Court Reiterates Common-Law Limitations on Preferred Stock Redemptions
Reprinted with permission from the May 6, 2015 edition of the Delaware Business Court Insider. © 2015 ALM Media Properties, LLC. All rights reserved. Further duplication without permission is prohibited. (ALMReprints.com, 877.257.3382).
The Delaware Court of Chancery's recent decision in TCV VI L.P. v. TradingScreen, C.A. No. 10164-VCN (Del. Ch. Mar. 27, 2015), provides important guidance to preferred stockholders regarding the enforceability of mandatory redemption provisions when the corporation providing those rights is in financial distress. In TradingScreen, Vice Chancellor John W. Noble held that preferred stockholders of TradingScreen were not entitled to summary judgment on claims seeking to enforce a mandatory redemption provision in TradingScreen's charter because issues of fact existed as to whether the redemption would have impaired TradingScreen's ability to continue as a going concern.
Background
TradingScreen's corporate charter provided its preferred stockholders with mandatory redemption rights. Specifically, TradingScreen's charter authorized a majority of preferred stockholders to request TradingScreen to help the preferred stockholders sell their shares on satisfactory terms and conditions. If no buyer would purchase the preferred stock on satisfactory terms, then the preferred stockholders were authorized to require TradingScreen to purchase all or a portion of their shares by delivering written notice of the number of shares they wanted redeemed.
In early 2013, a majority of the company's preferred stockholders validly exercised their mandatory redemption rights. TradingScreen's board formed a special committee to find buyers of the preferred stock. After the special committee failed to find a satisfactory buyer of the stock, a majority of the preferred stockholders demanded, in writing, that TradingScreen redeem their shares.
In response, TradingScreen's special committee, relying on analysis from its outside financial adviser, AlixPartners, determined that TradingScreen did not have the funds to make the full redemption, and instead, could only fund a partial redemption and make pro rata payments to the preferred stockholders seeking redemption. Specifically, the special committee determined that a larger redemption would impair the company's ability to continue as a going concern, and was therefore impermissible.
The preferred stockholders brought suit against TradingScreen and three of its directors, alleging that TradingScreen's partial redemption breached the mandatory redemption provision in TradingScreen's charter. The preferred stockholders contended that Section 160 of the Delaware General Corporation Law, which limits a corporation's ability to purchase shares of its own stock to the corporation's statutory surplus, was the only restriction on TradingScreen's obligation to comply with the mandatory redemption provision in the corporate charter. The preferred stockholders contended that, because TradingScreen had sufficient surplus to make the full redemption, TradingScreen's decision to make only a partial redemption constituted a breach of the mandatory redemption provision.
The Court's Holding
The Court of Chancery disagreed with the preferred stockholders, instead holding that a Delaware corporation's ability to redeem stock is limited not only by Section 160 of the DGCL, but also by Delaware common law. The court explained that "in addition to the strictures of Section 160, the undoubted weight of authority teaches that a corporation cannot purchase its own shares when the purchase diminishes" or impairs the company's ability to continue operating as a going concern. The court also made clear that these common-law limitations are impliedly read into every corporate charter and limit a corporation's ability to redeem stock irrespective of the express language of the corporate charter.
In addition, the court explained the high burden preferred stockholders face in challenging directors' determination of a corporation's ability to continue as a going concern. The court stated that "decisions regarding a corporation's ability to continue as a going concern are necessarily made by a board as part of a 'judgment-laden exercise,'" and to succeed in challenging a board's determination, a plaintiff must prove that the "board acted in bad faith, relied on methods and data that were unreliable, or made a determination so far off the mark as to constitute actual or constructive fraud."
Under those standards, the court concluded the preferred stockholders' motion for summary judgment must be denied because "(i) the common law restricts TradingScreen's ability to redeem its shares when doing so would damage its ability to continue as a going concern and (ii) the special committee undertook a facially valid process finding that a full redemption would impair TradingScreen's continuing viability."
Key Takeaway
The Court of Chancery's decision in TradingScreen serves as an important reminder to preferred stockholders regarding the enforceability of mandatory redemption provisions when a corporation is financially distressed. Because corporate boards and committees have discretion to determine a corporation's ability to continue as a going concern, and are incentivized not to make redemptions when the corporation is suffering financially, preferred stockholders may encounter difficulty enforcing mandatory redemption provisions at the very time when those provisions are most valuable (i.e., when the corporation is in financial distress). Accordingly, preferred stockholders should carefully negotiate the terms of mandatory redemption provisions and should consider negotiating for additional protections for situations where a company is not able to pay the full redemption amount, such as the ability to elect additional board members or the right to receive interest on any amounts due with respect to stock that the corporation is unable to redeem.