THE PERIL AND PROMISE OF PREFERRED STOCK
BY BEN WALTHER*
ABSTRACT
This Article presents a comprehensive legal analysis of preferred
stock in the wake of the doctrinally transformative cases ofTrados (2009),
LC Capital (2010), and Thoughtworks (2011). These cases mark the
culmination of a long and gradual decimation of the legal rights of
preferred shareholders under Delaware corporate law. Preferred stock has become less secure than ever, as opportunistic issuers have demonstrated the ability and the willingness to divert its investment value to the common equity. As a result, it is disappearing, along with its unique financial
properties that help struggling firms avoid insolvency. This Article offers a
novel solution to restore preferred stock to viability: a specific division of corporate control between preferred and common that will allow them to harmoniously co-exist. One central advantage of this approach is that it requires no changes in existing law to be implemented; only clever, sophisticated bargaining by each side is required.
pg 163 (3/49) ("When determining which strategies the firm should
pursue, directors elected by common shareholders owe a duty solely to common shareholders and are not required to take into account the interests of preferred shareholders, as long as the firm does not
violate specific provisions of the preferred stock agreement."
.
pg 164 (4/49) shareholders, unlike creditors, cannot sue in contract to recoup either their principal investment or unpaid coupons, and the terms of a preferred stock investment, unlike those of a debt contract, can be altered unilaterally by the firm.'o As a result, the value of fixed income equity can be opportunistically
expropriated by common equity, by such means as dilutive mergers,
leveraged recapitalizations, or risk-seeking economic strategies." Not even venture capitalists are safe, despite their deep experience with preferred stock and their business power over the companies.12 Occasionally, they let down their guard, and then can only watch helplessly as their investments
are decimated.
(4/49) As discussed in Part
II., infra, dividends are not nearly as secure as interest payments, as they can be effectively discontinued by the board.
'oThe terms of a preferred stock investment are established by its certificate of designation, which becomes part of the company's certificate of incorporation when executed. See Matulich v.
Aegis Commc'ns Grp., Inc., 942 A.2d 596, 600 (Del. 2008). As such, the designated terms are subject to amendment in the same manner as any other provision of the certificate
pg 165 (5/49) This Article argues that preferred stock can regain its prominence if it evolves." Preferred shareholders need not rely on the law if they can obtain voting control over a majority of the seats of the board .20 This suggestion, in itself, is nothing new; preferred shareholders have long sought board control,
only to find that the common won't give it up, and for good reason."
a division of board
control between the two classes of equity in such a way to ensure their harmonious co-existence.22 The common would retain full power over executive compensation, to ensure that the directors and officers are sufficiently incentivized to pursue profitable, risky investments.23 The common would also retain its merger veto and continue to be the beneficiaries of the board's fiduciary duties, so as to prevent the preferred from seeking to liquidate the firm or drain its assets at the expense of the common. 24 The preferred would get operational control......
Preferred shareholders with board control could divert most or all of the firm's cash flow into their own coffers.
pg 166 (6/49) Divided board control ("DBC" forces the
common and the preferred to cooperate in efficiently managing the firm; each side understands that the alternative might lead to mutually assured destruction.26
One advantage of DBC over other reform agendas is that it can be
implemented under current law, simply by negotiation.27
pg 167 (7/49) II. THE PERILS OF PREFERRED STOCK
A. Preferred Stock Basics
Preferred stock is a class of stock that is senior to common equity in a firm's capital structure.32 If the corporation is liquidated, the preferred is paid off in full before the common can claim any assets." The amount of money that constitutes full satisfaction of the preferred's fixed claim is called the
liquidation preference.34 The preferred's seniority also extends to current income, meaning that the common cannot be paid any dividends until the dividends promised to the preferred are paid in full." Both the preference and the dividend-along with other contractual rights and protections, some of which will be discussed later in this Article-are determined by active bargaining between the investors and the issuing firm."
They are formally specified in a contract known as the certificate of designation," which becomes incorporated into the corporate charter when executed .38
As an illustration, consider a firm called Apoogle Oil capitalized with
two classes of stock: one million shares of preferred stock that each carry a $50 liquidation preference and a dividend of $5 per year, and ten million
32See FLETCHER CYC. CORP., supra note 9, § 5283.
