Delaware courts frequently are called upon to determine the “fair value” of a company’s stock. For a company whose capital structure includes preferred stock with a liquidation preference, there is the question of how to treat that liquidation preference when determining the per-share “fair value” of the common, the preferred, or some other specific class of the company’s stock.
Two recent Delaware Court of Chancery decisions by Chancellor Leo E. Strine Jr. demonstrate that the answer depends on whether the liquidation preference actually has been triggered (or otherwise represents a non-speculative payment obligation), or whether the payout of the liquidation preference is a matter of speculation. Importantly, that determination depends on the specific rights defining the liquidation preference, as set forth in the charter or certificate of designations, and does not necessarily depend on “market realities” that might suggest a discount for common stock relative to the preferred.
In In re: Appraisal of The Orchard Enterprises, Inc., owners of common stock dissented from a going-private merger between the company and the owner of almost all of its preferred stock, and sought the “fair value” of their common stock pursuant to the appraisal statute, Section 262 of the Delaware General Corporation Law. Under the “fair value” standard, a dissenting stockholder generally is entitled to his “proportionate share of fair value in the going concern.” In other words, the court determines the “fair value” of the corporation as a whole, which is sometimes called its “enterprise value,” and awards the dissenting stockholder his pro rata share of that value. However, in Orchard, the company argued that the amount of the liquidation preference should be deducted from the enterprise value before the common were allocated their pro rata share. The company argued, in essence, that the voting power and rights of the preferred guaranteed, as a practical matter, that the liquidation preference would be paid to the preferred in any future merger, and that the common should not be permitted to share in that value.
While the court noted that in certain situations “market realities” may suggest a discount for the common stock relative to the preferred, the court rejected the company’s argument as contrary to Delaware appraisal law. While the certificate of designations provided that the liquidation preference was to be paid in a “Change of Control” transaction “in which the stockholders of [Orchard] will receive consideration from an unrelated third party” (among other uncertain future triggering events), the going-private merger giving rise to the appraisal right did not trigger the payment of the liquidation preference. The possible payment of the liquidation preference to the preferred was too “speculative” to merit being deducted from the enterprise value available to the company’s equity holders. Rather, the court determined that the preferred should be treated on an “as-converted” basis with the common for purposes of determining the per-share fair value, since the preferred’s only right to share in the distributions of the company (i.e., dividends) while the company was a going concern was on that basis. The court reasoned that this result honored, inter alia, the specific contractual rights purchased by the preferred, and noted that “the appraisal remedy exists to a large extent to address the potential that majority power … will be abused at the expense of the minority.”
The court contrasted the situation in Orchard with the situation that it confronted earlier this year in Shiftan v. Morgan Joseph Holdings, Inc., where the company had a “firm legal obligation” to pay the liquidation preference six months from the valuation date. In that context, the “going concern value of the company … had to take into account the non-speculative … specific claim to the liquidation preference” held by the preferred stockholders. In less recent cases, the Court of Chancery has suggested that where the certificate of designations defines clearly the rights of preferred shareholders in an appraisal, that instrument delimits the “fair value” that the preferred are legally entitled to receive in an appraisal proceeding.
Thus, it is important not to assume in every case that the dollar amount of the liquidation preference represents equity value that ‘belongs’ to the preferred, to the exclusion of the common. How a liquidation preference will be accounted for under the Delaware fair value standard depends on the precise rights of the preferred stock, as well as the context that gives rise to the stockholders’ entitlement to a judicial determination of “fair value.” The answer may depend, for instance, on whether the liquidation preference reflects a put right by a certain date, or merely reflects a right to priority treatment in an uncertain future event like a third-party merger, dissolution, or liquidation. In this regard, it is important to emphasize that the rights of preferred stock are primarily “contractual in nature” and “open for negotiation.” Accordingly, those who draft preferred stock agreements, charters, and corporate transactions should consider carefully Orchard, Morgan Joseph, and other guiding opinions when considering the definition of the liquidation event and other terms of the liquidation preference, so that the corporate documents achieve what is intended in the event that a court is called upon to determine the “fair value” of the preferred or common stock.