Delaware Ruling Provides Cautionary Tale Against Favoring Preferred Stockholders
In a recent decision, the Delaware Court of Chancery refused to dismiss a breach of fiduciary duty claim accusing a board of directors of improperly favoring the interest of the company’s controlling stockholder to the detriment of the long-term interests of its common stockholders.
In 2008, the venture capital firm Oak Hill Capital Partners invested $150 million in a company called Oversee, which provides marketing solutions to online publishers and advertisers. A new corporation, ODN Holding Corp., was formed to facilitate the transaction. In return for the cash, Oak Hill received shares of preferred stock, which gave it the ability to exercise a mandatory redemption beginning five years after the investment. In the event ODN did not have enough funds available to redeem the stock, it would make redemption payments as funds became available.
Frederick Hsu, a founder of ODN, brought a lawsuit against the company’s board of directors in 2016 alleging, among other things, a breach of fiduciary duty of loyalty. The complaint contends that Oak Hill lost faith in the company’s ability to grow, so instead caused ODN to alter its business strategy by no longer focusing on growth and instead seeking to accumulate cash that could be used for redemptions.
In decision April 14, Vice Chancellor J. Travis Laster refused to dismiss the claim, saying the complaint adequately pled that the actions taken by the directors were unfair. Citing the Chancery Court’s 1997 decision in Equity-Linked Invs., L.P. v. Adams, the court said when discretionary judgment is required, it is generally the duty of the board of directors to prefer the interests of the common stockholders to the interests created by the special rights of preferred stock. Holders of preferred stock are entitled to fiduciary duty protection only when they rely on a right shared equally with common stockholders.
While the decision acknowledged the contractual obligation to redeem the preferred shares held by Oak Hill, it said the company took steps to satisfy the redemption before there was any obligation to do so. The company reversed a long-time business plan that focused on achieving growth and began to stockpile cash, divesting major assets at prices that were substantially less than what it paid to acquire them. For instance, it sold “the crown jewel” of its then-lone remaining business line for $600,000, after acquiring it four years earlier for $17 million.
“It can be reasonably inferred that the directors acted to maximize the value of Oak Hill’s Preferred Stock rather than seeking to promote the long term value of the Company for the benefit of the undifferentiated equity, and that the resulting transactions were unfair to the Company’s common stockholders,” the vice chancellor wrote, though he emphasized the case was still in its early stages.
Venture capital funds will commonly negotiate a right of redemption as part of their strategy to exit an investment in a startup. This decision makes it clear that directors may be in breach of their fiduciary duties when their actions favor the interests of the preferred stockholders over the holders of common stock. Even when faced with a mandatory redemption obligation, the board has a duty to common stockholders in figuring out how to meet that obligation.