Is Common Stock the Preferred Security? Recent Judicial and Legislative Developments Affecting Preferred Stock

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1 Is Common Stock the Preferred Security? Recent Judicial and Legislative Developments Affecting Preferred Stock Frederick H. Alexander Melissa A. DiVincenzo Morris, Nichols, Arsht & Tunnell LLP I. VOTING AND APPRAISAL RIGHTS A. Model Business Corporation Act Amendments 1. Application of Section 10.04(c) Group Voting Rule to Domestications, Non-profit Conversions, Entity Conversions and Merger or Share Exchanges. A new subsection (f) was added to Section 7.25 (quorum and voting requirements for voting groups) to provide that the group voting rule of Section 10.04(c) (which states that if a proposed articles of incorporation amendment that entitles the holders of two or more classes or series of shares to vote as separate voting groups under Section 10 would affect those two or more classes or series in the same or a substantially similar way, the holders of shares for all of the classes or series so affected must vote together as a single voting group on the proposed amendment unless otherwise provided in the articles of incorporation or required by the board of directors) now also applies to the group voting provisions in Sections 9.21 (domestication), 9.31 (non-profit conversion), 9.52 (entity conversion), and (merger or share exchange). 2. Clarification of Voting on Articles of Incorporation Amendments by Voting Groups in the Event of a Dissolution. The term dissolution was deleted in Section 10.04(a)(5) and (6) because the term distribution used in this Section alone includes all forms of distributions, including dividends and distributions in liquidation or dissolution. 3. Limiting Appraisal and Voting Rights. A new subsection (7) was added to Section 9.21 that provides that a company s articles of incorporation may limit or eliminate separate voting as a voting group for any class or series of shares on a plan of domestication unless the plan includes an amendment to the articles of incorporation following its domestication that requires separate group voting under Section The holders of shares that do not have a group voting right on a plan of domestication will have appraisal rights even if there has been an elimination of appraisal rights in the articles of incorporation. Section 9.31(6), a transitional rule addressing nonprofit conversions, was amended to make clear that if any provision of the articles of 2010 The views expressed herein are those of the authors and do not necessarily represent views of their firm.

2 2. incorporation, bylaws or any agreement to which any of the directors or shareholders are parties adopted prior to the effective date of Section 9.31 applies to a merger excluding provisions that eliminate or limit voting or appraisal rights, such provision shall also apply to a nonprofit conversion of the company. Section 9.52(6), a transitional rule addressing entity conversions, was amended to make clear that if any provision of the articles of incorporation, bylaws or any agreement to which any of the directors or shareholders are parties was adopted prior to the effective date of Section 9.52 applies to a merger excluding provisions that eliminate or limit voting or appraisal rights, such provision shall apply to an entity conversion of the company. New Section 11.04(g) provides that the articles of incorporation may limit or eliminate separate voting as a voting group for any class or series of shares in a merger or share exchange, but not if a plan of merger includes amendments requiring a separate vote under Section or if the merger or share exchange involves what is or would be an amendment to which Section would apply and is one that involves no significant change in the assets of the enterprise on a consolidated basis. Section 13.02, which addresses appraisal rights, was amended in conjunction with the amendments to Section discussed above. Formerly, except for shareholders of a subsidiary corporation that was merged under the short-form statute, only shareholders who were entitled to vote on a transaction were entitled to appraisal rights. This linkage was eliminated. Amended Section now provides that a corporation can eliminate or limit appraisal rights that would otherwise be available to preferred shares unless the holders of the series or class of preferred shares do not have a group vote on the action that would otherwise give rise to appraisal rights, or with respect to a conversion of a nonprofit entity under subchapter 9C or a conversion to an unincorporated entity under subchapter 9E, or a merger having a similar effect. Additionally, with respect to a disposition of assets, the appraisal section now provides an exception from appraisal rights in certain circumstances where shareholders are being treated on a proportionate basis in accordance with the corporation s governing documents in an arm s-length transaction.

3 3. B. Delaware Corporate Law 1. When Does Preferred Stock Vote as a Separate Class on Mergers and Charter Amendments? (a) Limited Class Votes for Charter Amendments. (i) DGCL Section 242(b)(2). This section provides that the holders of the outstanding shares of a class shall be entitled to vote as a class upon a proposed amendment, whether or not entitled to vote thereon by the certificate of incorporation, if the amendment would... alter or change the powers, preferences, or special rights of the shares of such class so as to affect them adversely. (ii) Adverse Effect. There is no class vote for Section 242 charter amendments unless the peculiar legal characteristics of a class are altered adversely. Hartford Accident & Indem. Co. v. W.S. Dickey Clay Mfg. Co., 24 A.2d 315 (Del. 1942). In Hartford Accident, the court construed the predecessor to Section 242(b)(2) of the DGCL, which granted a class vote on charter amendments that alter or change the preferences, special rights or powers given to any one or more classes of stock, by the Certificate of Incorporation, so as to affect such class or classes of stock adversely. Id. at 318. The court held that a charter amendment that increased the authorized number of shares of preferred stock did not require a class vote of the common stock regardless of any dilutive effect on the common because a class vote is required only when an amendment changes the rights incident to that class as compared with other classes of shares. Id. at 318. Where the corporate amendment does no more than to increase the number of the shares of a preferred or superior class, the relative position of subordinated shares is changed in the sense that they are subjected to a greater burden. The peculiar, or special, quality with which they are endowed, and which serves to distinguish them from shares of another class, remains the same. Id. at Benchmark Capital Partners IV, L.P. v. Vague, 2002 Del. Ch. LEXIS 90 (Del. Ch. July 15, 2002). The company s charter required a series vote for corporate action that would materially adversely change the rights, preferences and privileges of the junior stock. The charter also required a series vote to issue or

