A theory of preferred stock.

Author:Bratton, William W.
Position:Continuation of III. The Payment Stream through Conclusion, with footnotes, p. 1860-1906
  1. The Promise to Pay on Preferred

    We have seen that dividend and liquidation priorities remit considerable payment discretion to issuer boards of directors. Making a preferred issue redeemable only at the board's option is another way to expand board discretion. One-way redemption permits the board to pay down the preferred at its stated value when an alternative means of financing becomes more desirable or the preferred issue otherwise becomes burdensome. (173) The stated amount, even though it bears a more-than-passing resemblance to the principal amount of a bond, does not otherwise "come due" pursuant to a preset repayment schedule. The issuer can leave the preferred in its capital structure indefinitely. (174) The matter of payment being largely vested in the board's business judgment, the financial rights of priority-preferred holders, while created contractually, very much lie within the corporate paradigm. (175)

    Preferred also can be drafted to look like debt, with a promise to pay a fixed dividend (paralleling the payment of interest) and a promise to redeem the issue on a fixed date or series of dates (paralleling the repayment of principal). This discretion-constraining alternative has long been available, but companies have only sporadically used it. (176) When companies have taken this route, historically there has been a residuum of legal hostility. Some states have imposed statutory barriers to fixed redemptions, (177) and courts have resolved interpretive doubts respecting constraints on boards' payment discretion in issuers' favor. (178)

    There also was (and remains) a doctrinal barrier to enforcement of preferred payment mandates. Promises to pay dividends on stock or redeem stock for cash cannot be made absolute in the same sense as promises to pay interest and to repay principal on a bond. Because preferred is stock, the promise takes a second-order status. It is enforceable with respect to the common, (179) but carries a claim junior to claims of the corporation's creditors. The law embeds this junior status when it makes payments to preferred stockholders subject to state law legal capital rules and fraudulent conveyance law, both of which protect creditors of distressed corporations from opportunistic payouts to stockholders. (180) The former prohibit dividend or redemption payments that render the corporation's balance sheet insolvent or reduce a stated capital figure booked on the balance sheet as shareholder equity. (181) The latter protects corporate creditors on a going-concern basis by blocking payments on stock that leave the corporation with an asset base that is too small to sustain its business or that would disable it from paying its debts as they come due. (182)

    The law of preferred could simply refer to these well-articulated doctrines, block payments to preferred that violate them, and stop there. Some courts do simply state that the payment may not render the issuer insolvent. (183) Other courts, however, articulate a variety of unclear, open-ended limitations. (184) These cases prohibit redemptions that impair, (185) "prejudice," (186) or "injure" (187) interests of creditors, thus suggesting a barrier that is higher than the legal capital rules and fraudulent conveyance otherwise create. Whatever the phrasing, the burden of proof is on the preferred seeking to enforce its promise. (188) It is accordingly the drafting custom to condition preferred payment mandates on the presence of "funds legally available therefor." (189)

    The payment constraint's meaning is clear only at the extremes. On one side stands an issuer in severe financial distress. Here, the promise to pay on preferred is clearly unenforceable. On the other side stands an issuer in excellent financial health. Assume that a large mandatory redemption is coming due and the company has the cash or sources of financing to fund it. If the company nonetheless misses the payment, its easily verifiable ability to pay puts the preferred in a position to meet their burden of showing "legally available" funds and thus to bring a successful enforcement action. Even in this extreme situation, although the payment constraint's meaning is clear, the mandate itself is problematic. If the preferred sue on the unperformed promise, get a judgment, then levy execution on the judgment, they technically bootstrap themselves to the status of secured creditors, jumping over preexisting unsecured creditors. (190) However, given a healthy issuer, presumably no creditors will raise an objection.

