IN RE ORCHARD ENTERPRISES, INC. STOCKHOLDER LITIGATION
Submitted January 9, 2014
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Peter B. Andrews, FARUQI & FARUQI, LLP Wilmington, Delaware; Samuel J. Lieberman, Paulina Stamatelos, SADIS & GOLDBERG LLP, New York, New York; James S. Notis, Jennifer Sarnelli, Jonathan A. Adler, GARDY & NOTIS, LLP, New York, New York, Attorneys for Plaintiffs.
William M. Lafferty, Jay N. Moffitt, Bradley D. Sorrels, Christopher P. Quinn, MORRIS, NICHOLS, ARSHT & TUNNELL LLP, Wilmington, Delaware, Attorneys for Defendants Michael Donahue, David Altschul, Viet Dinh, Joel Straka, and Nathan Peck.
Philip Trainer, Jr., Toni-Ann Platia, ASHBY & GEDDES, P.A., Wilmington, Delaware; Kenneth J. Pfaehler, David I. Ackerman, DENTONS U.S. LLP, Washington, District of Columbia, Attorneys for Defendants The Orchard Enterprises, Inc., Dimensional Associates, LLC, Daniel Stein, and Bradley Navin.
LASTER, Vice Chancellor
In 2010, Dimensional Associates, LLC (" Dimensional" ) squeezed out the minority stockholders of The Orchard Enterprises, Inc. (" Orchard" or the " Company" ). The merger consideration was $2.05 per share. In 2012, Chief Justice Strine, writing while Chancellor, determined that the fair value of the common stock at the time of the merger was $4.67 per share. See In re Appraisal of The Orchard Enters., Inc., 2012 WL 2923305, at *8 (Del. Ch. July 18, 2012), aff'd,
__ A.3d. __, 2013 WL 1282001 (Del. Mar. 28, 2013) (TABLE). In this plenary action, the plaintiffs contend that Dimensional and the directors who approved the merger breached their fiduciary duties and should be held liable for damages.
After completing fact discovery, the parties filed cross motions for summary judgment. The plaintiffs contend that the defendants breached their duty of disclosure, that entire fairness is the operative standard of review, and that the merger was not entirely fair. They claim that Dimensional, Daniel Stein, Bradley Navin, and Michael Donahue breached their duty of loyalty and that judgment should be entered against them as a matter of law. Various combinations of defendants resist these determinations, contend that neither rescissory damages nor quasi-appraisal are available remedies, and assert that the directors who served on a special committee are exculpated from liability. The plaintiffs oddly named Orchard as a defendant, and Orchard adds that it cannot be held liable for breach of fiduciary duty or for aiding and abetting.
The plaintiffs' motion is denied except in two respects: one of the claimed disclosure violations was a material misrepresentation, and the standard of review for trial will be entire fairness with the burden of persuasion on the defendants. The defendants' motions are denied except in two respects: one of the alleged disclosure violations was factually accurate, and Orchard cannot be held liable on the theories asserted.
I. FACTUAL BACKGROUND
The facts are drawn from the materials presented in support of the cross-motions for summary judgment. When considering the plaintiffs' motion, conflicts in the evidence must be resolved in favor of the defendants, and all reasonable inferences drawn in their favor. When considering the defendants' motion, the opposite is true. The evidence in the record conflicts on many issues and can support competing inferences. At this stage of the case, the court cannot weigh the evidence, decide among competing inferences, or make factual findings.
A. Orchard And Dimensional
Orchard is a Delaware corporation that distributes music and video through digital stores and mobile carriers. Orchard's common stock traded on NASDAQ until the merger. The parties have sharply divergent views about Orchard's business prospects going into the merger, and each side has evidence that supports its view.
Dimensional is a private equity fund. Non-party Joseph D. Samberg is the founder of JDS Capital Management, LLC, the ultimate parent of Dimensional. He is also a senior executive officer of Dimensional.
Since 2007, Dimensional has controlled Orchard. As of the 2010 squeeze-out, Dimensional and its affiliates held approximately 42% of Orchard's common stock (2,738,327 shares) and 99% of its Series A convertible preferred stock (446,918 shares). Through these holdings, Dimensional wielded approximately 53.3% of Orchard's outstanding voting power.
