L-R: Joanna J. Cline, Christopher B. Chuff and, M. Duncan Grant of Pepper Hamilton.

It is well-settled Delaware law that a stockholder is deemed to be a controller when it owns more than 50 percent of the corporation's stock or it owns less than 50 percent of the corporation's stock, but nevertheless exercises actual control over the corporation or the challenged decision. A recent opinion by the Delaware Court of Chancery, Basho Technologies Holdco B  v. Georgetown Basho Investors, C.A. No. 11802-VCL, provides valuable guidance on the circumstances under which a minority stockholder, such as a venture capital (VC) firm, may be deemed to be a controlling stockholder such that it owes fiduciary duties to the corporation in which it has invested.

Though the opinion thoroughly reviews a variety of factors that could potentially influence such an analysis, the upshot of the court's guidance is that, if a VC firm exercises control over the corporation to secure benefits for itself at the expense of the corporation and its other stockholders, the VC firm is at risk of being deemed a controller and to have breached the fiduciary duties that arise as a result of controller status.

The Court's Factual Findings

Basho Technologies Inc. was a promising early-stage technology company, which had a business plan of developing a distributed database product. After a number of financings led by the plaintiffs, Basho needed more money. In 2011, VC firm Georgetown Basho Investors LLC invested in Basho. Georgetown became entitled to appoint one director to Basho's five-member board of directors. Georgetown appointed its president and managing member, Chester C. Davenport, to serve in that role.

Over the next three years, Georgetown led or co-led a series of preferred stock financings for Basho. Through them, Georgetown obtained the right to designate a second director to Basho's board and gained certain contractual rights that enabled it to block Basho from raising any outside funding without Georgetown's consent. Throughout 2012, in the midst of their efforts to sell Basho, Georgetown and Davenport blocked a number of proposed financings that would have deprived Georgetown of some of its blocking rights. In lieu of those financings, Georgetown and Davenport forced Basho to enter into a loan agreement with Georgetown, and, in the following months, Davenport purposely delayed funding the draws under that agreement as a way to “force Management to cooperate with [Georgetown].”

Further, in 2013, at a time when Basho was in desperate need of funding, Georgetown and Davenport forced through a Series G financing round, which the court found was highly favorable to Georgetown and unfair to Basho and its other investors. The Series G round gave Georgetown the right to appoint a majority of the board members. Georgetown appointed Jonathan Fotos, a Georgetown employee, to Basho's board. Georgetown also took additional steps to consolidate its control of Basho by, among other things, forming an executive committee through which Davenport and another Georgetown representative ran the company.

Thereafter, Georgetown, Davenport and Fotos continued to engage in self-dealing transactions, including approving a $650,000 loan from Georgetown and a $1.5 million loan from a third-party entity that Davenport controlled. Georgetown, Davenport and Fotos also continued to turn down proposed financings that would have diluted Georgetown's equity position. Ultimately, three of Basho's outside directors, the CEO and a number of other senior managers and key employees left the company. Basho never recovered. By 2016, Basho entered receivership, and its equity was rendered worthless.

The plaintiffs, former holders of Basho common and preferred stock, filed suit against Georgetown, Davenport and Fotos, claiming that they breached their fiduciary duties both before and after the Series G financing.

The Court's Analysis

After a trial on the merits, the court found in favor of the plaintiffs and awarded them roughly $20.3 million in damages. The court began its analysis by outlining the elements that a plaintiff must prove in order to prevail on a breach of fiduciary duty claim: A plaintiff must prove the existence of fiduciary duties, a breach of those duties, and causally related injury.

In assessing whether Georgetown, a minority VC stockholder of Basho, owed fiduciary duties in connection with the Series G financing, the court explained that a stockholder is deemed to be a controller and to owe fiduciary duties only when it owns more than 50 percent of the corporation's stock or it owns less than 50 percent of the corporation's stock, but nevertheless “exercises actual control” over the corporation's board of directors or operations.

