A theory of preferred stock.

• Author: Bratton, William W.
• Position: Introduction into III. The Payment Stream, p. 1815-1860

Should preferred stock be treated under corporate law as an equity interest in the issuing corporation or under contract law as a senior security? Should a preferred certificate of designation be subsumed in the corporate charter and treated as an incomplete contract filled out by fiduciary duty, or should it be treated as a complete contract with the drafting burden on the party asserting the right, as would occur with a bond contract? Is preferred stock equity or debt? This Article shows that preferred stock is both corporate and contractual--neither all one nor all the other. It sits on a fault line between two great private law paradigms, corporate and contract law, and draws on both. The overlap brings two competing grundnorms to bear when interests of preferred and common stockholders come into conflict: on the one hand, managing to the common stock as residual interest holder maximizes value; on the other hand, holding parties to contractual risk allocations maximizes value. When questions arise concerning the relative rights of preferred and common stock, the norms hold out conflicting answers. Delaware courts have taken the lead in confronting these questions by seeking to synchronize the law of preferred stock with the rest of corporate law--a project that has led to both innovation and stress.

This Article examines recent cases about preferred stock to show two facets of Delaware law coming to bear as the synchronization process proceeds: first, reliance on independent directors for dispute resolution, and second, the common stock--value maximization norm. These trends cause the law to tilt toward corporate norms, thereby disrupting allocated risks in heavily negotiated transactions, particularly in the venture capital sector. The Article makes three recommendations that would promote the goal of restoring balance between the corporate and contract paradigms. First, the meaning and scope of preferred contract rights should be determined by courts, rather than by issuer boards of directors. Second, conflicts between preferred and common should not be decided by reference to a norm of common stock-value maximization. Instead, the goal should be the maximization of the value of the equity as a whole. Third, independent-director determinations of conflicts between preferred and common should not be accorded ordinary business judgment review. Instead, a door should be left open for good faith review tailored to the context. This review would require a showing of bad faith treatment of the preferred where the integrity of a deal has been undermined, with the burden of proof on the board.

INTRODUCTION A. Corporate Legal Theory B. Institutional Posture and Normative Concerns C. Structure of This Article I. THE PARADIGMATIC BACKDROP: CORPORATE TREATMENT IN DEPRESSION-ERA EQUITY RECAPITALIZATIONS A. The Recapitalization Problem B. Cramdown C. Summary II. PREFERRED STOCK AS FIDUCIARY BENEFICIARY: MERGERS A. The Problem and the Alternative Solutions 1. Fiduciary Treatment and Standards of Review a. Blockholder Domination b. Dispersed Common Standard of Review 2. Contract Treatment a. The Preferred Contract as Complete b. Appraisal Rights 3. Summary B. Delaware Law C. James Analysis D. Summary III. THE PAYMENT STREAM A. The Promise to Pay on Preferred B. The Thought Works Solution C. An Explanation and an Alternative D. Summary and Analysis IV. PREFERRED IN CONTROL: VENTURE CAPITAL UNDER CORPORATE FIDUCIARY LAW A. Venture Capital Financing 1. The Upside and the Downside 2. Control Arrangements B. The Trados Intervention C. Trados and the Value-Maximizing Merger 1. Common Stock Maximization Versus Enterprise Value Maximization 2. Selling the Company Under Trados 3. Contracting Out of Fairness Scrutiny: Drag-Along Rights 4. Summary D. Trados and the Suboptimal Merger E. Standards of Review V. TRAVERSING THE PARADIGMATIC DIVIDE A. Doctrinal Overlap B. Delaware's Approach C. Consistency as an Alternative D. Value Maximization and Paradigmatic Conflict CONCLUSION INTRODUCTION

Preferred stock is undertheorized. The most recent comprehensive study appeared almost six decades ago. (1) Commentary on the subject since then has been sporadic. (2) Yet preferred stock's economic salience has increased notably in recent decades. The volume of new preferred offerings outstrips both that of initial public offerings (IPOs) of common stock and of new public common offerings by seasoned issuers. (3) Preferred also is the favored mode of investment in the venture capital sector. (4) Finally, it is much utilized in the financial sector. (5) For example, the U.S. Treasury purchased more than $200 billion of preferred under the Troubled Asset Relief Program. (6)

It is time for a new look at preferred. There are three reasons why such a review is warranted--the first theoretical, the second institutional, and the third normative.

