In our previous post about In re Trados, we provided some background on the facts, outcome and usefulness of the Trados case. In this installment, we will discuss the conflict of interest between the preferred stockholders and the common stockholders of Trados and the related analysis conducted by the Delaware Court of Chancery.
Divergence in Interests of Preferred and Common Stockholders
Due to the liquidation preference of preferred stock, preferred stockholders and common stockholders can have diverging interests in exit transactions. “Because of the preferred shareholders’ liquidation preferences, they sometimes gain less from increases in firm value than they lose from decreases in firm value. This effect may cause a board dominated by preferred shareholders to choose lower-risk, lower-value investment strategies over higher-risk, higher-value investment strategies.1
This divergence becomes more acute when the company is neither an outstanding success or a colossal failure. It is in these “sideways” investments that the amount of the outstanding liquidation preference of the preferred stock may be equal to or near the amount of the sale consideration in an exit transaction, resulting in the preferred stockholders receiving substantially all of the sale consideration and the common stockholders receiving little or nothing.
In Trados, the court determined that these tensions were present between the preferred stock, which was owned by the VC firms, and the common stock. In the proposed $60 million merger with SDL, Trados management would receive the first $7.8 million as a transaction bonus pursuant to a management incentive plan, the preferred stockholders would receive the remaining $52.8 million in respect of the $57.9 million of outstanding liquidation preference, while the common stockholders received nothing.
At a $60 million merger price, the preferred stockholders would experience every dollar of decline in value of Trados due to their liquidation preference, but would only share in a percentage of any increase in value of Trados above the liquidation preference (after taking into account any transaction bonuses). This is in contrast to the common stockholders that would experience no loss in their investment should the value of Trados decline below $60 million since their common stock was already worth nothing, but would have the possibility to receive some value should Trados increase in value above the liquidation preference (after taking into account any transaction bonuses).
Director Fiduciary Duties to Preferred and Common Stockholders
Judicial opinions often refer to directors owing fiduciary duties “to the corporation and its stockholders.” But it is important to understand what this means when the interests of different classes or subsets of stockholders differ, as in the case of preferred stock and common stock.
When deciding to pursue an exit transaction, directors consider and make the judgment that the sale consideration is greater than what the corporation would otherwise generate over the long-term. “The standard of conduct for directors requires that they strive in good faith and on an informed basis to maximize the value of the corporation for the benefit of its residual claimants, the ultimate beneficiaries of the firm’s value, not for the benefit of its contractual claimants.”2
The special rights and preferences of preferred stock that are not shared with common stock (such as liquidation preference) are contractual in nature.3 Directors do 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. Accordingly, if discretionary judgment can be exercised, it is generally the duty of the directors to prefer the interests of the common stock to the special rights or preferences of the preferred stock if that can be done faithfully within the contractual promises owed to the preferred stock.4
In the Trados case, the relevant inquiry is whether Trados’s payment of the liquidation preference to the preferred stockholders was an exercise of discretionary judgment. Generally, there are a few situations in which a liquidation preference would be paid that would not be in the board’s discretion (e.g., bankruptcy or insolvency, a change in control resulting from the purchase of stock from existing stockholders without board approval, a shareholder exercising a right to force the sale of the company).
In Trados, the court found that the directors made the discretionary decision to sell the company in a transaction that triggered the preferred stockholders’ contractual liquidation preference, a right that the preferred stockholders otherwise could not have exercised at that time.5 That is, the directors did not have to sell Trados, they could have continued operating it on a stand-alone basis. Because discretionary judgment could have been exercised to not sell Trados while remaining faithful to the contractual promises to the preferred stock, the directors had a duty to prefer the interests of the common stock to the liquidation preference of the preferred stock. This means that the court was required to determine whether the directors breached the fiduciary duties they owed to the common stockholders. We will examine this issue in a future installment of our series discussing Trados.
- Absent contractual rights of the preferred stock to force a sale or put their preferred stock to the company, most exit sales will fall within the discretionary judgment of the board. If possible, preferred stock investors should negotiate for rights (i) to force a sale of the company after a certain time period; or (ii) to require the company to redeem their preferred stock after a certain time period, to ensure that the preferred stock investor (as opposed to the board) can contractually initiate an exit transaction.
- Absent the exercise of these rights, in most exit sales directors will be required to prefer the interests of the common stockholders over those of the preferred stockholders and their liquidation preference.
- If a VC firm invests in preferred stock of a company and appoints a VC principal to the board of that company to mind its investment, that director has a quandry between considering the interests of the common stockholders (which it is required to do under Delaware law as illustrated in this blog post), and considering the interests of the preferred stockholders (which is the VC firm that is that director’s employer and whose fund investors that director is supposed to be working in the best interests of, as well as that director presumably being a fund investor himself or herself).
Our next post in the In re Trados series will examine this issue of director independence and conflicts of interest.