Georgetown owned less than 50 percent of Basho's stock. Therefore, the court was required to undertake the fact-specific inquiry as to whether Georgetown “exercised actual control” over the corporation. In conducting that analysis, the court reviewed a number of factors that, while neither exclusive nor dispositive, influence whether a VC firm is a controller. These factors include:

• The VC firm's ownership of a significant portion of the corporation's equity (albeit less than a majority).
• The VC firm's right or ability to designate directors (albeit less than a majority).
• The existence of provisions in governance documents that enhance the power of VC firms, such as negative voting power.
• The degree of control the VC firm has over particular directors.
• The degree of control the VC firm has over key managers or advisers that play a critical role in presenting information and making recommendations.
• The VC firm's ability to exercise contractual rights to channel the corporation into a particular outcome by blocking or restricting other paths.
• The VC firm's other commercial relationships with the corporation that provide it with leverage over the corporation, such as lending relationships.
• The ability influence decisions through high-status roles, such as CEO, chairman or founder.

Under that rubric, the court found that Georgetown exercised actual control over Basho. The court came to this conclusion based on a combination of the following factors: Georgetown's use of its contractual blocking rights to cut off the company's access to other sources of funding such that Basho had no other option than to accept Georgetown's funding proposals; Georgetown's interference with members of Basho's management; the degree of control that Georgetown had over Basho's advisers in connection with the sale and fundraising process; and Georgetown's insistence on the Series G financing, including Georgetown's threats of adverse actions if the company did not accept the Series G financing.

Notably, the court found that Georgetown used its ability to block equity raises as a potent measure to exert control over Basho. Georgetown's blocking right was significant (but not determinative) to the control analysis in this case because Basho was a “cash-burning, asset-light company that could not borrow and that required regular rounds of equity financing to build out its business.” As explained by the court, “when cash is like oxygen, self-interested steps to choke off the air supply provide a strong indicator of control.”

The court was careful to note that, although significant in this case, the ability to block equity raises will not always contribute to a finding of control. For example, “for a profitable company that can finance its own business plan out of working capital, or for a company that has access to multiple sources of financing, including debt,” the ability to block equity raises likely would not tip the scales much in favor of a finding of control.

The court also was sure to emphasize the fact-intensive nature of the control inquiry and that exercising consent rights, even in this case, is not independently sufficient to establish control. The court stated: “Lest sensitive readers fear that this decision signals heightened risk for venture capital firms who exercise their consent rights over equity financings, I reiterate that a finding of control requires a fact-specific analysis of multiple factors. If Georgetown only had exercised its consent right, that fact alone would not have supported a finding of control. The plaintiffs proved that Georgetown and Davenport did far more.”

Based on the confluence of factors described above, the court determined that Georgetown was a controller and owed fiduciary duties to Basho. It then analyzed whether Georgetown and certain of its board designees breached those duties and caused Basho causally related harm. The court concluded that they had and awarded the plaintiffs damages.

Key Takeaways

The key takeaways from the Basho decision, particularly with respect to the risk that a VC firm will be deemed to owe fiduciary duties to the corporation in which it has invested, are as follows:

• First, a VC firm may owe fiduciary duties to a corporation in which it has invested if it is deemed to be a controlling stockholder.
• Second, a VC firm may be deemed to be a controller when it owns more than 50 percent of the corporation's stock or it owns less than 50 percent of the corporation's stock, but nevertheless exercises actual control over the corporation's board of directors or operations.
• Third, determining whether a VC firm exercises actual control over the corporation is a fact-specific inquiry involving the analysis of multiple factors, including the percentage of stock the VC firm owns; how many directors the VC firm designates; the VC firm's ability to wield negative controls or other contractual rights; the degree of control the VC firm has over directors, managers or advisers; the VC firm's other commercial relationships with the corporation, such as lending relationships; and other factors that tend to increase the VC firm's ability to influence corporate decisions.
• Fourth, although potentially significant to the control inquiry in certain cases, particularly when the corporation is cash-starved, the exercise of consent rights is not determinative and, in some cases, may be deemed insignificant.
• Finally, the ultimate takeaway from the Basho opinion is that, if a VC firm exercises control over the corporation to secure benefits for itself at the expense of the corporation and its other stockholders, the VC firm is at risk of being deemed to be a controller and to have breached the fiduciary duties that arise as a result of that controller status. When in doubt, VC firms should retain experienced counsel with in-depth knowledge of Delaware law to navigate such legal questions and to help them stave off potential controller liability.

Christopher B. Chuff ([email protected]), M. Duncan Grant and Joanna J. Cline ([email protected]) are attorneys with Pepper Hamilton, resident in the firm's Wilmington office. They concentrate their practice in the areas of corporate governance and commercial litigation, stockholder litigation, fiduciary duties, and partnership and limited liability company disputes.