Opinion
C.A. No. 20360-NC.
Submitted: December 22, 2003.
May 20, 2004.
Bayard J. Snyder, Esquire Snyder Associates, P.A., Wilmington, DE.
Michael F. Bonkowski, Esquire, Saul Ewing LLP, Wilmington, DE.
Dear Counsel:
Pending is a motion to approve a proposed settlement of this derivative action. For the reasons set forth below, the motion is denied.
Plaintiff Strategic Asset Management, Inc. ("SAMI"), a shareholder of Nominal Defendant N-Viro International Corporation ("N-Viro"), brought this action to challenge the conduct of N-Viro's Board which allegedly was dominated by N-Viro's founder and chairman, Defendant J. Patrick Nicholson ("Nicholson"). SAMI's complaint focused on the efforts of N-Viro's directors, other than R. Francis DiPrete ("DiPrete"), SAMI's president, to entrench themselves and to award unreasonable compensation to Nicholson. All defendants, except for Nicholson, have entered into the Settlement Agreement and Release (the "Settlement Agreement") which the Court is now being asked to approve.
Thus, all members of the Board, except for Nicholson and DiPrete, (the "Settling Defendants") are participating in the proposed settlement.
The scope of the Court's role in evaluating proposed settlements of derivative actions and class actions is bounded by two sometimes competing policy considerations. First, there is a policy in favor of voluntary resolution of contested matters. Second, because of the fiduciary obligations borne by representative plaintiffs in derivative actions and class actions, the Court must satisfy itself of the "intrinsic fairness" of the proposed settlement. This task requires the Court to consider the claims and defenses, to evaluate the particular legal and factual circumstances of the case at hand, and "then to apply its own business judgment in determining whether the settlement is reasonable in light of these factors." Nottingham Partners v. Dana, 564 A.2d 1089, 1102 (Del. 1989) (quoting Polk v. Good, 507 A.2d 531, 535 (Del. 1986)). The burden of persuasion rests upon the proponent of the settlement. See In re MAXXAM, Inc./Federated Dev. S'holders Litig., 659 A.2d 760, 768 (Del.Ch. 1995).
SAMI asserts that its efforts have conferred numerous benefits upon N-Viro. Most of these benefits relate to securing the departure of Nicholson as N-Viro's chief executive officer and adjusting compensation obligations of N-Viro to Nicholson. The Settlement Agreement, however, pays scant express attention to Nicholson. It provides that N-Viro will vigorously contest any litigation or arbitration proceedings with Nicholson and that, under certain circumstances, Nicholson may continue to provide consulting services for N-Viro.
Otherwise, the Settlement Agreement addresses releases, including releases for the Settling Defendants, and fees and expenses to be paid to both SAMI's attorneys and to SAMI. The Settlement Agreement provides that "in full satisfaction of all claims by SAMI for its time and energy expended in this matter, N-Viro shall issue SAMI 75,000 warrants." These warrants have an exercise price of $0.72 per share. At the time of settlement, the underlying shares of N-Viro were worth slightly more than $1.00. By the time of the settlement hearing, N-Viro's stock had appreciated to $3.60 per share. Interestingly, the Settlement Agreement, although providing releases for the benefit of the Settling Defendants, imposes no obligations on them and does not recite that they have otherwise contributed to resolution of this matter except for agreeing with the terms of the Settlement Agreement. I also note that under the Settlement Agreement: N-Viro would release SAMI, SAMI would release the Settling Defendants, but N-Viro would not release the Settling Defendants.
Certain objectors oppose the settlement because of the issuance of warrants and contest the authority of the Board to approve a grant of warrants under the current circumstances. My reluctance to approve the settlement is more fundamental.
