Pursuant to Delaware law, all capital stock, by default, is created equal unless the company’s certificate of incorporation provides for certain classes or series of preferred stock that enjoy special contractual rights, powers, and preferences over shares of another class or series of capital stock. While the General Corporation Law of the State of Delaware (the DGCL) permits a company to create preferred stock, it provides drafters of preferred stock provisions with no specific guidance as to the nature or form of the preferred stock’s rights and obligations. Similarly, Delaware case law imposes few express mandates other than to require that shares of preferred stock have preference over shares of common stock (which typically takes the form of a preference as to dividends and/or distributions upon liquidation of the company).
With few requirements from the DGCL and Delaware case law, it is up to the drafter to set forth the particular terms, including the rights, powers, and preferences of the preferred stock. The terms of the preferred stock, particularly the economic rights, powers, and preferences, will be influenced by the context in which the preferred stock is being issued and the relative bargaining power of the company and its investors. The special rights, powers, and preferences typically associated with preferred stock consist of some combination of special dividends, liquidation, voting, redemption and/or conversion rights, and such rights, powers, and preferences must be clearly and specifically set forth in the company’s certificate of incorporation or in a certificate of designation (which has the effect of amending the company’s certificate of incorporation). For purposes of this article, a certificate of incorporation and a certificate of designation are referred to collectively as a “certificate of incorporation.”
The interpretation of the special contractual preferences of preferred stock is primarily governed by the principles of contract law. In addition, preferred stock provisions must be interpreted in the context of the DGCL and the case law interpreting it. Drafters of preferred stock provisions are deemed to have been aware of and have an understanding of such applicable laws. If a preferred stockholder asserts a claim related to a contractual right, power, or preference of the preferred stock, Delaware courts will interpret such rights, powers, and preferences as contractual rather than fiduciary in nature.
On the other hand, preferred stockholders have rights that are separate from those created by their contractual preferences. These separate rights are shared equally with the common stockholders and are fiduciary in nature. If a preferred stockholder asserts a claim related to a right that is not a preference, but instead is shared equally with the common stockholders, Delaware courts have suggested that both the preferred and common stockholders are owed fiduciary duties. For example, if preferred and common stockholders are entitled to vote on a certain matter, the directors’ duty to disclose all material information related to the matter extends to all of the company’s stockholders. If there is a divergence of interests between the holders of the preferred stock and common stock, however, it will generally be the duty of board of directors to prefer the interests of the common stockholders to those of the preferred stockholders. As a result, directors could be found to have breached their fiduciary duties if they favor the interests of the preferred stockholders under these circumstances.
Accordingly, precise legal drafting is the key to ensuring that a preferred stockholder’s investment is adequately protected. The special rights, powers, and preferences of the preferred stock must be expressed clearly and will not be presumed. This article sets forth common drafting pitfalls of which drafters of preferred stock provisions should be cognizant. Most of these pitfalls can be avoided by remembering one simple concept when drafting preferred stock provisions: the special rights, powers, or preferences of preferred stock must be expressed clearly and will not be presumed or implied.
Protecting Protective Provisions
Among the most highly negotiated contractual provisions related to preferred stock are the so-called “protective provisions,” which are contained in the certificate of incorporation and set forth a list of actions that the company cannot take without the prior consent of a specified percentage of the outstanding preferred stock. As its name implies, these provisions seek to protect the investment of the preferred stockholders from actions by the company that may dilute or diminish their investment. As some holders of preferred stock learned the hard way, however, the absence of a single phrase or the reliance on a general, catch-all provision can result in the elimination or circumvention of some or all of these highly negotiated protective provisions.
