New Enter. Assocs. 14 v. Rich

• Decision Date: 09 March 2023
• Docket Number: C. A. 2022-0406-JTL
• Parties: NEW ENTERPRISE ASSOCIATES 14, L.P., NEA VENTURES 2014, L.P., NEA:SEED II, LLC, and CORE CAPITAL PARTNERS III, L.P., Plaintiffs, v. GEORGE S. RICH, SR., DAVID RUTCHIK, JOSH STELLA, FUGUE, INC., GRI VENTURES, LLC, JMI FUGUE, LLC, RICH FAMILY VENTURES, LLC, and RUTCHIK DESCENDANTS' TRUST, Defendants.
• Court: Court of Chancery of Delaware

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NEW ENTERPRISE ASSOCIATES 14, L.P., NEA VENTURES 2014, L.P., NEA:SEED II, LLC, and CORE CAPITAL PARTNERS III, L.P., Plaintiffs,
v.
GEORGE S. RICH, SR., DAVID RUTCHIK, JOSH STELLA, FUGUE, INC., GRI VENTURES, LLC, JMI FUGUE, LLC, RICH FAMILY VENTURES, LLC, and RUTCHIK DESCENDANTS' TRUST, Defendants.

C. A. No. 2022-0406-JTL

Court of Chancery of Delaware

March 9, 2023

Date Submitted: January 24, 2023

C. Barr Flinn, Paul J. Loughman, Michael A. Carbonara, Jr., YOUNG CONAWAY STARGATT & TAYLOR, LLP, Wilmington, Delaware; Michele D. Johnson, LATHAM & WATKINS LLP, Orange County, California; Eric Leon, Nathan Taylor, Meredith Cusick, Amanda R. Kurzydlowski, LATHAM &WATKINS LLP, New York, New York; Counsel for Plaintiffs.

John P. DiTomo, Sebastian Van Oudenallen, MORRIS, NICHOLS, ARSHT & TUNNELL LLP, Wilmington Delaware; Patrick Montgomery, Paul Weeks, KING & SPALDING LLP, Washington, DC; Counsel for Defendants.

OPINION ADDRESSING MOTION TO DISMISS UNDER RULE 12(B)(6)

LASTER, V.C.

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Fugue, Inc. (the "Company") is a startup that spent six months looking for a buyer. No one was interested. After declaring the sale process a failure, the Company needed capital.

Management represented that a financing round led by an investor named George Rich was the only available option. In return for the financing, the Company agreed to issue shares of preferred stock that carried powerful blocking rights. Rich brought David Rutchik and other investors into the round, and all received shares of preferred stock.

Three months after the recapitalization, the Company had $8 million on its books, was no longer in distress, and had received a preliminary inbound expression of interest from a potential acquirer. Rich, Rutchik, and the Company's CEO comprised the board of directors (the "Board"). The Board approved a transaction in which selected preferred stockholders, including Rich and Rutchik, purchased additional shares at the original issue price, set when the Company was in distress. The directors also granted themselves millions of options, with the strike price set at one tenth of the value of the common stock implied by the recapitalization.

The preliminary expression of interest blossomed into an acquisition at a healthy valuation. When the transaction closed, the preferred stockholders received a return of nearly 750%. The option holders received a return of 3,200%. Those gains came at the expense of other Company stockholders, who suffered dilution from those equity issuances and therefore received a lesser share of the merger consideration.

The plaintiffs are two investors who had funded the Company before the recapitalization. One of the plaintiffs had a right of first offer ("ROFO") that applied to

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any issuance of securities. The Company did not honor the ROFO for the second offering of preferred stock. That plaintiff has stated a claim for breach of contract, as well as a claim for tortious interference with contract.

The plaintiffs have attempted to assert claims for breach of the duty of disclosure. They argue that when asking a subset of the preferred stockholders to execute a written consent approving the second offering of preferred stock, the directors had an obligation to disclose that the Company had received a preliminary expression of interest from a potential acquirer. That claim would fail in the context of a publicly traded entity. Under the facts and circumstances present in this case, it is reasonably conceivable that the information was material given that (i) the Company had told its investors three months earlier that its process of exploring alternatives had failed, (ii) management had simultaneously told its investors that it would take two to three years before the Company had built up its business to a point where it could be sold, and (iii) the directors were seeking approval to sell shares of preferred stock to selected investors, including two insiders, at the same distressed price set in the recapitalization.

