Are Preferred Stockholders Second-Class Citizens?
A recent decision of the Delaware Court of Chancery significantly affects the ability of preferred stockholders to cash out their investment in a Delaware corporation. Preferred stockholders need to take notice if they are to realize their investment expectations. The decision in In re Trados Shareholder Litigation, C.A. 1512-VCL (Del. Ch. Aug. 16, 2013), holds that directors elected by the preferred stockholders must protect the interests of the common stock or face potential liability if they favor the interests of the preferred stockholders.
First, some brief background may be helpful to explain why the Trados decision is so important. For many years, preferred stockholders were content to have the right to compel redemption of their preferred stock upon the events spelled out in the company's certificate of designation that established the "preference" that made their stock "preferred." For example, a typical preferred stock might have the right to be redeemed after a fixed time. Then in 2011, the Court of Chancery and Delaware Supreme Court held that the statutory and common-law limits on stock redemptions out of "funds legally available" might allow directors not to redeem the preferred and leave the preferred stockholders locked into their investment, in SV Investment Partners LLC v. ThoughtWorks, 7 A.3d 973 (Del. Ch. 2010), aff'd, 37 A.3d 205 (Del. 2011).
To avoid the problem of an unsympathetic board prepared to reject redemption as permitted by ThoughtWorks, preferred stockholders sought the right to elect a majority of the board of directors if the existing board was unwilling to carry out the exit strategy favored by the preferred stockholders. That is where Trados comes into play. While the events in Trados go back well before the ThoughtWorks case, the two decisions in combination affect the interests of preferred stockholders.
Trados held that when the directors are beholden to the preferred stockholders who elected them, this makes those directors not independent. As a result, the business judgment rule does not apply to the directors' decisions concerning the preferred stock, and instead their actions must be justified under the entire fairness standard of review. Further, Trados concluded that the directors had a duty to protect the interests of the common stock, even if at the expense of the preferred stockholders' interests. Hence, in the absence of a clear contractual right of the preferred, the directors must favor the common stockholders. Translated to the real world, for example, that means that the directors elected by the preferred stockholders might not vote to sell the company when the common stockholders would receive nothing in the sale because the preferred stock's liquidation preference takes up all of the sale price.
Indeed, directors who violate this duty to the common stockholders face real liability exposure. The Delaware statutory protection of directors against damage judgments does not apply to a "breach of the director's duty of loyalty to the corporation or its stockholders." Directors acting improperly to favor the preferred stockholders who elected them would not be protected from a damage award. Furthermore, when as in Trados the alleged breach of duty involves a cash-out of the common stockholders, damages would be measured by a court's views on conflicting expert opinions in a trial. If the court concluded that the common stock received less than the residual "fair value" of that stock, the directors would be liable for the shortfall.
This places directors in a difficult position when faced with the desire of preferred stockholders to be bought out, even while the sale will not provide much if anything to common stockholders. This problem is particularly rocky when the company's prospects are not favorable. For if the directors refuse a sale and the preferred stock is dragged further underwater, the preferred stockholders will be damaged. While admittedly there is little precedent for a damage award to preferred stockholders in those circumstances, that is hardly comforting to the directors facing such a claim.
What, then, to do about this Trados dilemma? First, the problem of how to protect the preferred stockholders might better be addressed at the outset of their investment. For example, the parties might choose to use an alternative structure, like a limited liability company or limited partnership, where the Delaware statutes expressly provide that the parties may modify or eliminate the duty of loyalty. If the parties use a corporation as the investment vehicle, they may provide in the certificate of designations that the rights of the preferred stock include both drag-along rights and a provision expressly permitting the directors to favor preferred stockholders when their liquidation rights are triggered by the passing of time or a specified event. Yet those solutions may not be ironclad.
As to drag-along rights, the Court of Chancery in both Trados and ThoughtWorks endorsed the enforcement of drag-along rights to require common stockholders to sell their stock when the preferred stockholders decide to sell their stock. As with any collective action, there are problems with enforcing drag-along rights. How those problems will be worked out remains to be seen.
As to authorizing favoritism of preferred stockholders by provisions in the company's certificate of incorporation, that solution, too, has its problems. To date, there is no direct precedent to guide the drafter of such a provision. There is ample precedent for conflict of interest exculpation provisions in limited liability company and limited partnership agreements that might be useful. Nonetheless, such a provision in a corporate charter remains untested.
A more traditional approach to solving the director's dilemma of how to reconcile the claims of preferred and common stockholders is found in Delaware merger law. In Trados, the court held there was an unfair process used to decide whether to sell the company. According to the court, the mistakes arguably included incentives to management to seek a buyer quickly with the common stock effectively paying for those incentives while being cashed out for nothing, failing to use a special independent negotiating committee to decide whether to sell Trados, misinforming the directors of the scope of their fiduciary duties and not making the sale contingent on the approval of the common stockholders. If those mistakes are avoided, it may be possible to have the decision to sell subject to the business judgment standard of review. The recent application of that standard to controlling stockholder mergers suggests it may be applied to decisions to sell the company even when the common stockholders receive little or nothing.
Obviously, these steps to ensure a fair process will come at a cost. Common stockholders will not vote to approve a sale unless they get something out of it, for example. However, some recent settlements of class actions brought by dissatisfied common stockholders when the preferred received most of the sale proceeds suggest that the common stock payment need not be a significant part of the deal. After all, something is better than nothing.
Exactly how the Trados dilemma will play out remains to be seen. The suggestions made here to resolve the preferred-common conflict are probably not the only ones available. But, Delaware corporate law has shown it will evolve to enable parties to make investment decisions with clear and enforceable expectations as to their rights and obligations. It will do so here as well.