In a recent opinion, Hsu v. ODN Holding Corp. (Del. Ch. April 25, 2017), the Delaware Court of Chancery refused to dismiss a lawsuit alleging that the company’s directors and others breached their fiduciary duties by selling assets to fund the redemption of preferred stock. Along the way, the court suggests that the fiduciary duties of directors may in certain cases require that the rights of preferred holders be intentionally violated. The ODN case is the latest in a line of Delaware cases where the courts have not reflexively enforced the redemption rights of preferred stockholders, and may cast a shadow on the rights of preferred holders generally.

The Case

In 2008 venture capital firm Oak Hill Capital Partners sponsored an investment of $150 million in Oversee.net, a technology-based marketing solutions company for online advertisers. To facilitate the investment, the parties formed ODN as a holding company for Oversee.net, and in exchange for their investment, Oak Hill received 53,380,783 shares of preferred stock. Oak Hill’s preferred stock carried mandatory redemption rights which required ODN to redeem Oak Hill’s shares using legally available funds.

In 2009 Oak Hill purchased additional shares in ODN and became the company’s controlling shareholder. The company’s business strategy changed dramatically two years later when ODN began selling off large portions of the company, for fractions of what the company paid to acquire these businesses only a few years prior. The divestitures caused ODN’s annual revenues to plummet, going from $141 million in 2011 to $11 million in 2015, and the cash that was generated was used to redeem two rounds of Oak Hill’s preferred stock.

In response to the redemptions, Frederick Hsu — one of Oversee.net’s founders — filed a lawsuit against Oak Hill (as ODN’s controlling shareholder), ODN’s directors and several of ODN’s officers for breach of fiduciary duty. The suit claimed that, in liquidating ODN’s assets to fund Oak Hill’s redemptions, the defendants sought to benefit Oak Hill to the detriment of ODN’s common shareholders. The defendants filed a motion to dismiss Hsu’s lawsuit on the grounds that ODN was contractually obligated to satisfy Oak Hill’s redemption rights. The defendants were not in breach of their fiduciary duties, they argued, because the company had no choice but to take the actions necessary to fund the redemptions.

The court refused to dismiss the action. It held that the facts “support[ed] a reasonable inference that the individual defendants acted in bad faith to benefit Oak Hill by maximizing the value of its contractual redemption right.” Oak Hill itself, the court found, could be found liable either for breach of its own fiduciary duty as a controlling shareholder or for aiding and abetting the breaches of the individual defendants. In assessing whether the defendants could be seen to have acted in bad faith, and therefore breached their duty of loyalty to the company, the court at least preliminarily adopted the entire fairness of review. This standard typically applies when a controlling shareholder — here Oak Hill — is viewed as being on both sides of a transaction, and places the burden on the defendants to establish the propriety of their conduct.

The Court’s Analysis

General Principles

Relying on prior case law, the decision provides a useful synthesis of the rights and ranking in the corporate hierarchy of preferred stock under Delaware law (internal and external quotation marks omitted):

  • As a general matter, the rights and preferences of preferred stock are contractual in nature.
  • Preferred stockholders are owed fiduciary duties only when they do not invoke their special contractual rights and rely on a right shared equally with the common stock.
  • A board does 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.
  • Because the fiduciary principle does not protect special preferences or rights, the fiduciary-based standard of conduct requires that decision makers focus on promoting the value of the undifferentiated equity in the aggregate.
  • Consequently, it generally will be the duty of the board, where discretionary judgment is to be exercised, to prefer the interests of common stock — as the good faith judgment of the board sees them to be — to the interests created by the special rights, preferences, etc., of preferred stock.
  • In circumstances where the interests of the common stockholders diverge from those of the preferred stockholders, it is possible that a director could breach her duty by improperly favoring the interests of the preferred stockholders over those of the common stockholders.
  • This principle is not unique to preferred stock; it applies equally to other holders of contract rights against the corporation.
  • It is true that the fiduciary status of directors does not give them “Houdini-like powers” to escape from valid contracts. Only if the directors breached their fiduciary duties when entering into a contract does it become possible to invalidate it on fiduciary grounds.
  • But the fact that a corporation is bound by its valid contractual obligations does not mean that a board does not owe fiduciary duties when considering how to handle those contractual obligations; it rather means that the directors must evaluate the corporation’s alternatives in a world where the contract is binding.
  • Even with an iron-clad contractual obligation, there remains room for fiduciary discretion because of the doctrine of efficient breach. Under that doctrine, a party to a contract may decide that its most advantageous course is to breach and pay damages.

Application to the Case

As presented by the court, the complaint alleged that the board breached its duty of loyalty by managing ODN, before the redemption provisions of the preferred stock came into effect, to maximize the value of the redemption right, rather than to maximize its value for the benefit of equity holders generally. For purposes of a motion to dismiss, the court found this plausible. In this regard, the court noted:

  • The preferred stock did not pay a cumulative dividend. Once the redemption right ripened, the amount of the redemption obligation would not increase.
  • To the contrary, because ODN would be redeeming the preferred stock over time with future dollars, the present value of the obligation would diminish.
  • The preferred stock was effectively trapped capital, which the company could have used for the benefit of the residual claimants.
  • Over a long-term time horizon, ODN conceivably could have grown its business, gradually redeemed all of the preferred stock, and then generated returns for its common stockholders.
  • Instead, the directors engaged in hasty divestitures at seemingly fire-sale prices, virtually destroying ODN’s ability to generate income.

Putting this all together, the court held that the allegations of the complaint supported a reasonable inference that dismembering the company to maximize the value of the redemption right of the preferred stock was not fair to the equity generally and therefore constituted a breach of the duty of loyalty.

Observations

This is not the first time a Delaware court has declined to defer to the redemption rights of preferred holders. In TCV, L.P. v Tradingscreen Inc. (Del. Ch. March 27, 2015), the court held that a company was not obligated to mandatorily redeem preferred stock where the redemption would call into question the ability of the company to continue as a going concern. The court was following the holding of an earlier Delaware case, SV Investment Partners, LLC v. Thoughtworks, Inc. (Del. Ch. November 10, 2010), which reached a similar conclusion.

The ODN case goes in a different direction, but with the similar theme that rights of preferred stockholders are not absolute or inviolable. In this case, the court observed that the directors were under no obligation to manage a corporation so as to assure that the preferred holders will realize their contract rights. To the contrary, the court suggested that directors may be required to actively disregard the interests of preferred stockholders in order to manage the corporation for the long-term benefit of the holders of common stock.

Various suggestions are being offered for safeguarding the interests of preferred investors in the wake of the ODN ruling. For example, the court in ODN paid special attention to the absence of dividend cumulation, so that there was little downside for the company to defer payment of the redemption price. A board might not be able to ignore a looming preferred redemption obligation, where embedded in the terms of the preferred stock are escalating penalties for a failure to redeem. It is difficult to foresee, however, all situations in which the principles articulated in the ODN case may come into play. The important watchword for preferred investors may therefore be to approach their investment from a purely contractual perspective, and not to expect that a board, or the courts for that matter, will stretch to assure that their rights are protected.