Let’s say, hypothetically, that Founder starts Startup. Startup hits some speed bumps. Founder leaves. New management turns the company around. Venture capital investors, equipped with the usual panoply of information rights, board observer rights, and board seats, are aware that there are some “bluebirds of happiness” in Startup’s future. Founder – out of the loop and out of nowhere – reappears with notice that he wants to sell his Common Stock to a third party buyer on the cheap. In accordance with the terms of a customary venture capital right of first refusal, he asks whether the VC’s will waive or exercise their ROFR. Do the insider VC’s have to say anything about the coming good news, or can they just exercise their purchase right and jump on a cheap stock windfall?
Amazingly, as of 2009 this was “a matter of first impression both in Delaware courts and … elsewhere.” Latesco, L.P. v. Wayport, Inc., C.A. No. 4167-VCL Del. Ch. (July 24, 2009) (“Wayport One”), at 17. Already an important venture capital ROFR case, Wayport One skidded to a halt this month with a page turner out of the Court of Chancery called In re Wayport, Inc. Litigation, Cons., C.A. No. 4167-VCL Del. Ch. May 1, 2013 (“Wayport Two”). For ROFR basics, see AskVenture, Feld and Startup.
The Backstory: Got Wireless?
Way back in 1996, Wayport was a pioneer in the development of WiFi hotspots, i.e., the use of a wireless router to provide internet access within a defined local area. Although there was a complex stew of plaintiffs and defendants in the subject litigation, for simplicity this post will refer only to the lead plaintiff (the “Founder”) and the venture capital fund ultimately found liable for damages (referred to as “Venture Fund”). Founder was Wayport’s initial CEO and the named inventor on most of the company’s patents. As with most internet-related startups in the late 1990’s, life for venture-backed, Austin-based Wayport was good. In 1998-1999 the company closed several Preferred Stock financing rounds. Of analytical relevance is that the investors, including Venture Fund, received what appear to have been customary venture capital rights of first refusal on any sale of Founder’s shares.
As things turned out, Wayport’s business went sideways in the dot com bust. Founder transitioned from CEO to President in 2000, and left the company altogether in late 2001. Under new management, Wayport rebounded. By 2005, it was generating some $100M in annual revenue, it was profitable, and the board was thinking IPO. Strategies for monetizing the company’s still substantial patent portfolio took center stage in the board’s strategic discussions. Founder - an outsider but still the named inventor possessed of relevant technical knowledge - reappeared on the scene as an ersatz participant in those efforts … variously offering opinions and disparaging the new management team. Wayport Two, at 7-11.
Against this backdrop the events which gave rise to nearly FIVE years of litigation unfolded … . (1) Founder made a series of secondary sales of his Wayport Common Stock to a third party and to Venture Fund, (2) in the midst of Founder’s secondary sales and without informing him, Wayport sold a material portion of its patent portfolio to Cisco for (the “Cisco Patent Sale”), and (3) shortly after Founder consummated the last of his secondary sales, Wayport was acquired by ATT at roughly 5x the price per share at which he had been selling.
Founder, “certain that he had been wronged but searching for a theory of recovery,” sued Wayport, Venture Fund, Wayport’s General Counsel and others, “alleg[ing] a variety of claims sounding variously in fiduciary duty, contract, fraud, and restitution.” Wayport One, at 12. Conflating the alleged wrongs, Founder’s complaint was that in failing to inform him of, well … something, Wayport and its management misled him into selling his shares on the cheap.
As a procedural matter, various claims were dismissed, giving rise to Wayport One. In a venture capital rarity, other claims went to trial, resulting in Wayport Two.
Both cases are important reads with ample technical analysis. My own view of the combined, practical learning follows below.
A. Not a Securities Law Case
First and foremost, it is important to note that neither Wayport One nor Wayport Two are securities law cases. The Wayport cases analyze insiders’ disclosure obligations under Delaware law relating to corporate fiduciaries. Thus, the statements made in either case – for example, that there is a duty to disclose [this] or no obligation to disclose [that] – are grounded in (1) Delaware corporate laws regarding the duty of care and duty of loyalty, and (2) common law fraud as such is viewed in Delaware. There may or may not be wholly different conclusions as a matter of federal and state securities laws. More below.
