Silicon Valley +1 650 352 0514 rscudellari@reedsmith.com

Sara Y. Mo Associate, Silicon Valley +1 650 352 0529 smo@reedsmith.com

Sarah R. Wolff Partner, Chicago +1 312 207 6424 swolff@reedsmith.com

…or the Reed Smith lawyer with whom you regularly work.

Corporate & Securities Alert

Delaware Decision Raises Concerns for Private Company DirectorsA recent decision by a Delaware Chancery Court raises the possibility of breach of fiduciary claims against directors of Delaware corporations who approve a transaction that favors the interests of preferred stockholders over those of common stockholders. On July 24, 2009, the Delaware Court of Chancery, in the case of In re Trados Incorporated Shareholder Litigation, denied defendants’ motion to dismiss breach of fiduciary duty claims arising out of the approval by Trados’ board of directors of a merger in which the company’s preferred stockholders received $52 million in merger consideration and its common stockholders received nothing. The court’s ruling in In re Trados is significant primarily because it raises the possibility of breach of fiduciary claims against directors of Delaware corporations who approve a transaction that favors the interests of preferred stockholders over those of common stockholders.

Factual Background

Prior to the merger at issue, Trados was a venture-backed Delaware corporation that had been losing money and had little cash to fund continuing operations. The Trados board of directors, which consisted of seven members, four of whom were designees of, and otherwise had financial interests in, venture capital funds that collectively owned 51 percent of the outstanding shares of the company’s preferred stock. In April 2004, the board began to discuss the potential sale of the company. Approximately three months later, SDL made an acquisition proposal in the $40 million range.

Trados’ financial condition improved markedly during the fourth quarter of 2004, in part because of the efforts of Trados’ executives to reduce spending while bringing in additional cash through debt financing. In addition, Trados reported record revenue and profits from its operations in the fourth quarter of 2004, which, at the time, alleviated the immediate need for cash. Despite its improved performance, the board continued to work toward a sale of the company; and in July 2005, SDL acquired Trados for $60 million.

Of the $60 million received by Trados, approximately $52 million was distributed to its preferred stockholders in partial satisfaction of their liquidation preference, and approximately $8 million was distributed to its executive officers pursuant to a bonus plan put in place a few months earlier to incent the executives to pursue a sale of the company in light of the $57.9 million liquidation preference held by the preferred stockholders. Consequently, Trados’ common stockholders received no consideration in the merger.

Breach of Fiduciary Duty Claim

Plaintiff claimed that the Trados board breached its fiduciary duty of loyalty when it approved the merger, alleging that (i) the merger was undertaken at the behest of certain preferred stockholders seeking a transaction that would trigger their large liquidation preference, thus allowing them to exit their investment in Trados because it was performing poorly; (ii) the merger favored the interests of the preferred stockholders, either at the expense of the common stockholders or without properly considering the effect of such merger on the common stockholders; and (iii) the four directors designated by the preferred stockholders had other relationships with the preferred stockholders and were incapable of exercising independent and disinterested business judgment, thus rebutting the protective presumption afforded by the business judgment rule.

Court Finds Facts Sufficient to Support Claim

Upon review of plaintiff’s pleading, the court found that plaintiff had alleged facts sufficient, for purposes of deciding a motion to dismiss, by demonstrating that at least a majority of the members of Trados’ seven-member board were unable to exercise independent and disinterested business judgment in deciding whether to approve the merger with SDL. The court further explained that

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plaintiff’s allegations had sufficiently rebutted the presumptions of the business judgment rule for purposes of a motion to dismiss. Accordingly, the court refused to dismiss plaintiff’s claim that the board breached its fiduciary duty of loyalty by improperly favoring the interests of the preferred stockholders over those of the common stockholders when it approved the merger.

No Alignment of Interests Between Preferred and Common Stockholders

The defendants attempted to counter plaintiff’s allegations that the board approved the merger at the behest of certain preferred stockholders wanting to exit their investment in Trados, by arguing the obvious alignment of the interests of the preferred and common stockholders in obtaining the highest sale price available for the company. The court rejected this “obviously alignment” argument because the merger resulted in a large liquidation preference payout for the preferred stockholders, while the common stockholders did not receive anything for their ownership interests, which was the worst possible outcome for the common stockholders. In taking the well-pleaded facts in the light most favorable to the plaintiff, which is the standard for deciding a motion to dismiss, the court found that, based on the facts, a reasonable inference existed that the common stockholders would have been able to receive some consideration for their Trados shares at some point in the future had the merger not occurred. The court explained that this inference was supported by plaintiff’s allegation that Trados’ performance had significantly improved in the months leading up to the merger, and the company had secured additional capital through debt financing during that time.

Duty of the Board to Favor the Interests of the Common Stockholders

Because the interests of the preferred and common stockholders were not aligned with respect to the decision to pursue the merger transaction, the court explained that Trados’ board owed its fiduciary duties to the common stockholders and not the preferred. In support of its findings, the court explained that, although directors owe fiduciary duties to both preferred and common stockholders, this duty applies only when the right claimed by preferred stockholders is a right that is equally shared with the common. The court stated that where this is not the case, it will generally be the duty of the board, where discretionary judgment is to be exercised, to prefer the interests of common stockholders to the interests created by the special rights and preferences of preferred stock, where there is a conflict. The court, therefore, opined that in situations where the interests of the common stockholders diverge from those of the preferred stockholders, it is possible that a director could breach a fiduciary by improperly favoring the interests of the preferred stockholders over the common stockholders.

The Directors Lacked Independence

For purposes of deciding a motion to dismiss, the court stated that pleading facts that support a reasonable inference that a director is “beholden to a controlling person or so under their influence that their discretion would be sterilized” is sufficient to defeat a motion to dismiss. The court held that alleging that four of Trados’ seven directors (i) were designated to the board by preferred stockholders, (ii) had employment or ownership relationships with the entities that owned preferred stock, and (iii) were dependent on preferred stockholders for their livelihood, was sufficient, under the plaintiff-friendly pleading standard on a motion to dismiss, to rebut the business judgment presumption with respect to the board’s decision to approve the merger.

Avoiding the Potential Pitfalls of In re Trados

It is important to note that the court did state that its decision in In re Trados was not intended to suggest that it would necessarily be a breach of fiduciary duty for a board to approve a transaction where the liquidation preference consumes all of the merger consideration. The question in this situation is whether a board of directors, in approving such a transaction, exercised independent judgment and properly considered the interests of the common stockholders.

Again, In re Trados was decided in light of the plaintiff-friendly standard required when deciding a motion to dismiss. Thus, the court was required to draw reasonable inferences from the allegations in the plaintiff’s favor. Such inferences need not be drawn when the claim moves to the summary judgment stage or beyond. Indeed, the court specifically observed that there might be other reasonable and even more likely inferences that could not be drawn when deciding a motion to dismiss, but which could be drawn when deciding a summary judgment motion or the ultimate claim on its merits.

