A post by Kevin Brady on Francis Pileggi's Delaware corporate law blog alerts us to Chancellor Chandler's decision in In Re: Trados Incorporated Shareholder Litigation, No. 1512-CC (July 24, 2009), read opinion here. The facts are fairly complicated. Suffice it for our purposes to say that Trados Inc. entered into a merger agreement with SDL, plc, under which Trados' preferred stockholders would get $57.9 million to satisfy their liquidation preference, management would get $7.8 million under a golden parachute-type arrangement, and the common shareholders would get exactly nothing.
A common shareholder brought a class action against the directors alleging breach of fiduciary duty. Brady explains:
The plaintiff claimed that the director defendants breached their fiduciary duty of loyalty to Trados’ common stockholders by selling the company when they did because “the Company was well-financed, profitable, and beating revenue projections.” In addition, the plaintiff complained that the director defendants, in approving the Merger, never considered the interest of the common stockholders in continuing Trados as a going concern, even though they were obliged to give priority to that interest over preferred stockholders’ interest in exiting their investments.”
Plaintiff contends that the merger took place at the behest of certain preferred stockholders, who wanted to exit their investment. Defendants counter by arguing that plaintiff ignored the “obvious alignment” of the interest of the preferred and common stockholders in obtaining the highest price available for the company. Defendants assert that because the preferred stockholders would not receive their entire liquidation preference in the merger, they would benefit if a higher price were obtained for the Company.
In the course of his opinion, Chancellor Chandler addressed the fiduciary duties corporate managers owe preferred stockholders:
Generally, the rights and preferences of preferred stock are contractual in nature. This Court has held that directors owe fiduciary duties to preferred stockholders as well as common stockholders where the right claimed by the preferred “is not to a preference as against the common stock but rather a right shared equally with the common.” [Citing Jedwab v. MGM Grand Hotels, Inc., 509 A.2d 584 (Del. Ch. 1986).] Where this is not the case, however, “generally 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.” Thus, in circumstances where the interests of the common stockholders diverge from those of the preferred stockholders, it is possible that a director could breach her duty by improperly favoring the interests of the preferred stockholders over those of the common stockholders.
Here the divergence of interest did implicate a preference of the preferred stock; namely, the liquidation preference. Ergo, no fiduciary duty to the preferred and potential liability for preferring their interests over that of the common.
I think Chandler got the law and its application to the facts right. I want to use this case, however, as a jumping off point for discussing the basic issue of whether there ought to be fiduciary duties to the preferred at all.
Unlike bondholders, who are creditors of the corporation, holders of preferred stock are nominally shareholders. In addition, while bond indentures tend to be lengthy and highly detailed, the organic documents governing preferred stock tend to be bare-bones affairs. To what extent are preferred stockholders therefore entitled to the benefits of fiduciary duties or other extra-contractual protections?
Jedwab v. MGM Grand Hotels, Inc., 509 A.2d 584 (Del. Ch. 1986), split the baby in an interesting way. A prospective buyer of MGM, Bally Manufacturing, made a total offer for the company, leaving to MGM’s board the task of dividing the proceeds between the common and the preferred. The preferred shareholders objected to the division set by the board. Did the board owe the preferred shareholders fiduciary duties of care and loyalty with respect to division of the deal?
The chancery court’s opinion acknowledged a number of prior Delaware decisions holding that “preferential rights are contractual in nature.” The chancellor rejected, however, the defendants’ asserted corollary that all rights of preferred stock are contractual in nature. Instead, the chancellor drew a distinction between the preferential rights and special limitations associated with preferred stock, which are created by the articles of incorporation or other organic corporate documents, and rights that both the preferred and common shares possess by virtue of being stock. The former are contractual in nature and, as such, the board’s sole obligation is to give the preferred their contract rights. The latter, however, may give rise to fiduciary obligations. The disputed merger implicated none of the relevant preferential rights or special limitations of MGM’s preferred. Accordingly, the court identified three aspects of the preferred holders’ complaint as implicating fiduciary duties: “(a) to a ‘fair’ allocation of the proceeds of the merger; (b) to have the defendants exercise appropriate care in negotiating the proposed merger; and (c) to be free of overreaching by Mr. Kerkorian [a controlling shareholder] . . . .”
Jedwab has a certain superficial plausibility, but proves unpersuasive on closer examination. First, a number of Delaware supreme court precedents in fact suggest that all of the rights of preferred stockholders are contractual in nature, not just those relating to their preferential rights and special limitations. See, e.g., Judah v. Delaware Trust Co., 378 A.2d 624, 628 (Del. 1977) (“Generally, the provisions of the certificate of incorporation govern the rights of preferred shareholders, the certificate . . . being interpreted in accordance with the law of contracts, with only those rights which are embodied in the certificate granted to preferred shareholders.”).