B. Two Types of Transactions
Second, IMHO much of the blogging and discussion of the Wayport cases conflate and therefore confuse two fundamentally different transactions:
The first is the exercise of a standard, contractual, venture capital right of first refusal by corporate insiders in accordance with its terms (a “ROFR Exercise”). An example of a ROFR Exercise would be thus: When startup founder wants to sell his startup shares to a third party, he or she must first offer those shares for sale at the same price and on the same terms to [x], where [x] is generally one or more venture capital investors/insiders. I think of ROFR Exercises as a sort of "quasi-call option" where the founder is short and the ROFR holders – [x] in this lexicon - are long. Therefore, vis-à-vis “party [x],” Founder makes his or her investment decision at the time of entering into the ROFR. The ROFR holder - [x] - makes its investment decision to exercise/buy or waive at downstream times, prices and terms determined by Founder.
The second type of transaction relevant here is the de novo, negotiated purchase of any stockholder’s shares by a corporate insider, where that insider is at an informational advantage (i.e., the insider is “inside” as it regards material information about the business and the stockholder is “outside” that flow of information) (a “De Novo Purchase”). Note that the term "De Novo Purchase" is my verbiage meant to convey the fact that a new transaction with a new investment decision is taking place, i.e., both outsider/seller and insider/buyer are making their respective investment decisions – again, vis-à-vis each other - at the same point in time.
In my view, the Wayport cases are important not only because they provide an analytical framework for distinguishing between these transactions as a matter of Delaware law, but also because they illustrate the steep and slippery slope that can exist between them.
C. Safe Ground
As it relates to a vanilla ROFR Exercise, Wayport One says it all in plain English:
[W]hat disclosures [are required of] an insider … when exercising [a right of first refusal][?] … This appears to be a matter of first impression both in Delaware courts, and, to the best of the court’s research, elsewhere. Courts have addressed the similar, but not entirely analogous, issues that arise when corporations [repurchase unvested employee shares upon] termination of employment, but it is hard to discern any general rule …
[Nevertheless, it is possible to view a customary venture capital ROFR as granting its holder with] the unconstrained right to buy shares when a notice of an intent to sell is given [even if that holder is a fiduciary]. Many factors beyond the mere existence of a contract distinguish the exercise of a right of first refusal from situations in which the law imposes strict fiduciary fidelity[:] First, it must be said that the exercise of a right of first refusal does not involve the fiduciary in soliciting sales or even offers to sell; on the contrary, the impetus for the transaction comes from the selling stockholder who has already arranged a separate sale requiring performance under the right of first refusal. Second, the fiduciary is not involved in any price negotiation with the selling stockholder; instead, the pertinent price negotiation is between the selling stockholder and the purchaser. Third … the selling stockholder often signs a right of first refusal agreement that contains no contractual right to information; thus, he has reason to know that any decision he makes to sell once he is no longer an insider will be made without access to the broad scope of information available to insiders. These factors all suggest the justice of enforcing a right of first refusal according to its terms. Wayport One, at 17-18.
Clear enough, and hard to argue any differently.
D. Soft Ground.
In my view, Wayport was litigated for five years and through trial because what began as a ROFR Exercise morphed into a De Novo Purchase, giving rise to a fundamentally different set of perceived and actual duties. Reducing a convoluted set of facts to an analytically relevant core, the dispute at bar involved Founder’s sale of shares of Wayport Common Stock in three tranches as follows.
** Sale #1: Wayport and certain ROFR holders waived their right of first refusal, allowing Founder to sell shares to an independent third party. Sale #1 was not ultimately at issue. Sound Bite … noncontroversial ROFR waiver.
** Sale #2: While Wayport and certain ROFR holders waived their right of first refusal, Venture Fund exercised its ROFR. Effectively, Founder sold shares to Venture Fund pursuant to the terms of an enforceable ROFR agreement. Sale #2 was not ultimately at issue. Sound Bite … noncontroversial ROFR Exercise.
** Sale #3: The wheels come off. When Founder attempts to sell more shares to an independent third party, Wayport suggests that Founder “sell additional … shares” to various corporate insiders in order to secure a further ROFR waiver from the holders thereof. After much sturm and drang, and with what the court called “transactional facilita[tion]” by Wayport’s General Counsel, Founder closes Sale #3 with various corporate insiders, including Venture Fund. Sound Bite … By asking Founder to put “additional shares” in play, Wayport converted a ROFR Exercise into a De Novo Purchase giving rise to different duties and a different analysis. As the Court of Chancery said …
[T]he request for extra shares is presumed … to distinguish the case from [a ROFR Exercise]. Because [Sale #3 is] not well cabined within the four corners of the [Right of First Refusal] Agreement, general fiduciary principles apply. Wayport One, at 19-20.