Under an agreement that governed a transaction in 2007 that created Orchard, Dimensional received the right to designate four of the seven members of Orchard's board of directors (the " Board" ). Its designees were Greg Scholl, Stein, Donahue, and Viet Dinh.
Scholl served as Orchard's CEO until his resignation in September 2009. He is not a defendant in this action.
Stein is an executive officer and a director of Dimensional. He acted as the point man for Dimensional in the events giving rise to the merger.
Donahue is a nominally disinterested and independent director. He served as Chairman of the Board and as Chair of the special committee formed to negotiate with
Dimensional. As Chair of the special committee, he acted as the point man for Orchard in negotiating with Stein.
Discovery revealed that Donahue has long-standing ties to members of the Samberg family. Donahue and Jeff Samberg, who is Joseph's brother, have been business associates and personal friends for approximately twenty years. They attended the NCAA Final Four together every year from 1999 to 2008, and they have invested together in fifteen different companies, either directly or through Greylock Partners, a venture capital fund. Donahue and Arthur Samberg, Joseph and Jeff's father, are also long-time friends.
Discovery further revealed that during the negotiation of the merger, Donahue approached Dimensional about serving as a consultant to Orchard after the merger closed. He got the job and provided post-closing consulting services for annual compensation of approximately $108,000.
Dinh is a facially disinterested and independent director. The plaintiffs have not identified any conflict-creating ties between Dinh and Dimensional, its principals, or Orchard.
B. The First Dimensional Proposal
On November 12, 2008, Stein informed the Board that Dimensional planned to contact third parties about buying Orchard or participating with Dimensional in taking it private. Stein asked the Board to direct management to cooperate with Dimensional and meet with interested parties. Stein also asked the Board to authorize the Company to enter into non-disclosure agreements with interested parties.
On November 14, 2008, the Board agreed to Dimensional's requests and formed a special committee of independent directors (the " Initial Special Committee" ) to oversee the Company's involvement. The committee members were Donahue, Dinh, Nathan Peck, and Joel Straka. Like Dinh, Peck and Straka were facially disinterested and independent directors. Donahue, the director with the closest relationship to Dimensional, served as Chair of the Initial Special Committee. The committee hired legal counsel, Patterson Belknap Webb & Tyler LLP (" Patterson Belknap" ), and determined that depending on the type of transaction proposed, they might need to retain a financial advisor.
Dimensional contacted fifty-three parties, and eleven entered into non-disclosure agreements with the Company. Eight met with Company management. Two parties--Stripes Group and Sony Music--expressed interest after the management meetings. Stripes Group submitted an initial proposal, and discussions continued with both Stripes Group and Sony Music through March 2009. Sony Music did not make a formal proposal, and Dimensional terminated the process in April 2009. At that point, the Board dissolved the Initial Special Committee.
C. The Second Dimensional Proposal
Five months later, in September 2009, Scholl announced his resignation as CEO, and the Board appointed Stein to serve as interim CEO in his place. On October 9, Stein contacted his fellow directors individually, told them that Dimensional was considering a going-private transaction, and proposed that the subject be discussed at the next Board meeting on October 13. On October 15, Dimensional delivered a formal proposal to squeeze out the minority for $1.68 per share, a 25% premium to the then-current stock price of $1.35 per share.
In response, the Board formed a second special committee (the " Special Committee" ). The Board gave the Special Committee the exclusive power and authority
to (i) negotiate the terms of a transaction with Dimensional, (ii) terminate consideration of Dimensional's proposal, (iii) solicit interest (or respond to inquiries) from third parties, and (iv) retain independent legal and financial advisors of its choosing.
The members of the Special Committee were Dinh, Donahue, Peck, Straka, and David Altschul. Except for Altschul, all had served on the Initial Special Committee. Altschul also is a facially disinterested and independent director. Donahue again served as Chair. Patterson Belknap again served as legal counsel. This time, the Special Committee hired Fesnak & Associates, LLP (" Fesnak" ) to provide financial advice and to opine on the financial fairness of a transaction with Dimensional.
