Recent Delaware case on redemption rights – Part Deux

Several years ago, I wrote about a few cases covering redemption rights.  My original post is here.

One of the cases involving Thoughtworks and SV Investment (aka Schroeders) is back for another look.  A copy of the opinion can be found here.

This decision refutes the popular urban myth that the term “surplus” means the same thing as “funds legally available” – these terms are the litmus test of whether a corporation has the capacity, and therefore the obligation, to redeem its shares at any particular time.

The court defines the term “funds legally available” as follows:  it contemplates “funds” (in the sense of cash) that are “available” (in the sense of on hand or readily accessible through sales or borrowing) and can be deployed “legally” for redemptions without violating DGCL Section 160 or other statutory or common law restrictions, including the requirement that the corporation be able to continue as a going concern and not be rendered insolvent by the distribution.

Here, the investors claimed that the company was obligated to continue redeeming their shares because it had “funds legally available”, per the terms of the company’s charter.  Despite the fact that an expert found that the company had $67-128 million in “surplus”, the court ruled that the company did not have the “funds legally available” and therefore was not obligated to make the $66,900 redemption payment.   The court reasoned that there was a substantial risk that the redemption would the company insolvent, which meant that the funds were not “legally available”, notwithstanding that there was “surplus” as found by the experts.

Thoughtworks’ redemption provision contained two limitations on the obligation “to redeem for cash.” Redemption could only be “out of any funds legally available therefor.”  The provision also excludes funds “designated by the Board of Directors as necessary to fund the working capital requirements of the Corporation for the fiscal year of the Redemption Date.”  To the extent that redemption cannot be effected, the charter requires pro-rata payments to the investors until they are paid out in full.  The charter also provides  that “[f]or the purpose of determining whether funds are legally available for redemption . . . , the Corporation shall value its assets at the highest amount permissible under applicable law”.

The board sought legal and financial advice with respect to the company’s redemption obligations per the charter.  The opinion quotes an interesting part of the memo provided to the board by the financial advisors:

“In declaring the amount of legally available funds for redemption, the Board must (a) not declare an amount that exceeds the corporation’s surplus as determined by the Board at the time of the redemption, (b) reassess its initial determination of surplus if the Board determines that a redemption based on that determination of surplus would impair the Company’s ability to continue as a going concern, thereby eroding the value of any assets (such as work in process and accounts receivable) that have materially lower values in liquidation than as part of a going concern, such that the value assumptions underlying the initial computation of surplus are no longer sustainable and the long term health of the Company is jeopardized, (c) exercise its affirmative duty to avoid decisions that trigger insolvency, (d) redeem for cash, (e) apply the amount declared pro rata to the Redeemed Stock, and (f) recognize the right of the Preferred Shareholders to a continuous remedy if the amount declared is not sufficient to satisfy in full the redemption obligation under the Charter.”

The court provides a succinct synthesis of the Delaware statutory law regarding redemption:

  • Section 160 of the DGCL authorizes a Delaware corporation to redeem its shares, subject to statutory restrictions.  In general, a corporation may redeem its own shares where the redemption does not result in the impairment of capital.
  • A repurchase impairs capital if the funds used in the repurchase exceed the amount of the corporation’s ‘surplus,’ defined by 8 Del. C. § 154 to mean the excess of net assets over the par value of the corporation’s issued stock.” Klang v. Smith’s Food & Drug Ctrs., Inc., 702 A.2d 150, 153 (Del. 1997).
  • Net assets means the amount by which total assets exceed total liabilities.” 8 Del. C. § 154.
  • Under Section 160(a)(1), therefore, unless a corporation redeems shares and will retire them and reduce its capital, “a corporation may use only its surplus for the purchase of shares of its own capital stock.” In re Int’l Radiator Co., 92 A. 255, 256 (Del. Ch. 1914).

The court goes on to distinguish the term “surplus” from “funds legally available” and provides a helpful history on the etymology of these terms.  “A corporation easily could have “funds” and yet find that they were not “legally available.”  A corporation also could lack “funds,” yet have the legal capacity to pay dividends or make redemptions because it had a large surplus.  Funds required to be withheld for taxes (e.g. payroll withholdings) and other statutory payment obligations are not to be considered as part of available funds.

Finally, the court provides a nice comparison of debt (including convertible debt)  and  equity, from the standpoint of redemption rights and investor protective provisions (see pp. 29-32).  This summary may be a useful read when negotiating term sheets (or explaining the difference to clients).

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