E. Special Facts.
In finding that that Sale #3 was a De Novo Purchase, Wayport Two confirms that the “Special Facts Doctrine” is the current, applicable Delaware law … at least for the time being. Thus, when a director, officer or other fiduciary seeks to buy shares from or sell shares to an “outside” stockholder, there is a duty to disclose “Special Facts.” My own formulation of this [rather murky] rule of law is this: A “Special Fact” is (1) a fact, event or circumstance, (2) known to the fiduciary but not to the “outside stockholder,” that (3) substantially affects the value of the stock in question. Typical examples include “important transactions, prospective mergers, probable sales of the entire assets or business, agreements with third parties to buy large blocks of stock at a high price, and impending declarations of unusual dividends.” Wayport Two, at 33-34, citing Ballantine. Importantly, Wayport Two reminds us that a “Special Fact” is always material, but a “material fact” is not necessarily special … “[t]he standard of materiality is … lower than the standard for a special fact.” Wayport Two, at 40.
Thus, per Wayport Two
Under the “special facts” doctrine, [insider venture capital funds are] free to purchase shares from other Wayport stockholders [in a De Novo Purchase], without any fiduciary duty to disclose information about [Wayport] or its prospects, unless the information related to an event of sufficient magnitude to constitute a “special fact.” If they knew of a “special fact,” then they had a duty to speak and could be liable if they deliberately misled the plaintiffs by remaining silent. Wayport Two, at 40.
Again, clear enough.
F. Trip Wire.
After parsing through the various transactions in dispute, the Court of Chancery dismissed all of Founder’s claims against all defendants save one: A finding of common law fraud – as opposed to a breach of fiduciary duty - in connection with Venture Fund’s De Novo Purchase in Sale #3.
How the Court of Chancery reasoned to this one finding of liability gives us the practical learning of the case in my view …
*** Chancery Analysis Part 1 - Special Facts?: Since Venture Fund was a majority stockholder with a board representative and therefore a fiduciary, were there any “Special Facts” under the Special Facts Doctrine that had to be revealed to Founder in connection with Sale #3? … .
The [Cisco Patent Sale] was a milestone in [Wayport’s] process of monetizing its patent portfolio, and it was sufficiently large to enter into the decisionmaking of a reasonable stockholder. But [Founder] did not prove at trial that the [Cisco Patent Sale] substantially affected the value of [his] stock to the extent necessary to trigger the special facts doctrine. [Founder] admitted that the [Cisco Patent Sale] did not necessarily imply anything about the market value of the remaining patents, and he himself believed - before and after learning of the Cisco sale - that the rest of [Wayport’s] patent portfolio was still worth hundreds of millions of dollars… . [Thus,] [b]ecause [it] did not know of any “special facts,” [Venture Fund] did not have a fiduciary duty to speak when purchasing shares from [Founder]. Wayport Two, at 42.
So … . Nope. No Special Facts. No need to say anything.
*** Chancery Analysis Part 2 - Did Buyer Create a Duty to Speak?: Of course, as a matter of law, if a director, officer or other fiduciary chooses to speak in connection the purchase or sale of shares from “outside” stockholder, they must do so truthfully. Wayport Two, at 28-29 and 45-48. So, did Venture Fund say anything?
Yep … In the build up to Sale #3 and before the Cisco Patent Sale closed, Venture Fund emailed the following to Founder:
[In connection our purchase of your shares, we] are not aware of any bluebirds of happiness in the Wayport world right now and have graciously offered to rep that [in the stock purchase agreement]. Wayport One, at 8; Wayport Two, at 20 (emphasis added).
Not surprisingly, the meaning of the phrase “bluebird of happiness” was “hotly disputed” at trial. Read in context, the Court of Chancery agreed with Founder’s view that the term meant “any unspecified good news” rather than [Venture Fund’s] narrower interpretation that it meant “an acquisition.” Wayport Two, at 20. In any event, and while there ought to be a rule about using the phrase “bluebird of happiness” in any document associated with any sale of securities, the email was true enough as a purely factual matter when written.
*** Chancery Analysis Part 3 - The Bluebird Lands: Three weeks after the “bluebird” email, Wayport closed the Cisco Patent Sale … .