1. Corporate Legal Theory

   The theoretical interest concerns the problem of defining the corporation's boundaries, asking the "who's in and who's out" question regarding the line dividing fiduciary beneficiaries from contract counterparties. The problem has been traversed extensively in corporate legal theory (7) without anyone noticing the special case of preferred. Preferred stockholders are the only corporate constituents who straddle the line--their participation being both corporate and contractual. It therefore follows that resolving problems relating to preferred stock offers special information about the corporation's borderland.

   The classic common stockholder surrenders capital to the company with no right to pull it back out: the stockholder takes the residual financial risk on both the downside and upside and gives up direct input into business decisions in exchange for a vote at an annual election of the board of directors. The interest can be viewed contractually, but the contract that emerges is almost entirely incomplete, with open-ended fiduciary duties substituted for negotiated financial rights. Whether viewed through the lens of corporate or contract law, common stockholders are seen as "insiders." Lenders also contribute capital to corporations, often for long periods, but they do so under contracts that create enforceable financial priorities. The contracts approach completeness, and courts balk when asked to imply additional rights in cases where lenders find themselves in vulnerable positions. (8) Lenders sit "outside" of the corporation, and look to specific, bargained-for rights to protect their interests rather than the apparatuses of governance and fiduciary duty.

   Stockholders are corporate, lenders are contractual, and a well-understood wall separates their legal treatments. Preferred stock straddles the wall. The holder receives a share of stock issued pursuant to the same corporate code and charter as a share of common stock. The stock, viewed in isolation, carries the same vulnerabilities as a share of common stock and exists in the same regime of rights and duties. The issuer then adds contract rights to the stock--either financial preferences or a debt-like right to be paid certain sums on set dates--thus rendering it preferred stock. (9)

   So is preferred stock equity or debt? Is it stock subject to the rules of corporate law or a senior security governed by contract law? Is it an incomplete contract filled out by fiduciary duty or a complete contract with the drafting burden on the party asserting the right? These are the central questions of the law of preferred stock. This Article provides answers and thus fills the void of corporate legal theory.

   Preferred stock sits on a fault line between two great private law paradigms, corporate law and contract law. It is neither one nor the other; rather, it draws on both. (10) The overlap involves two grundnorms and brings them into conflict. On the one hand, the corporate paradigm instructs that managing to the common stock, since stockholders are residual interest holders, maximizes value; on the other hand, the contract paradigm instructs that holding parties to contractual risk allocations maximizes value. When questions arise concerning the relative rights of preferred and common, the paradigms can hold out conflicting answers. Decisionmakers choose between the two, sometimes applying corporate law principles, while at other times opting instead for the framework of contract law. As a result, the law vacillates.

   This observation does not mean that the law never draws lines. Sometimes, clear categorical placements must be made, and preferred is effectively pigeonholed on one side or another of the debt--equity line. For example, bank capital rules treat preferred as equity (sometimes, on par with common), (11) Generally Accepted Accounting Principles (GAAP) require some preferred to be booked as debt, even though formally it is stock, while other preferred is booked as equity. (12)

   Things get harder and neat results prove elusive when courts address cases in which the economic interests of preferred and common stockholders come into conflict. The Delaware courts have attempted to effect a clean paradigmatic split by referencing corporate law when the matter concerns "a right shared equally with the common" and referencing contract law when the matter concerns special rights and preferences. (13) But this line of demarcation proves too vague and the area of paradigmatic overlap proves too extensive to permit easy compartmentalization. Decisions are not remitted to the law of debtor-creditor on the "rights and preferences" side of the split; rights shared with the common are not defined by exclusive reference to corporate law. Preferred sits on the line; it is both. Therefore, coherence in treatment cannot follow from black-and-white references to contract or corporate law. Both paradigms come to bear and decisionmakers need to synchronize their simultaneous application.

   This is not easy to do. This Article clarifies...