Delaware Court Of Chancery Finds Controlling Investor’s Cash-Accumulation Strategy In Advance Of Preferred Stock Redemption Payments Satisfied Entire Fairness
On May 4, 2020, Vice Chancellor J. Travis Laster of the Delaware Court of Chancery ruled in a post-trial opinion that a controlling investor’s efforts to accumulate cash in anticipation of its preferred stock redemptions were entirely fair. Frederick Hsu Living Trust v. ODN Holding Corp., No. 12108-VCL (Del. Ch. May 4, 2020). Plaintiff, a common stockholder of ODN Holding Corporation, alleged that the private equity firm that held a controlling interest—including a majority of the common stock and a series of preferred stock—along with the company’s directors and officers, breached their fiduciary duties by engaging in a cash accumulation strategy, rather than seeking to enhance the company’s long-term growth. Having previously sustained plaintiff’s claims at the pleadings stage, the Court held that defendants proved at trial that their conduct was entirely fair and entered judgment in favor of defendants.
As part of an investment transaction in 2008, the private equity firm received preferred stock in the company, the terms of which included redemption rights exercisable beginning in 2013 if there were sufficient funds legally available. According to the complaint, beginning in 2011, the controller steered the company into a cash accumulation strategy to make sure the funds were available for the redemption. For example, the firm terminated the company’s CEO and instructed management to cut expenses. Subsequently, the company also sold the business that had been its “major source” of net income. In 2013 and 2014, the firm exercised its redemption rights. Plaintiff alleged that the redemptions were funded by the sale of nearly all the company’s assets for less than fair value and ultimately left the company as a shell.
The Court found that plaintiff “proved that the cash-accumulation strategy conferred a unique benefit on [the controlling firm] by creating a pool of funds that the Company would be required to use to redeem . . . [the] Preferred Stock as soon as the Redemption Right ripened.” Therefore, the Court held that, in order to avoid liability, defendants bore the burden of proving that the cash-accumulation strategy was “entirely fair.”
The Court explained that the assessment of entire fairness entails two “aspects”—fair dealing and fair price—and emphasized that they are “not separate elements of a two-part test.” The Court found that, while defendants “fell short” on the fair process dimension of the entire fairness inquiry, they ultimately proved—with the “benefit of hindsight”—that their conduct did not amount to a fiduciary wrong.
Specifically, the Court determined that defendants proved by a preponderance of the evidence that the company’s decline was not caused by the controlling firm’s self-interested conduct but rather “intense industry headwinds and competitive pressures.” Moreover, the Court concluded that there were no alternative opportunities that the company could have pursued that would have altered the outcome. Indeed, based on the evidence produced at trial, the court reasoned that the company’s common stock would have been worthless with or without the cash-accumulation strategy. The court also noted that the controlling firm held a majority of the common stock and thus had an incentive to create value and grow the company, which it tried to do in addition to securing its return of capital.
In sum, the Court explained, the “concept of fairness is . . . not a technical concept” and the “economic dimension of the analysis can be the predominant consideration in the unitary fairness inquiry.” Here, the Court found, defendants proved that it was “value-maximizing” to accumulate cash to be used for the redemptions.