It is unknown whether the plaintiff will ultimately prevail on the breach of fiduciary duty claims related to the Trados board’s decision to approve the merger with SDL. Until that question is decided,

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directors of Delaware venture-backed corporations should remain cognizant of the possible pitfalls created by In re Trados. Practical steps for directors to consider attempting to avoid those pitfalls, in situations where the liquidation preference of the preferred stockholders would consume all, or substantially all, of the proceeds in a sale of the company, include:

Obtaining the approval of directors not designated by a preferred stockholder holding a �liquidation preference or otherwise eligible to receive merger consideration from a management retention or bonus plan

Engaging investment bankers to find other potential acquirers to find the highest possible price �

Carving out a piece of the merger consideration for the common stockholders, particularly when �the company has positively trending financial performance or enough cash to operate as a going concern

Seeking the unanimous approval of the merger by the common stockholders, whether by vote �or written consent (the affirmative vote of a majority of common stockholders may be required for Delaware corporations with a substantial presence in California because of California Corporations Code Section 2115)

While these practical steps, either singularly or in combination, do not ensure that a claim for breach of fiduciary duty claim will be dismissed based on In re Trados, they may help minimize the risk that any such claim will be successful on the merits.

About Reed Smith

Reed Smith is a global relationship law firm with nearly 1,600 lawyers in 23 offices throughout the United States, Europe, Asia and the Middle East. Founded in 1877, the firm represents leading international businesses, from Fortune 100 corporations to mid-market and emerging enterprises. Its lawyers provide litigation and other dispute resolution services in multi-jurisdictional and other high-stakes matters; deliver regulatory counsel; and execute the full range of strategic domestic and cross-border transactions. Reed Smith is a preeminent advisor to industries including financial services, life sciences, health care, advertising, technology and media, shipping, energy trade and commodities, real estate, manufacturing, and education. For more information, visit reedsmith.com.

This Alert is presented for informational purposes only and is not intended to constitute legal advice.

© Reed Smith LLP 2010. All rights reserved.

“Reed Smith” refers to Reed Smith LLP, a limited liability partnership formed in the state of Delaware.

Delaware Court Leaves Directors at the HelmIn 'Lyondell,' high court defers to business judgment of disinterested board in managing sale of company

William Savitt The National Law Journal

June 2, 2009

Although there are fewer deals since the current economic crisis began, courts have continued tomake important law governing the behavior of directors considering the sale of a company. De-spite a political climate tilting in favor of stricter scrutiny of corporate conduct, appellate courtshave reaffirmed the principle of judicial deference to the business judgment of disinterestedboards of directors and resisted lower court attempts to ratchet up the standard of review.

In the significant -- perhaps even landmark -- decision of Lyondell Chemical Corp. v. Ryan , No.401, 2008, 2009 WL 790477 (Del. 2009), the Delaware Supreme Court in April issued its broad-est statement yet affirming the discretion of directors to manage the sale of a company as theysee fit. The court firmly rejected post-merger stockholder claims that Lyondell's directors failedto act in good faith in selling the company, even assuming (given the summary judgment pos-ture) that they did nothing to prepare for an impending offer and did not conduct an "auction"before entering into a merger agreement.

The en banc decision, authored by Justice Carolyn Berger, is a sweeping rejection of attempts tosubject directors to personal liability for their action in response to acquisition proposals. It sendsa clear signal to courts in Delaware, and others applying Delaware corporate law, that deferentialbusiness judgment review remains the standard governing challenges to arm's-length mergertransactions.

The case arose out of the Lyondell board's approval of a $13 billion cash offer from Basell AF inJuly 2007. Shareholder plaintiffs complained that the board had breached its duty of loyalty byentering into the merger agreement without sufficiently canvassing the market -- even though 11of the 12 Lyondell directors were independent and disinterested and the offer carried a 45 per-cent premium to Lyondell's stock price. Lyondell's certificate of incorporation contained an ex-culpatory provision that shielded directors from personal liability for violations of the duty ofcare but not the duty of loyalty.

The Delaware Chancery Court denied the directors' motion for summary judgment in July 2008.The court construed the duty of a director, first announced in Revlon Inc. v. MacAndrews &Forbes Holdings Inc. , 506 A.2d 173 (Del. 1986), to seek the highest possible price when selling

a company, with a rigor that surprised many observers. It held that the directors' "unexplainedinaction" after the company was put "in play" -- by Basell's indication in a U.S. Securities andExchange Commission (SEC) filing that it might seek to buy Lyondell -- created an inferencethat they might have breached their duty of loyalty by "consciously disregard[ing]" their duty tomaximize the sale price. By subjecting Lyondell's independent directors to the risk of personalliability for their approval of a third-party transaction, the court seemed to open the door to moreintrusive judicial review of director conduct.

The door was promptly shut by the Delaware Supreme Court. Hearing the case on interlocutoryappeal, the court found that the lower court had misapplied the law in three ways: First, it im-posed a so-called Revlon duty before the board had even decided to sell the company; second, itinterpreted Revlon as creating a set of specific requirements that directors must follow in a sale;and, third, it treated an allegedly imperfect sales process as equivalent to "a knowing disregard ofone's duties that constitutes bad faith" and thus a breach of the duty of loyalty.

'WAIT AND SEE' APPROACH

Rejecting the view that a Revlon duty arises when a company appears to be "in play," the courtheld: "The duty to seek the best available price applies only when a company embarks on atransaction -- on its own initiative or in response to an unsolicited offer -- that will result in achange of control." The court found that the board had appropriately exercised its businessjudgment by taking a "wait and see" approach in response to Basell's SEC filing. The decisionthus reaffirms that boards need not institute an auction in response to an unsolicited indication ofinterest and that corporate directors retain the right to "just say no" when a potential buyeremerges.

The Supreme Court also rejected the lower court's holding that Revlon requires a board to followa specific path in a sale process. Since at least Barkan v. Amsted Industries Inc. , 567 A.2d 1279(1989), the Delaware Supreme Court has instructed that there is "no single blueprint" for com-plying with Revlon. In Lyondell , the court confirmed that "[n]o court can tell directors exactlyhow to accomplish that goal [of getting the best price in a sale], because they will be facing aunique combination of circumstances, many of which will be outside of their control." Applyingthat lesson, the court found no potential basis for liability in the board's approval of the mergerafter deliberating for only seven hours and without conducting an auction or even a limited mar-ket check.

The most important aspect of Lyondell , however, is the holding that hindsight debate about whatdisinterested directors could have done differently in arranging a merger cannot support a dam-ages claim for a breach of the duty of loyalty based on a failure to act in good faith. Because"there are no legally prescribed steps that directors must follow to satisfy their Revlon duties"during a sale, "the directors' failure to take any specific steps during the sale process could nothave demonstrated a conscious disregard of their duties" necessary to support a duty of loyaltyclaim based on bad faith.

