On July 6, 2018, Vice Chancellor Travis Laster delivered a verdict for the plaintiffs in Basho Technologies v. Georgetown Basho Investors, No. 111802 (VCL) (Del. Ch. July 6, 2018). After a bench trial, the Delaware Chancery Court awarded approximately $20 million to former shareholders of Basho Technologies Inc. against a minority shareholder using its shareholder consent rights. The opinion explores whether, in the context of financial distress and an attempted rescue financing, minority shareholder consent rights can result in exercising “actual control over the business and affairs” of a corporation, which is the predicate for imposing fiduciary duties on a minority shareholder.

To the extent that a minority shareholder relies upon its blocking rights to obtain what might be viewed as an “unfair” advantage for itself, Basho suggests that there is potential exposure as a fiduciary. The shareholder here used its consent rights to prevent a rescue debt financing to Basho, a highly distressed company. The decision should cause investors to consider carefully relying upon shareholder consent requirements in the context of financial distress.

Interestingly, the decision used company valuations made in connection with secondary offerings to determine values before and after the self-dealing financing to calculate damages. This article continues an ongoing analysis of negative control rights previously discussed in a prior installment of this column. (See Corinne Ball, ”Distress M&A: Fifth Circuit Affirms Effectiveness of Shareholder Consent Requirement for Commencing a Bankruptcy Proceeding in Franchise Services of North America Inc.,” NYLJ (June 28, 2018).)

In Franchise Services of North America v. United States Trustee (In re Franchise Services of North America), No. 18-60093, 2018 U.S. App. LEXIS 13332 (5th Cir. May 22, 2018), the U.S. Court of Appeals for the Fifth Circuit determined that consent or blocking rights held by an investor over filing for bankruptcy were not fundamentally inconsistent with bankruptcy and that such rights did not impose fiduciary duties upon a minority shareholder, anticipating that Delaware courts would require exercising actual control as the predicate for imposing fiduciary duties.

In contrast with Franchise Services, where the corporation tried to bypass the investor's consent rights, in Basho the corporation respected the consent requirements and ultimately failed. Basho raises questions regarding the efficacy of relying upon such consent rights. Both cases involved a distressed situation, but the Chancery Court addressed the exercise of consent rights, suggesting that in distress situations aggressive pursuit of an investor's self-interest can result in the imposition of fiduciary duties on a minority shareholder.

Background

The litigation stems from Basho's liquidation and receivership in 2016. In 2010, defendant Georgetown Basho Investors LLC invested in Basho and placed Georgetown's president, Chester Davenport, on Basho's board of directors. Over the next three years, Georgetown and Davenport led or co-led several aggressive rounds of preferred stock funding. In 2012, the company began to make industry headlines as a potential cloud-based storage competitor for the likes of Amazon and others. However, by 2013, Georgetown's stewardship had pushed Basho into a “position of maximum financial distress.” At that time, Davenport and Georgetown forced through a Series G financing round that would later be characterized as “highly favorable to Georgetown and unfair to Basho and its other investors.” This final round consolidated Georgetown's control of the board and led to the departure of three incumbent seat holders.

Davenport's efforts to sell Basho to channel the bulk of the proceeds to Georgetown were unsuccessful. The Chancery Court opined that the failure of the sales effort and consequent liquidation of Basho could be attributed to “siege” tactics, which may have cooled the market's interest. Subsequently, the former holders of common and preferred stock of Basho brought this lawsuit alleging breach of fiduciary duty claims against Georgetown, Davenport, and Jonathan Fotos, a Georgetown-appointed Basho board member.

The opinion focuses on the blocking rights Georgetown acquired in funding Basho prior to the Series G round. The Chancery Court recognized that blocking rights are common features frequently demanded by preferred stock investors, giving veto rights over significant actions or corporate governance matters. At trial, plaintiffs proved that Georgetown, despite being a minority shareholder, exercised effective control through use of these rights. During a time of encroaching insolvency, Davenport rejected several funding opportunities that could have alleviated financial distress but at the cost of Georgetown losing some of these blocking rights.

Georgetown was also a lender to Basho. Evidence presented at trial indicated that Georgetown used its lender position to limit Basho's ability to draw on the credit line, to accelerate Georgetown's takeover and to stave off alternative funding offers.

