Provides instructive guidelines for interpreting complex preferred stock provisions
Preferred stock provisions have been the subject of countless judicial decisions over the years. Because preferred stock is as much a creature of contract as it is of corporate statute, issuers and investors frequently have found themselves at odds over the meaning of preferred stock rights and preferences in a variety of scenarios.
Recently, in Shiftan et al. v. Morgan Joseph Holdings, Inc.,1 the Delaware Court of Chancery was asked to consider the value of a series of preferred stock in the context of an appraisal proceeding under Section 262 of the Delaware General Corporation Law (“DGCL §262”). In the course of ruling in favor of the preferred stockholders on their preliminary summary judgment motion, the Court offered some instructive guidelines for resolving interpretational disputes over complex preferred stock terms.
Morgan Joseph Holdings, Inc., an investment bank founded in 2001, had outstanding two classes of preferred stock – Series A and Series B – the terms of which were set forth in Morgan Joseph’s certificate of incorporation. The Series A Preferred Stock provided for two types of redemption events. The first, a mandatory “Automatic Redemption” designed to enable the Series A preferred stockholders to “harvest their investment” at a price of $100 per share, was triggered upon the occurrence of a variety of events, including the ten-year anniversary of the initial placement of the stock on July 1, 2011. The second, an “Optional Excess Cash Redemption,” gave the Series A preferred stockholders an option to require redemption from time to time, but only to the extent Morgan Joseph possessed “Excess Cash” as defined in the certificate of incorporation.
On December 28, 2010, Morgan Joseph consummated a business combination transaction with Tri Artisan Capital Partners, structured as a merger, by which both companies continued as wholly-owned subsidiaries of a new holding company. Pursuant to the terms of this transaction, the holders of Morgan Joseph’s Series A Preferred Stock were to receive a new Series A Preferred Stock issued by the holding company in exchange for their current holdings. Rather than accept this exchange, several of the Series A Preferred stockholders dissented from the merger and demanded an appraisal of their preferred shares under DGCL §262.
The Series A Preferred stockholders moved for partial summary judgment in the DGCL §262 proceeding, contending that because their preferred shares were subject to Automatic Redemption on July 1, 2011 – some six months following the merger – the Court should consider the $100 per share redemption price in determining the “fair value” of his shares. Morgan Joseph countered that it would not be required to complete a redemption on July 1, 2011 unless it had adequate Excess Cash, which at the time appeared unlikely. Because the provision governing Automatic Redemptions – in contrast to the provision governing Optional Redemptions – did not specifically mention the Excess Cash requirement, Morgan Joseph based this argument on a separate provision governing “Redemption Mechanisms” generally, which stated that “[i]f the Excess Cash legally available for redemption of … Series A Preferred Stock on any Redemption Date … is insufficient …, such Excess Cash which is legally available will be used first to redeem on a pro rata basis … the maximum possible number of shares of Series A Preferred Stock ….” Morgan Joseph argued that this reference “rendered the Excess Cash limitation applicable to Automatic Redemptions … as well as to Optional Redemptions ….” Further, Morgan Joseph pointed out that the merger itself was not an Automatic Redemption triggering event and, in fact, was completed before the tenth anniversary of the issuance of the Series A Preferred Stock. Therefore, according to Morgan Joseph, the $100 per share Automatic Redemption price was “irrelevant to the fair value analysis” in the appraisal proceeding.
The Court’s Analysis
Applicable Interpretative Principles
The Court began its analysis of partial summary judgment motion by identifying two distinct questions: first, whether the July 1, 2011 Automatic Redemption “was subject to an Excess Cash requirement,” and second, whether the Court could consider “a non-speculative, contractually required redemption event set to occur six months after the Merger” in determining the fair value of the Series A Preferred Stock in the DGCL §262 appraisal proceeding. Next, the Court noted that “[a] certificate of incorporation is a contract among the stockholders of the corporation to which the standard rules of contract interpretation apply.” Delaware’s “well-established contract interpretation principles” provide that “[c]ontracts are to be interpreted as written, and effect must be given to their clear and unambiguous terms.”
However, when the contract terms in dispute are not “clear and unambiguous,” Delaware courts must turn to other principles of interpretation. In this case, where the dispute is centered on preferred stock terms in a certificate of incorporation, the Court pointed to two competing principles employed by Delaware courts:
- In the case of certificate of incorporation provisions that are “fairly susceptible of different interpretations,” rather than relying on parol evidence which is “rarely available,” Delaware courts often invoke the principle that ambiguities should be resolved “against the drafter.” In these circumstances, the courts “construe the document to adhere to the reasonable expectations of the investors who purchased the security and thereby subjected themselves to the terms of the contract.”