The supreme court’s holding in Wood v. Coastal States Gas Corp., 401 A.2d 932 (Del. 1979), seems particularly problematic for Jedwab’s viability. In Coastal, plaintiff-preferred shareholders challenged a spin-off transaction as violating the provision of Coastal’s articles of incorporation governing conversion of their stock to common. Holding that its duty was to interpret the contract created by the conversion provision, the court concluded that the preferred stockholders’ rights were not violated. To be sure, Coastal involved a preferential right and thus fell into the category of rights that even Jedwab acknowledges to be contractual in nature. The Coastal court, however, used very broad language in defining the rights of preferred stockholders: “For most purposes, the rights of the preferred shareholders as against the common shareholders are fixed by the contractual terms agreed upon when the class of preferred stock is created.” The qualifier, “for most purposes,” does not leave a lot of wiggle room for Jedwab to sneak through. Even more significantly, however, the Coastal court expressly rejected the plaintiff-preferred shareholders’ claim that the spin-off unjustly enriched the common stockholders. In so holding, the court opined that whatever participation rights the preferred stockholders possessed must be created by the articles of incorporation. By thus rejecting an extra-contractual remedy, the Coastal court further confirmed the essentially contractual nature of preferred stockholders’ rights.
Second, Jedwab depends on the proposition that preferred stock is granted certain rights by statute and common law even where the corporation’s organic documents are silent. The chancellor cited two such examples: Where the contract is silent, preferred stock get the same voting rights as common stock. Where the contract is silent, preferred stock participates pro rata with the common in a liquidation. Neither of these examples, however, rise to the same level as conferring the benefits of fiduciary obligation on preferred stockholders. Neither entails the sort of open-ended inquiry required by fiduciary obligation, nor does either entail the same risk of conflicting interests.
Finally, from a policy perspective, several objections to Jedwab can be noted. For example, it creates a two masters problem. Jedwab does not eliminate potential conflicts of interest between the holders of preferred and common. Whose interests must the board maximize when those interests clash? Chandler says the common, but seemingly only when the preferred’s preferences are involved.
On a related note, the Jedwab opinion makes clear that the preferred are not entitled to an equal share in the merger consideration—only to a fair share. Yet, how does the board decide what is fair ex ante? Even if the board makes a good faith effort to set a fair price, the indeterminacy of valuation means that reasonable people could differ. Conversely, if the prospective buyer proposed the division to be made between the common and the preferred, the board likely would escape liability. Among other things, the board could defend itself on causation grounds—i.e., whether or not the board breached its fiduciary duties, that breach was not the cause of plaintiff’s injuries. See, e.g., Dalton v. Am. Inv. Co., 490 A.2d 574 (Del. Ch.), aff’d, 501 A.2d 1238 (Del. 1985) (declining to reach issue of fiduciary obligation to preferred stockholders as there was no causal link between alleged breach and alleged injury).
Finally, Jedwab implies that the preferred may have greater rights with respect to nonpreference issues than with respect to preferences, which seems odd at best. Cf. Gale v. Bershad, 1998 WL 118022 (Del. Ch. 1998), in which Vice Chancellor Jacobs followed Jedwab in asking whether the right in question is “created not by virtue of any preference” but is “shared equally with the Common.” Id. at *5. As to contractual rights arising out of the preferred stock’s preferential rights or special limitations, however, Vice Chancellor Jacobs further noted that an implied covenant of good faith constrained the board’s discretion. Id.
In RGC Intern. Investors, LDC v. Greka Energy Corp., 2000 WL 1706728 (Del. Ch. 2000), Vice Chancellor Strine favorably referred to a characterization of Jedwab as an exception to the general rule “that the rights of preferred stockholders are largely governed by contract law and that corporate directors do not owe preferred stockholders the broad fiduciary duties belonging to common stockholders.” Id. at *16. I would prefer Jedwab to be seen not as a narrow exception to the general rule, but as an aberrational violation of that rule. It ought to be overturned on both doctrinal and policy grounds.
In fairness, Jedwab wrestled with a persistent problem in the preferred stock area. As noted, bond indentures are hundreds of pages long and deal with virtually every conceivable contingency. In contrast, preferred stock certificates of designation tend to be relatively short and to deal with only a few issues. Which leaves unresolved a nagging question; namely, how do you deal with issues that come up that the contract does not cover? The answer, by analogy to the bond setting, is to use an implied covenant of good faith rather than fiduciary duties. In this context, such a covenant would preclude the board from taking action that deprives the preferred of the benefit of their bargain. To the extent that covenant fails to provide adequate protections, portfolio theory teaches that the preferred stockholders should engage in self-help by diversifying their portfolio.
