A Fiduciary’s Personal Benefit Can Preclude the Approval of A Settlement Agreement if the Personal Benefit is Not Fair and Reasonable

By: Megan Wotherspoon and Calvin Kennedy

By letter-order dated January 14, 2016, Vice Chancellor John W. Noble found that a fiduciary’s self-dealing and personal benefit may preclude the approval of a settlement agreement.  By this order, the court refused to approve the proposed settlement because of the equity buyback provision made available only to the plaintiff fiduciary.

In Smollar v. Potarazu, the plaintiff Marvin Smollar (“Smollar”) brought a derivative action on behalf of nominal defendant VitalSpring Technologies, Inc. (“VitalSpring”) against defendant Sreedhar Potarazu, VitalSpring’s Chief Executive Officer (“Potarazu”). Following litigation of the matter, a settlement agreement was agreed to between the parties and submitted to the court for approval (the “Settlement Agreement”). In addition to the relief sought on behalf of VitalSpring, the Settlement Agreement granted Smollar, but not other VitalSpring stockholders, the right to sell Smollar’s shares in VitalSpring back to VitalSpring for the same amount he had purchased it fifteen years ago (the “Buyback Provision”). Other VitalSpring stockholders accordingly objected to the Settlement Agreement and argued that Smollar engaged in a form of self-dealing while serving as a fiduciary.

Smollar countered the stockholders’ claims with a number of arguments: (1) the stockholders still supported the settlement, despite the Buyback provision; (2) the Buyback Provision would  merely return Smollar’s original investment; (3) the Buyback Provision was negotiated after Smollar obtained most of the settlement benefits and therefore he had no improper motivation to accept the Settlement Agreement; (4) an independent Special Review Committee recommended the Settlement Agreement, which included the Buyback Provision; (5) VitalSpring stated that the value of Smollar’s stock in VitalSpring is worth more then he will be paid in the buyback; and (6) the recommendation of VitalSpring’s board, which consists of a majority of independent directors, should be respected as a matter of business judgment.

As stated by the court, its goal when assessing a settlement agreement is to determine if it is fair and reasonable. A fair and reasonable settlement agreement is not necessarily required to treat all stockholders identically, but the court closely scrutinizes any settlement agreements that award disparate benefits. Here, the court stated that Smollar’s arguments did not demonstrate that the purchase price in the buyback was fair or that there was a valid business reason for VitalSpring to agree to the buyback. The court noted that VitalSpring, and the other stockholders, did not receive any benefit from the Buyback Provision and therefore determined that it was a special benefit negotiated only for Smollar’s benefit. Thus, although the Settlement Agreement included many benefits for VitalSpring and the other stockholders, such benefits were outweighed by the self-dealing concerns raised by the Buyback Provision. As such, the court refused to approve the Settlement Agreement because the Settlement Agreement did not appear to be fair and reasonable.

Smollar v Potarazu

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