A federal appeals court recently handed down a chilling reminder of the risks inherent in failing to address conflicts of interest and process issues in distressed venture capital and private equity financings. In CDX Liquidating Trust v. Venrock Associates, No. 10-1953 (March 29, 2011), the U.S. Court of Appeals for the Seventh Circuit reversed a defense judgment and sent the case back for retrial, reviving the VC directors’ exposure to fiduciary duty liability and their funds’ exposure to aiding and abetting liability.
The basic contours of the story are all too familiar to anyone who navigated the shoals of the tech meltdown of 2000 – 2002:
Cadant Inc. was an early-stage company that developed cable modem systems for high-speed Internet access to the home. Venrock and J.P. Morgan (“the VCs”) were among its backers, having provided preferred stock financing in early 2000. By the fall of 2000, Cadant, like many technology companies, was in distress. The board considered a financing proposal from an outside investor group as well as a joint proposal from the VCs. Cadant chose the latter. In January 2001, the VCs provided an $11 million bridge loan with a 90-day term and a 10-percent annual interest rate. Cadant consumed those funds in a matter of months, and the VCs provided a second, $9 million bridge that included a 2X liquidation preference.
At the time of the loans, Cadant had seven directors. Four had originally come from the VCs. There is no indication that the other directors were constituted as an independent committee or had independent legal or financial advice. Instead, they reportedly had Eric Copeland, a Cadant director and Venrock principal, handle negotiations on Cadant’s behalf, even though Mr. Copeland had an inherent conflict of interest. The Court describes the three independent directors as “engineers without financial acumen … [who] were at the mercy of the financial advice they received from Copeland and the other conflicted directors.”
Ultimately, Cadant defaulted. In dire straits, Cadant agreed to sell all of its assets for stock then worth $55 million — sufficient to satisfy Cadant’s creditors and preferred stockholders, but insufficient to leave anything for the common stockholders. Cadant filed for bankruptcy, and a liquidating trust holding Cadant’s common stock pursued claims against the VC directors and their funds. While the trial court granted the defendants judgment at the close of the plaintiff’s case, the Court of Appeals reversed, sending the case back for a second trial — nearly a decade after the events at issue.
Putting to one side the trial practice aspects of the Court’s decision, both VC and non-VC directors can draw a number of practical lessons from it.
The decision in CDX Liquidating Trust marks another point in the trend toward increased judicial scrutiny of deal terms and processes in venture capital and private equity transactions. Like the much-publicized decision of the Delaware Court of Chancery in In re: Trados Incorporated Shareholder Litigation, No. 1512-CC (July 24, 2009), CDX Liquidating Trust reinforces that special care should be taken in distressed financings and subsequent exits, particularly where the VCs may stand to recover their investment (albeit with little or no gain — scarcely the business they are in), but the common stockholders may take nothing.
Legal News Alert is part of our ongoing commitment to providing up-to-the-minute information about pressing concerns or industry issues affecting our clients and colleagues. If you have any questions about this alert or would like to discuss the topic further, please contact your Foley attorney or the following individuals:
Roger A. Lane