A theory of preferred stock.
This Article examines recent cases about preferred stock to show two facets of Delaware law coming to bear as the synchronization process proceeds: first, reliance on independent directors for dispute resolution, and second, the common stock--value maximization norm. These trends cause the law to tilt toward corporate norms, thereby disrupting allocated risks in heavily negotiated transactions, particularly in the venture capital sector. The Article makes three recommendations that would promote the goal of restoring balance between the corporate and contract paradigms. First, the meaning and scope of preferred contract rights should be determined by courts, rather than by issuer boards of directors. Second, conflicts between preferred and common should not be decided by reference to a norm of common stock-value maximization. Instead, the goal should be the maximization of the value of the equity as a whole. Third, independent-director determinations of conflicts between preferred and common should not be accorded ordinary business judgment review. Instead, a door should be left open for good faith review tailored to the context. This review would require a showing of bad faith treatment of the preferred where the integrity of a deal has been undermined, with the burden of proof on the board.
INTRODUCTION A. Corporate Legal Theory B. Institutional Posture and Normative Concerns C. Structure of This Article I. THE PARADIGMATIC BACKDROP: CORPORATE TREATMENT IN DEPRESSION-ERA EQUITY RECAPITALIZATIONS A. The Recapitalization Problem B. Cramdown C. Summary II. PREFERRED STOCK AS FIDUCIARY BENEFICIARY: MERGERS A. The Problem and the Alternative Solutions 1. Fiduciary Treatment and Standards of Review a. Blockholder Domination b. Dispersed Common Standard of Review 2. Contract Treatment a. The Preferred Contract as Complete b. Appraisal Rights 3. Summary B. Delaware Law C. James Analysis D. Summary III. THE PAYMENT STREAM A. The Promise to Pay on Preferred B. The Thought Works Solution C. An Explanation and an Alternative D. Summary and Analysis IV. PREFERRED IN CONTROL: VENTURE CAPITAL UNDER CORPORATE FIDUCIARY LAW A. Venture Capital Financing 1. The Upside and the Downside 2. Control Arrangements B. The Trados Intervention C. Trados and the Value-Maximizing Merger 1. Common Stock Maximization Versus Enterprise Value Maximization 2. Selling the Company Under Trados 3. Contracting Out of Fairness Scrutiny: Drag-Along Rights 4. Summary D. Trados and the Suboptimal Merger E. Standards of Review V. TRAVERSING THE PARADIGMATIC DIVIDE A. Doctrinal Overlap B. Delaware's Approach C. Consistency as an Alternative D. Value Maximization and Paradigmatic Conflict CONCLUSION
Preferred stock is undertheorized. The most recent comprehensive study appeared almost six decades ago. (1) Commentary on the subject since then has been sporadic. (2) Yet preferred stock's economic salience has increased notably in recent decades. The volume of new preferred offerings outstrips both that of initial public offerings (IPOs) of common stock and of new public common offerings by seasoned issuers. (3) Preferred also is the favored mode of investment in the venture capital sector. (4) Finally, it is much utilized in the financial sector. (5) For example, the U.S. Treasury purchased more than $200 billion of preferred under the Troubled Asset Relief Program. (6)
It is time for a new look at preferred. There are three reasons why such a review is warranted--the first theoretical, the second institutional, and the third normative.
A. Corporate Legal Theory
The theoretical interest concerns the problem of defining the corporation's boundaries, asking the "who's in and who's out" question regarding the line dividing fiduciary beneficiaries from contract counterparties. The problem has been traversed extensively in corporate legal theory (7) without anyone noticing the special case of preferred. Preferred stockholders are the only corporate constituents who straddle the line--their participation being both corporate and contractual. It therefore follows that resolving problems relating to preferred stock offers special information about the corporation's borderland.
The classic common stockholder surrenders capital to the company with no right to pull it back out: the stockholder takes the residual financial risk on both the downside and upside and gives up direct input into business decisions in exchange for a vote at an annual election of the board of directors. The interest can be viewed contractually, but the contract that emerges is almost entirely incomplete, with open-ended fiduciary duties substituted for negotiated financial rights. Whether viewed through the lens of corporate or contract law, common stockholders are seen as "insiders." Lenders also contribute capital to corporations, often for long periods, but they do so under contracts that create enforceable financial priorities. The contracts approach completeness, and courts balk when asked to imply additional rights in cases where lenders find themselves in vulnerable positions. (8) Lenders sit "outside" of the corporation, and look to specific, bargained-for rights to protect their interests rather than the apparatuses of governance and fiduciary duty.
Stockholders are corporate, lenders are contractual, and a well-understood wall separates their legal treatments. Preferred stock straddles the wall. The holder receives a share of stock issued pursuant to the same corporate code and charter as a share of common stock. The stock, viewed in isolation, carries the same vulnerabilities as a share of common stock and exists in the same regime of rights and duties. The issuer then adds contract rights to the stock--either financial preferences or a debt-like right to be paid certain sums on set dates--thus rendering it preferred stock. (9)
So is preferred stock equity or debt? Is it stock subject to the rules of corporate law or a senior security governed by contract law? Is it an incomplete contract filled out by fiduciary duty or a complete contract with the drafting burden on the party asserting the right? These are the central questions of the law of preferred stock. This Article provides answers and thus fills the void of corporate legal theory.
Preferred stock sits on a fault line between two great private law paradigms, corporate law and contract law. It is neither one nor the other; rather, it draws on both. (10) The overlap involves two grundnorms and brings them into conflict. On the one hand, the corporate paradigm instructs that managing to the common stock, since stockholders are residual interest holders, maximizes value; on the other hand, the contract paradigm instructs that holding parties to contractual risk allocations maximizes value. When questions arise concerning the relative rights of preferred and common, the paradigms can hold out conflicting answers. Decisionmakers choose between the two, sometimes applying corporate law principles, while at other times opting instead for the framework of contract law. As a result, the law vacillates.
This observation does not mean that the law never draws lines. Sometimes, clear categorical placements must be made, and preferred is effectively pigeonholed on one side or another of the debt--equity line. For example, bank capital rules treat preferred as equity (sometimes, on par with common), (11) Generally Accepted Accounting Principles (GAAP) require some preferred to be booked as debt, even though formally it is stock, while other preferred is booked as equity. (12)
Things get harder and neat results prove elusive when courts address cases in which the economic interests of preferred and common stockholders come into conflict. The Delaware courts have attempted to effect a clean paradigmatic split by referencing corporate law when the matter concerns "a right shared equally with the common" and referencing contract law when the matter concerns special rights and preferences. (13) But this line of demarcation proves too vague and the area of paradigmatic overlap proves too extensive to permit easy compartmentalization. Decisions are not remitted to the law of debtor-creditor on the "rights and preferences" side of the split; rights shared with the common are not defined by exclusive reference to corporate law. Preferred sits on the line; it is both. Therefore, coherence in treatment cannot follow from black-and-white references to contract or corporate law. Both paradigms come to bear and decisionmakers need to synchronize their simultaneous application.
This is not easy to do. This Article clarifies the field with a close examination of four recurring points of dispute--equity recapitalizations, allocations of merger proceeds, enforcement of payment mandates, and fundamental changes effected by preferred in control. We show that dispute resolution in all four categories requires negotiation between the two paradigms rather than unwavering reliance on one or the other.
B. Institutional Posture and Normative Concerns
The Delaware courts have emerged as the dominant arbiters of preferred stock disputes. (14) What was once a disparate, multistate case law on the subject is now articulated by the Delaware judiciary in a closed, self-referential context--a context highly sensitive not only to each case's facts but also to its implications for the overall framework of Delaware corporate law. That framework has undergone notable developments over the past several decades. As ever, the Delaware courts accord respect to boards of directors' business judgments, but they now push boards to remit dispute resolution to independent directors and temper their board centrism by recognizing a norm of shareholder-wealth maximization.
Recent Delaware cases strive to integrate the law of preferred within this framework. The integration project both inspires innovation and causes stresses and strains. Unfortunately, the latter effects have been in ascendance recently as the courts have reset the balance between corporate and contractual treatment. Although framed in contractual terms, the rebalancing has the effect of pushing preferred deeper into corporate territory. Board decision-making primacy has that effect: because courts review processes leading to outcomes rather than the outcomes themselves, questions about substantive rights that a half century ago were seen as matters for judicial determination now devolve to corporate boards. (15) In addition, challenges to board judgments now can be viewed through the lens of common stock-value maximization. (16) The two frames, taken together, tend to assure that preferred stockholders lose their cases. Taken alone, this outcome would not be problematic, but destabilizing implications follow for the financial markets, particularly the venture capital sector. Arm's length deals are being undercut due to overemphasis of preferred's corporate character and under-emphasis of transactional context.
