Private Equity Firm Proves Strategy was Entirely Fair
Private equity firm Oak Hill Capital Partners owned ODN Holding Corporation, a holding company for Oversee.net. Oak Hill owned a majority of the Company’s common stock and all of its Series A Preferred Stock (the “Preferred Stock”). Oak Hill’s holdings gave it control over the Company at both the stockholder and board levels.
In 2011, after a potential M&A deal fell apart, Oak Hill focused on its right to compel the Company to redeem its Preferred Stock at its liquidation preference of $150 million (the “Redemption Right”). The Redemption Right was not effective until February 2013. Oak Hill used the intervening period to bolster available cash so the redemption right could be lawfully exercised. In mid-2011, Oak Hill terminated the Company’s CEO and instructed management to cut expenses to improve profitability. When the Company sold two of its four business units in January 2012, it did not reinvest the proceeds.
With the exercise of the Redemption Right on the horizon, the Company’s Board formed a special committee to negotiate with Oak Hill. In February 2013, Oak Hill told the committee that it was critically important for Oak Hill to receive $45 million by March 2013. The committee agreed to that amount.
After the redemption, the Company continued to accumulate cash. The major source of the Company’s net income was its Domain Monetization business. Although profitable, that business was in steady decline. In April 2014, the Company sold the Domain Monetization business for $40 million. A second special committee approved the fairness of the price. A third special committee agreed to use all $40 million to redeem shares of Preferred Stock from Oak Hill.
The sale of the Domain Monetization business left the Company with only its Vertical Markets business. Over the following three years, the Company sold off that business in pieces. The Company persisted as a shell through the ensuing litigation with approximately $10 million in cash and a single, developmental-stage, travel-oriented website.
Frederick Hsu co-founded the Company and was the second largest holder of its common stock after Oak Hill. According to the Delaware Court of Chancery’s decision in The Frederick Hsu Living Trust v. Oak Hill Capital Partners III, L.P. et al, Hsu maintained that Oak Hill and its representatives on the Board breached their fiduciary duties by causing the Company to accumulate cash in anticipation of a redemption, rather than investing it in the Company’s business to promote long-term growth. He asserted that senior officers of the Company and other members of the Board breached their fiduciary duties by going along with Oak Hill’s cash-accumulation strategy.
At trial Hsu proved that the cash-accumulation strategy conferred a unique benefit on Oak Hill by creating a pool of funds that the Company would be required to use to redeem Oak Hill’s shares of Preferred Stock as soon as the Redemption Right ripened. Because the strategy conferred a unique benefit on the Company’s controlling stockholder, the defendants had the burden at trial of proving that the pursuit of the cash-accumulation strategy was entirely fair.
As is well known, the concept of fairness has two basic aspects: fair dealing and fair price. The fair process dimension of the entire fairness inquiry examines the procedural fairness of the decision, transaction, or result being challenged. It considers the manner in which the challenged decision, transaction, or result came about. The Court found the defendants fell short on this dimension of the analysis. The reasons appear to be that Oak Hill directed managements’ actions and the lack of Board approval of the cash accumulation strategy. Noting that Hsu only challenged the cash accumulation strategy, and not the decision to redeem shares or the prices at which assets were sold, the Court found the lack of process was not fatal. The reason was that although the two aspects –fair dealing and fair price — may be examined separately, they are not separate elements of a two-part test. The test for fairness is not a bifurcated one as between fair dealing and price. All aspects of the issue must be examined as a whole since the question is one of entire fairness.
The fair price dimension of the entire fairness inquiry examines the substantive fairness of the decision, transaction, or result being challenged. In the traditional formulation, it relates to the economic and financial considerations of the transaction under challenge, including all relevant factors: assets, market value, earnings, future prospects, and any other elements that affect the intrinsic or inherent value of a company’s stock.
The defendants proved at trial that the cash-accumulation strategy was entirely fair. The defendants proved by a preponderance of the evidence that the Company declined not because of the cash-accumulation strategy, but rather because of industry headwinds and relentless competition, most notably from Google, Inc.
The defendants also proved by a preponderance of the evidence that if the Company had reinvested its net income, it could not have generated a return sufficient to create value for the holders of common stock. The record also showed that although Oak Hill had an interest in achieving a return of capital, Oak Hill’s overall ownership position in the Company, including its ownership of a majority of the common stock, gave Oak Hill an incentive to create value for the common. Here, Oversee’s common stock would have ended up worthless with or without the cash-accumulation strategy.
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