Rhodes v. SilkRoad Equity, LLC,  Del. Ch., No. 2133-VCN (April 15, 2009), read letter opinion here. Prior opinions in this case from the Delaware Chancery Court were reviewed on this blog here.

Kevin Brady, a highly respected Delaware litigator, provides us with the benefit of his following review of this Delaware Chancery Court decision.

On April 15, 2009, Vice Chancellor Noble granted partial summary judgment in this action involving a dispute between the former founder of a company who sold 80% of his interests, claims he was later forced out and his interest extinguished for an unfair price allegedly in accordance with the terms of a buy-back provision in the purchase agreement. Fittingly given the date, one of the claims that was extinguished was plaintiffs’ challenge regarding IRS penalties.

InterAct Public Safety Systems (“InterAct””), a software development corporation was founded by plaintiff William A. Rhodes III (“Rhodes”). Plaintiff Wijnant van de Groep (“van de Groep”) is Rhodes’s son-in-law, and a former officer and shareholder of InterAct. In 2000, InterAct entered into a contract with BellSouth. In October 2000, in an effort to secure more capital, InterAct entered into negotiations with defendants Andrew J. Filipowski (“Filipowski”) and Matthew G. Roszak (“Roszak”). Defendant SilkRoad Equity, LLC (“SilkRoad”), a Filipowski controlled company, entered into a stock purchase agreement with Interact in December 2004, whereby SilkRoad acquired 80% of the outstanding stock of InterAct in exchange for: (i) a $100 payment to Rhodes and Van de Groep; (ii) a $5 million contingent payment to Rhodes; and (iii) a $10 million line of credit to InterAct (the “SPA”).

SPA — Option to Purchase Plaintiffs’ Shares

The SPA included a provision granting defendants the option to purchase the plaintiffs’ shares for “fair market value” and on July 25, 2006, defendants gave notice that they were exercising their option to purchase the remaining 20% interest from the plaintiffs. The purchase price was based on a valuation by Houlihan, Lokey. In response, plaintiffs filed suit alleging, among other things: (i) breach of fiduciary duties by defendants’ for engaging in self-dealing transactions involving four companies under defendants’ control (the “sister companies”) and by failing timely to pay IRS payroll penalties incurred by InterAct before the SPA ; and (ii) self-dealing in the InterAct acquisition of TrueSentry, another defendant controlled entity. Defendants responded by claiming that plaintiffs breached certain provisions of the SPA including the representations and warranties. Both sides moved for partial summary judgment. Since the parties later agreed that TrueSecurity was never acquired by InterAct, summary judgment was granted for defendants with respect to that allegation.

Self-Dealing — Entire Fairness Review – Focus on Price

The plaintiffs claimed that SilkRoad’s transactions with the sister companies demonstrated unfair process and price. In addressing the defendants’ motion for summary judgment, Vice Chancellor Noble stated that the focus of his analysis would be primarily on price because, “if the Defendants are unable to show fair price, summary judgment will be denied whether a fair process is demonstrated or not.” Thus, in order to get summary judgment, the defendants had to submit undisputed evidence that “demonstrates that the rates InterAct was charged by each SilkRoad sister company were entirely fair in light of prevailing market rates for the same or similar services.”

SilkRoad’s Transactions with Sister Companies

Vice Chancellor Noble then analyzed in great detail, the relationships and transactions between InterAct and the sister companies in light of plaintiffs’ allegations of self-dealing that the defendants were allegedly siphoning cash from InterAct and depressing its value under the entire fairness standard. With respect to each of the four sister companies, the Court concluded that the plaintiffs set forth enough facts to demonstrate a material issue as to the fairness of the price and thus, defendants’ motion for summary judgment was denied with respect to those allegations.

IRS Penalties

Prior to the defendants’ acquisition of InterAct, the plaintiffs failed to cause InterAct to pay nearly $1 million in federal payroll taxes. After defendants acquired the company, they appealed the IRS decision regarding penalties and interest but to no avail. The plaintiffs argued that these expenses (the penalties and interest) should not have been considered by Houlihan Lokey in valuing InterAct for the purposes of purchasing plaintiffs’ shares. However, the defendants presented evidence that they were not included in the financials submitted to Houlihan. As a result, the Court granted defendants’ motion for summary judgment on this issue.

Plaintiffs’ Summary Judgment Motion

The Court next analyzed plaintiffs’ motion for summary judgment as to defendants’ counterclaims alleging breach of the SPA regarding the plaintiffs’ representations and warranties concerning: (1) the balance sheet of InterAct as of September 30, 2003, and September 30, 2004; (2) North Carolina Sales and Use Taxes; (3) products and services provided to InterAct’s customers ; and (4) the ownership or licensing of software in InterAct’s possession. After a detailed analysis of the facts, the Vice Chancellor found that with the exception of the North Carolina Sales and Use Tax, plaintiffs failed to carry their burden and summary judgment was denied.