The Chancery Court found that Georgetown's first term sheet included “onerous” terms: a liquidation preference at three times invested capital, a cumulative dividend at 8 percent, and the right to elect five out of the seven board seats, among others. The board was given just 72 hours to consider and eventually rejected the offer. The court characterized Davenport's reply as a threat to cut off draws provided under the loan agreement.

The record reflects additional instances during the Series G solicitation process when Davenport and Georgetown employed dilatory tactics to impede third parties from investing. During this same period, the board expressed anxiety over Basho's deteriorating financial condition. In several engagements with a superior third party offeror, Georgetown would indicate support initially, but would later withdraw its support in what appeared to be an attempt to undermine the option. The bidder eventually backed out, citing Davenport's involvement as a concern. Indeed, the court observed that “Davenport had maneuvered the Company into a position of maximum crisis.”

Under immense pressure, the board reluctantly accepted Georgetown's revised Series G offer in January 2013. As the new majority shareholder, Georgetown promptly appointed an “executive committee” and, later, a new CEO. Earl Galleher, one of the original founders and the last board member to resign, sued.

Core Holdings

Effective Control Period and Series G Round. The court first addressed whether Georgetown and Davenport owed fiduciary duties in connection with the Series G round. Davenport, as a board member, clearly did. The analysis was more difficult for Georgetown, which was a mere stockholder. The court, however, found that Georgetown also owed fiduciary duties. Delaware law imposes fiduciary obligations on stockholders who “exercise control over the business and affairs” of a corporation. Plaintiffs did not contend that Georgetown exercised this control generally, but rather with respect to a single transaction: the Series G round. The opinion cites several Chancery decisions for an amalgam of non-exhaustive elements that can show control over a transaction.

The court took specific aim at the way Georgetown wielded its Series F-derived blocking rights to exercise dominion over the Series G process. Specifically, Georgetown's ability to veto any equity financing meant the cash-starved company could not secure further funding without the stockholder's agreement. Georgetown regularly reminded the board that outside offers would need to be acceptable to it.

Beyond the blocking rights, the opinion also categorizes lending agreements as a contractual mechanism that can be used to exercise control in a transaction where it forces management to cooperate with the stockholder-lender. Four additional facts were persuasive in demonstrating shareholder control of the transaction: (1) the intentional spread of misinformation and “engaging in combative behavior,” (2) interference with management, (3) the retention of an investment bank to manage a sale process on behalf of the shareholder rather than the company itself, and (4) insisting on entry into the Series G round with onerous terms, threats, and short deliberation periods as Basho neared insolvency.

The Chancery Court reviewed the action under the entire fairness test, ruling that the process was decidedly unfair to Basho. With at least two potential investors, Georgetown directly contacted the third party and immediately expressed disappointment in the offer and indicated its intent to pursue a Georgetown-led offer—tactics that eventually eliminated those opportunities. Combined with Georgetown's limitations on lending draws to Basho, the Court found that the board was compelled to approve the Series G round in order to fund the company as a going concern. The court found that these facts “weigh[ed] heavily against a finding of fairness.”

The fair price analysis undertaken was heavily influenced by the court's view of fair process prong. The court unfavorably compared the final Series G terms to an alternative offer that Basho lost due to Georgetown's actions. The defendants drove away alternative offers, provided misinformation, and conveyed a negative image of Basho. The board rejected Georgetown's first offer as being too harsh, and only accepted the final offer—with minor changes—after being driven to the brink of insolvency.

In the end, only $2.5 million in new money resulted in exchange for Georgetown obtaining “hard” control and the fact that outside investors showed minimal interest in filling out the Series G round served to punctuate the court's finding of unfair price.

The court next found that the unfair transaction caused injury to the plaintiffs. In reply, the defendants made an estoppel-like argument that Galleher was not entitled to remedial relief because he agreed to the terms of the Series G round, essentially arguing acquiescence. Rejecting this defense theory, the court pointed to Galleher's consistent opposition to the defendants' actions, going so far as to record his objections in the board minutes filed contemporaneously with the Series G transaction documents and citing the instant case to the coerced sale in Bakerman v. Sidney Frank Importing (Del. Ch. Oct. 10, 2006). Threats of personal litigation, time constrictions for consideration of the offer, the aforementioned imposition of the Series G transaction, and Galleher's consistently voiced opposition to the transaction all fell within the Bakerman precedent.

