Let the Buyer (of Preferred Stock) Beware
Preferred stock is often the vehicle of choice for investors looking to buy into early stage growth companies.
Investment in preferred stock almost always includes a number of advantages over common stock: preference in assets should the corporation be liquidated, preference in the payment of dividends, and often, a contractual right to redeem the shares for a predetermined value at a given time. It is this last privilege that is at issue in Frederick Hsu Living Trust v. ODN Holding Corp., a Delaware case in which the Court of Chancery is exploring the potential for board member and investor liability resulting from a breach of fiduciary duty to the common stockholders of ODN. The case highlights a number of corporate governance issues important to investors, corporate officers and board members.
The fact of the matter is that the key players in ODN acted as many investors would; they did what they viewed as necessary to salvage a tanking investment. Unfortunately, they went too far (at least in the eyes of the court).
In 2008, venture capital firm Oak Hill Capital Partners sponsored a $150 million investment in the then-ascendant tech company, Oversee.net. To facilitate this investment, the parties formed the Delaware-based ODN Holding Corporation. Oak Hill was granted shares of preferred stock in ODN in exchange for its investment, and was given the option to require ODN to redeem them at any time beginning in February 2013. Eventually, Oak Hill became ODN’s controlling stockholder, and purchased enough capital stock to take control of the board as well.
Business continued as usual for two years following the Oak Hill investment, and ODN stood by its prior commitment to growth, making some $23.7 million in acquisitions. However, everything changed in 2011. Oak Hill decided that year that “exercising its contractual redemption right in February 2013 was the most effective way to achieve the return of its capital.” In 2011, ODN halted all acquisitions, sold off two of its four business lines, and doubled its cash reserves at the behest of Oak Hill. The corporation was clearly preparing for a large redemption event, going so far as to institute bonuses for certain officers should that redemption total at least $75 million for the holders of preferred stock. After a few offers and counter-offers concerning the terms of redemption, ODN and Oak Hill agreed to a payout of $45 million, not enough to trigger the redemption bonuses, but sufficient to reduce ODN’s cash reserves to a mere $5 million.
With this change of direction came the lawsuit. It alleges that no longer was the ODN board (controlled by Oak Hill) acting in line with its fiduciary duty to its stockholders in the aggregate. Rather, it was acting in furtherance of its contractual rights to its preferred stockholders.
Oak Hill exercised its full redemption right in March 2013, and in accordance with the agreement, ODN paid out the $45 million. Unsurprisingly, Oak Hill was not satisfied with this first payout. Consequently, the Oak Hill-controlled board and senior officers set out to gut ODN in search of additional funds for further preferred stock redemption. When all was said and done, ODN was left a shell of its former self. It sold the bulk of its assets, slashed its employee base and experienced a 92 percent decline in annual revenue from 2011 to 2015. Through these steps, Oak Hill received an additional $40 million in redemption payments, bringing the total to $85 million. This resulted in a loss on its initial $150 million investment, but it was ostensibly a smaller loss than it would have suffered had ODN continued to focus on long-term growth.
Unfortunately for Oak Hill, one of the original founders of Oversee.net, and a holder of a significant portion of ODN common stock, was outraged. Frederick Hsu brought suit in Delaware court in March 2016, alleging multiple breaches of fiduciary duty, waste, unlawful redemptions and unjust enrichment. The defendants (which include ODN’s board members, officers and Oak Hill) moved for summary judgment on all six of the claims levied against them, and in April 2017, the Court of Chancery denied their motion on four of those six.
A long established tenet of corporate governance is that the ultimate obligation of any corporation is to maximize value to its stockholders; any actions undertaken by the corporation and its directors that do not serve this end are breaches of the duty of loyalty.
A breach of the duty of loyalty is the primary charge brought by Hsu against ODN. He alleges in his complaint that the defendants violated this duty to the common stockholders when they broke up ODN in order to raise funds to satisfy the redemption rights of the preferred stockholders. Of course, the primary beneficiary of this plan was Oak Hill, whose representatives and appointees proposed and oversaw the selloff process. The court agreed that there is a triable issue of fact in regards to this potential fiduciary breach, and thereby exposed the defendants to liability.
It is here that corporate board members, officers and investors should take note. The court opined that the fiduciary principle does not protect the special rights or preferences of preferred stockholders; rather, decision makers have a duty to maximize the value of the “undifferentiated equity in the aggregate.”
This means that the duty of the board is to prefer the interests of common stock over the special rights and preferences of preferred stock when discretionary judgment is being exercised. While preferred stock is technically a form of equity, the court views the obligations to the preferred holders as primarily contractual. Fiduciary duties are owed only to residual claimants, and in the vast majority of instances, this means the common stockholders. Therefore, a board is permitted to focus on the interests of preferred stockholders only insofar as those interests are consistent with the interests of the common stockholders. To otherwise focus on the privileges of the preferred stockholders (as the defendants in the ODN case appear to have done) is to invite potential liability for a breach of the aforementioned fiduciary duty of loyalty.
According to the Delaware Court of Chancery, boards need to consider the potential for an “efficient breach” when dealing with odious contracts.
If the penalties to be paid as a result of the breach of contract are less than the costs of fulfilling said contract, it is the duty of the board to consider breaching: “directors who choose to comply with a contract when it would be value-maximizing (broadly conceived) to breach could be subject, in theory, to a claim for breach of duty.” In the case at hand, the ODN board should have considered breaching its contractual duty to redeem Oak Hill’s preferred stock. The corporation would have incurred penalties in doing so, but it’s possible that the resultant losses would have been less than the destruction of value incurred in honoring the Oak Hill redemption. It is important to note that the generally lenient business judgment rule did not apply here because it was a self-interested transaction; the entire fairness doctrine was instead applied.
Investors considering the purchase of any type of stock with special rights should contemplate taking steps to safeguard their privileges from contractual breach by their investment target.
The ODN case has further important implications for investors who purchase preferred stock. When investments fail to pan out, sponsors often attempt to mitigate losses by using the special preferences associated with their preferred stock. ODN indicates that Delaware courts are willing to critically evaluate board decisions regarding the contractual obligations to preferred stock when those decisions also affect common stockholders. If the board goes too far, sacrificing the welfare of the common stockholders to satisfy contractual obligations to the preferred, it is possible that the board will be in violation of its fiduciary duties. To safeguard their preferred status, as well as to limit potential liability, purchasers of preferred stock should consider taking steps to incentivize boards to honor their enumerated privileges. These steps would likely take the form of provisions that would provide relief should a mandatory redemption (or any other guaranteed preference) go unsatisfied. We recommend possibilities that include cumulative dividends, favorably priced conversion options of the preferred stock to common stock, automatic issuance of common stock or even a mandatory sale of the company. Essentially, the investor’s goal should be to put a thumb on the scale in favor of honoring the privileges associated with its preferred status. Making it more painful for a board to breach contractual obligations increases the likelihood that the preferred stockholder’s preferences will be upheld, thereby providing greater protection from loss.
With the court’s refusal to dismiss the case, the ultimate finding regarding Oak Hill’s liability remains to be seen. However, in some respects this holding could turn out to have unintended consequences – in promulgating a decision that would seem to benefit common stockholders (and that was certainly the court’s intention), the court may have inadvertently pushed investors to structure even more aggressive preferred stock terms.
For more information, please contact a member of our Early Stage & Emerging Companies practice group.