Once the Cisco sale occurred and [Venture Fund] learned of it, the “no bluebird” [email] became materially misleading, and [Venture Fund] therefore had a duty to speak. Instead, [Venture Fund] remained silent. For purposes of fraud, the decision to remain silent placed [Venture Fund] in the same position as if [it] knowingly made a false representation … Wayport Two, at 48.
*** Chancery Analysis Part 4 - Damages: Thereafter, Sale #3 was consummated. In the court’s view, Venture Fund engaged in actionable common law fraud by closing the purchase of Founder’s shares without speaking. As damages, the Court of Chancery awarded Founder an amount equal to (x) the price per share he would have received in the sale of Wayport to ATT for the shares in question, less (y) the amount he received in Sale #3 from Venture Fund … in absolute dollars approximately $470,000 in the aggregate.
G. Take Aways.
#1 - ROFR Creep.
In the final analysis, the Wayport cases boil down to this: Instead of purchasing its contractually allotted portion of shares under the terms of the applicable ROFR agreement, Venture Fund purchased (1) an allotment of supplemental shares, (2) made available for Venture Fund’s benefit, (3) by Founder, (4) at the request of a corporate officer. While there is absolutely nothing wrong with this in concept, it does alter the fiduciary duty analysis. Sound Bite … Be alert when you exceed a ROFR because different rules apply.
#2 – Email-palooza.
Wayport Two is, if nothing else, a study in the use of email. Putting aside the “bluebird” email that single-handedly created the only liability running to any defendant, Wayport Two reads like a multi-year email log among the venture capital investors, the Founder, Wayport management and outside counsel. Sound Bite … Yet another reason to remember that email is forever.
#3 – The Dangers of Being a “Transactional Facilitator.”
Although he was absolved of all liability by the Court of Chancery, Wayport’s general counsel was an individually named defendant in the suit all the way through trial. From the available public record it is hard to find fault in anything he did … . he communicated with Founder, Venture Fund, and other stockholders, he communicated with Wayport’s board and officers, he prepared at least some of the stock purchase agreements and related transfer documentation, and he supervised “his paralegal” in parts of the mechanical stock sale process. One possibility: The Court of Chancery expressly noted that it was the general counsel who first proposed to Founder that “additional shares” be made available for Venture Fund (Wayport Two, at 14). This, plus what the court described as counsel’s role as a “transactional facilitator” (Wayport Two, at 43) seemed to create sufficient questions of fact to keep him ensnared. Hmmm … a law practice post by itself for another day.
#4 – The Securities Laws Still Apply.
Nothing in the Wayport cases changes the general applicability of the securities laws to secondary sales of private company securities. For the broad reach of the antifraud rules under the federal securities laws see, e.g., Sec. & Exch. Comm’n v. Stiefel Labs. Inc., No. 11-cv-24438-WJZ (S.D. Fl. filed Dec. 12, 2011); and see also Stiefel Employees and Stiefel Retirement Plan. Sound Bite … I would submit that a founder makes an investment decision when they agree to sign a ROFR agreement, arguably making the strict execution of that agreement by its terms perfunctory; on the other hand, IMO a founder asked to pony up “additional shares” is being asked to make a new investment decision, exposing the buyer to scrutiny under the full panoply of securities laws. Complex topic, and also a post for another day.
#5 – Corporate Law Nuance.
Wayport Two reminds us that a corporation does not owe a fiduciary duty to its stockholders. Wayport Two, at 44. It is the corporation’s directors and officers that owe fiduciary duties to the corporation’s stockholders.
#6 – Corporate Hygiene.
Although it is impossible to tell from the published opinions, it appears that up to six right of first refusal agreements arguably controlled the right of first refusal at issue. At the time of the events in question, plaintiffs alleged that the operative ROFR agreements spanned a Third Amended and Restated Right of First Refusal and Co-Sale Agreement all the way through and including an Eighth Amended and Restated Right of First Refusal and Co-Sale Agreement. See Wayport One, at 6, note 2. While there is nothing per se improper about parallel ROFR agreements, I submit that the apparent ambiguity and therefore questions of fact created by the multiple operative agreements proved unhelpful when the rubber met the road in this matter. Sound Bite … Generally speaking, single, master, amended and restated agreements as to venture capital rights are a good thing (i.e., one master voting agreement, not several in parallel; one master ROFR agreement, not several in parallel, etc.).
© david jargiello 2013 all rights reserved