PREFERRED STOCKHOLDERS LOSE CLEVER REDEMPTION ARGUMENT

Date: February 3rd, 2011

As many company founders know, preferred stock financings with venture capital firms and other savvy investors frequently involve a redemption right. The redemption right gives an investor the right at some time in the future to compel the company to buy back the stock the investor purchased in the financing. Experienced securities lawyers know that such redemption rights have many implications. For example, FAS 150, an accounting rule issued by the Financial Accounting Standards Board (FASB), requires that certain redemption rights be reflected at once as liabilities on a company’s financial statements. Obviously, this can affect a company’s net worth and possibly make it more difficult for the company to obtain loans, lines of credit or other financing. Another implication is that even if a company agrees to redeem stock in the future, it may not be able to do so legally.

Here in Washington, it has long been understood that a corporation may not buy back its own shares if after doing so:

(a) the corporation would not be able to pay its liabilities as they become due in the usual course of business; or

(b) The corporation’s total assets would be less than the sum of its total liabilities plus, unless the articles of incorporation permit otherwise, the amount that would be needed, if the corporation were to be dissolved at the time of the distribution, to satisfy the preferential rights upon dissolution of shareholders whose preferential rights are superior to those receiving the distribution.

RCW 23B.06.400

Thus, regardless of what an investment contract or a company’s articles of incorporation may state, Washington law prohibits a company from buying back shares of its stock when either of the foregoing conditions exist. This kind of restriction is not unique to Washington.

Recently, a preferred stock holder of a Delaware company filed a lawsuit challenging the company’s decision not to honor a redemption provision cemented in its Certificate of Incorporation. SV Investment Partners, LLC et.al. v. Thoughtworks, Inc., 7 A.3d 973 (2010). Thoughtworks’ Certificate of Incorporation granted the preferred stockholders the right after five years to have their stock redeemed “for cash out of any funds legally available therefor.” The preferred stockholders claimed Thoughtworks was obligated to buy back their stock, the purchase for which was about $67 million, and argued that “funds legally available” meant just “surplus” funds. They hired an expert witness who testified at trial that the company had surplus funds of $68 million to $137 million and, therefore, had enough money to buy back the stock. Thoughtworks and its board disagreed. They believed that if the company repurchased all the stock owned by the preferred stockholders, it would be insolvent.

The redemption provision in the Certificate of Incorporation stated as follows:

On the date that is the fifth anniversary of the Closing Date . . . , if, prior to such date, the Company has not issued shares of Common Stock to the public in a Qualified Public Offering . . . each holder of Preferred Stock shall be entitled to require the Corporation to redeem for cash out of any funds legally available therefor and which have not been 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, not less than 100% of the Preferred Stock held by each holder on that date. Redemptions of each share of Preferred Stock made pursuant to this Section 4 shall be made at the greater of (i) the Liquidation Price and (ii) the Fair Market Value (as determined pursuant to Section 4(e) below) of the Preferred Stock.

The preferred stockholders believed that the redemption provision of the Certificate of Incorporation meant that any funds beyond the company’s “working capital requirements” would be surplus and that such funds would be legally available for the company’s use in repurchasing stock. Their argument was clever, but not persuasive.

The statute applicable to this case was Section 160 of the Delaware General Corporation Law (DGCL), which states in part:

(a) Every corporation may purchase, redeem, receive, take or otherwise acquire, own and hold, sell, lend, exchange, transfer or otherwise dispose of, pledge, use and otherwise deal in and with its own shares; provided, however, that no corporation shall:

(1) Purchase or redeem its own shares of capital stock for cash or other property when the capital of the corporation is impaired or when such purchase or redemption would cause any impairment of the capital of the corporation, except that a corporation other than a nonstock corporation may purchase or redeem out of capital any of its own shares which are entitled upon any distribution of its assets, whether by dividend or in liquidation, to a preference over another class or series of its stock, or, if no shares entitled to such a preference are outstanding, any of its own shares, if such shares will be retired upon their acquisition and the capital of the corporation reduced in accordance with §§ 243 and 244 of this title.

Looking at this statute, the Delaware court focused on the language stating that redeeming shares is not permitted “when the capital of the corporation is impaired.” Delaware courts consider a redemption as impairing a company’s capital when the repurchase price exceeds the amount of the company’s “surplus.” Another Delaware statute defines “surplus” to mean the amount exceeding the company’s net assets over the aggregate par value of the company’s issued stock. “Net assets” are defined as the amount by which total assets exceed total liabilities. So, for example, if a company’s stock has a par value of $1.00, there are 100 shares issued and outstanding and the company’s net assets are $150, the company’s surplus is $50. Thus, the company only has $50 available for the repurchase of its stock.