We propose a contrasting framework built on three principles. First, courts, rather than issuer boards of directors, should determine the meaning and scope of preferred contract rights. Second, conflicts between preferred and common should not be decided by reference to a norm of common stock--value maximization. Instead, the goal should be the maximization of the value of the equity as a whole, with the enterprise rather than the common stock as the value yardstick. Third, independent-director determinations of conflicts between classes of preferred and common should not be accorded ordinary business judgment review. Instead, a door should be left open for good faith review tailored to the context--a rule leading to judicial intervention when there has been a showing of bad faith treatment of the preferred that undermined the integrity of a deal.
C. Structure of This Article
Part I describes the corporate--contract balance set during the first half of the twentieth century. The courts confronted downside situations in which preferred stockholder claims interfered with corporate equity recapitalizations that would have enhanced enterprise value. Preferred holders played the contract card, analogizing to the claims of bondholders. The companies insisted that the preferred, as stock, be made to sacrifice for the good of the enterprise. The companies won; preferred henceforth would irretrievably be stock, and the corporate law paradigm would limit claims to contractual priority.
Part II addresses problems arising from acquisitions of preferred stock issuers. Although a corporate charter can fix an allocation of merger proceeds for a preferred class in advance, such a term often is omitted. It follows that a merger creates an allocational issue for decision by the issuer board of directors, a body elected by common stockholders. The preferred holders frequently complain about the conflicted result. We show that a plausible case can be made for either corporate or contract treatment--the former meaning fiduciary scrutiny along majority-to-minority lines and the latter limiting the preferred to rights explicitly reserved by contract and the statutory appraisal remedy. We go on to show that both approaches have influenced Delaware decisions, thereby creating a classic case of mixed signals in mutual tension due to paradigmatic overlap. The tensions recently came to a head in a Delaware Chancery Court decision, LC Capital Master Fund, Ltd. v. James, in which the court forcefully resolved them by treating the charter as a complete contract, effectively expanding the board's zone of allocational discretion. (17) But we read the contract in question differently than did the Chancery Court. In particular, we show more generally that preferred stock contracts cannot presumptively be modeled as complete and that the common stock-maximization norm has no productive role to play in merger allocation disputes. At the same time, we share the Chancery Court's aversion to full-dress fiduciary review and agree that statutory appraisal usually affords an adequate remedy. (18) We think that some minor boardroom process adjustments and minimal judicial scrutiny under the good faith rubric can both finesse the problem of paradigmatic ambiguity and accommodate the interests at stake.
Part III considers the paradigmatic overlap occasioned by preferred with mandatory dividend and redemption rights--debt-like promises to pay preferred holders. The promises take second-order status because their performance is conditioned on the presence of "legally available funds" as defined by corporate legal capital rules, fraudulent conveyance law, and an open-ended and conflicting body of old cases. The Delaware Chancery Court has taken a new look here as well. In SV Investment Partners, LLC v. Thought Works, Inc., it resolved ambiguities in favor of corporate treatment by leaving the decision whether to pay to the business judgment of issuer boards of directors. (19) We agree that ambiguities need resolution but suggest that the modern legal framework better accommodates resolution in the opposite, contractual direction.
Part IV addresses the venture capital context, where preferred stockholders often control the board of directors but also operate under pressure to monetize their equity investments. The Chancery Court, at the behest of complaining minority common, recently reviewed a sale engineered by exiting venture capitalists. (20) The In re Trados court opened a wide door to intrinsic fairness review on the common's behalf (21)--in our view, too wide. Part IV looks critically at Trados and projects that the case will negatively impact the venture capital business model. We trace the problem to the court's application of the common stock-maximization norm and recommend, first, that enterprise value maximization be substituted as the fiduciary yardstick and, second, that a door be opened to waiver by common of fiduciary protection in venture deal documentation.
Part V reviews the Article's sequence of analyses and asks whether a more consistent regime of across-the-board corporate or contract treatment would improve matters. We find that a paradigmatic harmonization initiative would disturb both transactional risk allocations and corporate governance. Rather, preferred is dual and works only when both paradigms are consulted.
I. THE PARADIGMATIC BACKDROP: CORPORATE TREATMENT IN DEPRESSION-ERA EQUITY RECAPITALIZATIONS
Courts confronted the choice between the corporate and contract paradigms in stark terms during the first half of the twentieth century. In those days, American industrial firms routinely financed with priority, cumulative preferred. (22) "Priority" means that a set preferred dividend must be paid before a dividend may be paid to the common, but that the preferred dividend may be skipped at the discretion of the board of directors. (23) "Cumulative" means that past skipped preferred dividends must be made up before the common can receive dividends. (24) Although there is no promise to make a payment, the cumulative priority can constrain
the issuer board's freedom of action.
The priority arrangement works well in prosperous times. The enterprise creates free cash flows and the preferred gets its dividend at a rate of return higher than that on the same issuer's bonds. However, even moderate distress alters the situation in the following manner: The enterprise pays its bondholders and even turns a small profit, but the board needs to reinvest every cent to keep the business functioning; therefore, it withholds preferred dividends. Under the cumulative feature, dividend arrearages gradually build up. The arrearages in turn prevent the company from making periodic payments on its common, thus inhibiting the sale of additional common to raise new equity capital. As more arrearages accumulate, the issuer's equity capital structure becomes increasingly dysfunctional, with the lion's share of the marginal economic interest appended to the preferred even as the votes for the board of directors stay with the common. (25) Under this scenario, preferred rights look increasingly like barriers to progress for the enterprise as a whole.
During the Great Depression, such capital structures crowded the corporate landscape. (26) The project of clearing the wreckage triggered disputes that posed fundamental choices between contract and corporate treatment. Contract law privileged preferred fixed claims and reinforced barriers, while corporate law facilitated the barriers' removal. The early twentieth-century courts emphatically endorsed corporate treatment, and the choice has stuck. The result is a curious hybrid legal status for the preferred: contract rights, no matter how thickly applied, are potentially subject to diminution for the good of the enterprise.
This Part recounts the Depression-era choice set. Section I.A describes the problem confronting the issuer of preferred in arrears more fully than the brief overview above. Section I.B sets out the solution of a cramdown recapitalization and the resulting legal questions and finishes by looking at the courts' move to corporate treatment in resolving these issues. Section I.C considers the paradigmatic implications of this Part's points.
A. The Recapitalization Problem
Consider hypothetical ABC Corporation, which has a total market equity capitalization of $100 million. There are one million preferred shares outstanding and two million common shares, with the preferred trading for $80 per share and the common for $10 per share. The preferred carries a cumulative dividend preference plus a liquidation preference under which its holders will be paid $100 per share along with all accrued dividends before the common receives any liquidation proceeds. The liquidation preference plus dividend accruals total $150 per share.
An infusion of new capital into ABC will facilitate a turnaround. Money is tight and no loans are available; therefore, a new equity offering makes sense. The preferred arrearages, however, block this option, since a new common issue holding out no prospect of cash returns will not sell for much in the market. Alternatively, if the preferred can be transformed into common through a recapitalization, the arrearages will disappear. A successful recapitalization to an all-common structure will increase the company's equity to $120 million.
An allocation question arises: Recapitalization increases the pie's size to $120 million and then slices it and hands the pieces to the preferred and the common by any of a range of possible splits. At one end, the entire gain could be allocated to the preferred, which would follow if the preferred received eight common shares for each preferred share (eight million to the preferred, valued at $100 million; two million to the common, valued at $20 million). At the other end, the entire gain could be allocated to the common, which would follow from a four-to-one allocation to the preferred (four million to the preferred, valued at $80 million; two million to the common valued at $40 million). Directly in the middle, an exchange ratio of six-to-one evenly splits the $20 million gain (six million to the preferred valued at $90 million; two million to the common valued $30 million).
Assume that the board decides to split the gain equally and recapitalize on a six-to-one basis. How does it successfully structure the recapitalization? The board could set up a voluntary exchange offer, asking the preferred to tender back their shares and, in turn, receive six common for each preferred tendered. Unfortunately, the offer creates a hold-out problem. The preferred can refuse to tender and insist on a more favorable ratio. Even if a majority of the preferred cooperate, a minority will likely stand pat. If 80% of the preferred holders accept, the 20% holding out retain their stock with liquidation preference and arrearages intact at $150. If their ploy works, the holdouts eventually get their arrearages paid down, coming out significantly ahead of the others. This holdout possibility destabilizes the transaction.