In Beck v. Dobrowski , 559 F.3d 680 (7th Cir. 2009), the 7th U.S. Circuit Court of Appeals simi-larly shielded directors' decision-making from post-transaction second-guessing. The case arose

out of Blackstone's deal to acquire Equity Office Properties (EOP) in early 2007, also at a sub-stantial premium to market. Shareholders of EOP brought suit under § 14(a) of the Securities Ex-change Act, alleging that the merger proxy should have included additional valuation informa-tion and details of the benefits that top EOP executives would receive in the transaction, andcomplaining generally about the terms of the transaction and the conduct of the sale process.

Writing for the panel, Judge Richard Posner rejected the merger proxy shareholders' claims as"too feeble" to survive. Posner confirmed that "the antifraud provisions of federal securities laware not a general charter of shareholder protection." Such protection, the court made clear, re-mains the proper province of state fiduciary duty law. Striking a blow for judicial efficiency, thepanel then affirmed the district court's stay of supplemental state fiduciary claims, explainingthat, to permit such claims to proceed while identical claims were pending in state court, wouldallow "different members of what should be a single class [to] file identical suits in federal andstate courts to increase their chances of a favorable settlement."

Lyondell and Beck indicate that courts remain unwilling to second-guess disinterested directorswho approve arm's-length merger transactions. But recent case law also illustrates the limits ofthis deference. In Gantler v. Stephens , No. 132, 2008, 2009 WL 188828 (Del. 2009), the Dela-ware Supreme Court held that allegations that a board improperly refused an acquisition proposalstated a claim for breach of fiduciary duty -- notwithstanding the general Delaware rule that aboard has no obligation to entertain merger offers. Key to the decision was the finding that a ma-jority of the board had conflicting personal interests that might have prevented it from impar-tially considering the potential transaction. The court was thus unwilling to reject claims that thedirectors sabotaged the sale, at least at the pleading stage. Taken together, these decisions con-firm that the touchstone for judicial approval of a corporate sale process is careful action by awell-advised board that reserves an appropriate role for disinterested directors.

William Savitt is a partner in the litigation department of New York-based Wachtell, Lipton,Rosen & Katz in New York. He represents corporations and directors in litigation involvingM&A, proxy contests, corporate governance disputes, class actions involving allegations ofbreach of fiduciary duty, and enforcement actions relating to corporate transactions.

Risks to Overbidders Under Delaware Law Posted by William Savitt, Wachtell, Lipton, Rosen & Katz on Monday January 18, 2010

Editor’s Note: William Savitt is a partner in the Litigation Department of Wachtell, Lipton,

Rosen & Katz. This post is based on a Wachtell Lipton client memorandum by Mr. Savitt and

Ryan A. McLeod, an associate in Wachtell Lipton’s Litigation Department.

A recent Delaware Court of Chancery decision refusing to dismiss damages claims by NACCO

Industries arising out of its failed attempt to acquire Applica Inc. provides important guidance for

parties contemplating an overbid and highlights the risks that remain even after a topping deal is

successfully closed. NACCO Indus., Inc. v. Applica Inc., C.A. No. 2541-VCL (Dec. 22, 2009).

The complaint alleged that while NACCO and Applica were negotiating a merger agreement in

2006, Applica insiders provided information to principals at the Harbinger hedge funds, which

were then considering their own bid for Applica. During this period, Harbinger amassed a

substantial stake in Applica (which ultimately reached 40 percent) but reported only an

“investment” purpose on its Schedule 13D filings, disclaiming any intent to control the company.

After NACCO signed up the merger, the complaint alleged, communications between Harbinger

and Applica management about a topping bid continued. Eventually, Harbinger amended its

Schedule 13D disclosures and made a topping bid for Applica, which then terminated the NACCO

merger agreement. After a bidding contest with NACCO, Harbinger succeeded in acquiring the

company.

NACCO brought claims against Applica for breach of the merger agreement’s “noshop” and

“prompt notice” provisions and against Harbinger for common law fraud and tortious interference

with contract. Vice Chancellor Laster largely denied defendants’ motion to dismiss. As to the

contract claims, the Court reaffirmed the utility of “no-shop” and other deal protection provisions,

holding that “[i]t is critical to [Delaware] law that those bargained-for rights be enforced,” including

by a post-closing damages remedy in an appropriate case. Good faith compliance with such

provisions may require a party to “regularly pick[] up the phone” to communicate with a merger

partner about a potential overbid, particularly because “in the context of a topping bid, days

matter.” Noting that the no-shop clause was not limited to merely soliciting a competing bid, and

that the “prompt notice” clause required Applica to use “commercially reasonable efforts” to

inform NACCO of any alternative bids and negotiations, the Court had “no difficulty inferring” that

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Applica’s alleged “radio silen[ce]” about the Harbinger initiative may have failed to meet the

contractual standard.

The Vice Chancellor also upheld NACCO’s common law fraud claims based on the alleged

inaccuracy of Harbinger’s Schedule 13D disclosures. After a careful review of jurisdictional

precedent, the Vice Chancellor dismissed Harbinger’s contention that all claims related to

Schedule 13D filings belong in federal court, finding instead that when a “Delaware entity

engages in fraud”— even if in an SEC filing required by the Exchange Act—it “should expect that

it can be held to account in the Delaware courts.” The Court then ruled that NACCO had

adequately pleaded that Harbinger’s disclosure of a mere “investment” intent was false or

misleading, squarely rejecting the argument that “one need not disclose any intent other than an

investment intent until one actually makes a bid.”

While the Court emphasized that NACCO was a fact-specific, pleadings-stage decision, the ruling

underscores the risks inherent in an overbidding situation. Parties to merger agreements must

respect no-shop and notification provisions in good faith or risk after-the-fact litigation, with

uncertain damages exposure, from a jilted partner. And contrary to what is sometimes believed,

Schedule 13D violations are not always curable with mere corrective disclosure, but may also

give rise to damages under state law. Potential topping bidders must carefully consider all the

public disclosures they make. Litigation risk remains even after the deal has closed.

© 2010 The President and Fellows of Harvard College

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When classes of stockholders clash William Savitt

December 07, 2009

Advising directors of public companies with multiple classes of stockholders is a notoriously tricky business. It is

settled law that a board owes indivisible and unremitting fiduciary duties to the company and all of its stockholders.

But in companies with two or more classes of stockholders, the interests of the classes may diverge, potentially

pulling the directors in conflicting directions even when times are good. Add in complex transactional situations

typical in a distressed economy — a struggling corporation contemplating a transaction that would benefit certain

preferred stockholders at the expense of the common, for example, or a merger that permits a controlling

stockholder to cash out his shares on special terms — and the task of balancing duties to different equity classes

can become a liability minefield.