    Between the two extremes, where the issuer is not in distress but does operate under financial constraints, the validity of preferred redemption claims is not clear at all. Board discretion starts to matter, despite the existence of an enforceable promise. To see why, consider two scenarios. Assume first that the board actually wants to make a promised payment to the preferred and that there would not be a fraudulent conveyance, but the company's balance sheet presents an obstacle under the legal capital rules. The willing board can surmount that obstacle because the legal capital rules provide it with discretion to alter the balance sheet numbers by revaluing assets, subject only to good faith review of its decision. (191) A heavy burden then falls on objecting creditors to show bad faith.

    Now turn to the more likely case in which a class of preferred comes due for redemption, and the board, which does not have the cash in a sock under the bed, resists the payment. As we have seen, the promise to honor the financial preferences held by the preferred is conditional: payment comes due only if funds are "legally available." The board, however, can defend by claiming that payment would "impair, prejudice, or injure" (192) creditor interests. The standard thus leaves impairment in the eye of the beholder, and it can be applied tightly and contractually or loosely and corporately.

    On a contractual reading, the enforcing court would aggressively push the recalcitrant issuer to the limit of fraudulent conveyance law by forcing it to liquidate assets to raise the cash. Alternatively, concern for creditor interests can lead to an expansive, corporate approach, in which the court would open up a discretionary envelope for the issuer's board of directors and thereby relieve the common stock interest of the payment burden. What began as creditor protection turns into common protection.

    Until recently, the leading promise-to-pay case was Mueller v. Kraeuter Co., decided by the New Jersey Chancery Court in 1942. (193) The court there took the contractual route and pushed the limits in favor of a payment to the preferred against a board that had been stalling while reinvesting earnings to expand the business. (194) But the preferred did not get a judgment for the entire amount the company owed them, because the issuer did not have the cash on hand; therefore, an immediate payment might have injured creditors. (195) The court instead drew on its equitable powers and ordered counsel to prepare a schedule of installment payments. (196)

    Other cases, however, have taken more of a corporate route. At the extreme is an 1879 Pennsylvania case, in which the court held that the preferred have no right to enforce the promise if it would cripple the issuer's business and impair the interests not only of creditors but also of common stockholders. (197)

    Unsurprisingly, financial practice has changed significantly since these cases were decided. Preferred dividends remain discretionary in many contexts, particularly in venture capital deals. (198) But mandatory dividend provisions are not uncommon. (199) Redemption provisions also depend on the deal. Perpetual preferred still is issued, but mandatory redemption terms are also not uncommon. (200) Indeed, with venture capital, exit via mandatory redemption is hardwired into the business model. (201)

  2. The ThoughtWorks Solution

    Thus sat the law and the practice until 2010, when a hard-fought litigation between a venture capitalist seeking to enforce a redemption right against a recalcitrant, but not insolvent, investee reached the Delaware courts. (202) That case, SV Investment Partners, LLC v. ThoughtWorks, Inc., resulted in a new and leading pronouncement on the enforceability of promises to pay preferred. (203) The Chancery Court's decision forcefully pushes the law in the corporate direction, implying that the preferred will not be able to get a judgment unless the issuer has cash on hand (or the equivalent). (204)

    The issuer in question sold $26.6 million of preferred to a venture capital firm in 2000, at the peak of the dot-com bubble. (205) The goal was to put the company in a position to go public at an early date, but the bubble's burst dashed those upside hopes. (206) Meanwhile, the charter provision creating the preferred contained a heavily negotiated five-year redemption provision, which contained the standard "out of any funds legally available" clause, (207) but otherwise took steps to put the screws on the issuer. The issuer got a year of grace in the event its working capital proved insufficient to redeem the preferred. (208) Once the one-year period expired the charter specified that redemption would be "continuous," that is, that the issuer would divert cash to preferred redemption on a going-concern basis. (209) The charter also provided that the company would value its assets at "the highest amount permissible under applicable law" when determining funds "legally available." (210)

    The issuer, a services company with a volatile earnings stream, took advantage of the grace year and thereafter consistently took the position that there were minimal or no significant funds available. (211) Duly prepped by counsel, ThoughtWorks' board of directors discussed the matter of redemption payment on a quarterly basis. It took into account a list of factors, and developed a plan "for the Board to...

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