May 15, 2017

Preferred Holders Take Another One on the Chin

This Kirkland & Ellis memo discusses Hsu Living Trust v. ODN Holding (Del. Ch.; 5/17) – the latest in a  series of Delaware cases standing for the proposition that when the chips are down, the board needs to “stick it” to the holders of preferred stock. (Sorry to get bogged down in legal jargon).

Delaware courts have long held that when the interests of the holders of common & preferred stock diverge, the board’s fiduciary duties run to the common, while the preferred has to look to whatever contractual rights it may have. But the ODN Holding case shows that when the going gets tough, even the most well-crafted contractual protections may not accomplish what the preferred holders intended. That’s because if there’s an opportunity for an “efficient breach”, a board’s fiduciary obligations to the common may require it breach the company’s contractual obligations to the preferred.

Here’s an excerpt that walks through the Court’s reasoning:

Vice Chancellor Laster refused to dismiss claims against the board of ODN that they breached their fiduciary duties to common stockholders by selling off pieces of ODN in anticipation of funding at least a portion of a mandatory redemption of the sponsor’s preferred stock that vested after five years, because the asset sales shrunk the company significantly and impaired its ability to generate long-term value to the remaining stockholders.

The court readily acknowledged the validity of the contractual obligation to the preferred holders to redeem their stock once the mandatory redemption right vested. However, VC Laster held that the board had a fiduciary duty to decide whether it was in the best interests of the common stock to commit an “efficient breach” of the company’s obligation to the preferred and not take actions to fund the redemption because doing so diminished the long term upside potential of the business (i.e., whether the portfolio company would be better off being subject to a damages claim from the holders of the preferred as compared to taking the company actions necessary to satisfy its obligations to the preferred).

The memo suggests a number of alternatives to avoid putting the board in the middle when it comes to protecting the rights of preferred stockholders. These include preferred terms that raise the economic consequences of a breach, strong “drag along” rights that allow preferred stockholders to compel a sale, & the use of alternative entities, such as LLCs, that don’t have a corporation’s fiduciary baggage.

John Jenkins