ODN Holding Reminds that Preferred Equity Rights Are Not Bulletproof
In an acquisition, a private equity buyer often receives preferred equity entitling it to certain unique rights, with sellers of the target company receiving “rollover” common equity for a portion of their sale consideration. Preferred stockholders’ unique rights include, among other possibilities, (i) the right to a fixed yield on their contributed capital in the form of accrued dividends (e.g., 10% per annum), (ii) a return of their contributed capital (and any accrued dividends) prior to any distributions to the common stockholders in the event of a sale or other liquidity event, and (iii) the right to force the company to redeem their preferred equity on a certain date. These rights are particularly valuable in a “downside” or “flat” scenario where the company has lost value or has not performed as well as hoped. The common equity might be wiped out, but at least the preferred equity is ensured of a minimum return (or at least the last part of any “haircut” taken by the equityholders).
But The Frederick Hsu Living Trust v. ODN Holding Corporation et. al. case, building on the In re Trados case decided by the Court of Chancery of the State of Delaware in August 2013, takes some of the bite out of these preferred equity rights. This case clarifies that a board of directors’ fiduciary duties apply even in the face of otherwise clear-cut contractual rights negotiated by preferred equityholders. Fortunately this case also suggests some ways for private equity buyers and their counsel to improve the effectiveness of these preferred equity rights and avoid some of the implicated issues.
This case involves a claim that the defendants -- affiliates of a private equity fund and certain directors and officers of the company acquired by the private equity fund -- breached their fiduciary duties of loyalty to the company and its stockholders by selling off the company’s assets so that the company had cash on hand to make redemption payments to the private equity fund. The court denied defendants’ motion to dismiss this claim, and the defendants’ actions will now be examined using a more stringent (“entire fairness”) standard of review under which the defendants must show that their actions involved both “fair dealing” and a “fair price”.
Affiliates of Oak Hill Capital Partners invested in Oversee.net in the form of Series A Preferred Stock in 2008, with Oak Hill having the right to require the company to redeem its Series A Preferred Stock in 2013 (for an amount equal to the original issue price for the stock plus all declared but unpaid dividends on the stock) to the extent of the company’s legally available funds. The Series A Preferred Stock did not pay a cumulative dividend. If the company’s legally available funds were insufficient at the time of exercise by Oak Hill of its redemption right, then the company was to redeem the maximum number of Oak Hill’s shares and take all reasonable actions (including, without limitation, selling assets) consistent with the fiduciary duties of its board of directors necessary to redeem the remainder of Oak Hill’s shares. Oak Hill (which was not initially the controlling stockholder) became the company’s controlling stockholder in 2009 when it acquired shares of Common Stock from the company’s founder. As of this time, Oak Hill’s equity holdings entitled it to appoint three out of a total of eight members of the company’s board of directors. Oak Hill’s three appointees included two principals, and one officer, of Oak Hill. Of the remaining five directors, three were appointed by the company’s common stockholders, and two were appointed jointly by Oak Hill and the company’s common stockholders.
During the 18-month period leading up to December 2007, the company made five acquisitions. From 2009 to 2011, the company continued its general expansion mindset and completed another couple of acquisitions. But beginning in 2011, the company stopped making acquisitions and nearly doubled its cash reserves, and in early 2012 the company sold two of its four business lines for an amount of about one-third of these lines’ original acquisition price, causing revenues to decline significantly. The company continued to accumulate cash throughout 2012, more than tripling the size of its cash reserves compared to prior periods. In August 2012, the company’s board of directors formed a special committee composed of two of the board members to evaluate the company’s alternatives for raising capital for, and negotiating with Oak Hill regarding, its redemption. Shortly thereafter the special committee delegated the task of creating a proposal to three company officers to whom the company’s compensation committee had in 2012 granted bonus opportunities that triggered when redemptions of Oak Hill’s equity exceeded $75 million. The special committee engaged in back-and-forth negotiations with Oak Hill regarding the terms of the redemption prior to the redemption date, and ultimately agreed to recommend to the full board that the company redeem $45 million of Oak Hill’s total of $150 million in Series A Preferred Stock in exchange for a 10-month forbearance by Oak Hill on requiring further redemptions (terminable by Oak Hill on 30 days’ notice). The company’s board of directors (excluding Oak Hill’s three appointees, who abstained from the vote) approved this arrangement, and the company made the redemption payment, leaving the company with only $5 million in cash (compared with a year-end average of over $15 million in prior years).
