When is a holder of preferred shares of a Delaware corporation entitled to have the corporation redeem its investment? In SV Inv. Partners LLC v. ThoughtWorks Inc., Nov. 15, the Delaware Supreme Court reaffirmed that question is answered by reference to the terms of the certificate of incorporation that establish the rights of the preferred stockholder and to the proof at trial.
At issue was a clause in the company's charter that required the company to redeem the entire amount of outstanding preferred stock "out of any funds legally available therefore and which have not been designated by the board of directors as necessary to fund the working capital requirements" of the company. The Court of Chancery had concluded that "funds legally available" meant funds that could be disbursed for redemption without violating the Delaware General Corporation Law, specifically Section 160 of the DGCL, or common law. The Court of Chancery had rejected the plaintiff's definition of "legally available funds" as meaning the same as "surplus."
The court also held that, even under the plaintiff's definition, the preferred stockholder had failed to prove that the company had, or was able to secure, funds legally available to satisfy the plaintiff's claimed redemption right of $64 million. The Delaware Supreme Court affirmed without determining whether the Court of Chancery's definition of "funds legally available" was correct because, even under the plaintiff's definition, the plaintiff had failed to prove its case.
This decision has several important lessons. First, for counsel to preferred stockholders, it is important to define terms and, in light of potential statutory limits on redemptions when a company is struggling, to seek alternative protections in the charter designating the rights of the preferred. The Court of Chancery suggested several: springing rights to board control, so-called "drag along" rights to sell the entire company to a third party without board involvement, or a forced sale of the company to the preferred stockholder. In the absence of such rights, under well-settled precedent, the Delaware courts will not rewrite the parties' agreement.
Second, for litigation counsel, focus carefully on the issue to be proved in soliciting expert testimony. The plaintiff relied upon one expert to show that the value of the company's equity was in the range of $68-$137 million and therefore funds were legally available for a $64 million redemption. The Court of Chancery rejected this testimony as not probative of the relevant issue and the Delaware Supreme Court quoted approvingly its reasoning in the affirmance:
"[She] concededly did not consider the amount of funds ThoughtWorks could use for redemptions while still continuing as a going concern. She never considered how making an eight-figure redemption payment would affect ThoughtWorks' ability to operate and achieve the projections on which her analyses relied. She had no thoughts on how ThoughtWorks might raise the funds for such a redemption payment. Although defensible as a theoretical exercise, her opinion does not credibly address the issue of 'funds legally available.' It does not reflect 'real economic value' or bear any relationship to what ThoughtWorks might borrow or its creditors recover. It offers no assistance in determining whether the board acted in bad faith, relied on methods and data that were unreliable, or made determinations so far off the mark as to constitute actual or constructive fraud."
Third, for appellate counsel, the case is a reminder of the difficulty of prevailing on appeal when the decision below is grounded on a factual finding based on a weighing of expert opinion. In that circumstance, the Delaware Supreme Court will not reverse except upon a showing that the lower court's factual finding was "arbitrary or lacking any evidential support." The Supreme Court here found that the court below had a logical reason for rejecting the plaintiff's expert witness, and that if the plaintiff obtained a judgment for the amount it sought, then the company could not meet its obligations and would face bankruptcy. The Supreme Court therefore found no reversible error in the Court of Chancery's decision that the plaintiff failed to prove its entitlement to a $64 million redemption.
Although this decision does not answer the question of what the phrase "legally available funds" means, it nonetheless provides guidance to issuers and holders of preferred stock. Holders of preferred stock are stuck with the rights for which they bargain. To the extent Delaware law may limit those rights precisely at the moment when preferred stockholders may most want to exit, counsel should consider drafting for clear alternative protection. If a conflict leads to litigation, be sure that any proffered expert testimony speaks directly to what is at issue. And if the lower court rules based on a factual finding grounded in a weighing of expert testimony, do not expect to prevail on appeal absent a showing that the trial court's finding was arbitrary or lacking any evidential support. None of these lessons is new but this case provides a fresh reminder.