"3 See id. § 5303.
34See BLACK'S LAW DICTIONARY (9th ed. 2009) ("A preferred shareholder's right, once the
corporation is liquidated, to receive a specified distribution before common shareholders receive anything." .
35See FLETCHER CYC. CORP., supra note 9, § 5299 ("The holders of preferred shares are entitled to be paid dividends, in accordance with the terms of their contract before any dividends can
be paid to the holders of common stock." (footnotes omitted)). In theory, preferred stock dividends can be noncumulative, meaning that the preferred holders have no claim on unpaid (or less than fully
paid) dividends from prior time periods. See id. § 5446 (distinguishing cumulative from noncumulative preferred dividends). Thus, the board could pay dividends to the common while
bypassing the preferred simply by (1) building up cash reserves by not paying any dividend for many time periods and (2) paying out that cash in the form of a special dividend to the common after
paying to the preferred its promised dividend for that single time period. See id. Absent extraordinary facts, a rational person would never purchase non-cumulative preferred, and hence it
will be assumed that all preferred stock is cumulative .
36See, e.g., Jedwab v. MGM Grand Hotels Inc., 509 A.2d 584, 593 (Del. Ch. 1986)
("[P]references and limitations associated with preferred stock exist only by virtue of an express provision (contractual in nature) creating such rights or limitations ." .
37See, e.g., DEL. CODE ANN. tit. 8, § 15 1(d) (2011) ("The holders of the preferred... shall be entitled to such rights upon the dissolution of, or upon any distribution of the assets of, the corporation as shall be stated in the certificate of incorporation or in the resolution or resolutions providing for the issue of such stock . . . ." .
38See Elliot Assocs. v. Avatex, 715 A.2d 843, 843 n.3 (Del. 1998) ("When certificates of designations become effective, they constitute amendments to the certificate of incorporation so that
the rights of preferred stockholders become part of the certificate of incorporation." .
20 14 167
DELAWARE JOURNAL OF CORPORATE LAW
shares of common stock initially purchased for $10 each. Assume that, three years later, Apoogle's net assets have grown to $200M. If the firm were liquidated at that point, the preferred shareholders collectively would collect $50M, and the common shareholders would receive $150M, or $15 per share. By contrast, if the firm's assets had shrunk to $60M, the preferred would still collect $50M, whereas the common shareholders would divide only the remaining $10M. Each year, the firm would pay $5M per year in dividends to the preferred, meaning that profits earned in excess of that amount could be paid to the common in the form of dividends.
pg 171 (11/49) What preferred stock can obtain, in theory, is control over the board."3 Indeed, board control is even better than a contract remedy; investors would have no need to go to court if the board were to do its bidding."
However, the preferred rarely gets control, as control is generally considered to be more valuable to the common." While the preferred can suffer a loss if the board, favoring the common, causes the firm to increase its risk, the inverse situation-in which the board does the preferred's bidding-can wipe out the common almost in its entirety," leaving the common with barely a cent."
(12/49) The board's fiduciary duties-which always run to the common'"-may offer but a token resistance against gradual, systematic looting. 9
That venture capitalists often obtain control rights for their preferred is
the exception that proves the rule." The venture capitalist ("VC" has an unusual amount of leverage over an entrepreneur (who holds common) desperate for funding that cannot be obtained elsewhere on better terms."
The VC may insist on control rights, and the common may be in no position to object. The transfer of control is also facilitated by the unique economics of the VC business.72
The entrepreneur need not fear that the VC will drain the cash of a successful startup," because it is far more profitable to sell that
cash flow to the public in the form of a public offering of common equity74 - and also profitable in the long term to share the proceeds of that sale with the entrepreneur."
http://www.djcl.org/wp-content/uploads/2014/0...-Stock.pdf
.......Do you still want Blank Check Preferred Stock?
If some firm or group got control of the BOD and the Preferred, does anyone think a RS w/AS of 100M shares would remain in place for a long time?
Who on the BOD would be representing the Common?
Does thinking about that make you feel warm and fuzzy?
I'd like more time and information, wouldn't you?
