In re Nine Systems Corp. S’Holders Litig., Consol. C.A. No. 3940-VCN (September 4, 2014) (Noble, V.C.)

By Marisa DiLemme

In re Nine Systems Corp. S’Holders Litig. involves the 2002 recapitalization of a two-year-old start-up company, Streaming Media Corporation, later known as Nine Systems Corporation (the “Corporation”).  The Corporation was going to have to liquidate unless it could carry out two acquisitions, and the purpose of the 2002 recapitalization was to fund these acquisitions. The recapitalization was approved by four of the directors of the Board of the Corporation, one the CEO of the Corporation and the other three employees of three private equity funds, two of which provided the financing needed for the acquisitions through the recapitalization, and the third of which was given a 90-day option to participate in the recapitalization but did not do so.  The fifth director, whose firm had brought in minority stockholders, was not kept informed regarding the recapitalization, which was highly dilutive to the minority stockholders, and never fully approved it.  The terms of the recapitalization were proposed by the director whose firm was the largest participant in the recapitalization based on his estimate that the Corporation was worth $4 million, without any independent valuation of the Corporation.  After the acquisitions, the Corporation became successful, and it was sold four years later for $175 million.

The Court concluded that the three private equity groups were a control group, and therefore the recapitalization was subject to the entire fairness test.  It held that even though the terms of the recapitalization satisfied that test, the processes that resulted in those terms were not fair, and therefore the transaction was not entirely fair.  Because of that, he decided that the Plaintiffs had not been damaged, but permitted them to seek attorneys’ fees.

A second issue involved a stockholder who sold most of his shares to the Corporation while the Corporation was engaged in discussions that shortly afterward resulted in the sale, which equated to $13 per share.

In the course of its decision, the Court made a number of significant findings:

  • Concerted action by unrelated stockholders that together own a majority of the stock of a corporation can cause them to be a control group, with the obligations of a control group (they become “functionally equivalent” to a control group).
  • The fact that a director of a corporation is also a fiduciary for a large shareholder (i.e., is a “dual fiduciary”) does not reduce the obligations of the director to the shareholders of the corporation.
  • Because the corporation could not complete two planned acquisitions without new money, in determining the fairness of the terms on which the corporation obtained the new money, the value that would be added by the acquisitions is to be ignored.
  • In valuing a corporation in order to determine the fairness of a recapitalization to minority stockholders, the fact that the recapitalization would convert debt into preferred stock is to be ignored.
  • Because the value of the corporation before the recapitalization was 0 (or in fact was negative), the fact that the recapitalization hugely diluted minority stockholders for the benefit of controlling stockholders did not result in damages to the minority stockholders.
  • Because entire fairness requires both fair process and fair price, a transaction with a price within, but near the low end, of the range of fairness may not be entirely fair if the process by which the transaction was approved was not fair.
  • A purchase by the corporation of shares from a stockholder for $1 each at a time when the officers and directors were actively pursuing transactions that shortly afterward resulted in a sale for $13 per share was not fraudulent and did not breach the directors’ fiduciary obligations, because the sale discussions were not “special facts” which the Board was under a duty to disclose to the stockholder (“A Board’s internal and generalized discussions of a potential transaction and their accompanying valuations would not qualify as material information” or as a special fact that had to be disclosed).

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