Does Trados Matter?

• Author: Cable, Abraham J.B.

1. INTRODUCTION 312 II. TRADOS AND REACTIONS BY COMMENTATORS 314 A. The Court's Holding 314 B. The Court's Style 316 C. Reactions by Practitioners 318 D. Reactions by Legal Scholars 319 III. THE INTERVIEWEES 321 A. Location 321 B. Practice Focus & Exposure to Delaware Law 321 C. Number 325 IV. THE MODEST EFFECTS OF TRADOS 325 A. Familiarity with Trados 326 B. Ex Ante Contracts 327 1. Drag-Along Rights 327 2. NVCA Sale Right 329 C. Deal Process 330 1. Trados Territory 330 2. Independent Board or Shareholder Approval 332 3. Common-Continuation Value 333 4. Allocations to Common 334 5. The Beneficiary Question 336 V. IMPLICATIONS 338 A. What's Distinctive About Silicon Valley? 338 1. Muted Judicial Influence 339 2. Implications for Delaware Jurisprudence 341 B. Application to Trados 343 1. Tightening Trados Triggers 344 2. Fair Process Informed by Customary Process 345 a. Assessing Common-Continuation Value 345 b. Endorsing Allocations to Common? 347 VI. CONCLUSION 349 I. INTRODUCTION

   In 2013, the Delaware Chancery Court issued an opinion that reverberated loudly in Silicon Valley. In the case of In re Trados Inc. Shareholder Litigation ("Trados"), (1) the court scrutinized the action of a board of directors controlled by venture capital investors. Specifically, the court considered the board's decision to sell Trados Incorporated (the "company" or "Trados") for an amount that, in accordance with customary Silicon Valley stock terms, resulted in payouts to venture capital funds holding preferred stock but no payouts to common shareholders. After a lengthy trial, the court ultimately found that the transaction was fair to the common shareholders because of the company's limited prospects. (2) Yet the case was notable for the court's sharp critique of the board for failing to more vigilantly serve common shareholders. (3)

   The case inspired a wave of law firm memos and client alerts speculating about effects on venture capital financing terms. (4) Leading law firms, acting through the National Venture Capital Association's legal forms group, developed an elaborate contractual "sale right" intended to contract around the case's holding. (5)

   Legal scholars also took note of the case. (6) In particular, they focused on language in the opinion adopting a rule of "common maximization." (7) Under this approach to conflicts between common and preferred shareholders, a board has a paramount duty to pursue value for the common holders even when preferred holders have negotiated for control of the board. (8)

   In this Article, I check back in on Trados by asking lawyers whether the case affects how they document venture capital financings or advise boards on exit transactions. This Article relies on original interviews with 20 lawyers, most of whom work for leading Silicon Valley firms. (9) These lawyers are predominantly "startup lawyers"--a distinct segment of the legal industry that guides high-risk startups through formation, financing, and eventual exit. (10)

   I observe that Trados has a modest but noticeable effect on their advice to clients. Interviewees report that a mix of Silicon Valley norms and practical impediments thwart efforts to contract around Trados at the time a venture capital fund initially invests. (11) But interviewees report that Trados does affect the process of selling a startup. Most noticeably, boards are more systematic in assessing the value of continuing as a company. (12) At the margins, Trados may even result in special allocations to common shareholders (payments to common shareholders in excess of their base entitlement). (13) Though this customary practice appears relatively consistent across interviewees, the consensus does not necessarily extend to more conceptual matters. The interviewees do not agree on whether Trados announced a new rule, and they do not converge on a single articulation of the applicable fiduciary standard. (14)

   Beyond capturing customary practice around Trados, the interviews provide a rare glimpse of the counseling moment when judicial pronouncements are transmitted to corporate managers. This presents an opportunity to examine the reach of Delaware courts as they seek to regulate the innovation economy from afar. After all, as Edward Rock stated in his influential depiction of Delaware jurisprudence, "what the business lawyer tells the client-rather than what the judge announces to the world-is the 'law.'" (15) Yet, there has been very little systematic study of how corporate lawyers actually translate judicial pronouncements into client advice. (16)