The “Hard” Control Period. The court also agreed with plaintiffs that the defendants caused Basho to enter into unfair, self-dealing transactions after the Series G round. The initial question of status as fiduciaries was much clearer after the funding, given that Davenport was still a director and Georgetown was now the majority shareholder. The newly appointed Fotos, as a director, also owed duties. Despite a nominal deadlock of three disinterested directors to three Georgetown-related directors, the Court held that two incumbents had “stopped resisting.” One of those would depart just two weeks later, and the other was based in Japan and only rubber-stamped actions. This left Galleher as the lone dissenter.

Davenport terminated the company's consulting agreement with Galleher, deleted his company email and other accounts, and instructed managers not to communicate with him. Over Georgetown's tenure in control, the court found that “stuff just happened” without any record of deliberations or meeting minutes, including extending a consulting agreement, approving loans with Georgetown and others, and engaging consultants to solicit interest in additional investment in the Series G Round. No new investors were forthcoming. Many of these actions occurred without proper board action but were later retroactively ratified en toto at an annual meeting.

By September 2016, Basho had defaulted on its primary loan agreement. In May 2017, it ceased operations. Despite the court's observation that certain of these interested transactions may have been entirely fair, the defendants made no attempt to argue the point, rendering them presumptively unfair. The court viewed these Georgetown actions as emblematic of its unsuccessful attempt to quickly sell the company. The court noted that it was “not possible to trace the causal relationship with certainty” but nevertheless found causation in the form of a “greased slide to failure.”

Conclusion

The most notable holding in the case—that Georgetown owed fiduciary duties in connection with the Series G funding—merits consideration for all investors assessing whether to use their blocking rights in a distress situation. To the extent that the decision is viewed as determining that “control over a transaction” is sufficient to impose fiduciary liability on a minority shareholder, it suggests that the existence and use of “blocking” rights against alternative offers in a distress situation may be risk-laden, particularly where the holder is seeking to advance its own interests to the detriment of the corporation and other shareholders, including using any lender or creditor leverage that it may have.

At first blush this “control over the transaction” ruling stands in contrast to the Fifth Circuit approach which held blocking rights were enforceable. Yet the Fifth Circuit addressed a theoretical block over a bankruptcy filing, dismissing the bankruptcy case and directing questions of shareholder rights to the state court, holding that the bankruptcy court was not the forum to challenge the shareholder consent rights provided to a bona fide investor. In Franchise Services there were no actions to review.

In contrast, in Basho, the well documented actions of the minority shareholder and its representatives were clearly offensive to the court, which held the minority shareholder to a fiduciary standard in assessing the exercise of its consent rights. While perhaps due to the egregious behavior of Davenport, investors nevertheless ought to be mindful of the ruling in a distress situation where acquiescence is likely unavailable as a defense.

The significance of a financially distressed circumstance is underscored by the approach taken to calculating damages. Defendants, unable to prove the entire fairness of the Series G funding round, were held jointly and severally liable for compensatory damages of $17,490,650 plus pre- and post-judgment interest. Interestingly, this award is based on a calculation of the difference in share value from the time of the Series G round and the filing of the suit, rather than a transaction-specific award. The court rooted its valuation in two Section 409(a) valuation reports stemming from the equity funding rounds that provided “a real-time, non-litigation driven, before-and-after assessment” of Basho's value.

Furthermore, the decision awarded additional damages post Series G that were based upon a theory generally applied to effect rescission (recovery of the wrongfully controlled property). That award of nearly $2.8 million plus post-judgement interest was calculated to accord with the determination that through Georgetown's taking control of and using the property, the value was destroyed to zero. The decision leaves little doubt that disloyal fiduciaries are responsible for all changes in value during the control period.

While the second prong of damages is relatively novel, the first prong also stands as a warning—those damages are similarly the consequence of exercising control where a minority shareholder uses consent rights to block a rescue transaction and advance its own proposal. Assuming that the consent rights are transferable with the shares, one may wonder if in a distress situation the distress investor can use the consent right to advance its own rescue, takeover or sale proposal without fear of being held to a fiduciary standard and entire fairness review.

Corinne Ball is a partner at Jones Day.