The absence of the simple phrase “including by merger or otherwise” could ultimately result in the inapplicability of all of the preferred stock protective provisions through amendments effected by merger rather than through a direct amendment to the certificate of incorporation. In Benchmark Capital Partners, IV, L.P. v. Vague, 2002 WL 1732423 (Del. Ch. July 15, 2002), aff’d, 822 A.2d 396 (Del. 2003), Benchmark Capital Partners (Benchmark) purchased shares of preferred stock of Juniper Financial Corp. (Juniper) in exchange for certain provisions in Juniper’s certificate of incorporation to protect Benchmark’s investment. These protective provisions included the requirement that Juniper obtain Benchmark’s consent prior to taking any action that would “materially adversely change the rights, preferences and privileges” of Benchmark’s preferred stock.
Several years later, when Juniper was in need of additional financing, Juniper and its potential investor proposed a transaction that would involve an investment of $50 million in financing in Juniper in exchange for shares of a new series of preferred stock of Juniper. In connection with the proposed transaction, Juniper initially considered amending its certificate of incorporation to permit the issuance of the new series of preferred stock, but reconsidered when it realized that Benchmark could invoke its protective provisions to block such action. Instead, to avoid Benchmark’s protective provisions, Juniper merged a wholly owned subsidiary with and into itself and, by virtue of the merger, amended and restated its certificate of incorporation. The amendments to the certificate of incorporation included the creation of a new series of preferred stock and the conversion of Benchmark’s existing preferred stock into a new series of junior preferred stock with diminished rights.
In response, Benchmark filed suit in the Delaware Court of Chancery seeking to preliminarily enjoin the merger on the basis that Juniper failed to obtain the votes required by two of its protective provisions – a series vote of the holders of each series of existing preferred stock on the merger because the amendments would “materially adversely change the rights, preferences and privileges” of such series, and a class vote of the holders of existing preferred stock because Juniper “authorize[d] or issue[d], or obligate[d] itself to issue, any other equity security . . . senior to or on a parity with” the existing preferred stock. Juniper responded that Benchmark was not entitled to a series or class vote related to the merger because the adverse change to Benchmark’s rights was the result of a merger, as opposed to a direct amendment to the certificate of incorporation, and Benchmark’s protective provisions did not expressly apply to mergers.
The court agreed with Juniper and held that protective provisions drafted to track Section 242(b)(2) of the DGCL (which provides holders of any class of capital stock with a class vote on an amendment to a certificate of incorporation that would “alter or change the powers, preferences, or special rights of the shares of such class so as to affect them adversely”) do not provide a class vote on a merger including one in which the certificate of incorporation of the surviving corporation is amended in the merger, absent an express provision of the certificate of incorporation to the contrary. Thus, because the protective provisions covering amendments to the certificate of incorporation did not include the phrase “including by merger or otherwise,” Juniper was able to amend its certificate of incorporation by virtue of merger to severely diminish Benchmark’s rights without Benchmark’s consent.
Benchmark is consistent with decisions of the Delaware Supreme Court, including Elliott Associates, L.P. v. Avatex Corp., 715 A.2d 843 (Del. 1998), that provided a “path” for future drafters of preferred stock provisions. The Supreme Court noted that when a charter “grants only the right to vote on an amendment, alteration or repeal, the preferred have no class vote in a merger,” but when a charter “adds the terms ‘whether by merger, consolidation or otherwise’ and a merger results in an amendment, alteration or repeal that causes an adverse effect on the preferred, there would be a class vote.” As a result, drafters of preferred stock provisions should be cognizant of this “path” and draft protective provisions accordingly.
Preferred stock provisions frequently provide that all shares of convertible preferred stock will convert automatically into shares of common stock upon the consent of the holders of a majority of the preferred stock. Where different series of preferred stock have different economic rights or protective provisions, holders of a series of preferred stock that do not own enough shares to block such an automatic conversion may lose their special economic rights or protective provisions if the holders of a majority of the preferred stock determine to convert the preferred stock into common stock. In Greenmont Capital Partners I, L.P. v. Mary’s Gone Crackers, Inc., 2012 WL 4479999 (Del. Ch. Sept. 28, 2012), the Delaware Court of Chancery considered whether, under Delaware law and the terms of the company’s certificate of incorporation, Mary’s Gone Crackers had the power to implement an automatic conversion of all of the shares of its Series A and Series B preferred stock into shares of common stock and subsequently to amend the certificate of incorporation to remove all references to the preferred stock (including its rights, powers, and preferences) without the consent of the holders of the Series B preferred stock.