The ABC board needs to cram down a recapitalization. Under the contract paradigm, strictly applied, cramdown is impossible. To see why, compare an issue of bonds that stands in the way of progress. To scale back the bondholders' claims, the issuer must either procure their unanimous consent to a direct amendment of the bond contract (27) or get a supermajority to consent to an exchange offer. (28) Either way, the issuer must confront the aforementioned holdout problem. (29) The debt claimant can face an involuntary haircut only in a bankruptcy reorganization proceeding, (30) and then only if every junior claimant is wiped out. (31)
Preferred stock worked the same way during the Victorian era. The Victorians took contract law seriously; amendments to corporate charters could not proceed without unanimous consent. (32) But the unanimity rule was relaxed during the early twentieth century when corporate codes were revised to permit charter amendment by majority vote. (33) This relaxation opened a route to an involuntary out-of-bankruptcy cramdown against preferred. Although the preferred's obstructive priorities are contract terms, they are embedded in the issuer's charter rather than in a freestanding contract (as occurs with debt securities). Once corporate codes allowed charter amendment by majority vote, it logically followed that the boards and common stockholders could join together to impose mandatory exchanges on preferred issues.
To see how, we return to ABC Corporation and note that the preferred holds only one-third of the votes. So, preferred shareholders accordingly cannot block an amendment approved by the board and submitted for shareholder ratification. At the same time, the common can be expected to vote in favor of an amendment only if it holds out a clear-cut gain. The board, concerned about this threat, takes a hard look at the six-to-one exchange ratio, and decides that the allocation favors the preferred enough that it could trigger possible resistance among the common. To avoid that undesirable outcome, it adjusts the ratio to five-to-one (71.5% or $85.7 million to the preferred and 28.5% or $34.3 million to the common) and submits the amendment to a vote.
The corporate-contract issue is joined at this point. Assume no preferred issuer has ever attempted such an amendment. The revised corporate code, read literally, not only permits it, but, indeed, contains a reservation clause that permits legislative amendments to alter existing rights. (34) Still, it is likely that a wall of conceptual resistance to the proposed amendment will exist. Preferred rights are widely assumed to be contractual and vested, (35) just like the rights of bondholders. However, when one views the preferred contractually, the amendment makes no structural sense: What stops the company from transferring value from the preferred to the common by cramming down a recapitalization on a one-to-one basis or a one-fourth-to-one basis? What is the value of a promise that can be unilaterally amended away by the promisor? Arguably, such rights are illusory and without value. Allowing the amendment, then, undercuts the financial transaction that created the preferred in the first place, particularly given a class of preferred issued and sold before the amendment of the corporate code.
The reviewing court faces a stark choice. Contract treatment ensures the consent of the preferred, but also leads to holdup and a dysfunctional capital structure. On the other hand, corporate treatment undercuts the deal but also applies the corporate code as written and facilitates a fresh start in the best interests of the corporate community.
Depression-era courts split on the question. Some, including the Delaware Supreme Court, held that the amended code's majority vote provision could only be applied prospectively--that is, to preferred created after the enactment of majority amendment. (36) Courts in most states, including New York, both in the Depression era and the decades following it, held that no such vested rights existed. (37)
The vested-rights era did not last long, even in Delaware. A few years after recognizing vested rights, the Delaware Supreme Court encountered a case in which an issuer used a different technique to the same end: Federal United Corp. v. Havender. (38) This time, instead of directly amending its charter, the issuer effected a "dummy" merger in which it created a wholly owned shell subsidiary and then entered into a merger agreement with the subsidiary pursuant to which the subsidiary was the surviving corporation. (39) Typically in these mergers, the merger agreement provides that the existing shares of the issuer, both preferred and common, will be "converted" into common shares of the surviving corporation. (40) The conversion strips the arrearages. Significantly, different sections of Delaware's corporate code governed mergers and charter amendments at the time; this practice continues even today. (41)
In Havender, the Delaware Supreme Court found the statutory difference to be determinative. (42) The code's merger section permitted the transaction in question and had always done so. (43) The preferred argued that the section's employment in the present case amounted to a formal ruse, in that it accomplished what the court had forbidden by direct charter amendment. (44) The court rejected this argument, along with a "vested contract rights" claim to unpaid dividends (45): transactional limitations found in one section of the code do not constrain a party's use of another section of the code to reach the same substantive result that the first section prohibits. (46) The point survives as Delaware's "bedrock" doctrine of independent legal significance. (47)
Henceforth, recapitalizations would be easily effected with or without the voting support of the preferred--so easily, in fact, to have prompted the legislature to make a concession to the preferred. Now, in Delaware and elsewhere, (48) a charter amendment that alters or changes "the powers, preferences, or special rights" of a given class must be approved by a majority vote of that class. (49) The class vote mandate holds out a veto of a one-sided amendment while substantially diminishing the holdout problem. But Part II demonstrates that the dummy-merger route to cramdown remains open. (50)
To create an absolute contractual claim against a corporation in exchange for an infusion of $1 million of capital, an authorized officer simply needs to write, "The corporation promises to pay you $1,000,000" on a piece of paper and sign it. Absent the holder's consent, the claim can be impaired only in the context of a bankruptcy proceeding. Resistance to unconsented impairment persists even there, manifested in the absolute priority rule. (51)
Preferred stock is stock issued under a corporate charter and is therefore more vulnerable than debt. The Depression-era courts removed the contract paradigm's protection to make way for enterprise value enhancement under the corporate paradigm. A question arises: Is there any way to invoke contract and draft the preferred into the same absolute contractual status enjoyed by debt? Parts II and III will show that such status is not possible. With preferred, corporate and contract inevitably overlap.
II. PREFERRED STOCK AS FIDUCIARY BENEFICIARY: MERGERS
When a corporate bond issuer merges into another corporation, the bonds, by operation of law, carry over to the surviving corporation's capital structure with their rights untouched. (52) It is different with preferred stock. When a preferred issuer merges into another company, the preferred lies on the corporate side of the line, and corporate law makes it possible for merging companies to effect top-to-bottom rewrites of their equity capital structures. What comes into the merger as a fixed interest security can come out the other end as cash, common stock, preferred with different rights and preferences, or debt, and, in any case, in an amount with a value determined by the issuer's board of directors. A merger also can be structured to leave a target company's preferred's rights unaffected, as would occur with a bond. But nothing requires such treatment. Mergers thus hold special risks for minority preferred. It would seem to follow that the preferred, as a minority voting class, should benefit from the same fiduciary protection extended to common stock minorities cashed out in parent-subsidiary mergers. (53)
It is not so simple, however. Preferred stock, as stock, does enjoy the protection of the duties of care and loyalty. Given, for example, injurious management self-dealing, a holder of preferred has the same standing as a holder of common to enforce the duty of loyalty in a derivative action. (54) But once we get past cases in which the preferred and the common share an interest in good, clean management, tensions between the contract and corporate paradigms undermine the preferred stockholder's case for fiduciary beneficiary status.
There are three countervailing considerations, the first two of which are corporate. First, the preferred's financial interest is defined by contract rights that conflict intrinsically with the interests of the common, and corporate law generally resists attempts to bring adverse contract counter-parties inside the fiduciary tent. (55) Second, it is thought that a single-minded focus on the common interest keeps management better focused on value maximization. (56) The third consideration is contractual: protective contract terms are available to preferred while publicly traded common tends to draw its rights from corporate law's background default regime.
However, the Delaware courts do entertain preferred claims of unfair treatment in the context of divisions of merger proceeds. This line of cases dates back to the early twentieth century but consists of cases that, at best, tentatively recognize these preferred rights. (57) These cases take such a tentative approach that the Delaware Chancery Court recently expressed second thoughts about the whole enterprise in LC Capital Master Fund, Ltd. v. James. (58)
This Part conducts a de novo review of preferred stockholders' rights in the merger context. Section II. A lays out the policy alternatives: (1) fiduciary scrutiny for preferred (which poses a difficult follow-up question about the proper standard of review) versus (2) the complete rejection of fiduciary scrutiny for preferred on the grounds that their rights are contractual and that the statutory appraisal remedy always provides adequate protection against oppressive treatment. Section II.B reviews Delaware precedent and shows that its reliance on both of the foregoing alternatives imbued it with internal contradictions. Section II.C considers the James opinion, which pushes in the direction of the contractual alternative in looking negatively at the fiduciary precedent without explicitly overruling it. We conclude that fiduciary review remains a necessary part of the law surrounding preferred rights in mergers, held in reserve for extreme cases. More particularly, given a merger allocation effected by a preferred issuer's independent directors, good faith suffices as the standard of review, but the issuer's board of directors should bear the burden of proof on the good faith question. Our treatment follows from a critical legal conclusion: preferred shareholders have no corporate law right to share in merger gain.