D. The Initial Negotiations
On October 24, 2009, Donahue told Stein that the Special Committee wanted him to resign as interim CEO in light of Dimensional's proposal. Donahue also told Stein that Dimensional's price was low. Later that day, Stein called back and indicated that Dimensional would increase its offer to $1.84 per share. On October 27, Stein resigned as interim CEO. He continued to serve as a director. The Board appointed Navin, previously the Company's Executive Vice President and General Manager, as interim CEO in Stein's place.
On October 30, 2009, the Company filed a Form 8-K disclosing Stein's resignation, Navin's appointment, Dimensional's initial proposal, and the subsequent increase from $1.68 to $1.84. The announcement stirred some third party interest. First to reach out was Tuhin Roy, a former executive of the Company's predecessor, who spoke with Donahue about making an alternative proposal. On November 7, Roy sent the Special Committee a letter expressing interest in a potential transaction and asking to be considered as a candidate for the CEO position. Donahue encouraged Roy to make a more formal transaction proposal.
Internally, the Special Committee worked with Fesnak and management to value Orchard's common stock. A key input was how to value the Series A. As preferred stock goes, the Series A was not a strong security. It did not have preferential cash flow rights and merely participated on an as-converted basis with the common in any dividend or distribution. For the conversion calculation, each Series A share equated to 3.33 shares of common, subject to adjustments for splits, combinations, and distributions. The Series A did carry an aggregate liquidation preference of $24.99 million, but the preference would be triggered only by a " voluntary or involuntary liquidation, dissolution or winding up" of Orchard. Transmittal Declaration of Samuel J. Lieberman (the " Lieberman Decl." ) Ex. 4 (the " Series A Certificate" ) § 2(a). The certificate of designations did not define liquidation broadly, nor did it give the Series A an extensive list of consent rights. The Series A also was not participating preferred, so after the payment of the liquidation preference, the common stockholders would " receive the remaining assets and funds of the Corporation." Series A Certificate § 2(b).
For purposes of Dimensional's squeeze-out proposal, the key question was whether to value the Series A on an as-converted basis or to base the valuation on the $25 million liquidation preference. The appraisal decision illustrates the significance of this issue. There, Chief Justice Strine held that the going concern value of Orchard was $36.8 million. If the Series A were credited with its full liquidation preference of $25 million, then 70% of that amount would go to the Series A, leaving the common stock with $1.85 per share. If the Series A were valued on an as-converted
basis, then 19% of the value would go to the Series A, leaving the common stock with $4.67 per share, the amount awarded in the appraisal.
A critical input for valuing the Series A was Section 2(c) of the Series A Certificate, which stated:
Payments and Distributions Upon Change of Control Event. For so long as any shares of Series A Preferred Stock remain outstanding, the Corporation shall not enter into or otherwise effect any transaction (or series of transactions) constituting a Change of Control Event (as defined below) unless (i) with respect to a Change of Control Event involving the sale or exclusive license of all or substantially all of the Corporation's assets or intellectual property . . . the Corporation shall as promptly as practicable thereafter liquidate, dissolve and wind up the Corporation and distribute the assets of the Corporation . . . to the Corporation's stockholders in accordance with Subsections 2(a) and 2(b) and (ii) with respect to a Change of Control Event involving a transaction in which the stockholders of the Corporation will receive consideration from an unrelated third party, the agreement governing such transaction (or series of transactions) provides that the consideration payable to the stockholders of the Corporation (whether in cash, securities or other property) shall be allocated among them in accordance with Subsections 2(a) and 2(b).
Id. § 2(c). The basic definition of a " Change of Control Event" included a merger or consolidation in which the Company or one of its subsidiaries was a constituent party, and it therefore encompassed a Dimensional squeeze-out. An exception to the basic definition excluded any merger or consolidation in which the holders of capital stock of the Company immediately before the merger continued to hold at least 51% of the capital stock of the post-transaction entity " in approximately the same proportion as such shares were held immediately prior to such merger or consolidation." Id. § 2(c)(A). A squeeze-out would not fall into the exception.
Although Dimensional has tried to portray Section 2(c) as a protective provision that benefited the Series A and Dimensional, it actually limited Dimensional's flexibility. Under the plain language of the provision, Dimensional could not engage in a squeeze-out. Section 2(c) called for Dimensional to receive its liquidation preference in a third party deal, but only if all of the transaction proceeds were distributed to Orchard's stockholders. Otherwise Section 2(c) blocked Orchard from engaging in transactions that could constitute a Change of Control Event. This decision therefore refers to Section 2(c) as the " Change of Control Block."