4 4. authorize securities senior to or on parity with junior preferred stock. Such votes could be waived by the senior stock except where the contemplated corporate action would diminish or alter the liquidation preference or other financial or economic rights of the junior preferred. The company intended to merge with a wholly owned subsidiary and, in that merger, amend the charter. The court held that the first series vote provision did not expressly extend to mergers and therefore, the preferred stockholders were not entitled to a series vote in the merger. With respect to the waiver of the second series vote, the court rejected a broad reading of the limitation on the waiver and found that the waiver language should be construed similarly to Section 242(b)(2). The Court found that the issuance of senior stock did not diminish or alter... financial or economic rights of the existing preferred under the principle that preferences must be express and will not be presumed. The Supreme Court affirmed this holding in Benchmark Capital Partners IV, L.P. v. Juniper Fin. Corp., 822 A.2d 396 (Del. 2003). Orban v. Field, 1993 Del. Ch. LEXIS 277 (Del. Ch. Dec. 30, 1993). In Orban, the common stockholders argued that the creation of a new class of preferred stock that diluted the voting power of the common stock required a class vote. The Orban court relied on Hartford Accident and explained that the right to vote is not a peculiar or special characteristic of common stock in the capital structure of [the corporation]. Id. at *22. Therefore, an amendment to the certificate of incorporation that creates a new class of preferred stock does not require a class vote of the common stockholders because the amendment does not adversely affect the peculiar legal characteristics of that class of stock. Id. In addition, the court explained that the new issuance diluted the voting power of all of the classes of stock, not simply the common stock. Similarly, the court rejected the plaintiffs argument that the amendments to the certificate of designation increasing the number of shares of certain series, and changing the conversion ratios and redemption provisions of other series required a class vote of the common stock, relying on Hartford Accident and finding that no special rights of common shareholders were adversely affected by those changes. Id. at *24.

5 5. Mariner LDC v. Stone Container Corp., 729 A.2d 267, 272 n.4 (Del. Ch. 1998) (stating that amendment to terms of preferred stock granting voting rights to a class formerly having none cannot in any way, be interpreted as having an adverse [e]ffect on the preferences, rights or powers of those shares and finding that preferred stockholders were not entitled to a class vote on a merger that effected a charter amendment where the amendment was required by the terms of an anti-destruction provision implicated by the merger). Special Considerations: Does a reverse stock split create an adverse effect? Although creation of senior stock is not, per se, an adverse effect, the terms of the junior stock should be reviewed to insure that creation of senior stock does not otherwise result in an adverse effect on powers, preferences or special rights of junior stock, e.g., provision that a series will be junior only to, or share in a liquidation pool exclusively with, specified other series. (iii) Series Vote? Section 242(b)(2) of the DGCL provides that if a proposed amendment would alter or change the powers, preferences, or special rights of 1 or more series of any class so as to affect them adversely, but shall not so affect the entire class, then only the shares of the series so affected by the amendment shall be considered a separate class for purposes of [the statute]. Consider reclassification of multiple series of preferred stock into common stock; amendment to add pay to play conversion term to multiple series. (iv) Class Vote to Increase or Decrease Number of Authorized Shares? Class vote required under Section 242. This class vote (but not the others provided for by Section 242(b)) may be denied in corporation s certificate of incorporation. See 8 Del. C. 242(b)(2).

6 6. (b) (c) Under Section 251 of the DGCL, Preferred Stockholders Do Not Have A Statutory Class Vote On Mergers. No Class Vote for Mergers Unless Charter Expressly Requires. Case law holds that to require a class vote on amendments effected through a merger, the terms of the stock must expressly require a class vote for mergers. The cases are reasonably clear that if a provision requires a class vote for adverse changes but does not by its terms specifically apply to mergers, it will not be construed to apply to charter amendments effected in a merger (including a recap merger with a subsidiary). See Elliott Assocs., L.P. v. Avatex Corp., 715 A.2d 843 (Del. 1998); Benchmark Capital Partners IV, L.P. v. Vague, 2002 Del. Ch. LEXIS 90 (Del. Ch. July 15, 2002), aff d, 822 A.2d 396 (Del. 2003); Watchmark Corp. v. Argo Global Capital, LLC, 2004 Del. Ch. LEXIS 168 (Del. Ch. Nov. 4, 2004); Tera Systems, Inc. v. Mentor Graphics Corp., 2003 Del. Ch. LEXIS 149 (Del. Ch. Aug. 21, 2003). Warner Communications Inc. v. Chris-Craft Indus., Inc., 583 A.2d 962 (Del. Ch. 1989). In Warner, the provision of the Warner charter at issue required a 2/3 class vote of the preferred stock to amend, alter or repeal any provision of the charter if such action adversely affected the preferences, rights, powers or privileges of the preferred stock. Warner merged with a Time subsidiary and was the surviving corporation. In the merger, the Warner preferred stock was converted into Time preferred stock and the Warner charter was amended to delete the terms of the preferred stock. The court rejected the argument that holders of the preferred stock were entitled to a class vote on the merger, reasoning that any adverse effect on the preferred stock was caused not by an amendment of the terms of the stock but solely by the conversion of the stock into a new security pursuant to Section 251 of the DGCL. The court also reasoned that the language of the class vote provision at issue was similar to Section 242 and did not expressly apply to mergers. Sullivan Money Mgmt., Inc. v. FLS Holdings, Inc., 1992 Del. Ch. LEXIS 236 (Del. Ch. Nov. 20, 1992), aff d, 628 A.2d 84 (Del. 1993). Sullivan involved the interpretation of a charter provision of FLS Holdings, Inc., which required a class vote of the preferred stockholders for the corporation to change, by amendment to the Certificate of Incorporation... or otherwise, the terms and provisions of the preferred stock so