A. The Problem and the Alternative Solutions
Mergers of preferred issuers tend to create allocational problems on the moderate downside. To see why, compare the downside and upside extremes. On the extreme downside, the issuer's debt load is unsustainable and any acquisition is likely to be through a Chapter 11 reorganization where the preferred's contract rights will be transformed into a matured claim with priority over the common, (59) On the upside, there is plenty for everybody so there is not much about which to fight. The preferred's dividends are paid up. If the preferred shareholders are fortunate enough to have a conversion privilege, they can protect themselves by converting. If they have no conversion privilege, the preferred's share of the issuer's value likely is capped at the stated liquidation amount, and there will be no serious argument that the preferred is worth less. (60) If the acquiring corporation wants the preferred out of the surviving corporation's capital structure, it can redeem the issue at the principal amount stated in the charter. If the acquiring corporation deems the preferred's financial terms favorable, it can leave the preferred in place.
Things are less clear-cut when a merger occurs on the moderate downside. To set up the problem, let us return to ABC Corporation and its $100 million market capitalization comprised of i million preferred shares trading for $80 and 2 million common shares trading for $10, with the preferred's liquidation preference and dividend arrearages totaling $150 per share. Assume that ABC's board of directors has entered into a merger agreement with XYZ Corporation for a consideration of $140 million. Further, assume that the board has fulfilled its duty to obtain a beneficial merger price (61) and that the acquirer wishes to cash out the preferred along with the common. A question arises regarding the preferred's share of the merger proceeds of $140 million--a share to be assigned by the issuer's board of directors.
We pose three possible results: Allocation 1 splits the $40 million merger gain evenly (if not pro rata) (62) with $100 million to the preferred and $40 million to the common; Allocation 2 splits the proceeds with $80 million to the preferred and $60 million to the common, thereby leaving the preferred in its premerger market position and allocating the entire gain to the common; and Allocation 3 gives $70 million to the preferred and $70 million to the common, thus transferring $10 million of the preferred's ex ante market value to the common.
The corporate and contract paradigms suggest contrasting responses when the preferred come to court and argue that a board's allocation is unfair. Under the corporate paradigm, the court entertains the fiduciary claim--a decision that requires articulating a standard of review. Under the contract paradigm, the court withholds fiduciary scrutiny on the ground that the preferred could have contracted for protection; preferred shareholders, having failed to do so, have left only the statutory appraisal remedy. We will show that both approaches are plausible but also problematic.
1. Fiduciary Treatment and Standards of Review
A decision to subject a preferred--common allocation of merger proceeds to fiduciary review follows from a rough analogy to duties for majority--minority common shareholders. Although the preferred stock contract might have specified a merger payout in advance (for example, liquidation value or liquidation value plus arrearages), it does not. This omission leaves the preferred in a vulnerable position--members of a board of directors who owe their positions to the votes of common stockholders fix the value of its participation. The common thus in some sense "control" the board. If the board, instead of proceeding in an even-handed way, skews the allocation of merger gain to the common, the situation arguably is one of a majority-dominated board using its control power to exclude the "minority" preferred to its detriment. (63)
The claim is stronger under Allocation 3, with its negative-sum wealth transfer, than under Allocations 1 and 2. No action can be grounded on the fact that an allocation falls short of the preferred's $150 liquidation preference. The Depression-era courts rejected such an absolute priority theory of fairness (64) and the Delaware courts have maintained that view in the cash-out merger context. (65) The law thus does not provide an objective calculus of fair allocation. Indeed, contemporary courts avoid such pie-slicing inquiries and instead review the boardroom process that resulted in the merger.
With process as the focus, courts must choose a standard of review. Corporate law offers a choice between the strict intrinsic fairness test and the less strict good faith standard, with variations within the two categories. Formulating and then sticking with a given standard will prove difficult because the analogy to majority-minority fiduciary duties may be stronger or weaker depending on the issuer's shareholding configuration. Accordingly, we analyze the standard of review question through two shareholding lenses--first, from the perspective of a blockholder-dominated board, and second, from the perspective of an independent-director board elected by dispersed shareholders.
a. Blockholder Domination
We begin with a board dominated by a blockholder, in which the blockholder owns a majority of the common shares and its agents comprise a majority of the company's board of directors. The merger allocation thus deeply implicates the blockholder's financial interests. Indeed, the situation strongly resembles the well-worn fact pattern of a parent-subsidiary merger where the parent company merges the subsidiary into itself using its control power to effect a lowball payment to the subsidiary's minority shareholders. (66) The best the preferred can expect is Allocation 2, yet they should be prepared for Allocation 3.
Analogizing this blockholder-dominated board situation to parentsubsidiary mergers should result in intrinsic fairness as the standard of review, with the burden of proof on the controlled board. (67) Under the parent-subsidiary merger cases, the fairness burden of proof can be shifted to the challenger if the subsidiary board appoints a special committee of independent directors to negotiate the merger price on the minority shareholders' behalf and accords the committee veto power. (68) It would seem to follow that the preferred here should have a veto-wielding special committee of disinterested directors appointed to negotiate its merger allocation.
However, the analogy is imperfect. In the parent-subsidiary context, intrinsic fairness review and the resulting special committee force a negotiation over a single point--the value of the subsidiary. Once the value is set, the relative proportions of stock ownership determine its allocation. The preferred's place in a merger is more complicated. The issuer, its majority stockholder, and its board negotiate the company's value with a third-party acquirer. A committee of independent directors may take the lead in that process on the issuer's behalf. (69) A second special committee representing the preferred would address an ancillary allocational matter--a matter unlikely to admit of a clear answer. The appearance of such an additional committee in the merger process would be cumbersome at a minimum. It also could be disruptive where the primary negotiation with the third-party acquirer (or group of potential acquirers) is ongoing. For instance, assume that a tentative price is on the table, but that questions remain open about the mode of payment (cash or stock) and acquirer financing (whether it will borrow money or issue new preferred). A second negotiation between the target issuer and its own preferred could raise valuation questions with spillover effects on valuation at the primary negotiation.
If the company deemed salient the potential negative consequences associated with a second preferred committee, it would refuse to form the committee, thereby remitting the preferred allocation to the special committee charged with approving the terms of the merger. The refusal would be significant, for independent-director negotiation is sufficient to shift the burden of proving unfairness, whether as to process or to price, to the complaining preferred. (70)
b. Dispersed-Common Standard of Review
Contrast the above with a case where both the common and preferred are widely held and a majority of the board is independent, and the independent directors own some common, either awarded as incentive compensation or purchased as a bonding exercise. Assume the merger leads to Allocation 2. One can still draw an inference of self-interest--the preferred get no share of the merger gain--but one also can give the independent board members the benefit of the doubt. Dispersion of the set of voting principals arguably relieves the board of pressure to skew the distribution in the common's favor. If the directors' holdings of common do not comprise significant portions of their personal wealth, we can imagine them as credible independent decisionmakers constrained by reputational interests. From this perspective, these directors are no less able to dispose of their financial conflict than to handle a conflict posed by a self-dealing transaction between a top manager and the company, a job they are routinely called on to perform. Leaving the decision to the business judgment of independent directors therefore seems more reasonable than in the blockholder case, discussed above in subsection II.A.1.a.
Thus, for the standard of review in this situation, we abandon the analogy to parent-subsidiary mergers that applied in the blockholder context and instead adopt an analogy to independent-director review of a management self-dealing transaction. In recent years the courts have relaxed the standard of review for these determinations. Under the former standard, the test was intrinsic fairness with the burden of proof on the plaintiff as long as disinterested directors had approved of the transaction. (71) More particularly, a board defending its approval of a self-dealing transaction would have the burden of proving its own disinterestedness and inquiry into the terms of the transaction. (72) If the board satisfied this burden, the plaintiff still would have a chance to prove that the value allocation was substantively unfair. (73) Such a showing would seem easy to make under Allocation 3, arguable under Allocation 2, and quite difficult under Allocation 1. Under the current, relaxed standard, however, the business judgment standard of review applies once a majority of the board's informed, disinterested directors approve the transaction. (74) At this point the plaintiff loses his direct shot at showing substantive unfairness and instead must show that the board acted in bad faith. (75)
2. Contract Treatment
This subsection examines the possibility of full-dress contract treatment. Under this approach, courts will refuse entirely to conduct fiduciary review, leaving complaining preferred holders with only the statutory appraisal remedy.
a. The Preferred Contract as Complete
A contractarian could defend corporate fiduciary law on the ground that common stockholders invest pursuant to an incomplete contract. (76) The common takes the residual interest along with the right to elect the board, but beyond that relies on the board's capabilities and fidelity along with the backstop terms of corporate law. Protecting that reliance with fiduciary principles is thought to be more efficient than forcing common stock investors to specify their rights ex ante. (77) Indeed, the set of possible contingencies for the common is so large as to make ex ante contractual specification unfeasible. (78) Since stockholder interests are so broad as to be non-contractible, incomplete transactions are inevitable, and therefore make fiduciary protection necessary.
