Don’t overplay your hand – that’s what the Delaware Court of Chancery is suggesting in a recent and important case for investors. If you own equity with control rights, “hardball” tactics like forcing “oppressive” financing terms could expose you to a breach of fiduciary duties.
Georgetown Basho Investors LLC, a fund led by Chester Davenport, began investing in data company Basho Technologies, Inc., in 2010. After a series of preferred stock financings, Georgetown gained the right to block outside capital raises. In 2014, Georgetown and Davenport forced a final preferred round that gave them control over the company and fairly egregious economics (including a 3x liquidation preference). Georgetown and Davenport took active steps to thwart outside financing pitches (including offers that the investment bankers found were more favorable to the company), controlled the negotiations with potential investors, and pushed aside management who opposed their terms. The Board of Directors rejected Georgetown’s offer, but then Georgetown refused to further fund a bridge loan, throwing the company into a liquidity crisis, and Georgetown gave the company one day to accept its final preferred round terms. After three board members resigned, Georgetown appointed a majority of the board and moved forward with the financing. Needless to say, this didn’t end well – the company later ran out of money and liquidated in 2017.
The Delaware Court of Chancery (which is, nationally, the key court for corporate governance issues) found that Georgetown and Davenport breached their fiduciary duties for self-dealing both in the preferred round and afterwards – Davenport as a board member and Georgetown as a shareholder.
Notably, and an important point for investors to remember, even though Georgetown didn’t own a majority of the stock, the Court reminded that a shareholder still owes a fiduciary duty if it exercises “control over the business affairs” of the issuer.
So is this the end of private equity investing? Well, the Court took pains to make it clear that this case is very fact-specific, pointing out that its decision doesn’t mean that there’s a “heightened risk for venture capital firms who exercise their consent rights over equity financings. … If Georgetown only had exercised its consent right, that fact alone would not have supported a finding of control. … Georgetown and Davenport did far more.”
This decision shouldn’t chill investing activity or the ability of investors to exercise their well-negotiated blocking rights. But, like in other areas of law (e.g, equitable subordination, lender liability), courts don’t like it when investors take too much advantage of their rights for their own benefit, to the exclusion of other stakeholders.
If you have any questions, please feel free to reach out to your GVM lawyer.
This information is only a summary and provides only general information about fiduciary duties and corporate law. It does not constitute legal advice, and you may not and should not rely on it.
By: Marc Hauser