7 7. as to affect adversely the rights and preferences of the preferred stock. Id. at *7. In that case, the preferred stock of FLS was converted into cash but FLS survived. The plaintiff argued that the conversion to cash was an elimination of the preferred stock and, therefore, was a change, by amendment or otherwise to the terms of the preferred stock. The court disagreed, holding that or otherwise cannot be interpreted to include a merger. The court pointed to other provisions of the charter where the drafters specifically required a class vote of another series of preferred stock to amend the terms of the preferred stock so as to affect adversely the rights of such stock, either directly or indirectly or through merger or consolidation with any other corporation. The court reasoned: The word merger is nowhere found in the provision governing the Series A Preferred Stock. The drafters failure to express with clarity an intent to confer class voting rights in the event of a merger suggests that they had no intention of doing so, and weighs against adopting the plaintiffs broad construction of the words or otherwise. Id. at *17. Elliott Assocs. v. Avatex Corp., 715 A.2d 843 (Del. 1998). In Avatex, the court construed a provision that expressly gave preferred stockholders a class vote on the amendment, alteration or repeal, whether by merger, consolidation or otherwise of provisions of the charter of Avatex Corporation so as to adversely affect the rights of the preferred stock. The challenged transaction involved the merger of Avatex into its wholly owned subsidiary, Xetava Corporation, in which the Avatex preferred stock was converted into common stock of the surviving corporation. The court, for purposes of its opinion, assumed that the preferred stock was adversely affected. The court distinguished Warner because the Avatex charter contained the whether by merger, consolidation or otherwise language and held that the preferred stock had a right to a class vote on the merger because the adverse effect was caused by the repeal of the Avatex charter and the stock conversion. The court concluded that the path for future drafters to follow in articulating class vote provisions is clear : When a certificate (like the Warner certificate or the Series A provisions here) grants only the right to vote on an amendment, alteration or repeal, the preferred have no class vote in a merger. When a certificate (like the First Series Preferred certificate here) adds the terms whether by merger, consolidation or otherwise and a merger results in an amendment, alteration or repeal that causes an adverse effect on the preferred, there would be a class vote. Id. at 855.

8 8. Benchmark Capital Partners IV, L.P. v. Vague, 2002 Del. Ch. LEXIS 90 (Del. Ch. July 15, 2002), aff d, 822 A.2d 396 (Del. 2003). In Benchmark, the company s charter required a series vote for corporate action that would materially adversely change the rights, preferences and privileges of the junior stock and it also required a series vote to issue or authorize securities senior to or on parity with junior preferred stock, but the vote could be waived by the senior stock except where the contemplated corporate action would diminish or alter the liquidation preference or other financial or economic rights of the junior preferred. The company intended to merge with a wholly owned subsidiary and, in that merger, amend the charter. The court held that the first series vote provision did not expressly extend to mergers and therefore, the preferred stockholders were not entitled to a series vote in the merger. 2. Amendment of Supermajority Provisions. Section 242(b)(4) provides that [w]henever the certificate of incorporation shall require for action by the board of directors, by the holders of any class or series of shares or by the holders of any other securities having voting power the vote of a greater number or proportion than is required by any section of this title, the provision of the certificate of incorporation requiring such greater vote shall not be altered, amended or repealed except by such greater vote. Starkman v. United Parcel Serv. of America, Inc., C.A. No (Del. Ch. Oct. 18, 1999) (transcript of oral ruling). Starkman involved a holding company merger where UPS formed two subsidiaries, one immediately below UPS and the second immediately below that firsttier subsidiary. UPS then merged with the second-tier subsidiary and its stockholders received stock of the first-tier subsidiary, New UPS, in exchange for their shares. UPS continued as a wholly owned subsidiary of New UPS and its charter was not amended in the merger. The plaintiffs in that case argued that the merger triggered a supermajority vote in the UPS charter that required an 80% vote for the amendment or deletion of a transfer restriction in the charter. The court disagreed, noting that the charter of UPS, which became a wholly owned subsidiary of New UPS, was not amended in the merger. In addition, citing Avatex and Warner, the court found that the supermajority vote provision would not have been triggered even if the charter provision of UPS had been amended in the merger, stating: I reach this conclusion because the Supreme Court in Avatex rested its holding on the presence of language in the Avatex certificate of incorporation specifically referring to the possibility of an amendment, alteration

