Recent Delaware and Maryland cases interpret redemption rights

Today’s VC deals (at least on the east coast) are likely to contain a redemption clause in the charter of the company, giving the investors a “put” right to make the company buy back their investment after some period of time has passed (usually 5 yrs or more).  VC funds have their own investors and want to see an exit within the same period, so the redemption right gives some additional (perhaps illusory) protection to the investors that they can cause the company to liquidate their position.  Of course, if the company does not have the money, little can be done.  The concept really works only when the company is financially stable, but the other stockholders do not want to liquidate their investment or sell (i.e. perhaps it is lifestyle company or there is disagreement on timing), which allows those with the put rights to seek a buyout.

Several recent decisions help interpret the scope of redemption rights in context. In Harbinger Capital Partners v. Granite Broadcasting, the Delaware Chancery Court ruled that preferred stock that was mandatorily redeemable by the company was still equity, not debt.  The case can be read here: http://courts.delaware.gov/opinions/(sa4fzq55kjmibv55xbn0sj45)/download.aspx?ID=78560.  The preferred stockholders sought to enjoin a sale of assets by the company by claiming that they were a creditor, and the sale a fraudulent conveyance.  Their argument was based largely on a recent change in accounting rules under GAAP and FASB that provided for a debt treatment of certain types of preferred stock with redemption features.  The court rejected that theory.  Relying on a long line of cases, it held that the rights of shareholders to recover dividends or to redeem their stock is dependent on the financial solvency of the corporation,’ and is therefore not a fixed liability.”  Marking its territory, the court also noted that FASB was neither lawmaker nor judge,” and should not have “the power to fundamentally alter the law’s understanding of the role of preferred shares.”

Another 2006 case by a Maryland state court had a different take on the issue.  In Costa Brava Partnership III v. Telos, (2006 WL 1313985) investors  argued that their preferred shares were debt because they “lack voting rights in most circumstances, yield fixed dividend payments, maintain a fixed maturity date, have redemption and liquidation rights which do not exceed the security’s issue price, retain priority over common stockholders, and are classified as “indebtedness” in the corporate charter. ”  They also argued that the company itself classified its accruing dividend obligations as debt on its financial statements.  The court stated that such conduct by the company would indicate the preferred stock is to be treated as debt.  Therefore, without expressly ruling on the issue of whether the investor can be considered a creditor, the court refused to dismiss a claim for fraudulent conveyance (which can only stand if ultimately Costa Brava is found to be a creditor).

Another 2006 Delaware Chancery Court decision, Thoughtworks v. SV Investment Partners (aka Schroeders), provides an interesting introspective on how courts interpret the mechanics of a redemption provision, and perhaps a useful roadmap on how they are negotiated.  The case can be read here:  http://courts.delaware.gov/opinions/(w0fpgu55x0mqkc45box4kbml)/download.aspx?ID=79250.  In typical Delaware court fashion, the court interpreted the redemption language in the charter very strictly and refused the company to delay its redemption payments to fund working capital.  The court looked at the history of negotiations, where the Company originally wanted to carve it entire budget out of available funds for redemption but the parties finally agreed on a carveout for a particular year (2005).   In light of the Harbinger case I am not sure what of the ultimate impact in this case, when it seems that the company may have trouble making the payment in any event.

Notwithstanding the strict constructionist approach on redemption, the court in Thoughworks took a different tack on interpreting a negative covenant in the charter.  The negative covenants did not expressly reference a material indebtedness provision, requiring consent only for any contractual arrangement providing for the payment of $500,000 or more.” The Court found that “such contractual arrangements can be easily read to include debt transactions.”  (I am not sure I agree).  This finding by the Court is a bit of a surprise, as I think most corporate and vc lawyers would find the language to be lacking.

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