Common Misconceptions Regarding Preferred Stock Create Risk of Costly Mistakes

This article originally appeared in Global Banking and Finance Review and is republished here with permission.

Preferred stock is commonly used for venture capital and private equity investments. It gives the investor the ability to convert to common stock if the deal succeeds, and also includes protection of the liquidation preference if things go poorly. Preferred stock also often provides the holder with the right to designate a director on the corporation’s board, giving him visibility and input regarding the corporation’s activities and direction. However, common misconceptions about the security of preferred stock and the benefits from designating a director may lead to costly mistakes.

Many investors believe the mandatory redemption date for preferred stock is 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.

Under Delaware law, a wide range of statutes and legal doctrines restrict the corporation’s ability to use funds to redeem preferred shares, rendering them not “legally available.” Among these, Delaware common law has long restricted a corporation from redeeming its shares when it is insolvent or would be rendered insolvent by the redemption. Consequently, a corporation easily may have funds but still find they are not legally available.

Corporate directors 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.

In a recent Delaware case, Frederick Hsu Living Trust v. ODN Holding Corp[i]., No. 12108-VCL, 2017 WL 1437308 (Del. Ch. Apr. 24, 2017), 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 ODN Holding complaint alleges that the preferred stockholder caused the corporation to alter its business plan by shifting its focus away from growth which benefitted common stockholders to raise cash that could be used for the redemption. The corporation sold three of its four lines of business in their entirety and divested the principal economic driver for the fourth line of business.

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. The board of directors of a Delaware corporation must, within the limits of its legal discretion, treat common stockholder welfare as the only end, considering other interests only to the extent that doing so is rationally related to common stockholder welfare.

Vice Chancellor Laster found that “a board does not owe fiduciary duties to preferred stockholders when considering whether or not to take corporate action that might trigger or circumvent the preferred stockholders’ contractual rights.”

The ODN Holding 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 common stockholders.

According to Vice Chancellor Laster, the plaintiff correctly observes that if the corporation lacked legally available funds when the redemption provisions of the preferred stock came into play, then the corporation would not have been able or obligated to redeem the preferred stock.At that point, the board could have continued to manage the corporation for the benefit of the common stockholders without having to make a massive redemption payment.

All that the preferred stockholder possessed and could enforce was a contractual right to require the corporation to redeem the preferred stock to the extent the corporation had legally available funds.But the redemption provisions do not foreclose a claim by the common stockholders that the directors breached their fiduciary duties by generating legally available funds.

The terms of preferred stock frequently provide the stockholder the right to appoint directors to the board of the corporation. Many investors wrongly assume the preferred-designated director will act to protect the preferred stockholder’s economic interests.

The law doesn’t recognize a special duty held by directors to any special class electing them. Although the director nominated by the preferred stockholder may have a natural affinity for the preferred stockholder’s economic interests, a director owes a fiduciary duty exclusively to the common stockholders, not to holders of preferred stock. Directors nominated by preferred stockholders are then put in the difficult situation of putting the common stockholders’ interests ahead of the preferred stockholder.The board has no fiduciary duty to maximize the preferred stockholder’s return or facilitate the preferred stockholder’s exit.

The preferred stockholder risks being drawn into stockholder litigation under the theory that the stockholder “aided and abetted” the breach of fiduciary duty by its designee directors. This litigation is more difficult to defend than garden-variety claims against corporate directors because the business judgment rule, a judicial presumption which protects directors from liability for good faith mistakes, does not apply in the conflict of interest context. Corporations also can’t indemnify directors against personal liability for breach of the duty of loyalty under Delaware law.

In short, investors must realize that the contractual protections granted to holders of preferred stock may be overridden by restrictions on the corporation’s ability to only redeem shares from legally available funds. The protections may also be overridden by directors’ fiduciary duties to common stockholders to manage the corporation’s legally available funds to prevent situations that are not in the best interests of those stockholders.