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This Pepper Hamilton memo discusses the Delaware Chancery Court’s recent decision in Basho Technologies v. Georgetown Basho Investors, (Del. Ch.; 7/18) and says that venture capital funds holding minority stakes may find themselves characterized as “controlling shareholders” owing fiduciary duties.  Here’s an excerpt with some of the key factors that may lead to such a conclusion:

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.

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.

The VC firm’s contractual right to block alternative financing played a key role in the Court’s decision in this case. However, as the memo notes, the existence of strong contractual rights does not inevitably lead to a minority shareholder being considered a controller.

In that regard, in Superior Vision Services v. ReliaStar, (Del. Ch.; 8/06), the Chancery Court declined to find that a minority shareholder’s exercise of a contractual right to block a dividend made it a controlling shareholder, noting that the shareholder did not control the Board’s decision making process concerning the declaration of a dividend.  The Court said that to hold otherwise would result in “any strong contractual right, duly obtained by a significant shareholder…, [being] limited by and subject to fiduciary duty concerns.”

– John Jenkins