Conflict of Interest Case Could Set Troubling Precedent for VCs

Cadant, a high speed modem company created at the height of the dot-com bubble, fell into financial distress in 2000.  Existing venture investors, Venrock and JP Morgan, submitted a proposal to the board for a bridge loan to the company.  A second investor group also submitted an investment proposal to Cadant’s board, but the company decided to accept the terms from the insiders.  The VCs bridge loan terms were rather aggressive (90 day term), but also indicative of the times as internet companies were imploding all over the place.  After the company spent the original bridge loan, the VCs the made a second bridge loan (this time with a 2x liquidation preference), which provided enough capital to sustain the company until its acquisition by Arris Group for $55 million.  The $55 million sale was just enough to pay off creditors and preferred shareholders.

Shortly thereafter, the common stock shareholders brought suit charging several directors with breaches of their duty of loyalty and also alleging that Venrock and JP Morgan aided and abetted the directors.  The case - CDX Liquidating Trust v. Venrock Associates – was appealed and was recently ruled upon in the 7^th Circuit Court.

It is no surprise that when things do not go as planned, people can turn against one another rather quickly.  I thought I might be helpful to walk through some background info on this case, why it matters for VCs and entrepreneurs, and how the Court’s ruling could impact venture.

Background 

• Cadant had a 7-member board comprised of 4 directors from the VC firms and 3 directors from the company.  The 3 company directors were all engineers, with “no financial experience” according to the defendants.
• Eric Copeland, a Principal at Venrock, negotiated the bridge loans on behalf of the investors, and disclosed a COI to the board before the negotiations began. 
• The sale to Arris was approved by a simple majority of both common and preffered voting together and the preferred voting separately.

Defendant’s arguments 

• The 3 engineers who represented the company did not have the financial acumen necessary to properly analyze and weight their options regarding the bridge loan.
• Mr. Copeland stated his COI, but then negotiated against the company with the help of Venrock and JP Morgan.

Some analysis

• It is hard to believe that the engineers were completely naïve, as bridge loans are fairly straightforward legal documents.  Also, the company representatives had the opportunity to consult with outside counsel, but chose not to do so.  If the engineers failed to act in the best interest of the company, is that really the VCs’ fault?  On the other hand, if the VCs dissuaded the engineers from seeking counsel, then the VCs clearly acted improperly.  Also, with such a large board, why wasn’t there an independent board member there in the first place?
• It is upsetting to see a company seek charges against a specific board member.  This is becoming more common in distressed situations as VCs are increasingly viewed as having deep pockets, while portfolio companies often lack funds to pay indemnification and lack adequate D&O insurance.  Mr. Copeland was most likely chosen to represent the VCs because he was the best they had to offer, and the board acknowledged Mr. Copeland’s COI because they believed that he would continue to serve the corporation loyally.  So, did Mr. Copeland break his fiduciary duty?  Were the engineers naïve to think that stating a COI was enough to prevent Mr. Copeland from negotiating preferred investment terms for the VCs?  Hard to say either way.  What I do know is that in 2000/2001 the internet investing world was in the tank and it was common for VCs, and begrudgingly accepted by startups, that financial terms would be aggressive for challenged companies.
• What I find troubling about the court documents is that while there is a lot of talk about VCs breaking their fiduciary duty, there is no talk about the company itself.  How many milestones did the company hit or miss?  Was it properly managed?  VCs don’t tend to arbitrarily throw aggressive terms around unless there are some fundamental underlying problems and risks that they need to hedge against.  

Court Opinion

• The Court argued that the VCs must prove that they obtained the highest reasonable value and therefore “caused” no loss to the common stock shareholders.
• The Court concluded that there is evidence that the oppressive terms of the bridge loans negotiated by Mr. Copeland contributed to Cadant’s inability to bring fair value.
• The Court rejected the defendant directors’ argument that there could be no breach of loyalty when their conflict of interest was fully disclosed.
• The Court concluded that the evidence of aiding and abetting on the part of Venrock and JP. Morgan was sufficient to get the plaintiffs to a jury.

With the case now going to jury trial, it will undoubtedly have an effect on the way VCs do business and think about their roles as company directors.  Foley & Lardner LLP does a great job of highlighting some practical lessons (shared below) that VCs can apply to avoid another case like CDX Liquidating Trust v. Venrock Associates.

“Address Board-Level Conflicts of Interest. First and foremost is the critical importance of identifying conflict of interest issues at the board level and implementing processes to address them — particularly in distressed situations, where resources and options are, by definition, constrained. An important point in the Court’s analysis was the fact that the non-VC directors did not step forward to act independently for the corporation, in light of the presence of conflicted directors.

Avoid “Sitting on Both Sides” of the Transaction. Of equal importance was the Court’s view that the VC directors used their positions to “act disloyally” — sitting on “both sides of the table” and obtaining terms favorable to them and harmful to Cadant and its common stockholders. These acts included using their knowledge that the disinterested directors would accept smaller bridge loans with shorter terms than the VCs would have expected and obtaining a 2X liquidation preference. In the Court’s view, these terms weakened Cadant’s ability to bargain with potential buyers by keeping Cadant’s runway short and reduced the likelihood that the common stockholders would receive anything.

Mere Disclosure of a Conflict Is Not Enough. An important detail the Court emphasized is that the mere disclosure of a conflict of interest does not absolve a director from liability for a subsequent breach of duty. In this case, the VC directors’ inherent conflict of interest was obvious and well known; the fact that the conflict was disclosed did not mean, however, that the VC directors could proceed to sit on both sides of the bargaining table and be immune from suit.

Prepare for Funds to Be Sued. Increasingly, VC funds are sued as “deep pocket” defendants, especially in distressed situations where portfolio companies often lack funds to pay indemnification and lack adequate (or any) D&O insurance. Here, the VC funds were claimed to have “aided and abetted” the directors’ breach of fiduciary duty. The twist is that the Court treated the funds as third-party lenders, not company insiders, and stated that they could be held liable if they, knowingly, either exploited the directors’ conflicts of interest or extracted terms that required Cadant to prefer their interests at the stockholders’ expense. Funds should consider how they will approach and handle such exposure, including the possibility of obtaining insurance or establishing reserves.

Prepare for Funds to Be Sued. Increasingly, VC funds are sued as “deep pocket” defendants, especially in distressed situations where portfolio companies often lack funds to pay indemnification and lack adequate (or any) D&O insurance. Here, the VC funds were claimed to have “aided and abetted” the directors’ breach of fiduciary duty. The twist is that the Court treated the funds as third-party lenders, not company insiders, and stated that they could be held liable if they, knowingly, either exploited the directors’ conflicts of interest or extracted terms that required Cadant to prefer their interests at the stockholders’ expense. Funds should consider how they will approach and handle such exposure, including the possibility of obtaining insurance or establishing reserves.

Watch Out for “Inside-Out” Economics. A final observation is that the claims in this case are being pursued by a liquidating trust, a creature of bankruptcy formed just for this purpose, without which the claims may not have been pursued at all. These trusts are typically funded by assets transferred from the bankrupt company’s estate — assets the VCs might have thought to be theirs, at least in part. In the absence of insurance coverage or indemnification, VCs may find that they are effectively funding, in whole or in part, both sides of an otherwise non-viable lawsuit against them.”