When preferred and common collide: a recent Delaware case gives directors appointed by preferred stockholders a reminder of their foremost obligation.

IT IS COMMON KNOWLEDGE that directors should act in the best interests of their corporation; however, where the interests of the corporation's different stakeholders are not aligned, directors can face complicated decisions. The board must often choose which constituency's interest will dominate. While in the sale of a company, this issue is relatively clear--directors obligations are to seek the best price reasonably available for the stockholders, issues can nonetheless arise when the interests of common stockholders conflict with those of preferred stockholders. A recent Delaware case deals with this situation, and reminds us of the primacy of the common stockholders.

In re Trados Incorporated Shareholder Litigation involved the sale of Trados Inc. to another company. Trados had issued preferred stock to various investors who also appointed four of Trados's seven directors. The preferred holders pushed for a sale of the company; ultimately, a deal was signed with a purchase price that would pay out the bulk (but not all) of the preferred stockholders' liquidation preference and provide Trados's management, which included two directors, with significant bonuses. The common stockholders, on the other hand, would receive nothing from the sale. Not surprisingly, some of the common stockholders sued the directors, alleging that they had negotiated and approved the sale without considering the common stockholders' interests and, instead, were only looking out for their own and the preferred stockholders' interests.

The Chancery Court denied the directors' motion to dismiss the common stockholders' suit, and in the process illustrated two important lessons.

First, the court found that six of Trados's seven directors had a conflict of interest or otherwise lacked independence, so their actions were subject to the exacting scrutiny of the entire fairness doctrine. The two directors who received management sale bonuses were "interested" because each received "a personal financial benefit [...] not equally shared by the stockholders ... that made it improbable such director could perform his fiduciary duties without being influenced by [his] overriding personal interest." The other four directors also were found to be not independent, not because they had been appointed by the preferred stockholders, but because a substantial part of their livelihood depended on the preferred stockholders (they were all employees, directors, and/or owners of the preferred stockholders). The plaintiff stockholders therefore satisfied their burden of establishing a lack of independence by showing that such directors were "beholden to a controlling person or so under [the controlling person's] influence that their discretion would be sterilized." And, as often is the case, this conclusion lead to the result that the directors lost their motion to dismiss and will have to proceed to trial (or a more expensive settlement).

The second lesson learned from In re Trados is that when the interests of the preferred and common stockholders conflict, directors' fiduciary duties run to the common stockholders. While the preferred stockholders in In re Trados asserted that their interests were in "obvious alignment" with those of the common stockholders in obtaining the highest price possible in the sale, the court was persuaded by the plaintiffs that the real question could instead be whether the interests were aligned regarding whether to pursue a sale of the company at all or, instead, to continue to operate the company. Reframed this way, the interests of the common stockholders would not have been aligned with those of the preferred holders because selling Trados left the common stockholders with absolutely nothing.

In general, the rights of preferred stockholders are limited to the express terms they have negotiated with the company, as set forth in the certificate of incorporation. While Delaware courts have found that directors sometimes owe fiduciary duties to preferred stockholders, these duties apparently exist only when the interests of the preferred holders are aligned with those of the common stockholders. Where the interests diverge, the board owes fiduciary duties to the common stockholders and the preferred holders must rely solely on their express contractual rights. Furthermore, the preferred stockholders cannot protect themselves by electing a director to look after their interests, since even such a director will be obliged to prefer the interests of the common stockholders over those of the preferred stockholders.

The preferred stockholder thus finds itself in a difficult position. Whereas holders of debt securities can usually look to lengthy indentures and other documents for their protections, terms governing preferred stock have historically not been as comprehensive. Preferred stockholders must remember that their rights generally will be limited to the contractual provisions contained in the company's certificate of incorporation, and that they cannot really depend either on their own appointed directors or the fiduciary duties of directors, generally, for any specific protections.

These issues can be especially tricky for private equity funds with investments in struggling portfolio companies. When conflicts arise between the funds and the other stockholders, it is best to allow committees of disinterested and independent directors deal with contentious decisions, such as whether to sell a distressed company or continue to operate it in hopes of better days. Directors should also pay close attention to what they say and do when conflicts arise, and make sure that the board minutes reflect that they were mindful of the interests of common stockholders in their decisions and were not solely acting in the best interests of the preferred stockholders who appointed them.

In the end, the rights of the preferred will take a back seat to the common, unless a different result has been negotiated in advance. And that's perhaps the third lesson of the Trados case--to deal with these potential conflicts when making the investment, and not wait until the parties are disputing how and whether to create an exit for some of the investors.

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Doug Raymond is a partner in the law firm Drinker Biddle & Reath LLP. He heads the firm's Corporate and Securities Group (www.drinkerbiddle.com).

The author can be contacted at douglas. [e-mail]. Luc Attlan, an associate with Drinker Biddle & Reath, assisted in the preparation of this column.