In late October 2009, Orchard's CFO, Nathan Fong, prepared a memo that analyzed Dimensional's proposal and the value of the Series A. Lieberman Decl. Ex. 2 (the " CFO Memo" ). The CFO Memo correctly stated that a Dimensional minority buyout would not trigger the liquidation preference:
Purchase by Dimensional of all outstanding shares of common stock not owned by Dimensional
. . . Under these circumstances, the minority stockholders would receive compensation for their shares in an amount equal to the price per share offered by Dimensional multiplied by the number of shares owned.
Sale to a Third Party of a Controlling Interest in The Orchard
In the event that Dimensional a sale [sic] of the company is consummated to a third party, the Series A Preferred
Stockholders would be entitled to receive the first $24,992,980 of the proceeds. . . .
CFO Memo at ORCHARD16954. On October 29, 2009, Fong emailed the CFO Memo to Michael Wolfe of Fesnak and to Special Committee members Donahue and Straka. The CFO Memo was reviewed with the full Board on December 11, 2009.
During a meeting on November 12, 2009, Fesnak provided the Special Committee with a preliminary valuation analysis. In those materials, Fesnak used a discounted cash flow methodology to calculate values for the company under three cases, labeled " aggressive," " neutral," and " worst." After giving 60% weight to the neutral case and 20% weight to the other cases, Fesnak determined that the minority shares of common stock for purposes of a Dimensional squeeze-out had a value of $4.84 per share. For purposes of the valuation, Fesnak valued the Series A on an as-converted basis. Fesnak did not use the $25 million face value of the liquidation preference. The Special Committee reviewed and discussed Fesnak's preliminary valuation.
In a November 17, 2009 email, Fong valued the Series A in the aggregate at just $7 million. He concluded: " I cannot see how the special committee can recommend Dimensional's offer to the minority share holders [sic]." Lieberman Decl. Ex. 3.
E. Roy Returns.
On November 18, 2009, Roy proposed to acquire all of Orchard's outstanding common stock for between $2.36 and $2.84 per share and all of the Series A for a combination of cash and equity in the post-transaction entity. The offer was conditioned on Roy's investor group obtaining financing. The Special Committee authorized the Company to enter into a non-disclosure agreement with Roy and permitted Roy to access the Company's electronic data room.
On November 23, 2009, Donahue spoke with Stein about Dimensional's squeeze-out proposal. Donahue told Stein that a third party had made a higher bid. Stein represented that Dimensional would sell to a third party as long as Dimensional received its full liquidation preference for the Series A. Based on Stein's representation that Dimensional would sell to a third party, the Special Committee told Roy to negotiate with Dimensional directly. Dimensional also negotiated directly with other third party bidders, with at least one other bidder being referred to Dimensional by the Special Committee.
On December 10, 2009, Stein told Donahue that Dimensional was not interested in Roy's bid because Roy would not pay the full liquidation preference for the Series A. Stein also cited a financing contingency in Roy's bid. On December 11, 2009, Roy withdrew his proposal because he was unable to reach an agreement with Dimensional.
F. The December 11, 2009 Meeting
On December 11, 2009, the Special Committee met. Stein attended a portion of the meeting and gave the same report on his discussions with Roy. Stein again represented that Dimensional would sell to a third party that offered pay the liquidation preference for the Series A. After Stein left, the Special Committee concluded that they would recommend a transaction with Dimensional on three conditions. First, the price offered for the common stock had to be at least in the range of $2.05 to $2.15 per share, subject to Fesnak's confirmation that such a price would be fair. Second, the merger would have to be conditioned on the affirmative vote of a majority of the minority stockholders. Third, the
merger agreement had to provide for a " go-shop" period.
The plaintiffs are deeply skeptical of the Special Committee's good faith in deciding to proceed on these conditions. They note that at the time the Special Committee made its decision, they had received advice from multiple sources indicating that the common stock would have a much higher value because the Series A liquidation preference was not triggered by a squeeze-out. The CFO Memo made this point. So did two prior memos from different outside consultants who each concluded that the Series A was not worth $25 million because there was " little to no chance" that the liquidation preference would be triggered. Lieberman Decl. Ex. 32 at ORCH53449. Both consultants valued the Series A on an as-converted basis at approximately $7 million.
