Poor pitiful or potently powerful preferred?

• Author: Strine, Leo E., Jr.
• Position: Response to article by William W. Bratton and Michael L. Wachter in this issue, p. 1815

In response to William W. Bratton & Michael L. Wachter, A Theory of Preferred Stock, 161 U. PA. L. REV. 1815 (2013).

Every policy proposal raises two questions. The first is whether there is a problem that requires a solution. The second is whether the proposed solution has more benefits than costs.

Because I am a judge, not a professor, my comments on Professors Bratton and Wachter's thoughtful Article (1) will be questioning rather than conclusory. Bratton and Wachter claim that the law lacks an adequate theory about preferred stockholders. (2) Specifically, they argue that this is problematic for society because preferred stockholders are deprived of the benefit of their bargain, a result that may imperil society as a whole because it undermines the ability of corporations to raise the capital needed for long-term investment. (3)

The solution to this problem is for corporate law to impose on directors the duty to protect the bargained-for expectations of preferred stockholders by somehow identifying the extra value--the lagniappe in more savory terms--that preferred stockholders should receive over common stockholders. These bargained-for expectations are, interestingly, not in the written contract. Rather, they constitute some noncontractual expectation that should be enforced, not as a matter of contract law, but because preferred stockholders should be seen as some form of specially entitled stockholders who have extra rights that, although not existing in the detailed contracts they negotiate with issuers, should be identified and enforced by courts in equity. (4) Equally interesting, Professors Bratton and Wachter admit that the extra rights can be and are frequently secured by preferred stockholders in their contracts, but they also contend that it is preferable to have courts enforce them as a matter of judge-made equity law than to require preferred stockholders to secure them in the contracts themselves. (5) The premise seems to be that after-the-fact litigation presents less of an efficiency drag and fairness problem than requiring preferred stockholders to secure their "preferences" in contract, and otherwise assuming that they will be treated no better and no worse than common stockholders. (6)

Not only that, when preferred stockholders wield control of the corporation, they can cause the sale of the corporation whenever they wish to cash out; even if the corporation is solvent, there are plausible growth scenarios in which the corporation could succeed and the sale will yield no proceeds to the common stockholders. (7) Put simply, if someone buys preferred stock in an early-stage company that is developing a potentially very valuable but also potentially worthless technology, at a discount to the liquidation preference payable in the event of a merger, and that preferred stock has board control rights, Bratton and Wachter say that the preferred stockholder may cause the corporation to be sold at fair market value, recover its liquidation preference, and leave the common with nothing, even if the company has two years of cash left to pay its bills and all of its common stockholders were sold stock on the basis that the company was a risky startup, steadfastly determined to see if the technology would pan out. (8) After the purchase of control by a preferred stockholder and the preferred controller's dominance of the board, the only fiduciary duty inquiry is to determine whether the sale was at fair market value--there is no duty to consider the interests of the common in seeing the risk that was the company's touted strategy to hazard actually taken. (9) So long as there is a market-based sale, the preferred can simply use its control of the board to secure its own desire for immediate payment, as if it were a creditor with a contractual right to demand repayment of its loan.

Having outlined Bratton and Wachter's thesis, I now return to my first question: Is there a problem? As an initial matter, I question whether preferred stock is undertheorized. The prevailing theory is simple: preferred stockholders are preferred to the extent that they secure preferences (i.e., additional rights that may have economic value) in their contract. (10) To the extent preferred stockholders fail to extract contractual preferences, they are entitled to no better treatment than other stockholders. (11) As preference holders, preferred stockholders are owed the duty the corporation owes to other contractual claimants, which is to honor their legal rights. Preferred stockholders are owed fiduciary duties by the board only insofar as they are like other stockholders. Thus, because preferred stockholders, like common stockholders, desire value from the company's performance, they may bring derivative suits if they suspect directors are self-dealing. Similarly, if the corporation is being sold, the preferred may bring a Revlon claim if they believe the board is not honoring its duty to maximize the sale value of the corporation. (12) But, the board owes no fiduciary duty to maximize the value of the preferred or to favor in any way the preferred over the common, except when contractually required. In fact, the law suggests that when push comes to shove, the board has a duty to prefer the common's interests, as pure equity holders, over any desire of the preferred for better treatment based on some generalized expectancy that they will receive special treatment beyond their contractual rights. (13) Indeed, if the preferred stockholders actually secure control of the board, they are then expected to fulfill this fiduciary responsibility and to refrain from using their power selfishly to extract a return of their own investment, unless they do so on terms that are shown to be fair to the common. (14)