Preferred stock arguably differs because its preferences are contracted for and presumably can be protected with explicit provisions. Indeed, there are well-known means of dealing with skewed merger allocations. The charter can dictate a merger price or otherwise provide that a merger constitutes a liquidation event and condition the transaction's effectiveness on payment of the liquidation preference. (79) Alternatively, the charter can require a class vote of the preferred to approve any merger, according the preferred a veto-group veto. (80) As a further alternative, the charter can require that the preferred be left unimpaired in the issuer or merger survivor's capital structure. (81)
Given the availability of contractual protection, fiduciary review can be withheld on a penalty default theory. (82) Under this theory, a skewed outcome in individual cases is acceptable on the assumption that withholding scrutiny in the long run causes the preferred to insist that merger contingencies be dealt with in the charter. Incorporating a penalty default here thus leads contractibility to trump fiduciary treatment.
This approach arguably fits in well with the corporate law paradigm that dominates our "shareholder value" era. As between the preferred and the common, today's regime of value enhancement signals the common as the appropriate fiduciary beneficiary because it holds the residual interest. Managing to the common is thought to encourage risk-taking, thereby creating value. The preferred, with its fixed income features, is a more financially conservative interest; therefore, it is best to keep preferred holders' interests out of the boardroom and instead force them to make their rights explicit on paper. In short, if the legal regime should stress maximizing value for the common, then any judicial intervention against a merger allocation that favors the common traverses a grundnorm, and is, by definition, inefficient.
A penalty default thus makes theoretical sense. It does not necessarily follow, however, that it makes cost sense in the real world, even to a common stockholder. Penalty defaults, as mooted in law and economics, do not force contracting for its own sake. Rather, by fixing the default at a result neither party is likely to want, (83) the rule compels parties to adjust by negotiation, thereby causing them to achieve an efficiency goal, such as the disclosure of more information or the invention of superior contract terms. (84) The additional information and new terms facilitate a more efficient allocation of risk in the contract. However, in the merger context, it is not clear that any efficiencies could be gained through the use of a penalty default. Nor is it clear that judicial intervention respecting merger allocations somehow constrains boardroom discretion to take risks. The intervention questions only an end-period decision, and does not envision preferred stock-value maximization as a going-concern fiduciary proposition.
More importantly, penalty default treatment of the preferred could disserve the common stock interest. For an illustration of this disservice, consider the following question: Why do preferred stock charter provisions often fail to provide for a merger class vote? We located new issues of preferred registered for public offering since 2009 on the SEC's EDGAR database and surveyed their certificates of designation. (85) Fifty percent of the certificates provided for merger class votes (or otherwise included effective protection in the event of a merger), while the other 50% left the preferred unprotected. (86) We also examined the certificates of preferred stock privately placed during the second quarter of 2011 and filed in EDGAR as disclosure exhibits. Only 29% of these certificates provided for merger class votes (or otherwise included effective protection in the event of a merger). (87) Issuers have a legitimate reason to resist the inclusion of merger class vote provisions in their charters. Class votes give preferred the ability to hold up a merger in moderate distress situations. Return to our ABC Corporation hypothetical, where a class vote would hand the preferred a bargaining chip for a premium price above $80. The preferred would only vote in favor of the merger when the allocation so favored the preferred as to cause the merger to lose the common's voting support. If the preferred stock lies in institutional hands, an aggressive negotiation is likely. Omitting the class vote makes it easier to sell the company and avoids a possible allocational skew that favors the preferred.
The same analysis applies to clauses that treat mergers as liquidations. The issuer has every reason to resist this concession. For example, with ABC Corporation, the preferred's liquidation preference soaks up the entire merger proceeds. (88) Under that scenario, ABC would have to negotiate with the preferred to get them to agree to the company paying less, using its privilege to walk away from the deal as a lever. Liquidation preference payment provisions thus make merger negotiations much more time-consuming and potentially less remunerative. From the issuer's point of view, then, a legal regime that pushes investors toward insisting on liquidation treatment makes little sense.
Alternatively, the preferred could contract for the right to remain in the capital structure of the entity surviving the merger, but such an approach also ties the issuer's hands. A potential acquirer of ABC Corporation is unlikely to favor retention of a preferred class with $50 in arrears. If it acquires ABC anyway, the price it pays to the common will have to be adjusted downward due to the cost of the preferred's accumulated contractual baggage. (89)
The contractual back-and-forth bolsters the case for fiduciary review. The best explanation for a preferred stock contract that omits to specify a merger price or provide for a class vote is the issuer's interest in avoiding a commitment to pay the preferred a premium over premerger value on a moderate distress fact pattern. The omission expands the issuer's zone of freedom of action and so facilitates enterprise value enhancement. While the omission is thus clearly rational for the issuer, it is only rational for the preferred if fiduciary duties cover merger allocations made by the issuer board of directors.
b. Appraisal Rights
The availability of statutory appraisal strengthens the case for contract treatment. (90) Under this remedy, dissatisfied shareholders can dissent from unfavorable mergers and demand a judicial appraisal of the value of their shares. (91) Let us imagine that the ABC Corporation merger payout goes to appraisal. The inquiry concerns the "fair value of the shares exclusive of any ... value arising from ... the merger" (92) and so is not about reaping a share of merger gain. Assuming that the $80 premerger market price reflected the value of the preferred, appraisal looks attractive only given Allocation 3. If, under Allocation 2, the preferred holders see the $80 market price as inaccurately low, they must marshal experts who can plausibly project increasing future ABC cash flows to show that the preferred is cumulatively worth more than $80 million. A successful challenge to Allocation 1 is highly unlikely, for the preferred's $150 million liquidation preference is relevant only to the extent it contributed to its premerger fair value.
Appraisal as the exclusive recourse available to holders of preferred presents several problems. First, virtually no recent case law exists on judicial valuation of preferred, (93) so the substantive parameters of such proceedings are a matter of speculation. Preferred holds out daunting problems for appraisers. Not only must they project a company's future cash flows under uncertainty, but the appraisers also must assess the probability that the issuer board will exercise its discretion to direct the projected flows to a future preferred dividend or redemption payment. Second, the process context in appraisal is not plaintiff-friendly. Appraisals may not be framed as class actions. (94) Appraisal plaintiffs accordingly must be large stockholders acting for their own accounts. This problem is less important today than it was formerly, due to the proliferation of hedge funds as strategic investors in publicly traded equity (95) and preferred's position as the vehicle of choice in venture capital finance. (96) Preferred stockholders thus increasingly tend to be large institutions with the wherewithal to undertake expensive appraisal litigation. (97) Third, the Delaware statute makes appraisal available only for a subset of mergers. Appraisal rights obtain if the preferred is privately held, as is the case with venture capital financing or a rule 144A offering (98) resulting in fewer than 2000 holders of record. (99) Appraisal also is available if the preferred stock is publicly traded and the merger consideration is cash or debt securities. (100) But there are no appraisal rights if the preferred is publicly traded and the merger consideration is publicly traded stock. (101)
To show how the three problems can combine to undermine the proposition that appraisal is an "adequate remedy," let us return to the dummy merger. Recall that dummy mergers provide a means to cram down an equity recapitalization against preferred, and that the Delaware courts sanctioned the technique in Havender. (102)
Let us turn back the clock at ABC Corporation to the time of the preferred's original public issue for $100 per share, for a total consideration of $100 million. Assume that times were good and that the 2 million shares of common trade for $100 per share. Two months later, an investment banker approaches ABC with a recapitalization plan under which the board engineers a dummy merger on a one-for-two basis. This merger would divide ABC's market capitalization, allocating one-fifth to the preferred ($60 million) and four-fifths to the common ($240 million). ABC submits the merger to its stockholders, and the common uses its majority to cram down the deal. ABC's preferred will not have the right to seek appraisal--the premerger preferred is publicly traded and the stockholders receive publicly traded stock as consideration in the merger, so the appraisal statute's exceptions apply. (103)
The ABC preferred's goose is cooked unless it can persuade a court to enjoin the transaction on fiduciary grounds. Although the hypothetical is unrealistic, it makes an important structural point regarding the vulnerability of the preferred: the level of exposure is more severe than often recognized, potentially permitting even this quasi-conversion of newly raised capital. Indeed, even if appraisal were available in this dummy merger, it would be unreasonable to leave it as the exclusive remedy for the preferred. The transaction is in manifest bad faith, and an ex ante injunction is the cleanest, most appropriate mode of intervention. Interestingly, an old line of Delaware cases waives appraisal exclusivity and permits injunctions against dummy mergers following from "acts of bad faith, or a reckless indifference to the rights of others interested, rather than from an honest error of judgment." (104) It bears noting that dummy mergers still occur, (105) if not in the particularly crude mode hypothesized here. We can likely attribute corporate restraint to the prospect of judicial scrutiny.