While N-Viro's stock was trading for a little more than $1.00 per share at the time the parties negotiated the Settlement Agreement, the Court cannot ignore the significant increase in price that had occurred by the time of the settlement hearing. SAMI points out that, after exercise of the warrants, transfer of the securities it receives will be restricted and, therefore, a marketability discount should be applied to assess the potential value of the warrants to SAMI. SAMI takes the position that a 35% discount would be appropriate. Accepting SAMI's proposed discount would leave an effective share price upon exercise, assuming that occurred on the date of the settlement hearing, of $2.34. Thus, at a reasonable minimum, the warrants to be conferred upon SAMI would then have had an approximate value of $120,000: ($2.34 share price minus $0.72 exercise price) (75,000 warrants). I acknowledge that any award tied to stock price will likely fluctuate in value between the time of the settlement and the time of the settlement hearing; nevertheless, the economic reality, as of the date of the settlement hearing, is a significant factor of the Court's analysis.
SAMI seeks an award by the Court to compensate it for its time and effort in pursuing this matter. Its efforts were undertaken by DiPrete, an officer of SAMI and a director of N-Viro. Thus, DiPrete is indirectly seeking compensation from N-Viro for his efforts, pursued apparently on behalf of SAMI, to prosecute this litigation. I note, however, that it is difficult to perform any rational allocation between his efforts undertaken on behalf of SAMI and those undertaken in his capacity as an N-Viro director and fiduciary.
SAMI has sought to justify the amount of the benefits that would accrue to it, ( i.e., the 75,000 warrants with an exercise price of $0.72), with a submittal evidencing that SAMI incurred overhead costs of $12,000 ( i.e., $1,000 per month for a year) in its efforts and human resources costs ( i.e., DiPrete's time) in the amount of $84,800: (seven hours per week) ($200 per hour) (52 weeks). Even with SAMI's projected marketability discount, the net value of the stock after exercise of the warrants ( i.e., assuming a conversion value of $2.34 per share instead of the market value at settlement of $3.60 per share) would provide a bonus to SAMI in an approximate amount of $35,000 over costs identified.
SAMI's methodology for determining its "costs" does not inspire confidence, and the Court expresses no view as to its ultimate reliability. The Court also notes that the Settlement Agreement allows N-Viro, under certain circumstances, to repurchase any unexercised warrants for $1.78 per warrant or to purchase any shares that SAMI obtained from the exercise of the warrants for $2.50 per share. The implicit value of repurchasing the warrants or purchasing the stock obtained through the warrants (assuming repurchase of all shares or warrants) would be approximately $134,000.
I now turn to my nonmonetary concerns about the Settlement Agreement. First, although in unique circumstances an award to the representative plaintiff might be appropriate for its efforts, the record before the Court does not suggest that any such award would be proper here. Awards to representative plaintiffs carry the risk that these plaintiffs have used their status to obtain additional personal benefits at the expense of the other shareholders — additional benefits made possible with the leverage acquired as the representative plaintiffs. Second, the award, when given any reasonable valuation as of the settlement date, would exceed substantially what SAMI has attempted — albeit not very convincingly — to justify. Finally, this is an action brought on behalf of N-Viro for the benefit of N-Viro. SAMI has not offered any reason as to why the cost of settlement of a derivative action should be borne directly by N-Viro, and not by the parties alleged to have been the wrongdoers. In short, the Settling Defendants are charged in SAMI's derivative complaint with having breached their fiduciary duties, but they apparently are not contributing to the settlement (not even to the payment of attorneys' fees).
There is some suggestion that SAMI is taking warrants in an effort to avoid imposing a greater cash burden on N-Viro. Whether the compensation is by warrants or by cash, it must still be reasonable. Although not entirely clear, SAMI may be seeking the warrants to avoid a greater cost obligation for payment of attorneys' fees. If the Court is to award attorneys' fees, they should be awarded as such.
See Ct. Ch. R. 23.1. ("In a derivative action brought by 1 or more shareholders . . . to enforce a right of the corporation . . .")
Whether a corporation may ultimately end up absorbing the costs of settlement indirectly, through indemnification obligations or otherwise, is a distinct question.
This is not a large case in terms of the actual compensation which SAMI seeks. However, the settlement, as proposed, suffers from several shortfalls, and the Court may not ignore the various problems merely because it is a small settlement.
The Court's principal concerns are with the benefits accruing to SAMI. The Court's impression is that the award to SAMI is integral to the settlement and that all parties would not seek approval of the settlement without that component.
Accordingly, for the foregoing reasons, the motion to approve the Settlement Agreement is denied.