9 9. or repeal by merger, consolidation or otherwise. The critical language, referring to merger, consolidation or otherwise, was not found in Warner and is not found here. Thus, Warner, which was reaffirmed by the Supreme Court, requires that I read [the supermajority vote provision] to pertain only to charter amendments proposed in accordance with Section 242 of the Delaware General Corporation Law. Because the transaction at issue is a merger proposed under the authority of Section 251 of the Delaware General Corporation Law, Warner requires a finding that [the supermajority provision] has no application. Id., transcript at When Are Preferred Stockholders Entitled to Appraisal? (a) (b) (c) Mergers and consolidations generally. With some exceptions, appraisal rights are available to stockholders of constituent corporations in mergers and consolidations effected pursuant to Sections 251, 252, 253, 254, 257, 258 or 263 of the Delaware General Corporation Law (the DGCL ). The right to pursue appraisal extends to any stockholder of record who: (1) owns shares of stock on the date that the stockholder demands appraisal; (2) continues to hold the shares through the effective date of the merger or consolidation; and (3) neither votes in favor of the merger or consolidation nor executes a written consent in favor of the transaction. 8 Del. C. 262(a) and (b). Other transactions. A corporation s certificate of incorporation may also provide for appraisal rights for shares of any class or series of stock following an amendment to the certificate of incorporation, a sale of all or substantially all of the assets of the corporation, or any merger or consolidation in which appraisal rights would not otherwise be available. 8 Del. C. 262(c). Purchasers of preferred stock can contract away their appraisal rights. Section 262 represents a statutorily conferred right [that] may be effectively waived in the documents creating the security only when that result is quite clearly set forth when interpreting the relevant document under generally applicable principles of construction. Thus, where a certificate of designation provided that preferred stockholders would receive their liquidation preference upon a merger, the preferred stock had a stated value in a merger and was not entitled to appraisal rights where they received that amount. In the Matter of the Appraisal of Ford Holdings, Inc. Preferred Stock, 698 A.2d 973, 977 (Del. Ch. 1997).

10 10. (d) Section 262 generally applies without regard to voting rights. Appraisal rights are generally available to all stockholders, whether or not their shares are entitled to vote on the merger, unless otherwise provided by a certificate of incorporation. But see Section 251(f) and (g) (no appraisal rights in certain mergers where stockholders do not vote). 4. Recent Appraisal Rights Cases. (a) In re Appraisal of Metromedia Int l Group, Inc., 971 A.2d 893 (Del. Ch. 2009) (Chandler) Preferred stockholders of Metromedia International Group sought appraisal following CaucusCom Ventures, L.P. s tender offer, top-up and short form merger. However, Chancellor Chandler held in his post-trial opinion that a non-consensual conversion provision in the preferred stock s certificate of designation forced the preferred stockholders to accept conversion into common stock according to a specific calculation following a merger, and that the specified calculation constituted the exclusive fair value to which the preferred stockholders were entitled. Rather than considering different methods of valuation for purposes of an appraisal, Chancellor Chandler bound the preferred stockholders to the non-consensual conversion procedure for which they had contracted. Importantly, valuing the preferred exclusively on an as converted to common basis eliminated value attributable to the preferred s stated rights (liquidation preference, etc.). The court ruled that this was compelled by the anti-destruction provision in the preferred which stated that following a merger, the preferred became convertible into whatever the common stock received in the merger. The court also awarded payment of accrued dividends as part of the as converted formula. While the court found that the mandatory payment of the dividends upon the instant facts was unambiguously provided for in the certificate of designation, Chancellor Chandler noted that even if the dividend language was ambiguous, contra proferentem would apply to favor the preferred stockholders interpretation, because the company was the drafter of the document.

11 11. (b) Berger v. Pubco Corp., 976 A.2d 132 (Del. 2009) (Jacobs) Following a short-form merger cashing out the minority stockholders of Pubco Corporation, a minority stockholder sought a quasi-appraisal remedy, arguing that the majority stockholder s notice of the Section 253 merger violated the duty of disclosure because, inter alia, it failed to describe the methodology by which the purchase price was determined and did not attach a version of Section 262 (the Delaware appraisal statute) that included the most recent year s amendments. Chancellor Chandler concluded that the notice constituted a violation of the duty of disclosure and imposed a quasiappraisal remedy in which minority stockholders would be required to (1) opt in to the quasi-appraisal class and (2) escrow some of the merger consideration that they received, in order to bear some of the risk that the amount awarded in appraisal would be less than the merger consideration. On appeal, the Supreme Court determined that the optimal remedy is an opt out system without any escrowing required, thereby giving all minority stockholders the opportunity to receive the greater of the merger consideration or the amount awarded in appraisal. The minority stockholders being able to have it both ways following the controlling stockholder s disclosure violation was seen as an appropriate corollary to cases holding that stockholders lose their appraisal rights if they fail to adhere to technical requirements of Section 262. II. DUTIES TO PREFERRED STOCKHOLDERS A. Contractual and Fiduciary Duties Duties to preferred stockholders are primarily contractual and fiduciary duties generally are not implicated by matters relating to the specific preferences or limitations of the preferred stock. Jedwab v. MGM Grand Hotels, Inc., 509 A.2d 584 (Del. Ch. 1986). In Jedwab the plaintiff, a preferred stockholder, argued that the preferred were entitled to fair apportionment of the merger consideration and that the directors breached their fiduciaries duties to the preferred in the negotiation of the merger. The Jedwab court explained that, generally, directors do not owe fiduciary duties to preferred stockholders in matters relating to preferences or limitations that distinguish preferred stock from common. Id. at 594. Instead, the relationship between the corporation and the preferred stock is contractual in nature and the scope of the duty is properly defined by reference to the specific words evidencing that contract. Id. However,

