The Song of Preferred Stockholders: 'You Get What You Asked for, Not What You Need'
Edward M. McNally
This article was originally published in the Delaware Business Court Insider | April 27, 2011.
For a number of years, private equity investors bought preferred stock as their investment vehicle. That this stock was considered equity rather than debt made it particularly desirable for startup companies that need to conserve their borrowing capacity. For the investors, preferred stock also might have a favorable tax treatment on the inevitable day when it was redeemed by the issuing company. All the investor had to do was provide sufficient protection for itself by the rights given to its preferred stock by the issuer’s certificate of incorporation. Seems simple enough.
Yet even the most sophisticated equity investors have failed to get what they actually need to protect their investment. They have asked for literally dozens of different rights as preferred stockholders, only to find out later that they failed to get what they really needed to secure the return of their investment. While it is true that in some cases preferred stockholders are also owed the fiduciary duties owed to common stockholders, that is not good enough. After all, they are "preferred." Why have they failed to protect themselves?
There are two basic legal principles that affect the ability of preferred stockholders to protect their investment. First, it is settled Delaware law that preferred stockholder rights are based on their "contract," what the company’s certificate of incorporation provides for the preferred stock. The courts will not grant them rights they did not get in the certificate.
Two recent Delaware decisions illustrate this principle. On March 29. in Fletcher International Ltd. v. ION Geophysical Corporation, the Chancery Court said the preferred stockholder sought to protect its investment by bargaining for the right to consent to the sale of any stock by a company’s subsidiary. In that way the parent company’s most valuable assets, its subsidiaries, could not be diluted without the preferred stockholder’s approval. But when the parent company wanted to do a deal that the preferred stockholder did not approve, the parent company just formed a new subsidiary and sold that subsidiary’s stock itself. Because the certificate of incorporation only prohibited a stock sale by a subsidiary and not by the parent company, the court permitted the sale to go forward over the preferred stockholder’s objection. No amount of complaining about form over substance did the preferred stockholder any good. It still lost.
SV Investment Partners v. Thoughtworks Inc., a Nov. 10, 2010, Chancery Court decision, reached a similar disappointing result for the preferred investor. There, the preferred stock had the right to be redeemed out of "funds legally available" on the redemption date. On that date the company had a "surplus" — its assets were worth more than its debts. However, the court ruled that the preferred was not entitled to be redeemed. It reasoned that because the company had legitimate needs for its cash, those funds were not "legally available" for redemption. In short, the precise wording the preferred stockholders asked for in the certificate of incorporation did not get them what they needed to be redeemed.
Getting around this first legal principle of strictly limiting the preferred’s right is not as easy as just giving it the power to elect directors upon default. For then the second legal principle that affects preferred stockholder rights comes into play. Directors have a fiduciary duty to all stockholders, even if those directors have been appointed just by the preferred stockholders. Hence, in the Thoughtworks situation, even if the majority of the directors had been elected by the preferred stockholders, they well may have had a duty to not use its funds for redemption when other uses of cash were better for Thoughtworks.
Indeed, recent Delaware decisions have criticized directors elected by preferred stockholders who wrongly favor the preferred stock. Because of those decisions, I suspect that it is the desire to avoid assuming any fiduciary duty to other stockholders that causes some private equity investors to not seek board control even if they are not timely redeemed.
What then are the remedies of the poor preferred stockholder left to only the terms of his or her preferred stock "contract" in the face of ingenuous schemes to work around his or her rights?
To begin with, the reality is that most of the time preferred stock ends up with the preferences it asked for at the bargaining table. Even if redemption may be postponed beyond the redemption date, steeply accruing post-redemption date carrying charges cannot be ignored forever. The price to be paid is just too steep, particularly if the company is to be sold to a third party or go public. Moreover, private equity investors learn quickly. The loopholes validated by past decisions will close in the next deal. The information exchange is just too fast to permit a clever avoidance tactic to be used for very long.
Finally, as the Thoughtworks decision points out, there are multiple existing ways a preferred stockholder may protect his or her investment. Requiring that redemption be paid by a short-term note, drag-along rights or even a forced sale of the company may all protect preferred stockholders. The vigilant preferred investor will remain as "preferred" as he wants, so long as he knows what to ask for in advance. Careful drafting is the key to the desired result.
Edward M. McNally (firstname.lastname@example.org) is a partner at Morris James in Wilmington and a member of its corporate and fiduciary litigation group. He practices primarily in the Delaware Superior Court and Court of Chancery handling disputes involving contracts, business torts and managers and stakeholders of Delaware business organizations. The views expressed herein are his alone and not those of his firm or any of the firm’s clients.