On July 6, 2018, the Delaware Court of Chancery imposed $20.3 million in damages on Georgetown Basho Investors, LLC (Georgetown), an investment fund; its President and Managing Member, Chester Davenport; and Board member Jonathan Fotos, after finding their actions led to the downfall of Basho Technologies, Inc. (the Company). The Company was once a promising, early stage technology company which developed the Riak database, an open-source NoSQL distributed database that allows its users to store, replicate, and retrieve data on a large scale basis even in the event of hardware failures.
Georgetown first invested in the Company in 2011 and continued to gain control over the next few years through a series of preferred stock financings. Through these financings, Georgetown gained blocking rights, enabling it to control the Company’s access to capital and giving it effective control over the Company. In 2013, when the Company was in a desperate financial state, Georgetown forced through a Series G financing which gave it hard control and unfairly benefited Georgetown to the detriment of the Company and its other investors. Throughout the Series G financing process, Davenport engaged in combative behavior, and at times communicated in ways that were nonresponsive, conflicting, and hostile, including threatening to stop providing funding to the Company. Davenport delayed a potential investment from a new investor, then subsequently offered onerous terms from Georgetown for the investment round after the new investment offer fell through. Davenport’s actions left the Company in a position of maximum crisis, with no other option but to accept Georgetown’s offer. After forcing through the Series G financing on Georgetown’s terms, Georgetown gained the right to appoint a majority of the members of the Board, added its allies to the Board, including Georgetown employee Jonathan Fotos, and created an Executive Committee to consolidate its control. Following the Series G financing, Georgetown, Davenport, and Fotos continued to engage in self-dealing transactions and turn down capital that would have undermined Georgetown’s control. During this time, several outside directors, upper management, and key employees left the Company and Georgetown replaced them with allies. Georgetown’s goal from the outset was to sell the Company quickly and benefit from the sale, but its actions made investors doubt the Company. Georgetown was ultimately unable to generate funding or sell the Company. The Company entered receivership in 2016 and was liquidated.
The former holders of the Company stock brought suit alleging that Georgetown, Davenport and Fotos (the Defendants) breached their fiduciary duties to the Company during two time periods, before and after the Series G financing. The court found that Davenport owed a fiduciary duty in his capacity as director of the Company. Despite being a stockholder without majority voting power who otherwise would not owe fiduciary duties in that capacity, the court found that Georgetown owed a fiduciary duty because it exercised actual control over the Company’s business and affairs through a number of factors leading up to the Series G financing. When a transaction involving self-dealing by a controlling shareholder is challenged, the court reviews the actions under Delaware’s highest standard, an entire fairness standard, which means proving the transaction was the product of fair dealing and fair price. The court found that the Defendants failed to carry the burden of proving the terms of the Series G financing were entirely fair. After the Series G financing, Georgetown controlled a majority of the Company’s voting power, and was obligated to act as a fiduciary. Davenport and Fotos owed the Company fiduciary duties as directors. The court found that the Defendants continued to control the Company in a self-interested manner following the Series G financing and breached their fiduciary duties. The court held Georgetown and Davenport jointly and severally liable for $17.5 million in damages for their actions leading up to the Series G financing and held Georgetown, Davenport and Fotos liable for $2.8 million for their actions after the Series G financing. The court’s decision centered on the Defendants’ egregious actions in controlling the Company against the Company’s interests, including securing self-dealing financing, freezing out directors, and refusing other financing sources in order to maintain their control and position the Company for a quick sale which would disproportionately benefit themselves. The court concluded that the Series G financing “started the Company on a greased slide to failure, and the Defendants’ actions after the Series G financing contributed to the Company’s completion of that journey.”
The decision should serve as a warning to investors that their actions may be subject to fiduciary duties, even if they do not have a controlling majority vote. Investors should be aware that they must carefully take the interests of the company into account when acting on behalf of the company and be prepared to defend their actions in court under the entire fairness standard.
Melissa Pang (LAW ’13) is a member of the Corporate and Securities Practice Group and the International Practice Group at White and Williams. Her practice focuses on general corporate, transactional, and securities law, counseling investors and international companies in legal matters including: general corporate governance, employment agreements, mergers, acquisitions, and divestitures, equity and debt financing, and private equity transactions.