348 F.3d 584 (7th Cir. 2003), 02-4330, Kennedy v. Venrock Associates
|Citation:||348 F.3d 584|
|Party Name:||Kennedy v. Venrock Associates|
|Case Date:||October 29, 2003|
|Court:||United States Courts of Appeals, Court of Appeals for the Seventh Circuit|
Argued May 27, 2003.
Rehearing Denied Nov. 18, 2003.
[Copyrighted Material Omitted]
James A. McGurk, Hugh G. McBreen (argued), McBreen, McBreen & Kopko, Chicago, IL, for Plaintiff-Appellants.
David A. Rammelt, Kelley, Drye & Warren, Alexander Dimitrief (argued), Kirkland & Ellis, Chicago, IL, for Defendant-Appellees.
Before BAUER, POSNER, and COFFEY, Circuit Judges.
POSNER, Circuit Judge.
This is a suit by common shareholders of Cadant, Inc. (now CDX Corporation). The
defendants are two corporate entities that we'll call "Venrock" and "J.P. Morgan" and individuals associated with them, but we defer consideration of the individual defendants to the end of the opinion and till then use "defendants" to denote just the entities. The suit is based on federal securities law and state antifraud law. It charges the defendants, though they are not affiliated with each other (an important point to stress, because throughout the plaintiffs' briefs the defendants are lumped together under the name, coined by the plaintiffs' lawyers, "Venrock Affiliates," which is not to be confused with "Venrock Associates," the name of one of the defendants), with having acted "in virtual tandem" to seize control of and plunder Cadant. In doing so they are alleged to have violated the fiduciary duty that they owed the plaintiffs by virtue of having obtained control of the corporation. The plaintiffs, who own roughly a quarter of the company's common stock, seek $100 million in damages.
Cadant is in bankruptcy, and the district judge dismissed the complaint on the ground that the plaintiffs' claims, though styled as individual ("direct") claims, really are derivative claims and thus belong to Cadant. If so, they must be litigated in the bankruptcy court--where the plaintiffs and the other shareholders would have to share any liquidation value with Cadant's creditors, who happen to include the defendants.
We construe the facts as favorably to the plaintiffs as the record, which is limited to the 123-page complaint and the exhibits attached to it, permits, while of course not vouching for the accuracy of the allegations. Cadant was formed in 1998 by Venkata Majeti and others to develop cable modem termination systems, which enable high-speed Internet access to home computers. Though based in Illinois, the company was incorporated in Maryland. Majeti and the other founders received common stock in the new corporation at the outset. The company issued additional stock the next year to the plaintiffs for $7-$8 million (the exact amount is not in the record). The year after that the company issued the defendants preferred stock for $12 million; others received preferred stock as well, but between them the defendants received and still own 90 percent of it. A principal of Venrock, named Copeland, became a member of Cadant's five-member board of directors. The other four board members, however, had no affiliation with either Venrock or J.P. Morgan. The plaintiffs irresponsibly contend that one of the four, a Mr. Rochkind, though unaffiliated with either Venrock or J.P. Morgan, owned some of the preferred stock in Cadant and was therefore "aligned" with the defendants.
The following year, 2000, the board turned down a tentative offer by ADC Telecommunications to buy Cadant for some $300 million. Later that year the board proposed and the shareholders approved the reincorporation of Cadant in Delaware, which provides less protection to minority shareholders than Maryland does.
By the beginning of 2001, Cadant, like many other start-up companies in Internet-related businesses, was in deep financial trouble. The defendants--having spurned more favorable financing possibilities for Cadant (the leitmotif of this suit is that the defendants, although controlling the company, repeatedly missed chances to sell or finance it that would have saved it from insolvency)--agreed with each other and with the board of directors to make Cadant an $11 million bridge loan. (A bridge loan is a short-term loan to tide the borrower over while he seeks longer-term financing.) The loan was for 90 days at an
annual interest rate of 10 percent and also gave the lenders warrants (never exercised) that they could use to purchase common stock. The terms were highly favorable to the lenders.
Only about 60 percent of the $11 million loan was lent by the defendants. The other owners of preferred stock were eligible to participate in the loan, including the director who though not affiliated with either Venrock or J.P. Morgan owned some of that stock. It is unclear whether he participated in the loan, but probably he did because the board voted him some options to buy common stock in Cadant.
Shortly before the bridge loan was made, a representative of J.P. Morgan had been added to Cadant's board, raising the number of directors to six. And earlier, in September, one of the independent directors had been replaced by an employee of J.P. Morgan named Lyon, so that half the board was now controlled by the defendants. Shortly afterwards, still another representative of the defendants was added to the board, so that between them the defendants at last controlled a majority of the board's members (four out of seven). But this lasted only until March (2001), by which time Lyon had resigned from J.P. Morgan (the exact date of his resignation is unclear).
Within a couple of months of receiving the bridge loan, Cadant had run through the entire $11 million. In May the defendants arranged for a second bridge loan, this one for $9 million, which gave the lenders (who again included the defendants) a preference in the event that Cadant was sold or otherwise liquidated: they would be entitled to "an amount equal to 200% of (i) outstanding principal amount of the Loans plus (ii) any accrued but unpaid interest thereon." (On liquidation preferences generally, see Don Clark & Lisa Bransten, "E-Business: Starting Gate," Wall St. J., Mar. 19, 2001, at B6; Colin Blaydon & Michael Horvath, "Liquidation Preferences: What You May Not Know," Venture Capital J., Mar. 1, 2002, p. 45; see also Ravi Chiruvolu, "It May Be Time to Hit the Reset Button on Liquidation Preferences," Venture Capital J., July 2002, p. 28. Of course a "liquidation preference" of sorts is implicit in the status of a lender or a preferred shareholder, since both have priority over common shareholders.) The first loan was then amended to add a (smaller) liquidation preference. The defendants discouraged a search for alternative financing on terms that would have been more favorable to Cadant, because they wanted to suck out Cadant's assets by means of the liquidation preferences.
Cadant defaulted on the second bridge loan. The lenders did not foreclose. Instead Cadant sold its entire assets to a firm called Arris Group in exchange for stock worth at the time of the sale (January 2002) some $55 million, an amount just large enough to satisfy the claims of Cadant's creditors and preferred shareholders. The board turned down alternatives that would have been better for Cadant but worse for the defendants, who remember were preferred shareholders but also creditors by virtue of the bridge loans. The sale to Arris was approved by Cadant's board and also, as required by Delaware law and the articles of incorporation, by a simple majority of Cadant's common and preferred shareholders voting together as a single class and a simple...
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