12 12. where the right asserted is a right shared equally with the common, the existence of such right and the scope of the correlative duty may be measured by equitable as well as legal standards. Id. See also Quadrangle Offshore LLC v. Kenetech Corp., 1999 Del. Ch. LEXIS 213, at *24-*25 (Del. Ch. Oct. 13, 1999) (reciting rule that preferred stockholder s rights are usually set forth in certificate of designation but where their interests are harmonious, preferred shareholders share with common shareholders the right to demand loyalty and care from the fiduciaries entrusted with managing the corporation and finding that preferred stockholders liquidation preference created economically antagonistic relationship with common such that terms of certificate controlled). B. Allocation Issues. Where there is more than one class or series of stock, directors may have conflicts with stockholders because of their affiliation with one or more classes or series of stock, thereby requiring application of the entire fairness standard. 1. Case Law Conflict In re Trados Inc. S holders Litig., 2009 Del. Ch. LEXIS 128 (Del. Ch. July 24, 2009) (finding, on a motion to dismiss, that the plaintiff had adequately rebutted the presumption of the business judgment rule by alleging that a majority of the members of a corporation s board, who had ties to holders of a large percentage of the company s preferred stock, were interested in a merger where the preferred stockholders received cash and the common stockholders received nothing in the merger). In re FLS Holdings, Inc. S holders Litig., 1993 Del. Ch. LEXIS 57 (Del. Ch. Apr. 2, 1993) (requiring a board comprised exclusively of directors owning large amounts of common stock or directors who were affiliates of the company s controlling stockholder to demonstrate the fairness of an allocation of consideration that clearly favored the common stock over the preferred stock). Jedwab v. MGM Grand Hotels, Inc., 509 A.2d 584 (Del. Ch. 1986) (applying entire fairness test to allocation of merger consideration where one element of consideration was apportioned wholly to the shares of the controlling stockholder). Lewis v. Great W. United Corp., 1978 Del. Ch. LEXIS 723 (Del. Ch. Mar. 28, 1978) (applying entire fairness test where a corporation that was controlled by a 65% common stockholder structured a merger treating preferred less favorably than common).

13 Case Law No Conflict In re General Motors Class H S holders Litig., 734 A.2d 611 (Del. Ch. 1999). In General Motors, the plaintiffs alleged that the directors breached their duty of loyalty to the holders of General Motors Class H Common Stock because a recapitalization transaction favored the General Motors $1 2/3 Common Stock. The plaintiffs alleged that the directors owned more $1 2/3 Common Stock, in terms of number of shares and dollar value, than Class H Common Stock and that, accordingly, the entire fairness standard should apply. The court rejected the plaintiffs argument, holding that the business judgment rule applied, noting that the amount of $1 2/3 Common Stock held by the directors was not so substantial as to have rendered it improbable that [the] directors could discharge their fiduciary obligations in an even-handed manner. Id. at 618. Giammalvo v. Sunshine Mining Co., 1994 Del. Ch. LEXIS 6 (Del. Ch. Jan 31, 1994), aff d, 651 A.2d 787 (Del. 1994). The challenged transaction in Sunshine involved the directors decision to refrain from paying dividends on the preferred stock. The plaintiff had argued that due to the directors ownership of common stock, the market price of which allegedly would have been adversely affected if the dividend had been paid on the preferred stock, the directors breached their duty of loyalty to the preferred stockholders. The court rejected the plaintiff s argument and held that the plaintiff had not rebutted the presumption of loyalty that is accorded the directors under the business judgment rule, noting that the plaintiff offered no evidence to establish that the directors received any personal benefit from their decisions with respect to the preferred stock. C. Payment of Waterfall May Not Be Conclusively Fair. A transaction may involve the payment of liquidation amounts that fully satisfy senior liquidation preferences without fully satisfying junior preferences or without distributing significant value to common stock. May the board refrain from doing a deal under these circumstances in order to seek value for the common stock? See Equity-Linked Investors, L.P. v. Adams, 705 A.2d 1040 (Del. Ch. 1997). The Equity-Linked court found no breach of fiduciary duty where the board took steps to continue the corporate enterprise at a time when its liquidation would have made the preferred stockholders whole (but the common stockholders would have received nothing), recognizing that the action taken by the board imposed economic risks upon the preferred stock which the holders of the preferred stock did not want and was taken for the benefit largely of the common stock. In re Trados Inc. S holders Litig., 2009 Del. Ch. LEXIS 128 (Del. Ch. July 24, 2009) (stating that the interests of the preferred stockholders and

14 14. common stockholders were [not] aligned with respect to the decision of whether to pursue a sale of the company or continue to operate the company without pursuing a transaction and declining to dismiss plaintiff s claim that the board breached its fiduciary duties by entering into a merger in which the preferred stockholders received cash consideration due to their liquidation preference and the common stockholders received nothing). Oliver v. Boston Univ., 2006 Del. Ch. LEXIS 75, at *119 (Del. Ch. Apr. 14, 2006) (finding that allocation of merger consideration was unfair because common stockholders were not appropriately represented in allocation process and awarding damages to common stockholders even though claims of preferred stockholders exceeded consideration offered). Orban v. Field, 1997 Del. Ch. LEXIS 48 (Del. Ch. Apr. 1, 1997) (rejecting attack on merger where common stock received no merger consideration and preferred stock received all merger consideration in accordance with liquidation preference of preferred stock). D. Allocation on As Converted Basis In re Appraisal of Metromedia Int l Group, Inc., 971 A.2d 893 (Del. Ch. 2009). In an appraisal action, the court found that provisions in the certificate of designation that established a non-consensual conversion procedure in the event of a merger limited the value to which the preferred stockholders were entitled. LC Capital Master Fund, LTD. v. QuadraMed Corp., 990 A.2d 435 (Del. Ch. 2010). The QuadraMed charter provided that, in the event of a merger, the preferred stockholders had the right to convert their preferred shares into common shares and then to receive the same consideration that the common stock received in such merger. Under the terms of the challenged merger agreement, the QuadraMed preferred stockholders would receive merger consideration that was pegged to this conversion right. The court denied the stockholders motion to preliminarily enjoin the merger, finding that the board had no duty to allocate additional value to the preferred beyond that provided by such conversion right. E. Issues Involving the Placement of Merger Consideration in Escrow to Secure Indemnification Obligations. 1. Common Provision: An amount is placed in escrow to secure the target s indemnification obligations to the acquiror. In determining how the amounts contributed to escrow are to be allocated among the holders of the capital stock of the target, the merger agreement often requires a pro rata contribution to the escrow by preferred and common stockholders based either on the consideration payable to each class or the aggregate