A plausible case can be made for both corporate and contract treatment for preferred in the merger context. At the same time, each paradigm leads to excess when applied full dress. Intrinsic fairness review under the corporate paradigm could unravel negotiations and in any event would occasionally hold up lawsuits by institutional preferred holders. Complete contract treatment coupled with appraisal exclusivity is untenable in extreme cases. A door needs to be left open for judicial scrutiny of the motivation for and effect of mergers. This qualified conclusion confirms our point about the intrinsic legal instability of preferred stock--because it straddles the corporate-contract divide, every problem admits a range of solutions. The next section turns to Delaware law and illustrates, through analysis of decided cases, this conceptual instability in action.
We note a point of contrast between the equity recapitalizations discussed in Part I and the mergers under discussion in this Part. Both involve transactions that create gain and trigger the carving of corporate pies. In both cases the pie can be sliced either (1) to split the gain between the preferred and the common; (2) to leave the preferred at its pretransaction value and allocate all the gain to the common; or (3) to transfer pretransaction value from the preferred to the common along with all of the gain. Assuming corporate treatment and fiduciary scrutiny, two questions arise: First, does the preferred have a right to gain-splitting in a recapitalization, a merger, both, or neither? Second, does a transfer of pretransaction value from the preferred to the common breach a right owed to the preferred in a recapitalization, a merger, both, or neither? We think that with regard to the gain-splitting question, the two transactional modes can be distinguished.
A recapitalization strips rights from the preferred to enhance enterprise value. The transaction makes everybody better off only so long as the gain is shared; a class vote imports a circumstantial guarantee that such sharing occurs. Given no gain sharing and absent class consent, the preferred surrenders rights without any return. Leaving the preferred holders stuck with their shares' pretransaction value differs from an affirmative transfer of value from the preferred to the common only as a matter of degree--either way, pure exploitation occurs.
Third-party mergers are different. The gain comes from an outside purchaser rather than from a sacrifice by the preferred. Moreover, there are fact patterns on which it is quite clear that the preferred has no right to share the gain. In an upside scenario where the company has grown and the preferred stock's premerger value is higher than its face value (whether due to an attractive dividend payout or a conversion privilege in the money), the merger parties will likely exercise their option to take out the preferred at its redemption price before any question about gain sharing arises. In other words, the preferred are treated as senior claims with a capped upside. In downside patterns, where the preferred's market value is below its liquidation value, the holders have a right to liquidation value in a merger only if the charter explicitly so provides. (106) A preferred stockholder's right to share merger gain in the downside fact pattern--an amount higher than the stock's premerger value but lower than its liquidation value--could be implied by analogy to the rights of minority common stockholders. But it is not at all clear that such an analogy should be drawn here. Nothing compels it, and reference to the contract paradigm undercuts it: if the preferred holders want a premium, all they have to do is negotiate a class vote.
B. Delaware Law
In this section, we put the hypothetical ABC Corporation preferred through a modern cashout merger, applying Delaware cases decided prior to the recent decision, LC Capital Master Fund, Ltd. v. James. (107) Section II.C reconsiders matters in light of James.
We will start the ABC Corporation cashout merger with one changed fact from our previous discussion of the company--the preferred's liquidation price plus arrearages now adds up to only $110 per share. XYZ Corporation proposes a $140 million cash merger to the ABC board, offering $110 per share for the preferred and $15 per share for the common. As has happened in litigated cases, XYZ makes its bid under the impression that the preferred must be paid its liquidation preference in order to be cashed out in a merger. (108) ABC's investment banker points out the error to XYZ at the same time that ABC's CEO suggests that the bid should allocate more to the common. XYZ reformulates the bid accordingly. The new bid is for the same total consideration, but now the offer is $80 per share for the preferred and $30 per share for the common. ABC's top executives collectively hold 15% of the common and no preferred. A majority of ABC's directors are independent, and all of these directors hold trivial amounts of the common and no preferred. After the reformulation of the bid, ABC organizes a committee of independent directors. The committee negotiates the merger and secures $10 million additional consideration. The added consideration is distributed between the common and the preferred in proportion with the existing allocation, making the final price $85.70 per share for the preferred and $32.15 per share for the common. The special committee determines the preferred-common allocation to be fair--a conclusion in line with that of its investment banker. At no point, however, does the committee consider the origins of the allocation or inquire further into the value of the preferred's claim. Nor does the committee request a valuation report addressing the allocational question from the investment banker. The preferred will not have a class vote because the charter does not provide for one, but in this case it will have appraisal rights. (109)
Claiming a breach of fiduciary duty by the ABC board, the preferred bring an action in the Delaware Chancery Court to enjoin the merger. The Delaware cases do not entirely reject this line of argument, but it is unlikely to succeed.
We already have seen that old dummy merger cases express a preference for the appraisal remedy but hold out the possibility of an injunction against a bad faith cramdown. (110) The modern precedent begins with the standard Chancellor Allen announced in 1986 in Jedwab v. MGM Grand Hotels, Inc.:
[W]ith respect to matters relating to preferences or limitations that distinguish preferred stock from common, the duty of the corporation and its directors is essentially contractual and the scope of the duty is appropriately defined by reference to the specific words evidencing that contract; where however the right asserted is not to a preference as against the common stock but rather a right shared equally with the common, the existence of such right and the scope of the correlative duty may be measured by equitable as well as legal standards. (111)
At a minimum, this standard means that the preferred will not be able to base a fiduciary claim on the merger's failure to yield its $110 liquidation preference plus arrears. (112) But it also stands for the proposition that a merger allocation between preferred and common is subject to fiduciary scrutiny.
A question nonetheless arises regarding the standard's division of the field into a contractual zone and a fiduciary zone. This approach could operate as a filter, dividing merger fact patterns into two groups, one subject to judicial scrutiny and the other immune from it. A specific question would be, if the preferred receive at least what the common receive, have they been treated equally under Jedwab? In ABC's case, such a scenario would mean taking the $150 million consideration and distributing it pro rata to the common and preferred at $50 per share. If such a division is "equal," the reason is that any consideration paid to the preferred beyond $50 by definition compensates it for its "contractual" rights and thus lies outside of fiduciary territory. If dissatisfied, the preferred can seek appraisal.
The Jedwab court did not directly address the above question, (113) but Chancellor Allen himself impliedly rejected the above narrow reading in a later opinion, In re FLS Holdings Shareholders Litigation. (114) In that case, the preferred received slightly more than the common. (115) The board of directors, dominated by representatives of the common, had steadily carved out a larger share for the common in the course of an extended negotiation. (116) Chancellor Allen asserted that the directors still had a duty to both classes and were "obligated to treat the preferred fairly," even though the standard of review was "somewhat opaque." (117)
Both the Jedwab and FLS Holdings courts discuss boardroom process. Jedwab suggests that a special negotiating committee for the preferred, composed of independent directors, is an important factor in a fairness determination, (118) while FLS Holdings implies that the presence of "a truly independent agency on the behalf of the preferred" plays an important role in figuring out if a transaction was fair. (119) In FLS Holdings, Chancellor Allen added that a valuation study prepared ex post by the board's investment banker amounted to a "relatively weak" protection. (120) Yet, ultimately the cases rejected a rule-based approach to process protections, concluding that while "such factors typically constitute indicia of fairness; their absence ... does not itself establish any breach of duty." (121)
Jedwab and FLS Holdings therefore stand for the proposition that the preferred can get more per share than the common and still get a hearing, but the cases do little else to add details to our understanding of preferred rights. Chancellor Allen later characterized the cases as providing a sort of backstop protection for preferred--they get the hearing when in an "exposed and vulnerable position vis-a-vis the board of directors." (122) Just what makes for exposure and vulnerability is unclear, although it bears noting that Jedwab and FLS Holdings involved issuers and boards under the immediate control of majority blockholders. (123) ABC Corporation, by contrast, has dispersed shareholders and a majority independent board.
