Thursday, October 13, 2011

What We’ve Got Here Is a Failure to Communicate

I just finished reading the Delaware Chancery Court’s opinion in Johnson v. Pederson.  To summarize, two founders squander (and allegedly misappropriate some of) their initial capital.  When they appoint a new CEO under investor pressure, he starts to investigate their wrongdoing and they promptly appoint a new board, which appoints a new CEO.  The new board and CEO quickly face problems.  A last-minute revised contract with the company's only customer/licensee (with upfront payments) manages to head off a shareholder revolt, but the new management’s positions (which are economically significant to them) are far from safe.  And they, too, conclude that they’ll have to sue one of the founders for misappropriating funds and assume that they, too, will be unceremoniously shown the door if they try.  They honestly believe that they can turn the company around but that the founders will sink it if they take back management.

The solution:  They offer a round of debt, convertible at a steep discount in the next round of preferred, to all existing shareholders.  But they offer it on such a short timeframe that no one has time to think about it, other than the board and its allies (who have advance warning and, in any event, get any deadline waivers they need).  They also secretly plan to give the new series of preferred the right to vote separately on anything requiring shareholder approval.  When they offer the new preferred to existing shareholders, they limit the total amount any shareholder can buy and downplay the supervoting rights.  As designed, most of the new supervoting preferred ends up in the hands of the board and its allies.

A little time later, the company’s sole licensee (and source of all its revenues) decides it would prefer to buy the company and, to that end, buys one of the founders’ shares (after discovering the supervoting shares and threatening the CEO that they would be “coming after you like a freight train” because of them).  The new shareholder then votes those shares (and a few more for which it gets proxies) to remove the board and sues in Delaware to void the supervoting right.

I’ll skip the legal detail (which is very worth reading if you’re a lawyer) and summarize:  No matter how important the board thinks it is to the future of the company, it breaches its fiduciary duties when it uses its powers for the primary purpose of preventing its own removal from office.  That’s not new law in Delaware, but cases applying it are relatively rare, so it’s a useful reminder.

Now I’ll back out from the facts as they unfolded and consider what should have happened.  Let’s review the parties and their interests.  The two founders would like to get value for their equity and are afraid of being held liable for their prior actions.  The company would benefit from stable management, needs cash and would like to get back the money the founders allegedly misappropriated.  The shareholders are frustrated that their investment seems to be going down the drain.  The licensee wants to buy the company.

Two solutions suggest themselves:  First, the board approaches the founders and offers to settle the company’s claims against them in exchange for some combination of money and surrendered shares (measures to mute their voting power are possible but would probably be overkill once the liabilities are released).  Second, the licensee negotiates with the board and the founders to buy the company in a deal that involves a release of the company’s claims against the founders (to secure their votes).

The first is a little better for the board.  The second is a little better for the shareholders.  What they have in common is negotiation and communication.  Instead the parties opted for wasteful trickery and litigation and look what it got them.  Yes, I know the licensee “won” but it took ten months of plotting, proxy solicitation and litigation.  And if the licensee now wants to buy out the rest of the shareholders, it will face the serious risk of fiduciary litigation inherent in a controlling shareholder transaction.

I don’t want to go too far in second guessing.  Reasonable solutions to simple problems often fail because of unreasonable people.  Maybe the founders were too crazy to take yes for an answer.  Or maybe the amount of the company’s misappropriation claims were too big to allow for a compromise.  However, there’s no indication in the opinion (rendered after a trial) that anyone actually tried to talk.  So I’m guessing it didn’t happen and it could have.

The point isn’t that we should all “just get along.”  People have differing interests.  Conflicts happen.  The point is that simple solutions often suggest themselves if you put yourself in the other parties’ shoes and look for ways to satisfy their interests.  Trickery and strong-arm tactics can be emotionally appealing, especially when you feel someone has done wrong and deserves punishment, but communication and negotiation is usually the more profitable approach.