   On this broader conceptual point, the interviewees describe a distinct business environment where Delaware law has muted effects. Due to a combination of resource restraints, litigation economics, and market realities, startups do not prioritize adherence to corporate caselaw. (17) In this environment, judicial broadcasts of corporate law principles might have less influence than they have with publicly traded companies. (18)

   I argue that this weaker "signal strength" should influence the court's judicial form. Though ambiguity may serve a recognized function in Delaware jurisprudence, a fuzzy doctrine of judicial intervention has an especially high cost in a context where boards are unable or unlikely to engage in procedural cleansing through independent board committees or disinterested shareholder votes. (19) In this setting, I recommend that Delaware courts both clarify triggers for fairness review and strive to define right-sized standards of conduct informed by existing customary practice.

   This Article proceeds in four parts. Part II provides an overview of Trados and reactions by practitioners and legal scholars. Part III describes the interviewees and their practice environment. Part IV describes the customary practice following Trados, including enhanced board process and additional payments to common holders attributable in part to the case. Part V identifies doctrinal and theoretical implications of the observations.

2. TRADOS AND REACTIONS BY COMMENTATORS

   The Trados litigation has been in the spotlight since the court issued an initial opinion in connection with a motion to dismiss in 2009. (20) The litigation remained prominent as the case went all the way to trial, resulting in a voluminous second opinion in 2013 that elaborated on the court's earlier decision. (21) This Part summarizes key aspects of the 2013 opinion and reactions by practitioners and legal scholars.

   1. The Court's Holding

      In Trados, the court confronted at least three key questions: (1) does the Trados fact pattern amount to a cognizable conflict of interest for directors affiliated with preferred shareholders, (2) if so, what fiduciary standard applies to the conflicted directors, and (3) was the transaction at issue fair to the common shareholders?

      First, the court held that board members affiliated with venture capital investors were conflicted when approving a merger resulting in payment of a liquidation preference to venture capital funds holding preferred stock. (22) Although the conflict may at first appear obvious based on the disparate payouts to common and preferred holders, the liquidation preference had been negotiated between the venture capital funds and an independent board. once an insider strikes a fair bargain with an independent board, courts will not necessarily scrutinize the performance of that agreement. (23) Accordingly, the court's analysis of the conflict hinged on the timing of the sale. (24) Drawing an analogy to long-recognized conflicts between debt (creditors) and equity (shareholders), (25) the court noted that a liquidation preference creates incentives to act conservatively and to prematurely accept acquisition proposals in circumstances where common shareholders might prefer a more risky strategy of continuing as a standalone company. (26) In these circumstances, common shareholders have nothing to lose and at least a remote chance of gaining by continuing. Preferred shareholders, in contrast, bear real risk in continuing because doing so jeopardizes their liquidation preference. (27)

      Having determined that the venture capital designees were conflicted, the court then imputed that conflict to the board's facially independent directors based on the "web of interrelationships that characterizes the Silicon Valley startup community" and a resulting "owingness" to the venture capital investors. (28) The court also found that other directors holding management positions at Trados were conflicted based on a management incentive plan providing for cash bonuses in connection with the sale. (29)

      After concluding its conflict analysis, the court then addressed the thorny question of to whom fiduciary duties are owed when the interests of common and preferred shareholders conflict. on this point (the "beneficiary question"), prior precedent and commentary proposed at least three competing theories.

      * Under the rule of common maximization, a board owes its primary duty to common shareholders when the interests of preferred shareholders and common shareholders come into conflict. (30) The board's duty is to maximize the value to common shareholders as residual claimants--in other words, to pursue all plausible value of continuing as a standalone company rather than accepting a sale price at or around preferred stock liquidating preferences.

      * Under the rule of enterprise maximization, a board's duty is to maximize the value of the entity, regardless of how proceeds will be distributed among shareholders pursuant to stock terms. (31)

      * Under the control-contingent approach, the fact that common holders ceded board control to preferred holders should be taken into account in evaluating fiduciary duty claims. Under this approach, a preferred-controlled board could favor the interests of preferred holders. (32)

      The Trados court specifically referred to each competing theory (33) and ultimately endorsed...