Jedwab and FLS Holdings are not the only modern cases about the scope of fiduciary duties for preferred stock in the Delaware canon. In HB Korenvaes, Chancellor Allen later voiced a contractual view of preferred:
[T]o a very large extent, to ask what are the rights of the preferred stock is to ask what are the rights and obligations created contractually by the certificate of designation.... In most instances, given the nature of the acts alleged and the terms of the certificate, this contractual level of analysis will exhaust the judicial review of corporate action challenged as a wrong to preferred stock. (124)
Finally, in the last case in the series, Equity-Linked Investors, L.P. v. Adams, Chancellor Allen gestured to common stock-value maximization:
[G]enerally it will be the duty of the board, where discretionary judgment is to be exercised, to prefer the interests of common stock--as the good faith judgment of the board sees them to be--to the interests created by the special rights, preferences, etc., of preferred stock, where there is a conflict. (125)
The applicable Delaware law appears to include the following five principles: (1) fiduciary intervention is possible where the preferred are in an "exposed and vulnerable position;" (126) (2) fiduciary duties are owed regarding rights shared equally with the common but not regarding preferences; (3) boards should prefer the common when exercising discretion; (4) the preferred should generally look to appraisal for a remedy; and (5) the preferred should protect themselves contractually.
This summary reveals that the relevant Delaware law is more than open-ended. It incorporates elements of both of the hard-edged alternatives laid out in Section II.A--fiduciary scrutiny and the view of preferred as a complete contract with appraisal as its exclusive remedy. The various components of the doctrine seem to stand in mutual tension; they do not "synthesize." If the board's duty is to favor the common when making discretionary decisions, it is hard to see how a boardroom process could breach a duty to the preferred, even on Allocation 3. Yet, if the default rule is explicit contractual protection with appraisal as the exclusive remedy for preferred, it is hard to see how vulnerability of the preferred and exploitation of its rights can ever be actionable. The tension follows from preferred's dual corporate and contractual character. Given the long list of choices, the judge in effect must make a menu choice, deciding which paradigm to stress given the facts of the case.
Let us now state a case for why the ABC preferred should receive fiduciary protection. This argument builds on four points about the process surrounding the merger. First, the allocational shift from the preferred to the common came at the insistence of ABC's CEO, who owned a significant chunk of common. Second, the subsequent deal management by ABC's independent directors failed to correct the allocational mishap because they did not inquire into the causal chain, the acquirer's business interests, or the relative values at stake. Third, all of the independent directors owned common, thus raising a question regarding their actual independence. Finally, the process did not include an independent agent to negotiate for the preferred. The question is whether the four points, taken together, show that the preferred's position was "exposed and vulnerable."
ABC will argue in response that Jedwab and FLS Holdings do not mandate a special committee (127) and that the availability of appraisal weighs against a request that a merger be enjoined. (128) To the extent the preferred seeks to show that its share of the merger price falls below the stock's intrinsic value, it should seek an appraisal. More importantly, a class of preferred walking away with a premium over market price has no cause to complain; if anyone has a complaint, it is the common whose merger gain has been diverted.
C. James Analysis
In LC Capital Master Fund, Ltd. v. James, then--Vice Chancellor Strine tilted emphatically toward the contract paradigm. The preferred in question had been issued in a rule 144A offering for $25 per share, an amount equal to its liquidation preference. (129) The charter provided for a $1.375 discretionary but cumulative dividend. (130) The stock was convertible into common at a conversion price of $15.50. (131) The initial $3.10 conversion price was set at the high end of the trading range of the issuer's common stock for the second quarter of 2004. (132) The common's price promptly declined; during the life of the preferred issue, there were only two quarters in which the stock price briefly, and slightly, exceeded the conversion price. (133) In the merger, the common were cashed out at $8.50 and the preferred at $13.71. (134) The $13.71 was derived by applying the conversion ratio (1.6129) to the common's merger consideration (135)--as if the charter provided (though it did not) that a merger triggered a mandatory conversion. (136)
The deal process had been tense. There were discussions with several suitors; one negotiation started out at a $25 per share figure for the preferred. (137) A committee of independent directors then took charge. (138) All members of the committee owned common, four out of five in trivial amounts, but with one holding an 8% block worth over $5.6 million. (139) The committee found itself between a rock and a hard place. The preferred would likely sue if its price was not raised above $13.71. But if the committee was to raise the preferred payout, it would run the risk that the deal would lose the voting support of the common, (140) 83.4% of which was owned by five hedge funds. (141) The committee also may have been wary of an additional potential lawsuit: counsel advised the committee that it needed to be "careful" about allocating more to the preferred, absent "special reasons," due to fears of a suit by common holders. (142) As it navigated these shoals, the committee dragged anchor on cashing out the preferred and tried to cut a deal with a second merger partner that would leave the preferred in the issuer's capital structure untouched, a result that apparently would have satisfied both the common and the preferred. Unfortunately, the second potential merger partner wanted to replace the preferred with debt that torpedoed the deal. (143) In the end, the committee approved the original merger, which cashed out the preferred at $13.71, without the support of a fairness opinion from its investment banker. (144)
The preferred, whose discretionary dividends appear to have been paid up to date, (145) took the position that its financial rights entitled it to a good bit more than $13.71. It saw $13.71 as the functional equivalent of Allocation 3. Then-Vice Chancellor Strine, however, refused to enjoin the merger and remitted the preferred to appraisal. (146)
The Strine opinion stoutly resisted invoking Jedwab and FLS Holdings. (147) The court in James could have rejected the preferred's claim to a second special committee on the facts of the case--the deal was fragile and a second special committee might have disrupted the negotiations (148)--but it went further by invoking both the complete contract and the common stock-value norm. The court asserted that the preferred, having passed up the opportunity to address merger pricing contingencies in the charter and negotiate a class vote or liquidation treatment, could not later call on the Chancery Court's solicitude. (149) Summarizing his attitude towards fiduciary protection of preferred holders, Chancellor Strine stated, "Our law has not, to date, embraced the notion that Chancery should create economic value for preferred stockholders that they failed to secure at the negotiating table." (150) Indeed, fiduciary law, far from requiring the board to make a fair allocation, prevents the board from doing so: the duty to favor the common could lead to liability for a director who intervenes to protect the preferred. (151)
Thus, the James court undertook to abrogate Jebwab and FLS Holdings. But it did so in dicta, and therefore should be read more narrowly. Taking a cue from the board committee, the court deemed the conversion price to be a contractually designated merger payout. (152) Where the charter fixes a merger payout, there is no basis for a claim of breach of fiduciary duty, since the board has no allocational decision to make. Indeed, given a fixed merger payout, any board that had allocated more than the fixed payout for the preferred would indeed be left open to a lawsuit by the common.
The court, however, did not indicate where and how the charter effects this result. Our review of the charter finds no express merger price designation. The charter's conversion provisions mention mergers, but only to set conversion rights going forward in a case where the preferred remains in the capital structure of the corporation surviving the merger. (153)
Since the charter does not expressly designate a merger price for preferred, the contractual allocation on which the court relies must be implied. It is hard to fathom an economic basis for such an implication. A conversion privilege is an option that gives a fixed interest holder an opportunity for upside gain. It does not have the converse effect of dragging the fixed interest holder down with the issuer--on the downside, the convertible holder relies on its fixed payment stream to preserve the value of its interest. (154) This heads-I-win-tails-you-lose result is not a free lunch; the conversion privilege's value is incorporated in the interest rate on the security. (155) Given this tradeoff, it makes no sense to have the convertible's value in a merger decline in lockstep with the issuer's common stock. (156) Indeed, it undercuts the deal. Nothing in the charter in James signals anything other than such a conventional arrangement. Any implications in the charter go in the opposite direction: it did provide for mandatory conversion, but only in the event the common stock sustained a price of $25.50, (157) an event that had never occurred. Otherwise, this conversion privilege was drafted as an option paid for by the holder to be held in reserve for the holder's benefit.