A pair of recent decisions from the nation's leading corporate-law trial court provides practical guidance for

directors with duties to multiple classes of stockholders and the lawyers who advise them. The upshot of both

reaffirms a core tenet of mergers and acquisitions practice: Process matters a lot.

COMMON STOCKHOLDERS PREVAIL

In In re Trados Inc. Shareholders Litigation, No. 1512, 2009 WL 2225958 (New Castle Co., Del., Ch. July 24, 2009),

the Delaware Court of Chancery ruled that, when the interests of common and preferred stockholders differ, a

board could breach its fiduciary duties by protecting the preferred at the expense of the common. Trados was a

developer of language-translation software. Four venture capital funds held preferred equity in the company, with

an aggregate liquidation preference of $57.9 million. Each of the preferred holders designated one member of the

seven-person board of directors; the remaining three were elected by the common stockholders.

With the company bleeding red ink in 2004, the board formed a special committee, consisting of directors

designated by the venture funds, to consider a potential sale transaction. Although Trados' performance was

improving by late 2004, the special committee and the board determined to sell the company in July 2005. Of the

$60 million merger price, management received $7.8 million under existing employment agreements, and the rest

was paid to the preferred stockholders in partial satisfaction of their liquidation preference. Common shareholders

received nothing.

In the ensuing class action litigation, plaintiffs alleged that the board breached its fiduciary duties to the common

stockholders by selling the company merely to allow the venture capital funds to exit their investment and receive

their liquidation preference. According to the plaintiffs, the board "never considered the interest of the common

stockholders in continuing Trados as a going concern, even though they were obliged to give priority to that interest

over the preferred stockholders' interest in exiting their investment."

The court found these allegations more than sufficient to state a claim. Because four of the seven directors were

both designated and employed by firms that held large preferred stakes, the chancellor found that a majority of the

board was neither "disinterested" nor "independent." The court refused to review the decision to approve the

merger under the deferential business judgment rule and instead shifted the burden to the defendants to prove that

the deal was entirely fair. For the same reason, the work of the special committee — exclusively staffed by

preferred designees — received no deference.

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Seeking to convince the court that there was no conflict, the defendants argued that the interests of the preferred

were "obviously aligned" with the common, because all classes of equity would have received more had the merger

price been higher. The chancellor was unimpressed. While everyone may have desired a higher price, the court

noted, the merger netted a $52 million payout to the preferred and nothing for the common. The court reasoned

that, when a company is in distress — when its worth is at risk of falling below the liquidation preference — the

preferred may be very differently situated than the common "with respect to the decision of whether to pursue a

sale of the company or continue to operate the Company," especially because the company's improving

performance supported an "infer[ence] that the common stockholders would have been able to receive some

consideration for their Trados shares at some point in the future had the merger not occurred."

Although there is no safe harbor for a board navigating a company with multiple classes of stockholders through the

zone of insolvency, Trados offers significant guidance. Directors nominated by a specific stakeholder must

safeguard the interests of the company as a whole and avoid even the appearance of favoring a narrow

constituency. The court recognized that a transaction that benefits some shareholders while returning nothing to

the common is not per se improper, but Trados shows that such deals may be painstakingly scrutinized. Boards in

these circumstances must take steps — including, in appropriate cases, the retention of expert advisers or the

formation of independent committees — that demonstrate deliberate decision-making in the best interests of the

company as a whole. These lessons are particularly important for private-equity sponsors and venture capital funds,

which often place employees on portfolio company boards and, in the process, take on duties to public co-investors.

The need for careful process is not limited to transactions involving companies with preferred shareholders. In

another recent decision, In re John Q. Hammons Hotels Inc. Shareholder Litigation, No. 758-CC, 2009 WL 3165613

(New Castle Co., Del., Ch. Oct. 2, 2009), the Court of Chancery clarified the standards that apply when a third

party pays different consideration for two different classes of stock — one held by a controlling shareholder and the

other by the public.

The case involved the sale of John Q. Hammons Hotels Inc., a company whose Class A common stock was publicly

traded and whose "high vote" Class B stock was entirely owned by John Hammons. In late 2004, a special

committee of the company's board explored potential third-party mergers. Hammons informed the committee that,

because of his particular business interests, he would consider a transaction only if he retained an interest in the

surviving entity and received a line of credit to continue developing new hotels. The committee ultimately

recommended that the board approve a transaction in which the Class A stock was cashed out at $24 per share, a

premium to the then-current trading price. Hammons' Class B shares were converted into a participating preferred

interest in the surviving company and lines of credit totaling $300 million. The deal was conditioned on the approval

of a majority of the minority shares actually voting, and it was approved and closed in 2005.

As in Trados, certain shareholders challenged the transaction, alleging that Hammons dominated the negotiation

process and received an undue proportion of the merger consideration. Ruling on cross-motions for summary

judgment, the court rejected the argument that the transaction was presumptively subject to the plaintiff-friendly

"entire fairness" standard of review. Because Hammons was not himself cashing out the shareholders or otherwise

"standing on both sides of the transaction," but was instead dealing with a third party, the chancellor concluded

that all defendants would be protected by the business judgment rule "if the transaction were (1) recommended by

a disinterested and independent special committee, and (2) approved by stockholders in a [fully informed and] non-

waivable vote of the majority of all the minority stockholders."

The court went on to rule, however, that, for the business judgment rule to apply, "there [must] be robust

procedural protections in place to ensure that the minority stockholders have sufficient bargaining power and the

ability to make an informed choice of whether to accept the third party's offer for their shares." The protections

here did not qualify, "both because the vote could have been waived by the special committee and because the

vote only required approval of a majority of the minority stockholders voting on the matter, rather than a majority

of all the minority stockholders."

The narrow lesson of Hammons is that the protection of the business judgment rule remains available to properly

structured third-party transactions in which a controlling class of stock is exchanged for different consideration than

public shares. Taken together, Trados and Hammons powerfully reaffirm the need for a careful process at every

stage in the planning of a multiple-class transaction.

William Savitt is a partner in the litigation department of New York-based Wachtell, Lipton, Rosen & Katz. He

represents corporations and directors in litigation involving mergers and acquisitions, proxy contests, corporate-

governance disputes, class actions involving allegations of breach of fiduciary duty, and enforcement actions

relating to corporate transactions.

Page 2 of 2

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www.potteranderson.com

December 2009

Mark A. Morton and John F. Grossbauer are partners in the Wilmington, Delaware law firm of Potter Anderson & Corroon LLP. The views expressed herein are solely those of the authors and do not necessarily represent the views of the firm or its clients.