In May 2014, the company (after recommendation of the special committee of a deal negotiated by the three officers who crafted the 2012 redemption and approval by the board of directors) sold one of its two remaining lines of business, which was the company’s primary revenue source. Around the same time, the board implemented an aggressive internal restructuring involving terminations of certain executives, employees and the lease for the company’s headquarters based on recommendations from the special committee and the three company officers mentioned above. In September 2014, at the special committee’s recommendation, the full board of directors approved an additional redemption payment of $40 million to Oak Hill (bringing the total redemption payments to date to $85 million and resulting in the three company officers mentioned above receiving their bonuses). Finally, in late 2014, the company sold the “crown jewel” portion of its remaining business line for $600,000 (the company had paid $17 million for it in 2010). From 2011 to 2015, annual revenues dropped 92%, from $141 million to $11 million.
The court emphasized that directors owe fiduciary duties to “the stockholders in the aggregate in their capacity as residual claimants, which means the undifferentiated equity as a collective, without regard to any special rights” and that directors are to “act in good faith to maximize the value of the corporation over the long-term for the benefit of the providers of presumptively permanent equity capital . . . .” In short, fiduciary duties are owed to common stockholders (and preferred stockholders only to the extent they are exercising rights also afforded to common stockholders), but directors have no duty to preferred stockholders to protect contractual redemption or other rights. Yet it is these contractual rights themselves that provide preferred stockholders the special protections associated with preferred equity. The court rejected the defendants’ argument that complying with binding contractual obligations to Oak Hill or any other third party (and taking necessary actions to do so) should override the directors’ fiduciary duties to common stockholders. Instead, the court noted that the directors should have considered (and may have concluded) that the long-term advantages to the common stockholders of breaching the company’s contractual obligation to make the redemption payment to Oak Hill outweighed the associated negative consequences of doing so (a so-called “efficient breach”). Further, because the redemption provision at issue only actually required payment to the extent of legally available funds, the company would not have technically breached the provision unless it actually possessed those funds (which it did not, until the board took affirmative actions to sell off assets in advance of the redemption date). And, although the redemption provision required the board to take reasonable actions to generate sufficient funds to effect the redemption, that requirement was specifically limited to actions consistent with the board’s fiduciary duties and would only kick in beginning on the redemption date if the company lacked sufficient funds (not before).
Still, in order to change the court’s standard of review of the board’s actions from the deferential “business judgment rule” to the tougher “entire fairness” standard, the plaintiff needed to allege facts to support that less than a majority of the directors were disinterested and not conflicted. Ultimately, of the nine directors who served during the relevant period, the court found that seven were potentially conflicted: (i) three because they were employees of Oak Hill, (ii) one because she was a senior-level employee entitled to a bonus based on redemptions of Oak Hill’s equity, and (iii) three outside directors, because it could be reasonably inferred that given Oak Hill’s control of the company they were not truly independent and acted in bad faith to maximize the value of Oak Hill’s redemption right (plus Oak Hill or its agents had prior contractual or other relationships with two of these directors). The use of a special committee was also insufficient in this context to defeat application of the “entire fairness” standard, because Oak Hill had actively participated via its board presence in the decisions at issue, plus Oak Hill through its controlling equity stake had influence over the special committee members and they were potentially tainted as a result. Therefore, defeating application of the “entire fairness” standard would have required both special committee approval and approval of a majority-of-the-minority equityholders, which was not obtained.
The court’s decision in the motion to dismiss stage is not a death knell to the defendants – they can still attempt to show that the sales of the company’s assets and their other actions leading up to the redemption were fair in terms of their process and economic outcomes (e.g., that the board’s decision to sell most of the company’s assets was a fair outcome for the common stockholders because long-term it was unlikely that any residual value could have been created for the common stockholders and that the various business lines were sold for roughly market value).
As we await final resolution of this case, private equity buyers and their counsel can take several steps to bolster their preferred rights. First, where feasible, a limited liability company (versus corporation) could be used as the investment vehicle. In contrast to Delaware corporation law, Delaware limited liability company law allows for a full waiver of all fiduciary duties of managers in a limited liability company agreement (but absent an explicit waiver, the default fiduciary duties will still apply). Of course a private equity buyer may not wish to waive these duties to the extent it is relying on them for its protection (especially in a situation where the private equity buyer is a minority investor or does not otherwise control the board, as in the ODN case). Second, additional “bells and whistles” could be added to the redemption rights package. For example, if the company fails to timely fulfill its redemption obligation, the contract might provide for an increased dividend rate (which continues to ratchet up as time passes). The board would need to take the associated reduction in value to the common stockholders into consideration when determining whether or not to effect the redemption, making it easier for a board to push for full redemption consistent with its fiduciary duties. In this scenario the contract might also allow the private equity buyer (in its capacity as a stockholder) to exercise “drag along” rights permitting it to force the other investors to participate in a sale of the company initiated by the private equity buyer (to the extent these rights do not already exist). Finally, a private equity buyer’s “preferred” investment could be structured as debt to provide debt-like remedies, including a lien, and an ability to foreclose, on company assets in the event of a redemption failure. This possibility would be subject to approval of any senior debtholders and, therefore, might not work within the structure of many private equity deals.