Preferred equity is a long-standing, flexible investment structure for private equity investors. The 2020 Spring issue of the Debevoise Private Equity Report reviewed preferred equity terms in the context of the wave of PIPE (private investment in public equity deal) deals that flooded the market in the early days of the pandemic, as pressure on corporate balance sheets and unavailability of traditional financing markets sent many companies on a race for near-term liquidity. While those pressures have eased, we continue to see many preferred equity deals, sometimes used to fill out the capital structure of a large buyout in place of traditional mezzanine debt, and sometimes used by “special situation” groups that target bespoke investment opportunities and are attracted to the degree of customization that preferred equity offers. But, as we have noted previously, preferred equity is not debt (even if considered debt for tax or regulatory capital purposes), and the ability to enforce rights as a preferred equity holder is subject to meaningful legal limitations.
A recent case in Delaware reinforces the potentially bitter aspect of this otherwise sweet form of investment. Our article featured in the 2016 Winter issue of the Debevoise Private Equity Report discussed various legal considerations associated with preferred equity. We noted there that the rights of preferred holders are contractual in nature and that an issuer’s directors owe no fiduciary duties to the preferred holders in respect of such rights. Although this may not sound so different from the rights of a lender, preferred holders do not benefit from creditor rights or remedies. This is the case even if the preferred equity has certain debt-like features, such as mandatory redemption or cumulative dividend obligations. Under Delaware law, equity cannot be redeemed if it would impair the capital of the issuing company. Courts largely defer to the good faith determination of the issuer’s board of directors as to whether redemption of preferred equity would result in impairment of its capital.
In the recent Delaware Court of Chancery decision Continental Investors Fund LLC v. TradingScreen Inc., et al., Vice Chancellor Laster set forth a detailed explanation of the nature of a preferred equity interest and the principles underlying the reasons why preferred holders’ rights – and in particular redemption rights – may be difficult to enforce. In that case, the preferred holders were ultimately fully redeemed, but that process took over five years. The Court found that the failure to redeem earlier was not a “default” under the terms of the preferred, and thus the provision of the preferred that required the company to pay interest in the event of a default was not triggered.
Vice Chancellor Laster explained the court’s deference to an issuer’s board of directors in determining whether the issuer has sufficient legally available funds to effect a redemption, as long as the board did not act in bad faith or fraudulently, and emphasized that the court’s review of such determination does not involve a valuation exercise in the vein of a “mini-appraisal”:
“When bringing a claim for a breach of a mandatory redemption provision, the plaintiff must prove that the corporation had additional funds that it could deploy legally for redemptions (commonly called ‘funds legally available’), yet failed to deploy the funds for that purpose . . . . Whether the corporation had funds that could have been deployed legally to redeem more shares is not a valuation exercise that the court decides as if the case were a mini-appraisal. A board’s determination as to the amount of funds legally available is a judgment-laden exercise entitled to deference. In the absence of bad faith or fraud on the part of the board, courts will not substitute our concepts of wisdom for that of the directors’ as to the amount of funds available for redemptions.”
If a preferred holder seeks to establish that an issuer failed to comply with a mandatory redemption right, it must prove that the board (1) acted in bad faith, (2) relied on unreliable methods or data or (3) made determinations so far off the mark as to constitute actual or constructive fraud.
Vice Chancellor Laster distinguished rights in a preferred stock certificate of designation from other contract claims: “Both the [Delaware General Corporation Law] and the common law impose restrictions on redemption rights that other contract claimants do not face . . . . An equity investor is not like other contractual claimants: The equity investor purchased equity, which is presumptively permanent capital.”
Issuers have often taken pains to ensure their mandatory redemption provision includes the words “funds legally available” or a similar variant so that it is clear the holder’s redemption right applies only in such circumstances. However, Vice Chancellor Laster reminds us that a comparable limitation is implied by law, and thus the presence or absence of such limitation in a mandatory redemption provision does not affect the plaintiff holder’s burden of proof to establish that the issuer in fact had sufficient legally available funds to deploy for redemptions.
To put these enforcement limitations in context, Vice Chancellor Laster also pointed out that such limitations confer substantial benefits on both issuers and investors, such as by enabling preferred equity with debt-like features to be classified as equity for tax purposes, which can avoid imputed interest for investors, lower the cost of capital for issuers, and allow regulated issuers to meet capital requirements: “A sophisticated investor that opts to purchase preferred stock . . . must take the bitter with the sweet.”
While enforcement limitations with respect to mandatory redemption rights in preferred equity investments are unavoidable, an investor does have tools to improve its position, given the highly customizable nature of the instrument. For example, a certificate of designation might provide that if the issuer fails to redeem the preferred equity when required to do so, whether due to lack of sufficient funds or otherwise, such failure constitutes a “triggering event” that would result in specific consequences benefitting the investor. These consequences may include an increased dividend rate, additional governance rights, a right to force the issuer to pursue a sale of the company, a decrease of the conversion price or an obligation to establish a sinking fund into which free cash flow would be deposited for use solely to redeem or make dividend payments on the preferred equity.
The “triggering event” concept can improve a preferred investor’s position and mitigate its risk with respect to its contractual rights beyond just a mandatory redemption provision, including an issuer’s failure to pay dividends or otherwise to take specific actions. At the end of the day, the one right of a preferred equity holder that should be unassailable is the right to derive value at the expense of the common equity in a downside scenario. But cases such as Trading Screen reinforce the fact that the drafting of the preferred terms must be done carefully so that even this basic right is not undone due to the disfavored legal status of contractual elements of preferred stock relative to debt or other contractual instruments.