Under the company’s certificate of incorporation, a vote of the majority of the holders of the outstanding shares of Series A and Series B preferred stock (voting together) had the right to automatically convert their shares into shares of common stock. Because the holders of the Series A preferred stock (who enjoyed fewer benefits under the certificate of incorporation than the holders of the Series B preferred stock) owned a majority of the total shares of preferred stock, the holders of the Series A preferred stock had the ability to automatically convert all of the shares of the outstanding Series A and Series B preferred stock into common stock without the consent of the holders of the Series B preferred stock. In early 2012, Mary’s Gone Crackers solicited and received consents from a sufficient number of holders of the Series A preferred stock to effect the automatic conversion of all the shares of the company’s preferred stock into shares of common stock.
A holder of the Series B preferred stock filed suit in the Delaware Court of Chancery claiming that the consent of the holders of the Series B preferred stock was required to effect the automatic conversion (and subsequently to amend the charter) based on certain protective provisions contained in the company’s certificate of incorporation, including consent rights over the company’s ability to take any action that would alter or change the powers, preferences, and rights of the Series B preferred stock. The court disagreed and held that the automatic conversion provision in the certificate of incorporation is a right of the holders of the preferred stock. Accordingly, the automatic conversion by the holders of a majority of the preferred stock to common stock was an effectuation of that right and was not an alteration or change to a right of the Series B preferred stock. The court noted that had the drafters of the preferred stock provisions intended for an automatic conversion to be subject to the consent rights of the holders of the Series B preferred stock, they could have expressly listed that right among the other consent rights of the holders of the Series B preferred stock. Because the holders of Series B preferred stock did not expressly bargain for the right to consent to any automatic conversion of the preferred stock, the holders of the Series A preferred stock were able to exercise the automatic conversion right and convert all of the shares of the preferred stock into common stock without the consent of the holders of the Series B preferred stock.
What About Subsidiaries?
When drafting preferred stock protective provisions that prevent the company from taking certain actions without the vote or consent of the holders of the company’s existing preferred stock, drafters should be aware that such provisions will not necessarily apply to any subsidiary of the company. Unless subsidiaries are specifically included within the scope of this protective provision, a subsidiary of the company could take actions that the company would otherwise be prevented from taking without the prior consent or vote of the preferred stockholders. For example, in In re Sunstates Corp. Shareholder Litigation, 788 A.2d 530 (Del. Ch. 2001), the Delaware Court of Chancery considered whether a preferred stock protective provision prohibiting the company from repurchasing its own shares when dividends were in arrears applied to purchases of the company’s stock by its subsidiaries. Consistent with prior decisions holding that the special rights of preferred stock must be expressed clearly, the court held that the relevant protective provision, which did not expressly provide that it applied to any subsidiary of the company, did not apply to purchases of the company’s stock by its subsidiaries. Further, the court noted that if the investors wished to prevent subsidiaries of the company from making such repurchases, they could have done so by including of the phrase “or permit any subsidiary of the company to take any such action.”
“No Impairment” Clauses
Protective provisions often include a “no impairment” clause, which typically provides that a company will not take any action that would impair the rights, powers, and preferences of the holders of the company’s existing preferred stock. In WatchMark Corp. v. ArgoGlobal Capital, LLC, 2004 WL 2694894 (Del. Ch. Nov. 4, 2004), the Delaware Court of Chancery rejected an argument that a “no impairment” clause operated as a gap filler to confer consent rights over actions that were not specifically addressed by the protective provisions in the certificate of incorporation. Delaware courts will not infer rights that are not expressly set forth in the certificate of incorporation, and thus “no impairment” clauses cannot be relied upon to provide protection that is not otherwise specifically granted.
