Delaware Court Of Chancery Ruling Provides a Cautionary Tale for Investment Fund Directors Seeking to Monetize Their Investment
In The Frederick Hsu Living Trust v. ODN Holding Corp., et al., one of the founders of ODN Holding Corporation (the “Company”) filed suit against the controlling stockholder, the board and certain officers of the Company for cash redemptions of preferred stock allegedly made in violation of statutory and common law instead of using the Company’s cash to maximize the value of the Company for the long term benefit of all stockholders. The Delaware Court of Chancery granted defendants’ motions to dismiss claims of waste and unlawful redemption. However, the Court of Chancery denied defendants’ motions to dismiss claims of breach of fiduciary duty, aiding and abetting a breach of fiduciary duty, and unjust enrichment finding that the allegations of the Plaintiff supported a reasonable inference that the entire fairness standard would apply and that individual defendants may have acted in bad faith.
In February 2008, defendant, Oak Hill Capital Partners invested $150 million in Oversee.net, a California corporation. The parties formed the Company, a new Delaware corporation, to facilitate the transaction, and in return for its cash, Oak Hill received 53,380,783 shares of preferred stock. The terms of the preferred stock gave Oak Hill the ability to exercise a mandatory redemption right beginning five years after the investment. Oak Hill began as a minority investor but purchased enough shares of common stock in 2009 to gain a majority of the Company’s voting power. After gaining majority control, the Company’s board of directors (the “Board”) was enlarged to eight members and a third Oak Hill director was appointed. The composition of the Board was three “Oak Hill Directors” and five non-Oak Hill Directors. However, these directors included the CEO, one of the co-founders a portion of whose interest was bought by Oak Hill, a long-time corporate attorney who practiced at a law firm that represented Oak Hill and was social friends with one of the Oak Hill Directors. The balance of the directors were men who regularly served on Silicon Valley company boards, a fact included in the complaint as evidence that they would be influenced by Oak Hill and want to remain on good terms with an important investor in the community.
The complaint alleges that beginning in 2011, Oak Hill caused the Company to alter its business plan by no longer focusing on growth, and instead seeking to accumulate cash that could be used to pay the redemption from which only Oak Hill could benefit. The actions alleged to be consistent with evidence of this directional reset included the sale of three of the Company’s four lines of business for less than their purchase price, decisions not to make any acquisitions after 2010, and a tripling of the Company’s cash reserves. In August of 2012, the Board formed a special committee (the “Special Committee”) to evaluate options for raising capital for the redemptions and to negotiate with Oak Hill regarding the terms of any future redemptions. The Special Committee included the director who had a social relationship, prior representation of Oak Hill and other board service with an Oak Hill Director. There were several rounds of restructuring and cost cutting occurring over the years between 2011 and 2015 at the direction of a Special Committee repeatedly formed in the context of deals and corporate actions designed to generate cash for redemptions. Notably one of the Company’s outside directors left the Board at the end of 2011. The Company actively sought debt financing to effect the redemptions but was unable to secure a transaction that would allow redemption of the preferred stock as a use of proceeds. Further, at one point the Company officers revised their view on the amount of cash reserves necessary to run the Company by half, in an apparent effort to free cash for the payment of Oak Hill’s redemption in March of 2013 of the first $45 million of Oak Hill’s preferred stock.
In February of 2014 the Board was advised of an acquirer interested in the Company’s Domain Monetization business, which was the primary source of revenue at that time. Because the proceeds of a sale could meet Oak Hill’s objective of generating cash legally available for a redemption, a Special Committee was again formed due to the conflict of interest for Oak Hill Directors. However, the Special Committee delegated the negotiations to three senior Company officers who had bonuses tied to achieving $75 million in preferred stock redemptions, a bonus plan approved by a compensation committee comprised of an Oak Hill Director and the director who had sold a portion of his investment in the Company to Oak Hill.
The transaction was approved by the Board in April and closed May of 2014. With the closing of the sale of the Domain Monetization business, Oak Hill was able to redeem another $40 million of preferred stock in September of 2014. The redemption in September of 2014 brought the total above a $75 million trigger, which entitled the officers negotiating the deal to bonuses of nearly $600,000. In determining whether there was sufficient surplus to make the redemption, the Board did not treat the Oak Hill preferred stock as a current liability as it appeared on the Company’s balance sheet (consistent with Generally Accepted Accounting Principles) for either the March 2013 or the September 2014 redemptions. The significance thereof was that the Company would not have had the legal funds for redemption if the preferred stock liability was counted.
Following the sale of the Domain Monetization business, the Company had one remaining line of business divided into Retail, Travel and Consumer Finance segments. Retail generated half of the Company’s remaining revenue at this point and the most valuable piece of the Retail segment was Shopwiki. In 2010 Shopwiki was acquired for $17 million. In December 2014, the Company sold Shopwiki for $600,000. The divestitures between 2011 and 2015 reduced the Company’s annual revenue by 92%.
