Many investors treat the mandatory redemption date for preferred stock as the equivalent of a loan maturity date. Many also believe the corporation is unconditionally obligated to repurchase the preferred shares.
They are wrong on both counts. Preferred stock provides no guaranteed right of payment, and its redemption obligation is treated neither as debt nor as a current liability.
Corporate directors also have substantially more discretion than many assume regarding whether, when and how to raise additional funds to finance the redemption of preferred stock. The directors’ fiduciary duty is to maximize the enterprise value for the long-term benefit of the common stockholders.
Corporate directors are under no fiduciary duty to liquidate the company or sell off major assets to fund a “mandatory” preferred stock redemption.
Banks are generally reluctant to provide funds to finance stock redemptions even though they will provide credit for corporate growth and general operations under similar circumstances. Therefore, the preferred stockholder expecting the return of his capital may arrive at the mandatory redemption date to find the company simply telling him he’ll have to wait until they have the money — and that the company isn’t making extraordinary efforts to raise it.
A recent Delaware case, Frederick Hsu Living Trust v. ODN Holding Corp., No. 12108-VCL, 2017 WL 1437308 (Del. Ch. Apr. 24, 2017), should make directors ever more cautious about taking extraordinary corporate actions to finance contractually agreed-to mandatory redemptions.
In that case, the Chancery Court sided with the common stockholders, who claimed that the preferred stockholder and the board of directors violated their fiduciary duty to the common stockholders by taking extraordinary steps to raise funds to finance the mandatory redemption.
The story began when a venture capital firm invested $150 million in preferred stock of ODN Holding Corp., a Delaware corporation and the holding company for Oversee.net. Prior to the investment, Oversee.net was pursuing a rapid growth strategy that involved numerous acquisitions.
It should be noted that preferred stock is an extremely common investment structure in today’s venture capital environment. Preferred stock provides the investor the upside of converting to common if the deal succeeds and the downside protection of the liquidation preference if things go poorly.
The ODN Holding preferred stock gave the venture fund the ability to exercise a mandatory redemption right beginning five years after its investment. Upon redemption, the company would repurchase the preferred shares by paying cash equal to the original issue price plus any declared but unpaid dividends.
Consistent with Delaware corporate law, the preferred stock terms included a provision that if the funds of the company legally available for redemption were insufficient to redeem the total number of shares of preferred stock, then the funds that were legally available would be used to redeem the maximum possible number of shares, ratably, among the holders of the shares of the redeemed stock.
The terms of the preferred stock deal also provided that if, on the redemption date, the legally available funds were insufficient to redeem the total number of preferred shares, “the company thereafter shall take all reasonable action (as determined by the company’s board of directors in good faith and consistent with its fiduciary duties) to generate, as promptly as practical, sufficient legally available funds to redeem all outstanding shares of preferred stock, including by way of incurrence of indebtedness, issuance of equity, sale of assets, effecting a merger or sale of assets or otherwise.”
However, a key provision of this contractual obligation also stated that any actions to generate additional funds would be “determined by the company’s board of directors in good faith and consistent with its fiduciary duty.” An important distinguishing fact in the ODN Holding situation was that the holders of the preferred stock were not entitled to receive a cumulative preferred dividend. Therefore, the redemption right, as measured on a present value basis, declined over time.
The longer the company delayed the redemption, the better for the common stockholders. This set up a stark conflict between the economic interests of the common shareholders and the preferred.
The ODN Holding complaint alleges that roughly three years after the venture firm’s investment, the firm concluded that exercising its contractual redemption right was the most effective way to achieve a return on its capital and exit the investment.
Although the company was profitable, the venture firm became disenchanted with the rate of corporate growth. The venture firm presumably wanted to redeploy its assets and management focus on more attractive investments as soon as possible. As a result of the venture firm’s decision to exit the investment, the venture firm and its designees on the company board found themselves stuck between their fiduciary duty to common stockholders and the terms of the preferred investment documents.
Although the venture fund-nominated director may have a natural affinity for the fund’s economic interests, as a matter of Delaware law the director owes a fiduciary duty exclusively to the common stockholders — and not to the holders of preferred stock, warrants or debt.
That representative is therefore placed in a difficult situation, tasked with putting the common stockholders’ interests ahead of the venture fund’s. The law would expect the director to oppose or delay the redemption of the preferred stock, even if required by contract terms, when the company cannot raise the funds without exceptional hardship.
The ODN Holding complaint alleges that the venture firm caused the company to alter its business plan by shifting its focus away from growth, whether internally or by acquisition, and instead seeking to accumulate cash that could be used for the redemption. As a result of this alleged directional change, the company stopped making acquisitions in order to build its cash reserves.
The company unsuccessfully explored obtaining a bank loan to fund the redemption. The banks were not willing to consider a loan used for redemption, although additional bank borrowing was available for corporate growth and expansion purposes.