- By contrast, in the case of disputes over certificate of incorporation provisions governing the rights of preferred stock, “preferences claimed by preferred stockholders must be clearly set forth [in the governing document] and will not be presumed or implied by the court.”
The Court recognized that these two principles – one which seemingly favors stockholders generally over issuers while the other creates a presumption that weighs against the interests of holders of preferred stock – “arguably [are] in tension.” The Court sought to resolve this “tension” by creating a middle ground: “this disciplinary principle of narrow interpretation of stock preferences is not intended to blind a court to all relevant evidence, but instead to prevent the judiciary from implying or presuming preferences without a clear basis for doing so. In other words, unless the parol evidence resolves the ambiguity with clarity in favor of the preferred stock, the preferred stockholders should lose.”
Excess Cash Not Required for Automatic Redemptions
With these principles in mind, the Court turned to the parties’ competing interpretations of the applicable redemption provisions. The Court was not persuaded by Morgan Joseph’s argument that Automatic Redemptions were subject to the availability of Excess Cash, concluding that Morgan Joseph was “straining to create an ambiguity when in fact there is none.” The Court observed that, had it wished to do so, Morgan Joseph could have inserted language expressly subjecting the Automatic Redemption to the Excess Cash requirement as it did for Optional Redemptions. Because Morgan Joseph did not include such a provision, the Court ruled, the “reasonable interpretation” of the Redemption Mechanisms “is that the reference to ‘any Redemption Date’ was just a measuring rod (the when) for Optional Redemptions … [that] did not turn Automatic Redemptions into Optional Redemptions subject to the Excess Cash pre-condition …. Rather, it simply explained how an Optional Redemption would work in the event that there was not enough Excess Cash to satisfy all demands.”
Although not necessary to its conclusion, the Court also explained that even if it had found the redemption provisions to be ambiguous, “the parol evidence makes clear that [the Series A Preferred stockholders’] interpretation is indisputably correct.” Particularly persuasive in this regard was the Information Material used by Morgan Joseph “as advertising material to the buyers of the Series A Preferred Stock,” which serves as “strong evidence of what Morgan Joseph believed when it authored the [Series A provisions]” and, as such, “speaks to the reasonable expectations of the Series A investors.” This material, in the Court’s view, “shows that the July 1 Automatic Redemption was presented to the investors in the Series A Preferred Stock as the definite last date on which they had a firm right to exit their investment – an exit opportunity not contingent on the existence of Excess Cash.”
Relevance of Automatic Redemption Terms to Fair Value Analysis
Next, the Court recognized that in a DGCL §262 appraisal proceeding, its “task” is “to ‘determine the fair value of the shares exclusive of any element of value arising from the accomplishment or expectation of the merger or consolidation,’ taking into account ‘all relevant factors.’” Such factors include “all non-speculative information bearing on the value of the shares at issue in an appraisal.”
In this instance, because “the value of preferred stock is determined solely from the contract rights conferred upon it” by the governing document, “when the court values the Series A Preferred Stock, it must take into account the economic reality that the Series A would have been entitled to a mandatory redemption [at $100 per share] … just six months after the Merger.” This “specific, non-speculative contractual right” was, in the Court’s view, “inarguably an important economic factor bearing on the value of the Series A as of the Merger date that any reasonable investor or market participant would have taken into account” in deciding whether to accept the merger consideration or seek an appraisal under DGCL §262.
Finally, the Court related that this conclusion would “work no harm” on Morgan Joseph or its “other equity holders.” As to the former, Morgan Joseph “chose to effect the Merger knowing that it had different series of stock with differing contractual claims on the company’s value.” As to the latter, this type of result “is what you sign up for when you invest in a company with senior security holders entitled to specific preferred rights with economic value ….”
While the Morgan Joseph decision is obviously fact specific, the Court’s analysis provides informative guidelines for interpreting complex preferred stock provisions. The unique status of preferred stock in the capital structure of a Delaware corporation makes an analysis of their relative rights and preferences – in DGCL §262 appraisal proceedings and otherwise – different from that which applies to common stock, which is more a creature of law than of contract. At the same time, there are specific rules of interpretation applicable to preferred stock terms that are not necessarily the same as those governing contract interpretation generally. Drafters of preferred stock terms – and, significantly, the related disclosure documents used to promote the stock to potential investors – who ignore these realities do so at their peril.