Delaware Court Allows Fiduciary Claims Over Venture Capital Firm's Alleged Self-Dealing
The Delaware Chancery Court in a recent ruling refused to dismiss fiduciary duty claims against a venture capital firm accused of exploiting its control over a portfolio company. The Chancery Court’s decision in Carr v. New Enterprise Associates Inc. reinforces the principle that a controlling stockholder cannot take advantage of its dominant position and engage in self-dealing.
Background and Decision
Kenneth Carr, a co-founder of medical device company Advanced Cardiac Therapeutics, filed a lawsuit in My 2017 against New Enterprise Associates, one of the world’s largest venture capital firms. Carr alleged the preferred stock offering that allowed NEA to become ACT’s controlling stockholder was approved by a conflicted board and severely undervalued ACT. The lawsuit also alleged NEA orchestrated the potential sale of ACT to a third party at a low price in order to incentivize the buyer to also acquire and invest in NEA’s other portfolio companies.
Preferred Stock Offering
Following a December hearing, Chancellor Andre G. Bouchard on March 26 allowed a claim for breach of fiduciary duty to proceed against directors who approved the preferred stock offering. The court evaluated the transaction under the entire fairness standard, which requires the defendants to show the transaction “was the product of both fair dealing and fair price.” Typically, actions of directors are viewed with deference under the business judgment rule. That rule is a presumption that, in making a business decision the directors of a corporation acted on an informed basis, in good faith, and in the honest belief that the action was in the best interest of the company. The business-judgment rule insulates directors from liability if the directors acted in good faith, without conflicts of interest, and they did what they believed to be in the best interest of the corporation. If a plaintiff can show a conflict of interest, as in this case, the burden shifts to the directors to show the entire fairness of the transaction.
Chancellor Bouchard said Carr sufficiently alleged facts that called into question both the process and the price of the preferred stock offering. With respect to process, the court said the offering was approved without the benefit of a financial advisor or fairness opinion. As to price, the judge noted the stock offering placed an approximately $15 million valuation on ACT - 20% of the price that was proposed during a warrant transaction less than three months later.
“Such a gap in value in the span of just a few months, without any allegations about intervening events that increased ACT’s value meaningfully, supports an inference that NEA was able to gain control on the cheap through the series A-2 financing,” Chancellor Bouchard wrote.
The court also found the lawsuit sufficiently alleged that NEA knowingly participated in the board’s breach of fiduciary duty. One of ACT’s directors served as an NEA partner, so his alleged knowing can be imputed to NEA, the court wrote.
The court further allowed breach of fiduciary duty claims against both the directors and NEA relating to a warrant sale to the third party.
With respect to the directors, the court analyzed the transaction under the defendant-friendly business judgment rule. Nonetheless, the court found Carr pled facts such that it is reasonably conceivable that the directors breached their duties in connection with the approval of the transaction. The court found, among other things, there was an “objectively superior” offer, yet the board did not pursue that offer or use it to attempt to extract a higher price from from the third party.
As to NEA, the court said Carr alleged, in essence, that NEA prioritized its fund’s overall rate of return over maximizing value for ACT’s stockholders, which “is precisely the kind of behavior that controllers may not engage in under Delaware law.”