......sure am looking forward to that information
BY BEN WALTHER*
ABSTRACT
This Article presents a comprehensive legal analysis of preferred
stock in the wake of the doctrinally transformative cases ofTrados (2009),
LC Capital (2010), and Thoughtworks (2011). These cases mark the
culmination of a long and gradual decimation of the legal rights of
preferred shareholders under Delaware corporate law. Preferred stock has become less secure than ever, as opportunistic issuers have demonstrated the ability and the willingness to divert its investment value to the common equity. As a result, it is disappearing, along with its unique financial
properties that help struggling firms avoid insolvency. This Article offers a
novel solution to restore preferred stock to viability: a specific division of corporate control between preferred and common that will allow them to harmoniously co-exist. One central advantage of this approach is that it requires no changes in existing law to be implemented; only clever, sophisticated bargaining by each side is required.
pg 163 (3/49) ("When determining which strategies the firm should
pursue, directors elected by common shareholders owe a duty solely to common shareholders and are not required to take into account the interests of preferred shareholders, as long as the firm does not
violate specific provisions of the preferred stock agreement."
. pg 164 (4/49) shareholders, unlike creditors, cannot sue in contract to recoup either their principal investment or unpaid coupons, and the terms of a preferred stock investment, unlike those of a debt contract, can be altered unilaterally by the firm.'o As a result, the value of fixed income equity can be opportunistically
expropriated by common equity, by such means as dilutive mergers,
leveraged recapitalizations, or risk-seeking economic strategies." Not even venture capitalists are safe, despite their deep experience with preferred stock and their business power over the companies.12 Occasionally, they let down their guard, and then can only watch helplessly as their investments
are decimated.
(4/49) As discussed in Part
II., infra, dividends are not nearly as secure as interest payments, as they can be effectively discontinued by the board.
'oThe terms of a preferred stock investment are established by its certificate of designation, which becomes part of the company's certificate of incorporation when executed. See Matulich v.
Aegis Commc'ns Grp., Inc., 942 A.2d 596, 600 (Del. 2008). As such, the designated terms are subject to amendment in the same manner as any other provision of the certificate
pg 165 (5/49) This Article argues that preferred stock can regain its prominence if it evolves." Preferred shareholders need not rely on the law if they can obtain voting control over a majority of the seats of the board .20 This suggestion, in itself, is nothing new; preferred shareholders have long sought board control,
only to find that the common won't give it up, and for good reason."
a division of board
control between the two classes of equity in such a way to ensure their harmonious co-existence.22 The common would retain full power over executive compensation, to ensure that the directors and officers are sufficiently incentivized to pursue profitable, risky investments.23 The common would also retain its merger veto and continue to be the beneficiaries of the board's fiduciary duties, so as to prevent the preferred from seeking to liquidate the firm or drain its assets at the expense of the common. 24 The preferred would get operational control......
Preferred shareholders with board control could divert most or all of the firm's cash flow into their own coffers.
pg 166 (6/49) Divided board control ("DBC"
forces the common and the preferred to cooperate in efficiently managing the firm; each side understands that the alternative might lead to mutually assured destruction.26
One advantage of DBC over other reform agendas is that it can be
implemented under current law, simply by negotiation.27
pg 167 (7/49) II. THE PERILS OF PREFERRED STOCK
A. Preferred Stock Basics
Preferred stock is a class of stock that is senior to common equity in a firm's capital structure.32 If the corporation is liquidated, the preferred is paid off in full before the common can claim any assets." The amount of money that constitutes full satisfaction of the preferred's fixed claim is called the
liquidation preference.34 The preferred's seniority also extends to current income, meaning that the common cannot be paid any dividends until the dividends promised to the preferred are paid in full." Both the preference and the dividend-along with other contractual rights and protections, some of which will be discussed later in this Article-are determined by active bargaining between the investors and the issuing firm."
They are formally specified in a contract known as the certificate of designation," which becomes incorporated into the corporate charter when executed .38
As an illustration, consider a firm called Apoogle Oil capitalized with
two classes of stock: one million shares of preferred stock that each carry a $50 liquidation preference and a dividend of $5 per year, and ten million
32See FLETCHER CYC. CORP., supra note 9, § 5283.