Already alarmed by the sell-off of previous assets, when the plaintiff received the 2014 audited financial statements in December of 2015 and learned of the most recent redemption and the sale of Shopwiki, he sought books and records pursuant to Section 220 of the DGCL in January of 2016. On March 15, 2016 he filed this action (through his living trust, which holds his stock). The defendants moved to dismiss. The complaint states six counts: (i) breach of fiduciary duty by the individual defendants; (ii) breach of fiduciary duty by Oak Hill; (iii) aiding and abetting a breach of fiduciary duty; (iv) waste; (v) engaging in unlawful redemptions; and (vi) unjust enrichment. All claims were allowed to proceed except for waste and unlawful redemptions.
As to the individual defendants, the complaint alleged that the directors breached their fiduciary duties by abandoning the Company’s growth strategy, which was benefitting its common stockholders, in favor of selling off whole business lines and hoarding cash in order to provide the maximum amount Oak Hill could extract non-ratably from the Company by exercising its redemption right. Using the entire fairness test as the standard of review, the Court held that it can be reasonably inferred that the directors acted to maximize the value of Oak Hill’s preferred stock rather than seeking to promote the long-term value of the Company for the benefit of undifferentiated equity, and that the resulting transactions were unfair to the Company’s common stockholders. Further, the Court found support for a reasonable inference that each of the officer defendants favored Oak Hill’s interests over the undifferentiated equity because they were not independent of Oak Hill. As such the Court denied the motion to dismiss the count as to both the director and officer defendants.
Count II asserted that Oak Hill breached its fiduciary duties as a controlling stockholder by directing its employees/appointed directors to liquidate its investment in the Company and by accepting redemption payments when it knew that the funds existed as a result of defendant’s inequitable conduct. The Court found support for a reasonable inference that Oak Hill used its power as a controlling stockholder to cause the Company to sell assets and stockpile cash so that funds would be available when the redemption right ripened. Defendants argued that the complaint failed to state a claim because it plead no specifics as to directives given by Oak Hill or conduct engaged in by Oak Hill, as the corporation can only act through human agents. Oak Hill also claimed that fiduciary duties do not require self-sacrifice for the benefit of minority stockholders. The Court was not persuaded by either of defendants’ arguments and found that Oak Hill was able to extract cash to the exclusion of the Company’s other stockholders, thus supporting a reasonable inference of a breach of the duty of loyalty.
The Court briefly addressed the claim against Oak Hill for aiding and abetting. Despite the general rule that if a defendant has acted in a fiduciary capacity, then that defendant is liable as a fiduciary and not for aiding and abetting a plaintiff may proceed on both claims if it is disputed whether the defendant acted in a fiduciary capacity. While the Court found it highly likely that Oak Hill acted in a fiduciary capacity, Oak Hill did not concede the point, so it remained possible that aiding and abetting could be the plaintiff’s exclusive claim. As the factual allegations supported an inference that Oak Hill breached its duty of loyalty, those allegations also supported the similar inference that Oak Hill knowingly participated in the individual defendants’ breach of duty. Accordingly, the Court denied the motion to dismiss these claims.
The Court also denied defendants’ motion to dismiss the claim of unjust enrichment against Oak Hill and individual defendants who received bonuses on account of the $75 million redemption trigger. The decision states “[a]s its name implies, unjust enrichment is a flexible doctrine that a court can deploy to avoid injustice.” Finding it possible that the officers might have a defense to liability, yet still receive bonuses as a result of a fiduciary breach, the Court declined to dismiss the claim. Similarly, the Court found it possible that Oak Hill could show that it never acted in a fiduciary capacity and did not aid or abet a fiduciary breach. As unjust enrichment could provide the vehicle for the Company to gain back some or all of the redemption payments, the Court also declined to dismiss the Claim against Oak Hill.
The defendants were successful with their motions to dismiss the unlawful redemption claim and the waste claim. The unlawful redemption claim disputed whether the Board of Directors had legal power to cause the Company to engage in the redemptions. The plaintiff argued that if the preferred stock had been treated as a current liability for purposes of calculating surplus (consistent with the Company’s balance sheet), then the Company would have had a negative surplus when it engaged in the redemptions, thus violating Section 160 of the DGCL. However, the Court found that neither the statute nor the contractual terms of the preferred stock required the Company to treat the redemption claim as a current liability for determining surplus. As the contention that the Company violated Section 160 because the preferred stock was a current liability failed, the complaint did not state a claim upon which relief can be granted. Accordingly, that aspect of the complaint was dismissed.
Finally, the Court found that the allegations in the case did not satisfy the test for waste. For a waste claim to survive a motion to dismiss, a plaintiff must show “economic terms so one-sided as to create an inference that no person action in a good faith pursuit of the corporation’s interest could have approved the terms.” The Court granted the motion to dismiss because the consideration for the relevant transactions was not so one-sided to support a reasonable inference that the defendants irrationally squandered the Company’s assets.