G. The Final Price Negotiations
On December 14, 2009, Donahue conveyed the Special Committee's position to Stein. Stein countered at $2.00 per share with a go-shop but without a majority-of-the-minority condition. He again represented that Dimensional would sell to a third party that would pay the Series A's liquidation preference. On December 16, 2009, a third party strategic bidder contacted Donahue about a transaction.
Between December 14 and 21, 2009, Donahue and Stein continued to negotiate. On December 18, Stein raised Dimensional's offer to $2.10 per share with a go-shop but without a majority-of-the-minority condition. On December 28, another third party bidder contacted Orchard about a potential transaction.
On January 7, 2010, Stein made a new offer. He lowered Dimensional's price from $2.10 to $2.00 but proposed to include a go-shop and a majority-of-the-minority voting condition. Dimensional also wanted its expenses reimbursed if the minority stockholders voted down the transaction. Dimensional thus presented the Special Committee with a stark and self-interested choice: a lower price with a majority-of-the-minority vote, which would give the Special Committee members greater personal protection against liability, or a higher price without the increased personal protection.
On January 12, 2010, the Special Committee met to consider Dimensional's revised proposal. Fesnak informed the Special Committee that its models suggested a value of between $2.00 and $2.10 per share of common stock. To derive those ranges, Fesnak valued the Series A using the full face amount of its $25 million liquidation preference. In the appraisal proceeding, Robert Fesnak testified that he changed his valuation models and valued the Series A at its full $25 million liquidation preference because the Special Committee told him to do so.
The Special Committee decided to ask Dimensional for $2.10 per share. Donahue spoke with Stein, and on January 13, 2010, Dimensional proposed to split the difference at $2.05 per share with a go-shop and a majority-of-the-minority condition. Dimensional said it was a best and final offer.
The Special Committee met again on January 14, 2010. Based on analyses that valued the Series A using the full face amount of its $25 million liquidation preference, Fesnak indicated that it could opine that Dimensional's price was fair. The Special Committee resolved to accept the offer.
H. The Preparation Of The Transaction Documents
Over the next several weeks, Orchard and Dimensional prepared the transaction documents. During the negotiations, the
Special Committee asked Dimensional to give the minority stockholders a right to additional merger consideration if Dimensional turned around and sold Orchard to a third party for a higher price. Dimensional eventually agreed that if Dimensional sold 80% or more of Orchard's equity or assets within six months of the merger, then the minority stockholders would receive 15% of the upside.
Also during this period, Donahue interviewed three firms to conduct the go-shop process. On March 4, 2010, the Special Committee retained Craig-Hallum Capital Group LLC (" Craig-Hallum" ). On March 15, the Special Committee met to consider the final transaction documents. Still valuing the Series A using the full face amount of its liquidation preference, Fesnak opined that the merger was fair from a financial point of view to the Company's common stockholders. In rendering its opinion, Fesnak relied on a March 15, 2010 letter from Donahue which represented that " [t]he preferred stock liquidation preference at March 15, 2010 is $24.993 million." Lieberman Decl. Ex. 35 at SC3083. Fesnak's fairness opinion disclaimed providing any independent valuation of the Series A. It states, " [W]e have not made an independent evaluation or appraisal of the assets and liabilities (including contingent . . . liabilities) of the Company." Lieberman Decl. Ex. 59 at ORCH12302. The Special Committee approved the merger agreement.
I. The Go-Shop
During the go-shop process, Craig-Hallum contacted twenty-three strategic bidders and twelve financial buyers. Four entered into non-disclosure agreements. The go-shop was extended by one week, from 30 days to 37 days, to provide Craig-Hallum with additional time to complete discussions with two parties, one of which was Sony Music. No one submitted a formal proposal.
Meanwhile, shortly after the merger was announced, Rapfogel Partners Limited filed a putative class action in this court which contended that Dimensional and the Orchard directors breached their fiduciary duties by failing to pursue Roy's nominally higher proposal. Rapfogel moved for expedited proceedings, and the court denied the motion.