Consider Your Exit When You Enter
In In re Trados Inc. Shareholder Litigation, 2013 WL 4511262 (Del. Ch. Aug. 16, 2013), the Delaware Court of Chancery noted that a typical investor’s investment timeframe is at odds with a company’s perpetual existence. Accordingly, investors whose investment horizon will require the company to engage in a liquidity event in a finite time period need to consider their exit strategy when they invest. If there is a divergence of interests between the holders of the preferred stock and common stock in a sale because, for example, all of the sale proceeds would go to the preferred stock and none of it would reach the common stock, it will generally be the duty of the board of directors to prefer the interests of the common stockholders to those of the preferred stockholders. In fact, directors could breach their fiduciary duties if they favor the interests of the preferred stockholders under these circumstances. In Trados, the court identified several contractual exit provisions to address the difficult fiduciary duty issues that can arise if such contractual exit rights are not present. These options include contractual drag-along rights requiring other stockholders to sell their shares to a purchaser if a majority of the stockholders approve the sale, put rights allowing the stockholder to put their stock to the company at a predesignated price after a fixed period of time, or a contractual agreement with the company to commence a sales process after a fixed period of time. Each of these options has limitations but, given the difficult fiduciary duty issues in the absence of such rights, consideration should be given at the time of investment to having a contractual exit strategy.
Make Your Vote Count
In order to maintain control over their investment in the company, preferred stockholders often negotiate for certain special voting rights in exchange for their investment in the company. Any such voting rights must not only be clearly and specifically set forth, but they also must be carefully drafted to ensure that they are consistent with Delaware law and are included in the proper organizational document of the company.
Set Forth Election and Voting Rights
The most important voting right of preferred stockholders is often the right to designate a certain number of directors to the company’s board of directors. Under Delaware law, however, unless the certificate of incorporation provides otherwise, the majority of the stockholders of the company are entitled to elect all of the directors of the company. Thus, in order to provide preferred stockholders with the ability to designate a certain number of directors to the company’s board of directors, the election and voting rights of the preferred stockholders must be included in the certificate of incorporation. Election and voting rights of preferred stock that are only set forth in an investor rights agreement or a voting agreement and are not also included in a certificate of incorporation may not be specifically enforceable under Delaware law.
Vacancies to be Filled in Same Manner as Appointed
Many companies include a provision in their certificate of incorporation or bylaws that provides that any vacancy in a board seat may be filled by a majority of directors then in office. These provisions typically purport to apply regardless of whether the board seat was elected by a particular class or series of stock. It is not clear, however, that such a provision will work to fill a vacancy in a board seat that was elected by a particular class or series of stock. Section 223(a)(2) of the DGCL provides that, unless otherwise provided in the certificate of incorporation or the bylaws, “[w]henever the holders of any class or classes of stock or series thereof are entitled to elect 1 or more directors by the certificate of incorporation, vacancies and newly created directorships of such class or classes or series may be filled by a majority of the directors elected by such class or classes or series thereof then in office, or by a sole remaining director so elected.”
The inclusion of the permissive term “may” suggests that the procedure for filling vacancies and newly created directorships is merely permissive and is not exclusive of other mechanisms that may be set forth in the certificate of incorporation or the bylaws. Thus, vacancies in seats elected by the holders of a particular class or series of preferred stock may, unless expressly provided otherwise, be filled by other stockholders. Drafters should be aware of such potential issues and consider providing that any vacancies must be filled in the same manner as the director who was originally appointed to the board of directors and may not be filled in any other manner.