15 15. consideration payable to each holder as a percentage of the total consideration payable (cutting across classes). 2. Enforceability Issues: Contribution to the escrow based on the consideration payable to the class or series may violate the charter of the target company if the company has preferred stock outstanding. Although this approach is common, it may not give holders of preferred stock their full liquidation preference because, if all of the escrow is not released to target stockholders, the preferred stockholders may receive less and the common stockholders may receive more, than they would have been entitled to receive if the reduced escrow amount had been allocated as provided for in the charter. See National Venture Capital Association, Model Certificate of Incorporation, n.25 (2009), available at 3. Possible Solutions: Make stockholders parties to merger agreement. Amend the charter of the target to permit the proposed allocation so that holders cannot challenge the escrow for violating the terms of the stock set forth in the charter. Allocate so that the preferred stockholders always receive their liquidation preference even if some or all of the escrow is paid out. This essentially means that the escrow is allocated in the same proportions as the consideration would be allocated if there were no escrow (such that, in some circumstances, the total amount of the escrow would be allocated to the common and any proceeds released from the escrow would go to the common). F. Recent Cases Addressing Duties to Preferred Stockholders. 1. In re Trados Inc. S holder Litig., 2009 Del. Ch. LEXIS 128 (Del. Ch. July 24, 2009) (Chandler) Various venture capital firms invested in software development company Trados. In exchange, the investors together received 51% of Trados s preferred stock with a $57.9 million liquidation preference, minimal amounts of common stock, and the right to elect 4 of the 7 Trados directors. Eventually, the VCs expressed a desire to cut their losses in Trados, which it viewed as underperforming. The Trados board replaced its CEO, hired an investment bank, approved a management incentive

16 16. plan ( MIP ) to retain executives through the shopping of the company and to incentivize them to encourage the highest-priced deal, and formed an M&A committee to explore a sale. Trados engaged an investment bank to assist in identifying potential alternatives for a merger or sale of company. The investment bank initially identified twenty seven potential buyers of Trados, and contacted seven of them, including SDL, the eventual acquiror. SDL made an acquisition proposal in the $40 million range, which the board rejected. The new CEO was beginning to improve Trados s financial condition, but the Trados board continued to negotiate transactions over the next several months. Eventually, the board approved a merger with SDL for $60 million. Of the $60 million merger consideration, $7.8 million was paid to management according to the MIP and the remaining $52.2 million was paid to the preferred stockholders in partial satisfaction of the $57.9 million liquidation preference. The common stockholders received nothing. Common stockholders first brought an appraisal action. Then, almost three years later, they brought a class action alleging breach of fiduciary duty by the Trados board, arguing that Trados was wellfinanced, profitable, and beating revenue projections at the time of the merger, and that the directors improperly favored the preferred stockholders interests, which were not aligned with those of the common stockholders because of the liquidation preference. Chancellor Chandler denied defendants motion to dismiss, stating that the merger was the worst possible outcome for the common stockholders and that a reasonable inference existed that a majority of the board lacked independence because of their affiliation with the VCs who controlled the preferred. [G]enerally it will be the duty of the board, where discretionary judgment is to be exercised, to prefer the interests of common stock as the good faith judgment of the board deems them to be to the interests created by the special rights, preferences, etc., of preferred stock, where there is a conflict. (quoting Equity-Linked Investors, L.P. v. Adams, 705 A.2d 1040, 1042 (Del. Ch. 1997)). While the board had no discretion to modify the waterfall of liquidation preferences if a merger were approved, it did have discretion (and concomitant fiduciary duties) with respect to whether to pursue the merger in the first place.