Roy then submitted a revised proposal for a transaction that valued Orchard at $40.99 million. Citing Roy's lack of committed financing, the Special Committee concluded that Roy's proposal was not reasonably likely to lead to a superior proposal for purposes of the no-shop clause in the merger agreement, and therefore Orchard could not talk to Roy. Roy asked to conduct due diligence, and the Special Committee declined, again citing the no-shop provision. Rapfogel renewed its motion to expedite, and the court again denied the motion.
J. The Proxy Statement And Meeting Of Stockholders
On June 18, 2010, the Company disseminated its definitive proxy statement (the " Proxy Statement" ). The Proxy Statement recommended that stockholders vote in favor of (i) the merger and (ii) an amendment to the Series A Certificate that would permit the Change of Control Block to be waived by the holders of a majority of the Series A (the " Block Amendment" ). If the Block Amendment succeeded, then the Change of Control Block actually would become a protective right for the Series A, because the Company would not be able to engage in any transaction giving rise to a Change of Control Event unless (i) the transaction fell into the exception or (ii) the Series A gave their consent.
The Block Amendment technically was not conditioned on a majority of the minority vote, so Dimensional theoretically could approve it using its own voting power. But the Block Amendment was " conditioned upon and subject to the approval of the Merger Proposal." Proxy Statement at 90; accord id., Letter to Stockholders at 2; id., Notice at 1; id. at 8. If the merger proposal was not adopted, then the Block Amendment would not be presented. As a practical matter, the Block Amendment only would take effect if holders of a majority of the minority shares approved the merger.
Orchard held its meeting of stockholders on July 29, 2010. The merger was approved, with 58% of the unaffiliated shares voting in favor. The Block Amendment also was approved. The merger closed the same day.
Orchard's post-merger financial statements valued the Series A at $7,007,115, an amount consistent with its value on an as-converted basis. Orchard's audited December 31, 2010 financial statements also valued Orchard's preferred stock at $7,007,115. Orchard's unaudited statements for December 31, 2011 likewise valued the preferred stock at $7,007,115.
K. Donahue Works For Dimensional As A Consultant On Orchard.
In July 2010, just before the stockholder meeting, Donahue emailed Navin, Orchard's interim CEO, and expressed interest in helping him work through some issues for Orchard after the merger closed. Donahue forwarded it to Stein, who thought it was an excellent idea. Six days after the merger, Donahue met with Navin, then emailed Joseph Samberg to say that he had " [j]ust finished meeting w [sic] Brad [Navin]" and was " very encouraged about his focus and direction for the biz." Lieberman Decl. Ex. 9 at SC51534. Eleven days after the merger, Donahue was consulting with Joseph Samberg about Orchard's financial statements and with Navin about whether to retain Orchard's CFO.
Dimensional paid Donahue $33,000 in cash plus $5,886.88 in reimbursed expenses for his immediate post-merger consulting work. In September 2010, Dimensional sent Donahue a term sheet for serving as a director and " Executive Consultant." He would receive $108,000 annually in cash, a grant of preferred stock worth $36,000, plus equity compensation as a director. In January 2011, Donahue entered into a Board Services and Consulting Agreement with Orchard, which provided him with 27,384 shares of the common stock. The contract recited that as of January 1, 2011, the Board had determined that the Company's common stock had a fair market value of $2.95 per share, giving the grant a value of $80,782.80. Donahue also received $189,000 in cash compensation from Orchard in 2011. His total 2011 remuneration from Orchard added up to at least $269,782.80.
L. The Sale To Sony Music
On March 3, 2012, Dimensional signed a Master Purchase and Contribution Agreement with Sony Music that provided for a merger of Orchard with a Sony entity (the " Orchard/Sony Merger" ). Sony Music's interest in Orchard dated back to November 2008, and Sony Music had contacted Orchard about a transaction on several occasions.
Stein testified in the appraisal trial that he began discussing a potential transaction with Sony Music between the " beginning of 2011" and the " summer of 2011." Orchard, C.A. No. 5713-CS, at 243-45 (Del. Ch. Apr. 22, 1012) (TRANSCRIPT). Those discussions evolved ...