Telcom-SNI Investors, L.L.C. v. Sorrento Networks, Inc.

Telcom-SNI Investors, L.L.C., and other venture capitalists (plaintiffs) that owned most of the preferred stock in Sorrento Networks, Inc. (Sorrento) sued Sorrento, its parent company and common stockholder Osicom Technologies, Inc. (Osicom), and Osicom’s chairman and chief executives (defendants) for diluting the preferred shareholders’ interests. Sorrento was a California startup that needed constant cash infusions until an initial public offering (IPO) could be accomplished. An investor group including the venture capitalists invested about $48.4 million in Sorrento Series A preferred stock, its only preferred stock. To secure their investment, the investors negotiated protective provisions included in Sorrento’s charter and an investors’-rights agreement (IRA) that prohibited Sorrento from changing the Series A preferred shareholders’ rights or authorizing issuance of “any other equity security” without the approval of a majority of the preferred shareholders. The IRA gave the preferred shareholders significant additional rights. First, if no IPO occurred within a year, the preferred shareholders could redeem their shares at the original purchase price, if at least 50 percent of them requested redemption. Second, the preferred shareholders had a “right of first offer” that assured they could buy additional shares and maintain their proportionate interests if Sorrento offered additional equity interests for sale. The investors expected an IPO shortly afterward, but none occurred. Five months later, Sorrento re-incorporated in Delaware but reiterated the same protective provisions in its Delaware certificate. Meanwhile, Sorrento borrowed over $36 million from Osicom. When the year to complete an IPO had expired, the venture capitalists requested redemption, but Sorrento lacked funds to redeem their shares. Instead, less than two weeks later, Sorrento’s board authorized issuing an additional 15 million shares of Series A preferred stock to Osicom at $5.45 per share, without seeking the preferred shareholders’ approval. That number reduced the percentage of preferred shares requesting redemption to slightly below 50 percent. Osicom also planned to acquire an additional 6.6 million preferred shares to extinguish Sorrento’s debt to Osicom, which again would dilute the venture capitalists’ interests in preferred stock to below 50 percent. The venture capitalists requested a temporary restraining order and preliminary injunction to block the issuance of preferred stock. Sorrento nonetheless issued Osicom 2.7 million shares of preferred stock, then did not disclose it at the hearing the next day. The court issued a temporary restraining order before ruling on preliminary injunction.