The additional twist is that the plaintiffs do not allege that the directors had a duty to disclose the existence of the expression of interest to them. They allege that the directors breached a duty to disclose the expression of interest to other stockholders, resulting in injury to the plaintiffs when those stockholders were misled into approving the second offering at the same price paid in the recapitalization. Although this decision holds that the plaintiffs can assert that cause of action, the resulting claim is derivative,

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and the plaintiffs' standing to assert it was extinguished when the Company was sold. The same is true for the plaintiffs' related claims against other defendants.

The plaintiffs have sued the directors for breaching their fiduciary duties in connection with the sale of the Company. The plaintiffs contend that the second offering of preferred stock and the option grants were interested transactions, and they challenge the sale of the Company as unfair because it conferred a unique benefit on the directors by extinguishing any sell-side stockholder's standing to pursue derivative claims challenging those issuances, even though the merger consideration failed to afford any value to those derivative claims. The plaintiffs have standing to challenge the merger on that basis, and they have stated viable claims for breach of fiduciary against the directors and against Rich's affiliates as controlling stockholders, as well as a viable claim against Rutchik's affiliate for aiding and abetting breaches of fiduciary duty.

The defendants have an additional argument for dismissal that this decision does not reach. As part of the recapitalization, the plaintiffs entered into a voting agreement that contained a drag-along right. The plaintiffs covenanted not to sue the defendants over any transaction that met the conditions of the drag-along right. The court will address the implications of the covenant not to sue in a separate decision.

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I. FACTUAL BACKGROUND

The facts are drawn from the operative complaint and the documents that it incorporates by reference.^[1] At this procedural stage, the plaintiffs are entitled to have the court credit their allegations and draw all reasonable inferences in their favor.

A. The Company

Founded in 2012, the Company provides tools to build, deploy, and maintain a cloud infrastructure security platform. Josh Stella was a co-founder of the Company and serves as its Chief Executive Officer.

In 2013, plaintiff Core Capital Partners III, L.P. ("Core Capital") was the lead investor in the Company's seed round. Core Capital is an investment fund sponsored by Core Capital Partners, which describes itself as a venture capital firm headquartered in downtown Washington, D.C., with in excess of $300 million under management across three funds.^[2]

In 2014, plaintiffs New Enterprise Associates 14, L.P., NEA Ventures 2014, L.P., and NEA:Seed II, LLC invested in the Company. Each is an investment vehicle or fund sponsored by New Enterprise Associates, a name-brand venture capital firm. The

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distinctions among the entities are not important for this decision, which for simplicity refers to them as "NEA."

Across multiple rounds of financings, NEA invested a total of $36.1 million in the Company, and Core Capital invested a total of $1.7 million. In return for their investments, NEA and Core Capital received shares of preferred stock. The rights conferred by their preferred stock included an aggregate liquidation preference equal to their invested capital, and NEA and Core Capital each received the right to appoint one member to the Board. During this period, the Board had five members.

B. The Failed Sale Process And The Recapitalization

In the second half of 2020, the Company began exploring strategic alternatives. The principal goal was to find a potential acquirer. The process continued throughout 2020 and into the first quarter of 2021. During that time, the Company engaged with more than fifteen possible buyers.

Toward the end of the first quarter of 2021, Stella told the Board that the Company's efforts to find a buyer had failed. Stella also represented that that Company was running out of money and needed additional capital to continue operating. He indicated that the Company would use the new money to grow its business and position itself better as an acquisition target. According to Stella, that process would take two to three years.

To provide the growth capital that the Company needed, Stella recommended that the Company engage in a recapitalization that would involve the issuance of Series A-1 Preferred Stock to a group of investors led by Rich (the "Recapitalization"). Stella

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represented to the Board and the Company's existing investors that the Recapitalization was the only option available and that a market check for other financing sources had not generated any alternatives.

Based on Stella's representations, the Board authorized management to proceed with the Recapitalization.

C. The Terms Of The Recapitalization

The Company raised roughly $8 million in the Recapitalization. In return for this capital, it issued 13,129,810 shares of Series A-1 Preferred Stock (the "Preferred Stock"), reflecting a purchase price of $0.61 per share. The Recapitalization valued the Company's pre-transaction equity at $10 million.

Rich invested in the Recapitalization through two vehicles: GRI Ventures, LLC, and JMI Fugue, LLC (together, the "Rich Entities"). Both of the Rich Entities were special purpose vehicles that Rich formed for the investment. Rich controlled those vehicles through Rich Family Ventures, LLC. GRI Ventures was designated as the "Lead Investor" for the round. It invested $4,189,999.51 in return for 6,876,743 shares of Preferred Stock. JMI Fugue invested $999,999.62 in return for 1,641,227 shares of Preferred Stock. Together, the Rich...