First Principles for Addressing the Competing Interests of Common and Preferred Stockholders in an M&A Transaction

When engaged by a Delaware corporation with a common and preferred stock capital structure to provide advice in an M&A transaction, counsel should expect to face a complicated array of legal issues posed by the potentially competing nature of the interests of the common and preferred stockholders. Among other issues, counsel will be expected to advise the board on (i) the process to be used for determining the allocation of merger consideration among the common and preferred, (ii) how to overcome, or insulate the board from, potential conflicts within the boardroom, and (iii) how to account for the frequently competing, occasionally antagonistic, interests of common and preferred stockholders. In connection with such an M&A transaction, board counsel will be expected to provide clear and reliable guidance on these and other issues.

In anticipation of such engagements, counsel may wish to review the following primer, which sets forth a series of “first principles” to be considered when providing advice to boards of directors on their obligations in connection with M&A transactions involving common and preferred stock. Among other things, the primer addresses the contractual nature of preferred stock, whether the contractual rights of preferred stock may be negated or compromised, how the contractual rights of preferred stock intersect with the board’s fiduciary duties, and whether there are circumstances in which the board may favor the interests of common stockholders over those of preferred stockholders.

Fiduciary Duties of Directors

Under Delaware law, directors manage the business and affairs of the corporation.1 In fulfilling their managerial responsibilities, directors of Delaware corporations are charged with a fiduciary duty to the corporation and to all the corporation’s stockholders.2 The fiduciary obligations of directors fall into two broad categories: (i) a duty of care and (ii) a duty of loyalty. The duty of care essentially requires directors to be attentive and to inform themselves of all material facts regarding a decision before taking action. The duty of loyalty, on the other hand, requires that directors’ actions be motivated solely by the best interests of the corporation and its stockholders. The Delaware Supreme Court recently clarified that a “subsidiary element” of the duty of the loyalty is the obligation to act in good faith.3 A failure to act in good faith (i.e., bad faith) may be evidenced by an actual intent to do harm to the corporation or its stockholders or by an “intentional dereliction of duty, a conscious disregard for one’s responsibilities,” such as intentionally failing to act in the face of a known duty. 4

First Principles for Addressing the Competing Interests of Common and Preferred Stockholders in an M&A Transaction █ 2

The Contractual Nature of Preferred Stock

In general, all shares of capital stock of a corporation are equal at common law, and the preferences enjoyed by preferred owners exist only through express provisions in the “contract” between the corporation and the preferred stockholders.5 Accordingly, “to ask what are the rights of the preferred stock is to ask what are the rights and obligations created contractually by the certificate of designation.”6 However, even absent such express provisions in the contract, preferred stock has certain residual rights beyond the contract that exist:

With respect to matters relating to preferences or limitations that distinguish preferred stock from common, the duty of the corporation and its directors is essentially contractual and the scope of the duty is appropriately defined by reference to the specific words evidencing that contract; where, however, the right asserted is not a preference as against the common stock but rather a right shared equally with the common, the existence of such right and the scope of the correlative duty may be measured by equitable as well as legal standards.7

Therefore, according to Jedwab, when a board is analyzing the rights of preferred stockholders, the threshold question is whether an asserted right of the preferred is contractual — a “preferred right” — or equitable — a “residual right”.

The courts, however, have not articulated a bright-line rule to aid directors in this determination. Rather, the answer depends on the facts and circumstances generating the issue.8 Generally, however, contractual principles will govern disputes that arise out of either circumstances referred to in the contract or rights created by the contract.9 It is appropriate, therefore, to consider the rules of construction that the courts will apply when resolving such disputes.

The Rules of Contract Construction

When construing the rights afforded preferred stockholders by the terms of a certificate of incorporation or designation, a Delaware court will start by looking to general principles of contract construction.10 The court will “consider the entire instrument and attempt to reconcile all of its provisions ‘in order to determine the meaning intended to be given to any portion of it.’”11 The special rights granted to holders of preferred stock will be strictly construed, must be clearly expressed, and will not be presumed.12 When a provision is unambiguous, the court will give effect to the language as written,13 and “any ambiguity must be resolved against granting the challenged preferences, rights or powers.”14 While the Delaware courts have found that an implied covenant of good faith and fair dealing is evident in all contracts, including certificates of incorporation, the courts have rejected attempts to use the covenant of good faith and fair dealing to presume preferential rights of preferred stock that are not clearly expressed.15

First Principles for Addressing the Competing Interests of Common and Preferred Stockholders in an M&A Transaction █ 3

Preferred Stock Rights May Be Subject To Negation

Applying these rules of construction, the Delaware courts have, on a number of occasions, permitted companies to undertake transactions designed to avoid triggering or to affirmatively negate protective provisions of preferred stock. For example, there is a “long line of Delaware cases which, in general terms, hold that protective provisions drafted to provide a class of preferred stock with a class vote before those shares’ rights, preferences and privileges may be altered or modified do not fulfill their apparent purpose of assuring a class vote if adverse consequences flow from a merger and the protective provisions do not expressly afford protection against a merger.”16 Thus, in Warner Communications,17 the Court of Chancery considered whether the holders of a series of preferred stock were entitled to a class vote when the charter was amended via merger (rather than by the traditional means of a certificate of amendment) to adversely affect the terms of the series of preferred stock. In Warner, the charter expressly required a class vote of a particular series of preferred stock before the corporation could “amend, alter or repeal any of the provisions of the Certificate of Incorporation or By-laws of the Corporation so as to affect adversely any of the preferences, rights, powers or privileges of the Series B Stock or the holders thereof….”18 The Court, noting the distinction between the Delaware statutory provision governing charter amendments (Section 242) and the one governing mergers (Section 251) 19 observed that:

The draftsmen of this language — the negotiators to the extent it has actually been negotiated — must be deemed to have understood, and no doubt did understand, that under Delaware law (and generally) the securities whose characteristics were being defined in the certificate of designation could be converted by merger into “shares or other securities of the corporation surviving or resulting from [a] merger or consolidation” or into “cash, property, rights or securities of any other corporation.”