Eliminate Common Stockholders’ Ability to Vote on Amendments to Preferred Stock Provisions
Once preferred stock has been issued, regardless of whether it was created by a stockholder-approved amendment to the certificate of incorporation or by the board of directors in a certificate of designation pursuant to blank check authority, the terms of that series of preferred stock can only be altered by amending the certificate of incorporation under Section 242 of the DGCL, which requires the approval of all stockholders entitled to vote generally, including the common stockholders. Drafters of preferred stock provisions, however, can provide in the certificate of incorporation that common stockholders are not entitled to vote on any amendment to the certificate of incorporation that relates solely to the terms of one or more series of preferred stock, if the holder of such affected series is entitled to vote on the amendment. As a result, if the parties want to retain the flexibility to seek to change the terms of preferred stock without having to obtain the consent of the common stockholders, they must include a provision to that effect in the certificate of incorporation.
Voting Agreements Should Include an Irrevocable Proxy
In addition to the right to designate certain members of the company’s board of directors, preferred stockholders frequently enter into an agreement with the company and other stockholders to vote their shares for the election of certain designees to the company’s board of directors. Drafters of any such voting agreement should be aware that it may be difficult to enforce such an agreement (other than through costly litigation) if the voting agreement does not include an irrevocable proxy granting the holder of such proxy the power to vote the shares subject to the voting agreement in accordance with the terms of the voting agreement in the event that any party to the voting agreement fails to do so.
Appraisal Rights for Preferred Stock
As a general matter, holders of preferred stock have the same appraisal rights under Section 262 of the DGCL as the holders of common stock. Unlike common stock, however, the fair value of the preferred stock in an appraisal proceeding is based solely on the contractual rights granted to the preferred shares being appraised under the certificate of incorporation. As a result, the preferred stockholders are only entitled to rights that are clearly and expressly provided to them in the event of a merger in the certificate of incorporation and are not entitled to additional merger consideration through the appraisal process.
Whether a preferred stockholder is entitled to a preference over the common stockholders in a sale of the company depends on the terms of the preferred stock. Often the preferred stock has specific provisions governing its rights in a sale of the company. In the absence of such specific provisions, however, preferences to which preferred stock may be entitled in a “liquidation, dissolution or winding up” of the company will not apply to a merger, particularly where the terms of the preferred stock expressly state that a merger will not be deemed to be a liquidation, dissolution, or winding up for purposes of the liquidation provisions of the preferred stock. In the absence of such specification, the preferred stock will be deemed to have no “preference” over the common stock in a sale and instead will be entitled only to pro rata treatment with the common stock.
In determining the fair value of the preferred stock based on the certificate of incorporation, a Delaware court will not consider speculative or probable contractual features of the preferred stock. For example, in In re Appraisal of Metromedia International Group, Inc., 971 A.2d 893 (Del. Ch. 2009), the Delaware Court of Chancery rejected an argument by preferred stockholders that, in determining the fair value of the company’s preferred stock, the court should consider the preference of the preferred stockholders contained in the certificate of incorporation in connection with a redemption or liquidation because the preferred stockholders argued that it is likely that such an event could occur in the next few years. The court rejected the argument, noting that a redemption or liquidation of the preferred stock was too speculative, and determined that the preferred stockholders were only entitled to receive the amount per share as provided in the certificate of incorporation in the event of a merger.
On the other hand, the court will consider nonspeculative contractual features of the certificate of incorporation in determining the fair value of the preferred stock. For example, in Shiftan v. Morgan Joseph Holdings, Inc., 57 A.3d 928 (Del. Ch. 2012), in the determining the fair value of the company’s preferred stock, the court took into account the economic reality that the preferred stockholders would have been entitled to mandatory redemption of their shares just six months after the merger. Therefore, even though the redemption had not (and would never) take place due to the merger transaction, the fact that, prior to the merger, the redemption was certain to occur in the near-term (within six months) was relevant to the court’s determination of value of the preferred shares in the merger transaction.
As demonstrated by the examples set forth above, the precise words that drafters employ clearly matter in determining the special rights, powers, and privileges of preferred stock. Such rights must be set forth clearly in the certificate of incorporation and will not be presumed by a Delaware court if challenged. Accordingly, drafters should be familiar with the DGCL and the relevant case law and take great care to ensure that all of the desired provisions are clearly expressed and defined at the time of the preferred stockholders’ investment in the company.