In Manti Holdings v. The Carlyle Group (June 3, 2022), the Delaware Court of Chancery held that entire fairness review would apply to the challenged sale of The Carlyle Group’s portfolio company, Authentix Acquisition Corp., due to the pressure Carlyle allegedly exerted to cause a quick sale so that it could close out its fund, Carlyle Holdings, that had invested in the company. The court acknowledged that controlling stockholders generally have the same incentive as other stockholders to maximize stockholder value in a sale to a third party and that, as a result, a controller’s desire for liquidity typically has not been a basis for rejecting business judgment review of a challenged transaction. In this case, however, the court viewed Carlyle’s alleged desire to close out its fund as having rendered it conflicted such that the more stringent entire fairness standard of review was applicable. Vice Chancellor Glasscock wrote: “[T]he reality is that rational economic actors sometimes
do place greater value on being able to access their wealth than on accumulating their wealth.”
- The decision reinforces the court’s trend in recent decisions in finding it plausible that a sponsor’s desire for liquidity may create a disabling conflict. Notably, however, the factual context in which the court reached its decision included the board not having established a special committee to exclude the sponsor-affiliated directors; testimony that Carlyle exerted pressure on the directors to approve the merger; and a non-ratable benefit from the merger for the sponsor in obtaining a profit on its preferred stock investment while the holders of the common stock received almost nothing.
Background. To encourage Carlyle to invest in and become a controller of Authentix, the stockholders had entered into a stockholders agreement pursuant to which they agreed not to oppose any sale of Authentix approved by the board and by a majority of the outstanding shares (in other words, approved by the board and Carlyle). In 2017, the board and Carlyle approved a sale of Authentix to Blue Water Energy for $70 million. Under the terms of the stockholders agreement, the holder of the company’s preferred stock was entitled to receive the first $70 million of consideration paid in a sale of the company. Thus, with a sale at $77.5 million, Carlyle (as the holder of Authentix’s preferred stock) would make a profit on its preferred stock investment but the common stockholders (including the plaintiffs) would receive almost nothing for their stock. Litigation ensued. In previous decisions in the case, the court held that the terms of the stockholders agreement (i) constituted a waiver by the common stockholders of their statutory appraisal rights and (ii) did not preclude the plaintiffs from bringing a fiduciary suit against Carlyle and the Authentix directors. In this most recent decision, the court held that the plaintiffs had adequately stated a claim for breach of fiduciary duties by Carlyle and the Carlyle-affiliated directors on the Authentix board.
The court found it reasonably conceivable that the sale was a conflicted controller transaction and entire fairness review thus applied. The five-person Authentix board included two directors closely affiliated with Carlyle. The court readily concluded that it was reasonably conceivable (the standard for the survival of claims at the pleading stage) that the two directors, together with three
Carlyle entities (the fund owning a majority of Authentix’s stock, the general manager of the fund (which had a management agreement with Authentix), and the ultimate parent private equity firm), exercised control over Authentix. In addition, the court concluded that it was reasonably conceivable that Carlyle received a “unique benefit” from closing the sale quickly, which rendered the sale a conflicted controller transaction—and thus subject to entire fairness review.
The court found it reasonably conceivable that Carlyle derived a “unique benefit” from the sale and may have breached its fiduciary duties. The court noted the testimony of one of Carlyle’s representatives on the board that he was “under pressure” from Carlyle to sell the company quickly because it was one of the last investments still open in the applicable fund and Carlyle wanted to monetize and close the fund. This led the court to conclude that it was reasonably conceivable that Carlyle derived a unique benefit from the timing of the sale that was not shared by the other stockholders, in the context of the following factors:
- As noted, Carlyle received a non-ratable benefit in the merger from its holdings of Authentix preferred stock;
- Uncertainties about contracts that were key to Authentix’s business (and had resulted in several potential bidders dropping out of the process and all of the bidders including a large contingent component in their offer prices) were resolved, but Authentix nonetheless proceeded with the sale to Blue Energy without seeking to renegotiate or to reengage with other bidders; and
- The sole director who objected to the sale (initially urging that the timing be delayed until the contractual uncertainties were resolved, and later arguing against a sale price that would provide a profit to Carlyle while providing nothing for the other common stockholders) was ultimately excluded from the board’s deliberations on the sale.
The court found it reasonably conceivable that the Carlyle-affiliated Authentix directors may have breached their fiduciary duties. The court emphasized that these directors, as “dual fiduciaries” on both sides of the transaction, were “required to demonstrate their utmost good faith and the most scrupulous inherent fairness of the bargain.” Despite their dual fiduciary status, the court noted, the board did not form a special committee to insulate the sale process from their influence and they in fact participated in the sale process throughout and voted to approve the sale. As discussed, one of them testified that he was motivated to sell Authentix because Carlyle wanted to close its fund. Also, as noted, the board allegedly excluded from the process the lone director opposing the sale. On this basis, the court concluded that the Carlyle-affiliated directors may have acted disloyally in connection with the sale.
- Timing of the sale of a portfolio company should not be based solely on the PE sponsor’s desire to close out its investment fund. A sponsor’s desire for liquidity does not necessarily negate an identity of interest with the common stockholders in maximizing the sale price of the company. However, such a desire, when combined with aspects of the sale process indicating a disregard for maximizing the sale price for the common stockholders, can support a reasonable inference of fiduciary breach. Where the sponsor has a desire for liquidity, its representatives and the other directors on the portfolio company board should understand the reasons motivating the sale other than the sponsor’s desire for liquidity and those reasons should be reflected in the record.
- Directors generally should not exclude a dissenting voice in the boardroom. Where a director opposes a proposed sale, absent a specific reason to exclude the dissenting director, the other directors generally should listen to and consider the dissenting director’s views although they may disagree with and ultimately reject them.