* * *

It is thus elementary that the possibility of a merger represents a possibility of the most profound importance to a holder of stock with special rights or preferences.20

For that reason, the Court indicated, it was unlikely that the draftsmen, “who obviously were familiar with and probably expert in our corporation law,” would have chosen language that so closely tracked Delaware’s statutory provision governing amendments to a charter “had they intended a merger to trigger the class vote mechanism of that section.”21

The Delaware Supreme Court subsequently adopted the reasoning of Warner when it provided guidance on how to draft charter provisions to require a class vote for a charter amendment accomplished by a merger.22 In Avatex, the Delaware Supreme Court found that the charter provision at issue in that case was drafted properly to require a class vote of a series of preferred stock to approve an amendment accomplished by merger. The charter provision specifically provided for a class

First Principles for Addressing the Competing Interests of Common and Preferred Stockholders in an M&A Transaction █ 4

vote of a series of preferred stock in the event of any “amendment, alteration or repeal, whether by merger, consolidation or otherwise, of the Restated Certificate of Incorporation . . . which would materially and adversely affect any right, preference, privilege or voting power of the First Series Preferred Stock or of the holders thereof...”23 The Delaware Supreme Court found that this language was sufficient to trigger a class vote for a merger, even when the merger was a forward merger and no actual amendment of the charter occurred.24 The Court cautioned that:

The path for future drafters to follow in articulating class vote provisions is clear. When a certificate (like the Warner certificate or the Series A provisions here) grants only the right to vote on an amendment, alteration or repeal, the preferred have no class vote in a merger. When a certificate (like the First Series Preferred certificate here) adds the terms “whether by merger, consolidation or otherwise” and a merger results in an amendment, alteration or repeal that causes an adverse effect on the preferred, there would be a class vote.25

In light of Warner, Avatex, and similar cases,26 when advising a board in connection with a transaction, counsel should consider whether the board may have an obligation to structure the transaction in a manner that avoids triggering or affirmatively negates protective provisions of the preferred stock.

The Intersection of Contractual Rights and Fiduciary Duties

In the absence of an express preference addressing an issue in dispute, counsel will be expected to determine what residual fiduciary obligations a board of directors will owe to preferred stockholders in the particular context. As previously stated, Jedwab creates a second category of rights for preferred owners: those “shared rights” that exist equally amongst preferred and common stockholders27 and therefore impose upon the board an equal duty of care and loyalty to both constituencies.28 These residual fiduciary duties generally relate to the actions of the board in decision-making and disclosure29 but they may be limited, in many circumstances, by the conflicting interests of the common and preferred stockholders. When the interests of the common stockholders and the preferred stockholders are in direct conflict (and the preferred stockholders have no express preferential rights that are implicated), the Court of Chancery has found that a board of directors may choose to favor the interests of the common stockholders over the interests of the preferred stockholders so long as the board does not violate any fiduciary duty owed to the preferred stockholders.30

Conflicting Interests in a Sale of the Company

In connection with a sale of control, a board of directors has a duty to seek to obtain the highest value reasonably attainable for the stockholders.31 However, depending upon the way in which the transaction is structured, a corporation’s common and

First Principles for Addressing the Competing Interests of Common and Preferred Stockholders in an M&A Transaction █ 5

preferred stockholders may have conflicting interests. For example, in Equity Linked Investors, L.P. v. Adams, Genta Incorporated, a Delaware corporation (“Genta”), was “on the lip of insolvency” (confirm lip and not tip) and needed “to complete a financing transaction rapidly, or else face bankruptcy” within days.32 In liquidation, Genta would have been worth less than the $30 million liquidation preference of the issued and outstanding shares of preferred stock of Genta. Thus, a natural tension developed between the common stockholders and the preferred stockholders.33 The preferred stockholders sought “a means to cut their losses, which meant, in effect, liquidating Genta and distributing most or all of its assets to the preferred.”34 Importantly, however, the Court noted that “[t]he contractual rights of the preferred stock did not … give the holders the necessary legal power to force this course of action on” Genta.35

Under those circumstances, the board of directors of Genta decided to engage in a two-step financing transaction with a lender. In the first step of the financing, the lender provided $3 million in financing to Genta in exchange for convertible notes, warrants, and an immediate right to designate a majority of the members of the Genta board. The second step of the financing involved a promise by the lender to arrange additional financing for Genta, and, if the lender were unsuccessful in locating at least $3.5 million of additional financing for Genta within six months, the lender would lose its right to designate a majority of Genta’s board.

A preferred stockholder of Genta brought suit challenging that transaction. The Court of Chancery held that the board’s decision to favor the interests of the common stockholders over the interests of the preferred stockholders was not inconsistent with the board’s duties under Revlon. The Court noted that “the facts out of which this dispute arises indisputably entail the imposition by the board of (or continuation of) economic risks upon the preferred stock which the holders of preferred did not want,” and that “this board action was taken for the benefit largely of the common stock.”36 The Court concluded, however, that “those facts do not constitute a breach of duty” because “[t]he facts of this case … do not involve any violation by the board of any special right or privilege of the … preferred stock, nor any residual right of the preferred as owner of equity.”37 Although “[w]hat the board did, in effect, was to try on behalf of the common to exploit the preferred – by imposing risks without proportionate opportunity for rewards,” the Court found that the preferred stockholders were “open to this risk legally” as “a function of the terms of its security.”38 As such, it was perfectly permissible for the Genta board to choose the course it had chosen. The Court explicitly noted that “generally it will be the duty of the board, where discretionary judgment is to be exercised, to prefer the interests of the common stock … to the interests created by the special rights … of the preferred stock, where there is a conflict.”39

Importantly, however, the Court added that, while the Genta board determined, in its business judgment, to favor the interests of the common stockholders over the interests of the preferred stockholders, it is conceivable that, in a particular circumstance, a board of directors may reach a different business judgment and, consistent with its fiduciary duties in those circumstances, favor the interests of the preferred stockholders over the interests of the common stockholders.40

First Principles for Addressing the Competing Interests of Common and Preferred Stockholders in an M&A Transaction █ 6

Conflicting Interests in the Allocation of Merger Consideration

A board of directors owes a duty of loyalty to its stockholders and, as such, must fairly distribute the proceeds of a merger or sale among all classes of stock.41 However, “fair allocation” does not require equal distribution.42 If procedural safeguards are in place during the decision-making process, the board generally will enjoy the protections of the business judgment rule.43 When such safeguards are lacking, however, a court may specifically inquire into the fairness of the allocation and the transaction.44

For example, in In re Trados Incorporated Shareholder Litigation, the plaintiff alleged that, in determining to pursue a merger and in approving a merger pursuant to which the preferred stockholders and management would receive all the merger consideration and the interests of the common stockholders would be cancelled, the Trados board members breached their duty of loyalty by improperly favoring the interests of the preferred stockholders.45 The plaintiff, a common stockholder, contended that a majority of the board of directors was interested or lacked independence when approving the merger and that the conflicted directors improperly favored the interests of the preferred stockholders. Based on the plaintiff’s allegations that a majority of the board members had employment or ownership relationships with the preferred stockholders and depended on the preferred stockholders for their livelihood, the Court held that the plaintiff sufficiently rebutted the presumption of the business judgment rule (and therefore the burden would shift to the defendants to demonstrate the entire fairness of the transaction) and denied the motion to dismiss.46

Similarly, in Oliver v. Boston University, the Court found that the plaintiffs established a breach of the board’s duty of loyalty and required the defendant directors to demonstrate the entire fairness of the board’s allocation of merger consideration between holders of common and preferred stock.47 In this case, the board of directors was comprised of individuals tied to the preferred stock who treated the merger allocation negotiations with a “surprising degree of informality.”48 Although representatives of all the preferred stockholders were involved in the negotiations, the board took no steps (such as permitting a representative of the minority common stockholders to participate in negotiations on their behalf) “to ensure fairness to the minority common shareholders.”49 For that reason, the Court held that the defendants failed to carry their burden to demonstrate the fairness of the transaction to the holders of common stock.50