"3 See id. § 5303.
34See BLACK'S LAW DICTIONARY (9th ed. 2009) ("A preferred shareholder's right, once the
corporation is liquidated, to receive a specified distribution before common shareholders receive anything."
. 35See FLETCHER CYC. CORP., supra note 9, § 5299 ("The holders of preferred shares are entitled to be paid dividends, in accordance with the terms of their contract before any dividends can
be paid to the holders of common stock." (footnotes omitted)). In theory, preferred stock dividends can be noncumulative, meaning that the preferred holders have no claim on unpaid (or less than fully
paid) dividends from prior time periods. See id. § 5446 (distinguishing cumulative from noncumulative preferred dividends). Thus, the board could pay dividends to the common while
bypassing the preferred simply by (1) building up cash reserves by not paying any dividend for many time periods and (2) paying out that cash in the form of a special dividend to the common after
paying to the preferred its promised dividend for that single time period. See id. Absent extraordinary facts, a rational person would never purchase non-cumulative preferred, and hence it
will be assumed that all preferred stock is cumulative .
36See, e.g., Jedwab v. MGM Grand Hotels Inc., 509 A.2d 584, 593 (Del. Ch. 1986)
("[P]references and limitations associated with preferred stock exist only by virtue of an express provision (contractual in nature) creating such rights or limitations ."
. 37See, e.g., DEL. CODE ANN. tit. 8, § 15 1(d) (2011) ("The holders of the preferred... shall be entitled to such rights upon the dissolution of, or upon any distribution of the assets of, the corporation as shall be stated in the certificate of incorporation or in the resolution or resolutions providing for the issue of such stock . . . ."
. 38See Elliot Assocs. v. Avatex, 715 A.2d 843, 843 n.3 (Del. 1998) ("When certificates of designations become effective, they constitute amendments to the certificate of incorporation so that
the rights of preferred stockholders become part of the certificate of incorporation."
. 20 14 167
DELAWARE JOURNAL OF CORPORATE LAW
shares of common stock initially purchased for $10 each. Assume that, three years later, Apoogle's net assets have grown to $200M. If the firm were liquidated at that point, the preferred shareholders collectively would collect $50M, and the common shareholders would receive $150M, or $15 per share. By contrast, if the firm's assets had shrunk to $60M, the preferred would still collect $50M, whereas the common shareholders would divide only the remaining $10M. Each year, the firm would pay $5M per year in dividends to the preferred, meaning that profits earned in excess of that amount could be paid to the common in the form of dividends.
pg 171 (11/49) What preferred stock can obtain, in theory, is control over the board."3 Indeed, board control is even better than a contract remedy; investors would have no need to go to court if the board were to do its bidding."
However, the preferred rarely gets control, as control is generally considered to be more valuable to the common." While the preferred can suffer a loss if the board, favoring the common, causes the firm to increase its risk, the inverse situation-in which the board does the preferred's bidding-can wipe out the common almost in its entirety," leaving the common with barely a cent."
(12/49) The board's fiduciary duties-which always run to the common'"-may offer but a token resistance against gradual, systematic looting. 9
That venture capitalists often obtain control rights for their preferred is
the exception that proves the rule." The venture capitalist ("VC"
has an unusual amount of leverage over an entrepreneur (who holds common) desperate for funding that cannot be obtained elsewhere on better terms." The VC may insist on control rights, and the common may be in no position to object. The transfer of control is also facilitated by the unique economics of the VC business.72
The entrepreneur need not fear that the VC will drain the cash of a successful startup," because it is far more profitable to sell that
cash flow to the public in the form of a public offering of common equity74 - and also profitable in the long term to share the proceeds of that sale with the entrepreneur."
http://www.djcl.org/wp-content/uploads/2014/0...-Stock.pdf
.......Do you still want Blank Check Preferred Stock?
If some firm or group got control of the BOD and the Preferred, does anyone think a RS w/AS of 100M shares would remain in place for a long time?
Who on the BOD would be representing the Common?
Does thinking about that make you feel warm and fuzzy?
I'd like more time and information, wouldn't you?
......sure am looking forward to that information
4