The Delaware court made extremely short work of the preferred stockholders’ argument. The court noted that the preferred stockholders were simply equating “funds legally available” with “surplus.” Then, it explained to be “funds legally available”,

“…funds must both be “available” in the general sense of accessible, obtainable, and present or ready for immediate use, and “legally” so, in the additional sense of accessible in conformity with and as permitted by law….A corporation easily could have “funds” and yet find that they were not legally available.

After addressing issues specific to Delaware’s concepts of legal capital and “surplus”, the court then proceeded to list several circumstances in which a company’s funds are not legally available to be spent. In particular, the court focused on the well-known rule of common law restricting a corporation from redeeming its shares of stock when it is insolvent or if doing so would make it insolvent. The basis for this rule is that when a company is insolvent, its creditors have the senior claim to the company’s assets. With the court finding no equivalence between “funds legally available” and “surplus,” the preferred creditors’ argument collapsed quickly.

Of particular importance to the Thoughtworks case is the conduct of its board of directors. When the preferred stockholders demanded Thoughtworks buy back their shares of stock, the board of directors appears to have acted in a thoughtful and completely defensible manner. First, Thoughtworks sought the advice of its law firm and also engaged a financial consulting firm to advise the board about the company’s net assets and the extent to which any surplus existed. When surplus cash was available, the board caused the company to redeem as much of the preferred stock as it could. The board even attempted, unsuccessfully however, to raise additional funds to permit it to fund the redemptions demanded by the preferred stockholders. These actions were highly important to the court, which stated:

The factual record demonstrates that the Board has acted in the utmost good faith and relied on detailed analyses developed by well-qualified experts. For sixteen straight quarters, the Board has undertaken a thorough investigation of the amount of funds legally available for redemption, and it has redeemed Preferred Stock accordingly. On each occasion, the Board has consulted with financial and legal advisors, received current information about the state of the Company’s business, and deliberated over the extent to which funds could be used to redeem the Preferred Stock without threatening the Company’s ability to continue as a going concern. The Board’s process has been impeccable, and the Board has acted responsibly to fulfill its contractual commitment to the holders of the Preferred Stock despite other compelling business uses for the Company’s cash. This is not a case where the Board has had ample cash available for redemptions and simply chose to pursue a contrary course. Cf. Mueller v. Kraeuter & Co., 131 N.J. Eq. 475, 25 A.2d 874, 877 (N.J. Ch. 1942) (compelling corporation to take steps to redeem preferred stock where directors in prior years deployed funds exceeding amount of redemption obligation for purposes of expansion).

Most notably, the Board actively tested the market to determine what level of “funds” ThoughtWorks could obtain. A thorough canvass that included contacts with seventy potential funding sources generated a term sheet that would enable ThoughtWorks to borrow funds netting $ 23 million for redemptions, if and only if the “funds” were used to satisfy the entire obligation to the Preferred Stock. This proposal is the most credible evidence of the maximum funds legally available for a complete redemption of the Preferred Stock. There is no evidence that ThoughtWorks could obtain more funds for redemption or, importantly, that any third party would finance a partial redemption.

After shredding the preferred stockholders’s argument, the Court then took an interesting detour and discussed the commercial expectations of investors and companies that issue securities. The court pointed out that the legal impediments to redemption have been a feature of Delaware’s law since 1909! Knowing that, the court stated, investors have developed other ways to protect their investments and “secure exit opportunities.” For example, the court mentioned that the investment could have been made as debt, which would have been senior to equity in terms of repayment. The court’s opinion goes on to discuss other benefits of purchasing an equity stake in a company that an investor might find offset the weakness of a right of redemption attached to such equity, such as board seats, drag-along rights and the like. Then, in a final swipe at the preferred stockholders, the court wrote:

“…SVIP easily could have protected its investment and avoided its current fate through any number of means. SVIP decided not to, and that choice was rational at the time. SVIP bought the Preferred Stock at the height of the dot-com mania from a technology firm with an established track record, real revenues, and actual earnings — all of which compared favorably with many issuers then embarking on over-subscribed and first-day-popping IPOs. Everyone involved anticipated that ThoughtWorks soon would go public at a multi-billion dollar valuation. Instead, the bubble burst. Now, with hindsight, SVIP understandably wishes it had additional rights, but “it is not the proper role of a court to rewrite or supply omitted provisions to a written agreement.”

What should we take away from this case?

• Redeemable stock is always subject to the risk that the law may not allow a company to spend its money on the repurchase.
• If an investor wants priority of repayment, it should consider lending money to the company rather than making an equity investment.
• If an investor wants the right to payment at a certain time that comes with a debt instrument, but also wants the option to convert that debt to equity if equity is later seen as more attractive, then it should consider a convertible debt instrument.
• When faced with a demand for redemption or a put right, a board of directors should obtain advice from its lawyers and financial consultants to ensure that it has funds that can legally be used to fund the repurchase.
• When you’ve made your bed, you must lie in it.