In at least one case, however, the Delaware courts have suggested that a board’s duty of loyalty may be implicated if a majority of the directors own common stock and approve a transaction favoring the common stock. In FLS Holdings, the Court found that the plaintiffs established a claim for breach of the board’s duty of loyalty when no independent agency or advisor was appointed to represent the interests of the preferred stockholders during merger negotiations.51 The plaintiffs alleged that the directors owned large amounts of common stock, that the interests of the common stockholders were in conflict with the interests of the preferred stock in effectuating the merger, and that the defendant directors failed to employ an independent

First Principles for Addressing the Competing Interests of Common and Preferred Stockholders in an M&A Transaction █ 7

representative to protect the interests of the preferred. Under those circumstances, the Court found that the burden shifted to the defendant directors to demonstrate the fairness of the transaction to the holders of preferred stock.52

In each of these cases, the Court’s discomfort centered on the inherent conflict of a majority of the board and the absence of appropriate procedural protections for the equity interest(s) exposed to the potential abuses that may arise out of such conflict. At a minimum, therefore, these decisions emphasize the value of insulating procedures, such as a special committee of independent directors, a majority of minority stockholder vote, or, in the appropriate case, allowing a representative of the minority interest to participate directly in the negotiations concerning allocation.

Duty of Loyalty in Disclosures

A board of directors also owes all stockholders a duty to fairly and candidly disclose all facts material to a transaction.53 When the directors publicly or directly issue communications about the corporation, whether or not the directors request action from the shareholders, the disclosure must be made with due care and loyalty.54 A communication that is intentionally false or purposefully omits information constitutes a breach of the director’s residual duties if the omission or falsehood is intended to mislead the stockholders.55

In Kennedy, two letters sent to a preferred stockholder failed to mention an impending sale of assets that would have rendered the preferred stockholder’s shares valueless.56 According to the Court, the omitted information would have significantly affected the plaintiff’s exercise of its contractual rights.57 Similarly, in Eisenberg, the Court found the board’s disclosures misleading because they listed business and cost-saving rationales as the purposes for the corporation’s self-tender offer, when the record showed that the true purpose was to take advantage of the unusually low price of the preferred stock.58 While there was nothing per se wrong with this true purpose, failing to candidly disclose that purpose violated the board’s duty of loyalty because it omitted information material to the fairness of the tender offer.59 In the context of a self-tender, the Court noted, the candor and accuracy of a board’s disclosures are particularly important because such disclosures are not balanced with the disclosure of alternative positions.60

Conclusion

When considering an M&A transaction, a board must make a good faith business judgment as to whether the transaction is in the best interests of the company and its stockholders generally. In reaching that determination, however, the board should be cognizant of a number factors, including (i) the express contractual rights of the preferred stock as set forth in the charter or certificate of designation (e.g., blocking votes, liquidation preferences, etc.), (ii) the company’s contractual flexibility under the terms of the preferred stock to negate or overcome certain rights of the preferred

First Principles for Addressing the Competing Interests of Common and Preferred Stockholders in an M&A Transaction █ 8

stock (e.g., considering an alternative transaction structure when that would create leverage in negotiations with the preferred stockholders), (iii) whether the board suffers from a conflict (e.g., where a majority of the directors are elected by preferred stockholders and the proposed transaction would allocate some or all the merger consideration to the preferred stockholders), and (iv) whether the board may have the right or affirmative obligation to take actions with respect to the nature of the sales process or the allocation of the merger consideration that favor the interests of common stockholders over those of preferred stockholders.

Endnotes

1. 8 Del. C. § 141(a).

2. Directors of Delaware corporations owe fiduciary duties to all stockholders of the corporation they serve, not just to the holders of the particular class or series of stock that elected them. See Weinberger v. UOP, Inc., 457 A.2d 701, 710 (Del. 1983) (“Signal designated directors on UOP’s board still owed UOP and its stockholders an uncompromising duty of loyalty.”); Phillips v. Insituform of N. Am. Inc., 1987 WL 16285, at *10 (Del. Ch. Aug. 27, 1987) (“The law demands of directors … fidelity to the corporation and all its shareholders and does not recognize a special duty on the part of directors elected by a special class to the class electing them….”).

3. Stone v. Ritter, 911 A.2d 362, 369-70 (Del.2006).

4. In re Walt Disney Derivative Litig., 906 A.2d 27, 64, 66 (Del. 2006). See also Lyondell Chemical Co. v. Ryan, 970 A.2d 235, 244 (Del. 2009) (holding that the proper inquiry when deciding whether independent and disinterested directors had breached the duty of loyalty by failing to act in good faith was to consider whether they “utterly failed” to undertake their responsibilities). Bad faith will not, standing alone, directly result in a finding of personal liability. Rather, it will simply satisfy one element of a breach of the duty of loyalty. Stone, 911 A.2d at 370.

5. Jedwab v. MGM Grand Hotels, Inc., 509 A.2d 584, 593 (Del. Ch. 1985). See also Equity-Linked Investors, L.P. v. Adams, 705 A.2d 1040, 1042 (Del. Ch. 1997) (stating that “special protections offered to the preferred are contractual in nature”); Wood v. Coastal States Gas Corp., 401 A.2d 932, 937 (Del. 1979) (finding that, with respect to the conversion privilege, the rights of a preferred stockholder are “least affected by rules of law and most dependent on the share contract”).

6. HB Korenvaes Investments, L.P. v. Marriott Corp., 1993 WL 205040 (Del. Ch. June 9, 1993); see also Rothschild Inter’l Corp. v. Liggett Group, Inc., 474 A.2d 133, 136 (Del. 1984) (holding that “preferential rights are contractual in nature and therefore are governed by the express provisions of a company’s certificate of incorporation”).

7. Jedwab, 509 A.2d at 594.

8. Moore Bus. Forms, Inc. v. Cordant Holdings Corp., 1995 WL 662685, at *6 (Del. Ch. 1995).

9. Id.

10. See NBC Universal, Inc. v. Paxson Comms. Corp., 2005 WL 1038997, at *5 (Del. Ch. Apr. 29, 2005).

11. Wood, 401 A.2d at 937 (quoting Ellingwood v. Wolf’s Head Oil Refining Co., 38 A.2d 743, 747 (Del. 1944)).

12. Staar Surgical Co. v. Waggoner, 588 A.2d 1130, 1136 (Del. 1991); Rothschild Int’l Corp. v. Liggett Group Inc., 474 A.2d at 136; Wood, 401 A.2d at 937; Judah v. Delaware Trust Co., 378 A.2d 624, 628 (Del. 1977); Ellingwood v. Wolf’s Head Oil Refining Co., 38 A.2d at 747; Warner Communications, Inc. v. Chris-Craft Indus., Inc., 583 A.2d 962 (Del. Ch. 1989), aff’d, 567 A.2d 419 (Del. 1989) (TABLE).