The board decided to generate additional cash for redemptions through a restructuring that included massive cuts to expenses. This involved terminating executives, reducing the overall workforce and terminating the company’s lease on its Los Angeles headquarters.
The company sold three of its four lines of business in their entirety and divested the principal economic driver for the fourth line of business. In all these sales, the buyers paid less than ODN had paid to acquire the business units.
The divestitures had a dramatic effect on the company’s cash-generating capacity. In 2011 before the divestitures, the company generated revenue of $141 million. In 2015, after the divestitures, the company generated revenue of $11 million, a decline of 92 percent.
Section 160 of the Delaware General Corporation Law prohibits a corporation from redeeming its shares of capital stock when the capital of the corporation is impaired or when such redemption would cause any impairment of the capital.
The repurchase impairs capital if the funds used in the repurchase exceed the amount of the corporation’s “surplus,” which is defined by the statute to mean the excess of net assets over the par value of the corporation’s stock.
In addition, the redemption provisions of the DGCL limit the company to making redemptions out of “funds legally available.” This phrase is not synonymous with surplus. Outside the DGCL statute, a wide range of statutes and legal doctrines may restrict the corporation’s ability to use funds, rendering them not “legally available.” Among these, Delaware common law has long restricted a corporation from redeeming its shares when the corporation is insolvent or would be rendered insolvent by the redemption. Consequently, a corporation easily may have funds and still find they are not legally available.
Vice Chancellor J. Travis Laster explained in ODN Holding that the existence of a mandatory redemption right, even one that is ripened, does not convert the holder of preferred stock into a creditor.
A redemption right does not give the holder the absolute, unfettered ability to force the corporation to redeem its shares under any circumstances. The case law establishes limitations on the ability of preferred stockholders to force redemption.
Vice Chancellor Laster began his legal analysis in ODN Holding by recognizing the bedrock principle that the business and affairs of every corporation are to be managed by and under the direction of the board of directors. The existence and exercise of the board’s authority carries with it certain fundamental fiduciary obligations to the corporation and its stockholders.
Directors of a Delaware corporation owe two fiduciary duties: care and loyalty. The duty of loyalty mandates that the best interests of the corporation and its stockholders take precedence over any interests possessed by a director, officer or controlling stockholder that are not shared by the stockholders generally. Corporate fiduciaries are not permitted to use their position of trust and confidence to further their own interests.
The duty of loyalty includes a requirement to act in good faith. Delaware courts have found that a failure to act in good faith may be shown where a director intentionally acts with a purpose other than advancing the best interests of the corporation.
The board of directors of a Delaware corporation must, within the limits of its legal discretion, treat stockholder welfare as the only end, considering other interests only to the extent that doing so is rationally related to stockholder welfare.
In a world of many types of stock — preferred stock, common stock with special rights, common stock — and many types of stockholders, the question naturally arises: Which stockholders? The answer is the stockholders in the aggregate in their capacity as residual claimants, which means the undifferentiated equity as a collective, without regard to any special rights.
Under Delaware corporate law, equity capital is considered permanent capital because of the permanent existence of the corporation. The fiduciary relationship requires directors to act prudently, loyally and in good faith to maximize the value of the corporation over the long term for the benefit of the providers of presumptively permanent equity capital, as warranted for an entity with the presumptively perpetual life in which the residual claimants have locked in their investment.
The duty to act for the ultimate benefit of stockholders does not require the directors to fulfill the wishes of a particular subset of the stockholder base.
Vice Chancellor Laster found that “a board does not owe fiduciary duties to preferred stockholders when considering whether to take corporate action that might trigger or circumvent the preferred stockholders’ contractual rights.”
As a general matter, the rights and preferences of preferred stockholders are contractual in nature. Preferred stockholders are owed fiduciary duties only when they do not invoke their special contractual rights and rely on a right shared equally with the common stock.
Because the fiduciary principle does not protect special preferences or rights, the fiduciary-based standard of conduct requires directors to focus on promoting the value of the undifferentiated equity in the aggregate.
Given this obligation, directors must pursue the best interests of the corporation and its common stockholders, if that can be done faithfully with the contractual promises owed to the preferred.
Consequently, where discretionary judgment is to be exercised, the board is generally obligated to prefer the interests of common stock — as the good-faith judgment of the board sees them to be — over the interest created by special rights, preferences or special contractual rights of preferred stock.
The Chancery Court found that if the interests of the common stockholders diverge from those of the preferred stockholders, a director may breach the applicable duty and be exposed to potential personal liability by improperly favoring the interests of the preferred stockholders over those of the common stockholders.
The venture capital fund and its designated directors argued that the fiduciary duty standard of conduct did not apply because the preferred stock imposed a clear contractual obligation on the company. As they saw it, the company was bound by the contractual provisions of the preferred stock, so that directors did not have any decision to make about whether to comply with the contract.
