Investors frequently negotiate for a redemption right to ensure at least some return on preferred stock investments in a “sideways situation”—where the target company is neither a huge success nor an abject failure.  Continuing a consistent theme in recent Delaware jurisprudence, the Delaware Court of Chancery declined to dismiss a complaint alleging directors breached their duty of loyalty in taking steps to satisfy an investor’s redemption request.

In 2008, several funds affiliated with Oak Hill Capital Partners invested in preferred stock of ODN Holding Corporation.  The preferred stock carried a right to cause ODN to effect a redemption out of funds legally available therefor at any time beginning five years after the date of the investment, at a price equal to the original issue price, plus declared and unpaid dividends.  If funds were insufficient for a full redemption, the certificate of designations provided that the maximum amount of funds legally available would be used for the redemption and ODN would take reasonable actions, consistent with its board’s fiduciary duties, to generate funds to redeem the remaining shares.

Following a secondary purchase of common stock from another stockholder, Oak Hill became ODN’s controlling stockholder and appointed three of its eight board members.  The plaintiff alleged that, beginning in 2011, approximately two years prior to the date on which Oak Hill could exercise its redemption right, ODN changed its strategy substantially, in order to finance the looming redemption.  Despite a history of growth through acquisitions, the company stopped making new acquisitions and sold two of its four lines of business for a fraction of the price it had paid to acquire the businesses.  In subsequent years, ODN sold a third line of business and the “crown jewel” of its fourth line of business, resulting in a 92% decline in ODN’s revenue from 2011 to 2015.  In addition, the board granted officers a cash bonus incentive if ODN redeemed at least $75 million of preferred stock.

In 2012, the ODN board formed a committee of non-Oak Hill directors to negotiate with Oak Hill regarding the redemptions.  The committee—working with the company’s officers—approached Oak Hill with a proposal to redeem half of the preferred stock in exchange for Oak Hill agreeing to defer further redemptions until 2017.  Oak Hill rejected this proposal, and countered with a demand for ongoing redemptions as ODN sold assets, together with a 12% PIK dividend on any delayed redemptions.  The committee rejected Oak Hill’s counter-offer, but the committee and ODN’s board of directors ultimately agreed to redeem $45 million of Oak Hill’s preferred stock in exchange for a 10-month forbearance on further redemptions.

The plaintiff, one of ODN’s founders and a holder of common stock, brought suit alleging, among other things, that these actions constituted a breach of the fiduciary duties of Oak Hill and ODN’s board of directors.  The Court found that the complaint adequately pleaded conduct implicating the duty of loyalty of the board and Oak Hill and that entire fairness would be the appropriate standard of review.  In making this determination, Vice Chancellor Laster cited the oft-quoted admonition that directors must “promote the value of the corporation for the benefit of its stockholders.”  The stockholders for whose benefit the board must act are “the undifferentiated equity as a collective, without regard to any special rights.”

In addition, “[a] board does not owe fiduciary duties to preferred stockholders when considering whether or not to take corporate action that might trigger or circumvent the preferred stockholders’ contractual rights.”  In other words, the board’s duty to satisfy the special rights of preferred stockholders is merely contractual, not fiduciary.

Because Oak Hill’s rights were contractual (notwithstanding the fact that they were memorialized in ODN’s charter), they were subject to the doctrine of efficient breach.  The board must make a fiduciary determination in considering how to evaluate contractual obligations and it must consider its alternatives, including breaching its contractual obligations.  Here, Oak Hill possessed limited rights if ODN did not have sufficient cash to effect a redemption.  As a result, in failing to breach its contractual obligation to Oak Hill, the ODN board may have breached its fiduciary obligation to common stockholders, if its actions crippled the residual value of the common stock.