17 17. The court was careful to note that the procedural posture required it to pass over inferences that the Merger was in the best interest of the Company because it secured the best value reasonably available... and did not harm the common shareholders because, in fact, there was no reasonable chance that they would ever obtain any value for their stock. 2. Hokanson v. Petty, 2008 Del. Ch. LEXIS 182 (Del. Ch. Dec. 10, 2008) (Strine) In October 2003, Exactech, Inc. invested $1 million in, and agreed to provide up to $5 million in additional loans to, a struggling Altiva Corporation. In exchange for the investment, Exactech received Series C preferred stock and a negotiated buyout option that is, an agreement with Altiva and certain stockholders that gave Exactech an option to purchase all outstanding Altiva securities using a revenue-based formula. In 2007, Exactech exercised its option and entered into a merger agreement with Altiva; application of the formula resulted in merger consideration at the contractual floor. The Altiva board (comprised of Altiva s CEO, Exactech s CEO, and three outside directors who held Series B Preferred Stock) approved by written consent the merger agreement drafted to effect Exactech s option. Based on the preference rights of Altiva stock, the merger consideration was used to pay the Series C preferred stockholders liquidation preference in full and to pay 37.5% of the Series A and Series B preferences, but the common stock received nothing in the merger. Altiva common stockholders alleged that the directors breached their fiduciary duties in approving the merger agreement. Noting that the plaintiffs did not challenge the 2003 investment, the court granted defendants motion to dismiss, rejecting all fiduciary duty claims. VC Strine refused to ignore the practical realities of Exactech s option, which restricted the Altiva board s range of alternatives: Parties cannot repudiate their contracts simply because they wish they had gotten better terms. The Buyout Option and its underlying Contract Price Formula were the cost of capital for Altiva at a time when... it was facing financial ruin.... The fact that it was not enough to ensure a payout to all Altiva shareholders is not a license to deny Exactech the benefits of its bargain.

18 18. The court noted that Exactech was not Altiva s controlling stockholder simply because it held more Altiva stock than any other party (17% prior to the merger) and had one representative on the five-person Altiva board. The court also noted that even if the Altiva board had resisted Exactech s exercise of its option and held out for a higher price, the benefit of breaching the stockholders agreement would not accrue to the common stockholders: because the Series A and B stockholders only received 37.5% of their liquidation preference, even a renegotiation of the agreement that doubled the valuation of Altiva would not put common stockholders in the money. Additionally, the three outside directors and their affiliates were also substantial stockholders in Altiva s Series B preferred stock, which VC Strine took to mean that a majority of the board had strong motivation to consider attempting to bargain for a higher price in order to mitigate their financial losses if that option were at all feasible. 3. LC Capital Master Fund, Ltd. v. QuadraMed Corp., 990 A.2d 435 (Del. Ch. 2010) (Strine) After receiving numerous bids for the company, the QuadraMed board formed a special committee of independent directors to evaluate the bids. The committee discussed with counsel the issue of merger allocation and eventually approved the challenged merger. Under the terms of the challenged merger agreement, the common stockholders of QuadraMed would receive $8.50 per share, and the preferred holders would receive $ per share. The latter value was determined by reference to the preferred stock designation, which gave preferred stockholders the right to convert their shares into common shares in the event of a merger based on a conversion formula. Although the merger consideration was pegged to this conversion right, the preferred stock terms did not specify what preferred shareholders should receive in the event their shares were converted into cash in a merger, i.e., the charter did not include a deemed liquidation provision. The plaintiffs argued that the directors (who were also common stockholders) should not have determined the preferred stockholders allocation based solely on the value of such stock on an as-converted basis. Specifically, the plaintiffs alleged that the preferred stock had certain rights (including a high liquidation preference and a nonmandatory right to dividends) that were relevant to determining the

19 19. amount of consideration holders of such stock should receive that were not considered by the board. The court found that although the preferred stock designation did not mandate that the board give the preferred stockholders the same treatment as the common stockholders in a merger, the preferred stockholders had only bargained for and obtained a limited right: to receive the same consideration that they would have received if they had converted their shares into common shares pursuant to the conversion formula. Because the preferred stockholders were not entitled to a fixed amount upon a merger, the court found that the board could validly favor the common stockholders by providing the preferred stock only the baseline as-converted amount of consideration provided through their conversion rights. The court found relevant that the preferred had no annual right to mandatory dividends and no voting rights on a merger, and that under the terms of the designation, a merger did not trigger the right to receive certain dividends or a liquidation preference payment. (Notably, however, in a lengthy footnote, the court noted that it would be a harder case if (1) preferred stock had an absolute right to mandatory annual dividend payments of a large amount, (2) the company had the ability financially to pay those dividends, (3) the preferred had the right to convert based on a formula, (4) the preferred did not have the right to vote on a merger, and (5) under the certificate of designation, a merger was not a deemed liquidation.) The court also rejected certain claims that the directors in this case possessed a disabling conflict of interest simply because they owned common stock

20 Frederick H. Alexander Morris, Nichols, Arsht & Tunnell LLP 1201 N. Market Street Wilmington, DE (302) Frederick H. Alexander is a member of the Corporate Counseling Group of Morris, Nichols, Arsht & Tunnell LLP, which specializes in providing advice on corporate governance and transactions, including mergers and acquisitions, capital raising and corporate control contests. Mr. Alexander s work often involves counseling boards of directors and board committees, including special committees of directors appointed to negotiate mergers or other significant transactions. His work also involves providing formal legal opinions on issues involving Delaware corporate law and related matters. Mr. Alexander received his J.D., magna cum laude, from the Georgetown University Law Center in He completed his undergraduate education at University of Maryland, receiving a B.A. in Mr. Alexander is the Chairman of the Council of the Corporation Law Section of the Delaware State Bar Association. He is a member of the ABA Committee on Corporate Laws, the Editorial Board of the ABA Task Force on Public Company Acquisitions, and also serves on the ABA Task Force on Shareholder Proposals. Mr. Alexander was named one of the 500 leading lawyers in the United States in the 2010, 2009 and 2008 editions of the Lawdragon guide, and is one of five lawyers listed in the top category for Delaware Corporate/M&A lawyers in the 2010 edition of Chambers USA: America s Leading Lawyers for Business. He is also listed in the Best Lawyers in America and Super Lawyers Magazine. He is the co-author of The Delaware Corporation; Legal Aspects of Organization and Operation 1-4th C.P.S. (BNA 2010) and has written numerous articles, including Power to the Franchise or the Fiduciaries?: An Analysis of the Limits on Stockholder Activist Bylaws (Delaware Journal of Corporate Law, 2008); An Optimal Mix of Clarity and Flexibility (Delaware Lawyer Spring 2008); The Nuts and Bolts of Majority Voting, Corporation (Aspen Publishers), Analysis of the 2005 Amendments to the Delaware General Corporation Law (Aspen Law & Business 2005); Delaware Supreme Court Decision On Protection Of The Stockholder Franchise, 35 Sec. Law & Regulation, 243 (BNA 2003); Delaware Supreme Court Addresses Deal Protection, Enjoins Acquisition In Omnicare, Inc. v. NCS Healthcare, Inc., 6 Mergers & Acquisitions, 101 (BNA 2003)