However, while Vice Chancellor Laster recognized that “the fiduciary status of directors does not give them Houdinilike powers to escape from valid contracts … the fact that a corporation is bound by a valid contractual obligation does not mean that a board does not owe fiduciary duties when considering how to handle those contractual obligations; it rather means that the directors must evaluate the corporation’s alternatives in a world where the contract is binding.”
Even when there is an ironclad contractual obligation, the doctrine of efficient breach provides room for fiduciary discretion. Under that doctrine, a party to a contract may decide that its most advantageous course is to breach and pay damages.
Just like any other decision-maker, a board of directors could choose to breach if the benefits (broadly conceived) exceed the costs (again broadly conceived). A corollary of this principle is that directors who choose to comply with a contract when it would be value-maximizing (broadly conceived) to breach could be subject, in theory, to a claim for breach of fiduciary duty.
Moreover, a corporation’s legal duty to comply with a binding contract does not foreclose the fiduciary standard of conduct from governing decisions that affect the extent to which a contingent, conditional or otherwise potentially limited contractual obligation actually materializes.
In the ODN Holding situation, the common stockholder plaintiff is not relying on efficient breach theory. Instead, it is relying on the application of the fiduciary standard of director conduct to decisions that affect the scope of contractual obligations.
The complaint asserts that the board acted disloyally by selling businesses to raise cash to satisfy a future redemption obligation before there was any contractual obligation to redeem the stock. The plaintiffs contend that if the board had retained those businesses, they would have generated greater value for the benefit of the undifferentiated equity.
According to Vice Chancellor Laster, the plaintiff correctly observes that if the company lacked either surplus or legally available funds when the redemption provisions of the preferred stock came into play, then the company would not have been able or obligated to redeem the preferred stock.
At that point, the board could have continued to manage the company for the benefit of the undifferentiated equity without having to make a massive redemption payment.
In substance, the complaint alleges that before the redemption provisions came into effect, the board breached its duty of loyalty by managing the company in a manner that maximized the value of the preferred stockholders’ mandatory redemption right, rather than managing the company to maximize the value of the undifferentiated equity.
The existence and binding nature of the preferred stock redemption right does not foreclose the fiduciary standard of conduct from operating in this context.
All that the venture capital firm possessed and could enforce was a contractual right to require the company to redeem the preferred stock to the extent the company had surplus and legally available funds.
But the redemption provisions do not foreclose a claim by the undifferentiated equity that the directors breached their fiduciary duties by generating surplus and legally available funds. Consequently, there is room for a fiduciary duty theory on the facts of this case.
In ODN Holding, the holder of the preferred stock and its designees to the board sought to insulate themselves by appointing a special committee of disinterested directors to handle the redemption-related matters.
However, under Delaware law, in situations involving a conflict with a controlling stockholder, the most that can be achieved with a special committee is to shift the burden of proof, under the stringent entire fairness standard of review, from the defendants to the plaintiff. Only a well-functioning committee of independent directors can achieve that shift.
Determining whether a committee of independent directors is effective is a fact-intensive inquiry. However, it will normally be impossible to shift the burden of proof at the motionto- dismiss stage because the defendants do not have the luxury of arguing facts that would counter the plaintiff’s well-pleaded allegations, which at that stage of the case are assumed to be true.
The Chancery Court noted that the outcome could have been different if the venture firm’s preferred stock carried a cumulative dividend. Preferred stock often carries a cumulative dividend, which steadily increases the liquidation preference.
A cumulative dividend reduces the prospect that a corporation will generate value for the undifferentiated equity by delaying the redemption, because the company not only must continue as a going concern but must also generate a sufficient return to escape the gravitational pull of the large liquidation preference and a cumulative dividend.
In such a situation, common stock may be functionally worthless, because the company can never realistically generate a sufficient return to pay off the preferred stock and yield value for the common.
However, in ODN Holding, the preferred stock did not pay a cumulative return. To the contrary, because the company would be redeeming the preferred over time with future dollars, the present value of the obligation would diminish.
Over the long term, the company conceivably could have grown its business, gradually redeemed all of the preferred stock and then generated returns for its common stockholders. The preferred stock was effectively trapped capital, and the company could have used that capital for the benefit of the residual claimants.
ODN Holding may prove a turning point in the relationship between companies and preferred stock investors. Directors and common stockholders will be less likely to accede to the preferred stockholders’ demand that the company redeem their preferred stock as required by its terms when raising the funds presents significant hardship to the company and its business.
ODN Holding will change the bargaining dynamic. Directors appointed by the preferred stockholder will want to abstain from the deliberations about redemption of the preferred stock, and the remaining directors will be more careful documenting the reasonableness of their decision-making process and the fairness of the decision to the common stockholders.