13. Hibbert v. Hollywood Park Inc., 457 A.2d 339, 342-43 (Del. 1983).

14. In re Sunstates Corp. S’holder Litig., 788 A.2d 530, 533 (Del. Ch. 2001) (citing Sullivan Money Management, Inc. v. FLS Holdings, Inc., 1992 WL 345453, at *5 (Del. Ch. Nov. 20, 1992)).

15. Id. at 535 (analyzing a protective provision that prohibited the repurchase of shares of preferred stock of a corporation while dividends were in arrears and refusing to find that the purchase of such shares by a subsidiary of the corporation, when the charter did not specifically prohibit purchases by subsidiaries, was a violation of the implied covenant of good faith and fair dealing). See also Quadrangle Offshore (Cayman) LLC v. Kenetech Corp., 1999 WL 893575 (Del. Ch. Oct. 13, 1999) (analyzing a protective provision providing certain rights to the

First Principles for Addressing the Competing Interests of Common and Preferred Stockholders in an M&A Transaction █ 9

preferred stock upon liquidation and refusing to find that the directors of a corporation had violated a covenant of good faith and fair dealing by structuring a transaction, which the preferred stockholder alleged was a “de facto” liquidation, to avoid triggering the protective provision), aff’d, 751 A.2d 878 (Del. 2000) (TABLE).

16. Benchmark Capital Partners IV, L.P. v. Vague, 2002 WL 1732423, at *7 (Del. Ch. Jul. 15, 2002).

17. 583 A.2d 962 (Del. Ch. 1989), aff’d, 567 A.2d 419 (Del. 1989).

18. Id. at 965.

19. The voting requirements for mergers of domestic stock corporations are generally set forth in Section 251(c) of the General Corporation Law and do not provide for a class vote to approve a merger (absent a charter provision creating that right). 8 Del. C. § 251(c). The voting requirements for charter amendments are set forth in Section 242(b) of the General Corporation Law, which contemplates a class vote in certain circumstances as a matter of law (in addition to any class vote required by the terms of the charter). 8 Del. C. § 242(b).

20. Warner, 583 A.2d at 969 (citations omitted).

21. Id. at 970. See also Benchmark, 2002 WL 1732423, at *9 (finding that the holders of junior preferred stock would not have any class voting rights in connection with changes to a certificate of incorporation to be effected pursuant to a proposed merger, notwithstanding that those changes would affect the rights and preferences of the junior preferred stock adversely, because the terms of the junior preferred stock did not expressly confer class voting rights in connection with a merger).

22. Elliott Associates, L.P. v. Avatex, 715 A.2d 843 (Del. 1998).

23. Id. at 845 (emphasis added).

24. The Delaware Supreme Court found it important that the drafters included the term “consolidation” which contemplates a transaction in which the charter of the corporation would not be amended. Thus, the Court reasoned that the drafters must have intended to require a vote on a merger that effectively repealed the charter and adversely affected the series of preferred stock, regardless of whether the charter was actually amended in the merger. Id. at 851.

25. Id. at 855.

26. See Equity-Linked, 705 A.2d at 1057 (holding that, while “the board did, in effect, … try on behalf of the common stock to exploit the preferred,” the holders of preferred stock were “open to this risk legally” as “a function of the terms of its security.”).

27. Jedwab, 509 A.2d at 594.

28. Jackson Nat’l Life Insur. v. Kennedy, 741 A.2d 377, 387-89 (Del. Ch. 1999).

29. Id.

30. See Equity-Linked, 705 A.2d 1040.

31. Revlon, Inc. v. MacAndrews & Forbes Holdings Inc., 506 A.2d 173 (Del. 1986).

32. Equity-Linked, 705 A.2d at 1041, 1051.

33. The common stockholders had an interest in seeing Genta continue to develop “promising technologies in research” in an effort to obtain “a large part of the ‘upside’ gain.” The preferred stockholders, on the other hand, did not want Genta to put any of its current assets at risk, as “any loss that may eventuate will in effect fall, not on the common stock, but on the preferred stock.” Id., at 1041.

34. Id.

35. Id.

36. Id. at 1042.

37. Id.

38. Id. at 1057.

39. Id. at 1042 (emphasis added).

40. Id. (“While the board in these circumstances could have made a different business judgment, in my opinion, it violated no duty owed to the preferred in not doing so.”) (citing Credit Lyonnais Bank Nederland, N.V. v. Pathe Comm. Corp., 1991 WL 277613 (Del. Ch. Dec. 30, 1991) (finding that, when a corporation is in the vicinity of insolvency, an independent board may consider the impact upon all corporate constituencies in exercising its good faith business judgment for the benefit of the corporation)); Orban v. Field, 1997 WL 153831 (Del. Ch. Apr. 1, 1997) (engaging in a transaction in which the preferred stockholders received consideration but the common

First Principles for Addressing the Competing Interests of Common and Preferred Stockholders in an M&A Transaction █ 10

stock received nothing).

41. Id. at 387.

42. Jedwab, 509 A.2d at 596.

43. Kennedy, 741 A.2d at 387.

44. See In re Trados Inc. Shareholder Litigation, 2009 Del. Ch. LEXIS 128 (Del. Ch. July 24, 2009); Oliver v. Boston University, 2006 Del. Ch. LEXIS 75 (Del. Ch. Apr. 14, 2006); In re FLS Holdings Inc. Shareholders Litigation, 1993 WL 104562 (Del. Ch. Apr. 21, 1993).

45. 2009 Del. Ch. LEXIS 128, at *39.

46. Cf. Hokanson v. Petty, 2008 Del. Ch. LEXIS 182 (Del. Ch. Dec. 10, 2008) (dismissing common stockholders’ claim that directors breached their fiduciary duties when, after an investor exercised an option to acquire the company, the board entered into a merger pursuant to which all merger consideration was allocated to preferred stockholders).

47. 2006 Del. Ch. Lexis 75, at *118-20.

48. Id.

49. Id.

50. Id.

51. 1993 WL 104562, at *4-5

52. Id. See also Kennedy, 741 A.2d at 390-91 (Court reiterated its holding in FLS Holdings requiring directors to treat preferred stockholders with fairness and loyalty).

53. Eisenberg v. Chicago Milwaukee, 537 A.2d 1051, 1057 (Del. Ch. 1987).

54. Kennedy, 741 A.2d at 389.

55. Id.

56. Id. at 389-90.

57. Id.

58. Eisenberg, 537 A.2d at 1058-59.

59. Id. at 1060.

60. Id. at 1057.