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23 Melissa A. DiVincenzo Morris, Nichols, Arsht & Tunnell LLP 1201 N. Market Street Wilmington, DE (302) Melissa A. DiVincenzo is a partner in the Delaware Corporate Law Counseling Group at Morris, Nichols, Arsht & Tunnell LLP. She provides advice on corporate governance matters and various corporate transactions, including initial public offerings, mergers, asset sales, domestications and financing transactions. Ms. DiVincenzo s work involves guiding Delaware corporations on the requirements of the Delaware General Corporation Law, counseling boards of directors and board committees with respect to fiduciary duties, and providing formal legal opinions on issues of Delaware law. Ms. DiVincenzo received her J.D., magna cum laude, from The Dickinson School of Law of The Pennsylvania State University in She completed her undergraduate education at Mount Saint Mary s University, receiving a B.A., magna cum laude, in Ms. DiVincenzo is a member of the State Bar of Delaware and the Delaware State Bar Association. She is a member of the Committee on Mergers and Acquisitions of the ABA Business Law Section and is a member of the Judicial Interpretations Working Group of the Subcommittee on Mergers and Acquisitions

24 Patrick A. Pohlen Latham & Watkins LLP Silicon Valley Practice Areas: Global Co-Chair of the firm's Emerging Company Practice Group and a member of the firm's Corporate Department. He is one of the nation's leading attorneys in representing technology, clean technology and life science companies and the financial institutions (venture capitalists and investment banks) that finance them. His practice focuses on general corporate counseling, corporate governance, venture finance, public offerings, securities and mergers & acquisitions. Since 1997, has been ranked nationally in the IPO Journal's listing of the country's top ten IPO lawyers based on the number of initial public offerings completed. Professional Memberships/Accomplishments: Mr. Pohlen currently serves on the Corporate Laws Committee of the ABA. Mr. Pohlen was recently named one of the Top 100 Lawyers in California for 2009 by the Daily Journal and has also been named one of America s Leading Business Lawyers in Chambers USA in 2006, 2007, 2008, 2009 and Mr. Pohlen is a member of the California and New York bar associations. Publications and Lecturer: Mr. Pohlen has been guest lecturer and publisher of materials for several Practicing Law Institute seminars, including Securities Offerings and Securities Laws and Internet. He has also been an instructor at the University of Iowa College of Law, the University of Iowa College of Business and has been a guest lecturer for the Executive MBA Program at Rockhurst College. Civic/Community Involvement: Mr. Pohlen served as President of the Silicon Valley Branch of the Juvenile Diabetes Research Foundation (JDRF) and on the Board of Directors of the Bay Area Chapter of JDRF. Mr. Pohlen has also served on the Board of Directors of the Menlo-Atherton Little League (MALL) and has been active with MALL in numerous other capacities. Mr. Pohlen served on the Board of Directors of the Atherton Civic Interest League. Mr. Pohlen currently serves on the Board and is an advisor to St. Francis High School, Mountain View, California, and numerous affiliated entities. Education: BA degree from the Iowa State University. Mr. Pohlen was a member Phi Beta Kappa at Iowa State University. Mr. Pohlen received a Law Degree from University of Iowa College of Law, where he graduated with distinction. Personal: Married. Three children. SV\

25 Herbert S. Wander Katten Muchin Rosenman LLP Chicago Practice Areas: Concentrates on all aspects of business law, especially corporate governance, securities law and M&A. Has been the chief legal architect for many negotiated and hostile major M&A transactions. The SEC Chairman appointed him to Co-Chair the SEC s Advisory Committee on Smaller Public Companies. Professional and Civic Memberships: Past Chair of the American Bar Association s ( ABA ) 53,000 member Business Law Section ( BLS ). Current Chair of the Committee on Corporate Laws of the BLS. Was a member of the ABA s Commission on Multidisciplinary Practice and the Task Force on Attorney Client Privilege. Past President of the Jewish Federation of Metropolitan Chicago; Chair of the Michael Reese Health Trust; Director of Telephone & Data Systems Inc., a $3.3 billion public market cap telecommunications company. Has served two terms as a member of the Legal Advisory Committee to the New York Stock Exchange. Publications and Lecturer: Authored numerous articles in various publications including the Yale Law Journal, the Business Lawyer and the Northwestern University Law Review. Editor of Volume 49 of The Business Lawyer. Frequently speaks at institutes and programs of various business and legal organizations. Personal: BA degree from the University of Michigan and a Law Degree from Yale Law School, where he served on the Yale Law Journal.