April 5, 2018

Fiduciary Duties: Conflicts Snare VC Firm in Shareholder Claim

Conflicts are frequently a fact of life for VC & PE funds and their portfolio companies. But this Wilson Sonsini memo says that a recent Delaware Chancery Court decision is a reminder of the significant risks that that those conflicts can create for both the portfolio company’s board and the funds themselves.

In Carr v. New Enterprise Associates, (Del. Ch.; 3/18), Chancellor Bouchard declined to dismiss fiduciary duty claims against a VC investor & the board of its portfolio company. The lawsuit alleges breaches of the duty of loyalty involving a preferred financing round & the subsequent issuance of an option to buy the company to a 3rd party.

The exercise of the purchase option was contingent upon the 3rd party’s acquisition of another company backed by the VC investor – and the plaintiff also alleged that the holder of the purchase option had provided $31.5 million in funding to a separate company in which the VC firm was the largest investor.

The plaintiff argued that the preferred financing undervalued the company, involved conflicts, and inappropriately allowed the VC investor to gain a control stake. Here’s an excerpt summarizing the plaintiff’s argument & the Chancellor’s decision:

The essence of the alleged conflicts was that the board members were either affiliated with the venture firm, were participating themselves in the financing, or were members of management of other portfolio companies of the venture firm.

The court also refused to dismiss a claim that the venture firm had aided and abetted—”knowingly participated” in—the alleged breaches, given that the venture firm had a designee on the board who was partner of the firm and was allegedly “deployed” to seek an unfair price. At least at the pleadings stage, the court appeared receptive to criticisms that although the venture firm gained control of the company in the round, the board did not use a financial advisor or obtain a fairness opinion and only a “select” group of investors was allowed to participate.

As for the issuance of the warrant and the potential sale to the third party, the founder argued that the transaction was part of an orchestrated strategy to induce the third party to provide benefits to other portfolio companies of the venture firm in question. The court allowed this claim to go forward on similar grounds and also found for purposes of the motion to dismiss that, by the time the warrant was granted, the venture firm was a controlling stockholder, potentially with its own fiduciary duties and a conflict of interest.

The memo goes on to address the practical problems that Delaware’s fiduciary standards can create for VC firms & portfolio company directors.  Personal & business relationships between directors and funds can create potential conflicts of interest, while the participation in transactions by the funds or their affiliates can create conflicts for their principals with board seats.  Funds with substantial ownership & board ties also face the risk of controlling stockholder status, or risk an aiding & abetting claim.

This Francis Pileggi blog points out that the Chancellor’s opinion also includes a review of Delaware case law on the potential applicability of Revlon-like duties to a deal involving a controlled company.

John Jenkins