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From Securities Regulation Daily, July 12, 2018

Controlling investor, directors liable for nearly $20.3M for unfair transactions

By Mark S. Nelson, J.D.

Delaware Vice Chancellor Laster awarded a group of investors a total of $20,268,878 after a four-day trial at which the court found that an investor had controlled Basho Technologies, Inc. and that the investor and two directors had caused the company to engage in self-dealing transactions. A hallmark of the trial was that the defendants never made a serious attempt to show that a Series G financing that was at the heart of the shareholders’ case was entirely fair (Basho Technologies Holdco B, LLC v. Georgetown Basho Investors, LLC, Laster, J., July 6, 2018).

Investor influence. For a time, Basho Technologies was a promising technology start-up, although it often struggled to raise sufficient capital to keep its operations going. The company’s Series A, B, and C financings often involved its co-founder and CEO, who bought the company’s shares and arranged for others to invest in the company. Over time, however, Georgetown Basho Investors, LLC became increasingly enmeshed in Basho Technologies capital raises. Georgetown led the company’s Series D financing after having been turned on to the company by a mutual acquaintance from the accounting consultancy industry who knew Georgetown’s leader and Basho Technologies’ CEO.

Increasingly Basho technologies struggled to raise funds while at the same time Georgetown’s influence over the company grew. During this time, Basho Technologies’ CEO would depart (although the former CEO remained an investor for a while longer) and the company’s newly constituted leadership would narrowly avoid giving Georgetown majority control. But Georgetown eventually acquired highly favorable financing terms that afforded it blocking rights with respect to the company’s capital. A Series G financing came with even more strings attached for Basho Technologies.

In addition to the stringent financing terms, Georgetown was able to obtain additional board seats and eventually an executive committee was set up to run Basho Technologies. However, as the plaintiffs alleged, the executive committee caused Basho Technologies to engage in a series of self-dealing transactions. Basho Technologies would be placed in receivership and eventually cease operations. Plaintiff shareholders sued for breach of fiduciary duty and would eventually focus their case on Georgetown, Georgetown’s leader, and one other Basho Technologies director.

Series G funding not entirely fair. With respect to the Series G financing, the court said Georgetown’s leader easily owed a fiduciary duty to the plaintiffs because of his director status. Georgetown itself, however, required additional consideration by the court, which eventually concluded that it too owed a fiduciary duty because of the "totality of facts and circumstances" in the "aggregate" arising from Georgetown’s effort to shape Basho Technologies’ funding prospects in a draconian manner. Georgetown and its leader breached their fiduciary duties by engaging in a process and extracting a price that were not entirely fair.

Moreover, the defense of acquiescence was inapt. Said the court: "Galleher [Basho technologies’ former CEO] and the other directors faced a Morton’s Fork: approve the unfair offer or destroy the Company [footnote omitted]. Under these factual circumstances, the equitable defense of acquiescence is unavailable to the defendants."

As for the Series G remedy, the valuation chosen had Basho Technologies' common stock at $0.43 per share with a marketability discount of 22.5%; the result produced a valuation of the plaintiffs’ total stock holdings of $20,268,878. A similar valuation ($0.13 per share and 20% marketability discount) resulted in a post-Series G valuation of $2,778,228. By subtraction, the plaintiffs' damages were $17,490,650.

Remedy for self-dealing transactions. Georgetown’s leader (Davenport) and another director (Fotos), who had been appointed by Georgetown, were quickly found to owe the plaintiffs fiduciary duties because of their director status regarding post-Series G self-dealing transactions. Georgetown also owed fiduciary duties to the plaintiffs for its post-Series G behavior because it had by then acquired majority voting power in the company. As for entire fairness, the court said it could conceive of some interested transactions being entirely fair in this case, but the defendants never tried to establish that any of the transactions were entirely fair. Moreover, although the Georgetown-appointed director was, in the court’s view, not as culpable as Davenport, he could still be held jointly and severally liable.

The court then awarded the plaintiffs a form of rescissory damages (typically the award would not involve an asset whose value had declined, as was the case here) that equaled their post-Series G equity or $2,778,228, the same amount subtracted from the calculation of damages for the Series G transaction. Rescissory damages, however, are measured as of the judgment date, so the plaintiffs will get only post-judgment interest on the amount awarded.

The case is No. 11802-VCL.

Attorneys: R. Montgomery Donaldson (Polsinelli PC) for Basho Technologies Holdco B, LLC, Basho Technologies Holdco C, LLC, Basho Technologies Holdco E, LLC and Hunoby Enterprises, LLC. Barry M. Klayman (Cozen O’Connor) for Georgetown Basho Investors, LLC and Newport Beach Investors, LLC.

Companies: Basho Technologies Holdco B, LLC; Georgetown Basho Investors, LLC

MainStory: TopStory CorporateFinance CorporateGovernance CorpGovNews GCNNews DirectorsOfficers FiduciaryDuties DelawareNews

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