Second, there are reasons to doubt that preferred stockholders lack sufficient market clout to protect their interests at the negotiating table. Preferred stockholders are not obviously the "poor pitiful preferred" that Bratton and Wachter describe. That proposition makes little intuitive sense. No one has to buy preferred stock. Those who do are quite sophisticated. Preferred stock issuances often involve provisions such as: (1) a requirement for a class vote on any issues affecting the preferred, including any merger, asset sale, charter change, or issuance of more preferred shares, and (2) a liquidation preference in the event of merger, (15) In fact, Bratton and Wachter's own research reveals that half of the new issuances of preferred since 2009 give the preferred effective approval rights over mergers. (16) Although I am not sure what the authors consider "effective" protection, an earlier study of preferred contractual rights concluded that about eighty-one percent of preferred stockholders had negative covenants relating to business combinations. (17) And the common feature of a class vote solves most of the problems Bratton and Wachter raise in their Article. Instead of viewing the absence of such a common provision as an indication that a particular preferred stock issue has no extra holdup value and is therefore subject to no better treatment than the common, Bratton and Wachter fill a gap that they have little evidence to claim is a gap, rather than an intentional contract omission. Although the authors fear that common contractual provisions giving preferred stockholders the ability to protect themselves in a merger, default, or other event endangering their investment will result in "holdups" (i.e., where preferred stockholders use their ability to vote as a class to impede valuable corporate transactions), (18) they ignore the fact that such provisions are common and bargained for by issuers. Therefore, the common stockholders have no just reason to complain about them (assuming the preferred was issued for proper corporate purposes), and such provisions give the real parties an incentive to reach a mutually acceptable compromise.

The proposition that, instead of extracting these specific contractual rights and risking holdup by the real parties in interest, the preferred should be able to look to judges to give them "noncontractual contractual" rights as a matter of equity, rests on the idea that litigation about a nebulous proposition is more efficient than a mutually bargained-for contract. By way of example, in their discussion of SV Investment Partners, LLC v. ThoughtWorks, Inc., (19) Bratton and Wachter arguably overstate the extent to which courts, rather than statutory corporate law itself, should affect the ability of preferred stockholders to get full redemption when the issuer does not have the funds statutorily required for it to do so. (20) To them, the court "strip[ped] away a promise's contractual vitality by remitting the decision to perform the promise to pay to the discretion of the issuer's board, thereby subordinating the preferred's payment rights not only to the interests of the issuer's creditors, but to those of its common stockholders." (21) The court was supposedly biased against the preferred in accepting the issuer's position that there were no legally available funds unless the issuer had cash on hand (or the equivalent). (22)

This reading is strained for a couple of reasons. First, the preferred stockholders' right to mandatory redemption in the defendant's charter was governed by language saying that the preferred "shall be entitled ... to redeem [their stock] for cash out of any funds legally available therefore." (23) This language presupposes that the corporation must have cash on hand before making any redemption. But, as the trial court in ThoughtWorks found, the plaintiffs' own expert had "no thoughts" as to how the corporation might obtain the cash to finance a redemption, even though the size of the proposed redemption was approximately equal to the low end of the expert's estimate of the corporation's equity. (24) Furthermore, the corporation in...