ODN Holding comes on the back of Trados,[1] in which Vice Chancellor Laster applied entire fairness review when a company controlled by interested directors (appointed by preferred stockholders) sold itself in a transaction in which the common stockholders received no consideration for their stock.  The Trados Court nonetheless found that the transaction passed entire fairness muster because the common equity had no value prior to the transaction.  Similarly, in ODN Holding, the Court left open the possibility that the prices that ODN received for its various lines of businesses would ultimately be found fair or that ODN’s value did not exceed Oak Hill’s redemption amount.  Those issues could not be properly assessed at the pleading stage of the litigation.

The decision highlights for both investors and boards of directors a couple of noteworthy trends in Delaware jurisprudence:

  • For investors, the case is a reminder of the general lack of protections afforded to preferred stock.
    • Following the TradingScreen decision, we highlighted the need for investors to pay careful attention to the language of redemption provisions and to consider negotiating for additional protections for situations where a company is not able to pay the full redemption amount.
    • ODN Holding questions the benefits of one of the potential protections, granting preferred holders the ability to elect a majority of the Board. Investors should consider other protections—such as a penalty interest rate following a failure to effect a redemption or stockholder consent rights over company cash expenditures—to safeguard the benefits of the redemption right.  In addition, a preferred stock investor might seek to obtain a right —enforceable by specific performance—to foreclose on company assets or unilaterally cause a sale or liquidation of the company following the company’s failure to comply with a demand for redemption, which would eliminate board discretion and make a fiduciary challenge less likely.
    • An investment with a different structure may avoid the fiduciary issue. If ODN had been a limited liability company whose operating agreement eliminated fiduciary duties of the board, a common equityholder would not have had fiduciary duty grounds on which to sue.  (Of course, Oak Hill’s shifting role in ODN – initially as a preferred investor, but later as the controlling stockholder – highlights that it isn’t always clear whether an investor would prefer to waive fiduciary duties.)
    • Similarly, an investment structured as mezzanine debt rather than preferred stock would have provided the investor with additional protections. Although a company’s decision to make a debt repayment would also be subject to the efficient breach doctrine, debt repayment is not subject to Delaware’s limitation to make payments to equity holders only out of surplus and provides additional means of pursuing remedies.
  • For boards of directors, the case focuses attention on ongoing fiduciary obligations.
    • The mere fact that authorizing a contract complied with a board’s fiduciary duties at the time of signing does not mean that a company’s subsequent performance of the obligations in that contract will automatically pass fiduciary muster.
    • The decision also highlights the Delaware courts’ recent emphasis on the stockholder franchise. Under the procedure set forth in the MFW shareholder litigation, the ODN board’s decision-making likely would have benefited from more deferential business judgment review had an uncoerced and informed majority-of-the-minority stockholder vote on the divestitures been combined with ODN’s use of a special board committee (assuming that committee was independent and adequately-empowered).
    • On independence, the case continues the suspicion of Delaware courts of directors operating in the highly networked Silicon Valley community. Consistent with the Delaware Supreme Court recent decision in Zynga, the Court concluded that the following facts raised by the plaintiffs, taken together with the other allegations of the complaint, supported an inference that the outside directors cannot be considered disinterested or independent for purposes of determining the standard of review:
      • As to one director, (i) that he had worked for 15 years as a corporate attorney with the law firm that was Oak Hill’s current and long-time counsel, (ii) that he had worked alongside one of the Oak Hill board members on another board and (iii) that his son and the Oak Hill board member’s sons were friends;
      • As to another, that he had previously received $24 million from Oak Hill when it purchased a block of his otherwise illiquid shares in ODN; and
      • As to a third, that she was a highly compensated officer in a company controlled by Oak Hill.

Boards are well advised to carefully probe business and personal relationships in making independence determinations.  Controlling shareholders similarly have an interest in ensuring that potential conflicts are disclosed and independent committees are properly formed—as it does them little benefit to proceed with a special committee process that would be afforded neither benefits of MFW nor burden shifting in an entire fairness review.

[1] In re Trados Inc. S’holder Litig., 73 A.3d 17 (Del. Ch. 2013).