We do not read James to require this subversive reading of standard conversion provisions. The court would have had no reason to mention the appraisal option if the charter had in fact specified a merger payout, for such an appraisal would have yielded $13.71 and not a penny more. (158) We read the court's insistence on an ex ante contractual settlement the same way we read its rejection of Jedwab and FLS Holdings. In our opinion, the court, having determined on the facts to go the contractual route, emphasized contractual items in the doctrinal toolbox at the expense of fiduciary ones. Jedwab and FLS Holdings are still in the toolbox, even as the court's refusal to bring them to bear in James makes their future use less likely.
We have no quarrel with the result in the case, if only due to several specific facts in it. First, there was a large risk that an injunction might have caused the acquirer to walk away from the deal. Second, appraisal was available. (159) Additionally, as we read the facts, the preferred was not necessarily claiming a share of merger gain, but only the economic value of its participation. Roughly speaking, the preferred in James allege that they were forced into the most unfavorable division of value, Allocation 3. In this posture, given the risk of deal disruption, appraisal sufficiently vindicates the claim. Finally, as the court notes, the struggling board acted in good faith. (160)
The overlapping contract and corporate paradigms come to bear on James with more than their usual dysfunction. This is because the law, in its present posture, poses a stark dichotomy, asking the court whether the preferred's vulnerability and the board's exploitation of that situation combine to trigger intrinsic fairness scrutiny. If the preferred was vulnerable and exploited, heavy, potentially disruptive process obligations fall upon the board. If the preferred failed to satisfy those criteria, however, contract and appraisal determine the result. We believe courts can avoid this doctrinal sturm und drang by using the good faith standard of review employed in the old dummy merger cases. (161) Under this standard, the court asks whether the board acted in bad faith with reckless indifference to the rights of the preferred, as opposed to making an honest business judgment. (162)
The good faith standard opens a big tent that accommodates the results of all of the cases along with the overlapping paradigms. While James's contractual aspirations are understandable, a totally contractual posture is unsustainable. A pattern of incomplete contracting remains embedded in preferred stock drafting, leaving a door open for conscience-shocking opportunism by boards. Moreover, boards are more likely to exercise great care in making these allocational decisions if counsel advises them of the possibility of judicial second-guessing. Indeed, to assure scrupulous adherence to the standard of independent-director determination on a well-informed basis, we would specify that the burden of proof on the issue of good faith fall on the board of directors.
For the board to meet that burden without much trouble, we offer the following suggestion: the independent committee should include at least one director charged with representing the interests of the preferred. Such an approach is potentially disruptive because a dissenting vote by a committee member would virtually ensure future litigation. But we believe that the possibility of litigation would be minimized if courts clarified the law on the basic distributional point. We know of no principle according the preferred a right to Allocation 1 that would provide it with a share of the gain in a third-party merger. The corporate-contract paradigms would overlap more peacefully if courts explicitly announced the following proposition: the preferred's rights are capped at premerger value.
To the extent an issue of preferred wants a shot at gain in a merger, it should negotiate a class vote. Given this clarification, the preferred's representative would have the limited task of avoiding Allocation 3, one that looms large only in the absence of a market price establishing premerger value. Absent such a price, the representative should force the committee to confront evidence of premerger value in the form of a neutral investment banker report--something that does not appear to have occurred in James.
Good faith review thus would serve to direct the board to Allocation 2 and away from the temptation of Allocation 3. Absent bad faith, objecting preferred should have only appraisal as a remedy. Delaware corporate law should also be amended to make appraisal universally available to preferred forced to accept anything other than their existing stock.
We would make one additional change in the law. Courts need to remove common stock-value maximization from the doctrinal toolbox used to evaluate preferred's claims in mergers. The concept is analytically unsuitable. To see why, let us return to ABC Corporation and ask how a common stock-maximizing board should make the allocation. The answer is easy: it should employ Jedwab's core equity-versus-contract-rights distinction (163) and allocate the same $50 per share to everybody, transferring $20 million of premerger value from the preferred to the common. Carrying the point to its logical conclusion, the ABC board never should have allowed preferred arrearages to accumulate in the first place. Rather, it should have effected a one-to-one dummy merger against the preferred immediately upon issuance. The board in James should have done the same thing. With the preferred convertible into common at $15.50, an immediate dummy merger after sale of the preferred for $25 would have created $9.50 of shareholder value!
These contracts can be incomplete and make no business sense if a common-maximizing board has sole responsibility over their performance in the absence of backstop judicial scrutiny. Meanwhile, the law can satisfy the intuition that motivates the common-maximization principle by clearly blocking any preferred claim to a share of merger gain.
Finally, we note that the overlap of the two paradigms raises an alternate route to fairness review: the contractual duty of good faith. The analysis starts with Jedwab's division between contractual preferences and rights in common. (164) As the value impaired in the merger stems from the preference, the contract treatment arguably is appropriate. A party can trigger a contractual good faith constraint by exercising a contract right in such a way as to deprive a counterparty of core expectations, (165) which arguably is the case with the ABC proposal to allocate $50 per share to everyone in the merger. One could frame the case objectively and analyze the degree of deprivation, or subjectively and look at the culpability of the actors who effected the injury. (166) In the subjective framing, the contract case roughly tracks the corporate good faith case.
But some sticking points impede application of the contract variant. A special formulation of contractual good faith applies to financial contracts governing senior securities, under which good faith comes to bear only when the issuer traverses rights explicitly created in the contract. (167) In cases concerning bonds, this formulation tends to cut off good faith review. (168) The preferred can contend that this barrier does not apply because the merger has the effect of stripping its contract rights, but this theory is untested. Delaware precedent raises an additional barrier: good faith claims require a counterfactual finding as to whether the parties would have drafted for the right asserted by the preferred had they considered it. (169) If the right asserted is defined as a class vote, then a counterfactual finding cannot be made. If the right is defined more broadly as a right to have the preferred's going concern value considered in the merger allocation, then the contractual good faith case should lie.
Thus sketched, a contractual good faith case differs little from the corporate alternative, but for the two sticking points. An issue arises as to whether the corporate or contract good faith route is more "appropriate." In our view, the corporate path makes more sense. The courts opted for corporate treatment of mergers and charter amendments long ago, so a shift to contract only confuses matters further.
III. THE PAYMENT STREAM
Financial preferences, the basic rights making up the core of preferred stock's value, can be structured as priorities or as promises to pay. Either way, they exist in an ambiguous, unstable legal environment. We have seen that priority dividends in arrears can be stripped in a dummy merger. This Part turns to mandatory preferred to examine the strange, second-order status of an issuer's promise to pay a preferred dividend or redeem a preferred issue at stated value. Second-order status follows from preferred's dual nature. The promise to pay is, of course, contractual. But, because it is attached to a corporate equity interest, the law refuses to enforce preferred payment rights if doing so would impair the interests of contract creditors. The parameters of the enforceability of preferred's financial preferences remain unclear and admit of a narrow approach that enhances the promise's contractual power and a broad approach that emphasizes corporate status and makes enforcement difficult. One reason the doctrine is murky is that most of the cases in this area are old.
More recently, in SV Investment Partners, LLC v. ThoughtWorks, Inc., (170) the Delaware Chancery Court radically expanded the zone of enforcement constraint, stripping away a promise's contractual vitality by remitting the decision to perform the promise to pay to the discretion of the issuer's board, thereby subordinating the preferred's payment rights not only to the interests of the issuer's creditors, but to those of its common stockholders. (171) This Part sees ThoughtWorks as an updating exercise. The old cases are not only unclear but institutionally dated, relying on judicial business judgments about issuers' ability to pay. (172) The ThoughtWorks court, by submitting the matter to board discretion, aligns the legal treatment with the modern corporate law approach. The case also imports clarity by minimizing the old cases' dualistic use of the corporate and contract paradigms, pushing the treatment deep into corporate territory.
This judicial updating, however, swings the pendulum so far in one direction that it virtually knocks the promise out of the contract. Therefore, in this Part, we experiment with the converse approach, asking whether it is feasible to push the treatment of financial preferences deep into contract territory by minimizing the enforcement constraint. We show that this approach holds out no danger to corporate going concerns and protects transactional integrity.
Section III.A describes the doctrinal inheritance. Section III.B analyzes the ThoughtWorks opinion and the changes it made to the doctrine in the area of financial preferences. Section III.C accounts for the approach taken in the case and outlines an alternative. Section III.D provides a conclusion.
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|Title Annotation:||Introduction to III. The Payment Stream, p. 1815-1860|
|Author:||Bratton, William W.; Wachter, Michael L.|
|Publication:||University of Pennsylvania Law Review|
|Date:||Jun 1, 2013|
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