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«First Principles for Addressing the Competing Interests of Common and Preferred Stockholders in an M&A Transaction When engaged by a Delaware ...»

First Principles for Addressing the Competing Interests of

Common and Preferred Stockholders in an M&A Transaction

When engaged by a Delaware corporation with a common and preferred stock

capital structure to provide advice in an M&A transaction, counsel should expect

to face a complicated array of legal issues posed by the potentially competing

nature of the interests of the common and preferred stockholders. Among other

issues, counsel will be expected to advise the board on (i) how to account for the frequently competing, occasionally antagonistic, interests of common and preferred stockholders, (ii) how to overcome, or insulate the board from, potential conflicts October 2010 within the boardroom, and (iii) the process to be used for determining the allocation of merger consideration among the common and preferred. In connection with such Mark A. Morton is a partner and Pamela L. an M&A transaction, board counsel will be expected to provide clear and reliable Millard is an associate guidance on these issues.

in the law firm of Potter Anderson & Corroon LLP.

This primer sets forth a series of “first principles” to be considered when providing The views expressed advice to boards of directors on their obligations in connection with M&A transactions herein are solely those involving common and preferred stock. Among other things, the primer addresses of the authors and may the contractual nature of preferred stock, whether the contractual rights of preferred not be representative of the firm or its clients. stock may be negated or compromised, how the contractual rights of preferred stock This article was first intersect with the board’s fiduciary duties, and whether there are circumstances presented at the 6th in which the board may favor the interests of common stockholders over those of Annual Mergers and preferred stockholders.

Acquisitions Institute at the University of Texas School of Law on September 30, 2010.

Fiduciary Duties of Directors Under Delaware law, directors manage the business and affairs of the corporation.1 In fulfilling their managerial responsibilities, directors of Delaware corporations are charged with a fiduciary duty to the corporation and to all the corporation’s

stockholders.2 The fiduciary obligations of directors fall into two broad categories:

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Applying these rules of construction, the Delaware courts have, on a number of occasions, permitted companies to undertake transactions designed to avoid triggering or to affirmatively negate protective provisions of preferred stock. For example, there is a “long line of Delaware cases which, in general terms, hold that protective provisions drafted to provide a class of preferred stock with a class vote before those shares’ rights, preferences and privileges may be altered or modified do not fulfill their apparent purpose of assuring a class vote if adverse consequences flow from a merger and the protective provisions do not expressly afford protection against a merger.”22 Thus, in Warner Communications,23 the Court of Chancery considered whether the holders of a series of preferred stock

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30 Id. at 855.

31 See Equity-Linked, 705 A.2d at 1057 (holding that, while “the board did, in effect, … try on behalf of the common to exploit the preferred,” the holders of preferred stock were “open to this risk legally” as “a function of the terms of its security”).

32 Jedwab, 509 A.2d at 594.

33 Jackson Nat’l Life Ins. Co. v. Kennedy, 741 A.2d 377, 387-89 (Del. Ch. 1999).

34 See, e.g., Jedwab, 509 A.2d at 594 (finding that a preferred stockholder’s claim that merger proceeds were unfairly allocated “implicate[d] fiduciary duties and ought not be evaluated wholly from the point of view of the contractual terms of the preferred stock designations”); In re FLS Holdings, Inc. S’holders Litig., 1993 WL 104562, at *4 (Del. Ch. Apr. 2, 1993) (finding that “[i]n allocating the consideration of this merger, the directors, although they were elected by the common stock, owed fiduciary duties to both the preferred and common stockholders, and were obligated to treat the preferred fairly”), aff’d sub nom. Sullivan Money Mgmt., Inc. v. FLS Holdings, Inc., 628 A.2d 84 (Del. 1993) (TABLE); see also Fletcher, 2010 WL 2173838, at *7.

35 HB Korenvaes Invs., L.P. v. Marriott Corp., 1993 WL 205040, at *6 (Del. Ch. June 9, 1993).

First Principles for Addressing the Competing Interests of Common and Preferred Stockholders in an M&A Transaction █ 7

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36 Id.

37 Moore, 1995 WL 662685, at *6. When preferred stockholders assert fiduciary claims that relate to obligations expressly addressed in the certificate of designations, the Court “will review those claims as breach of contract claims and the claims for breach of fiduciary duty will be dismissed as superfluous.” Fletcher, 2010 WL 2173838, at *8 fn 57 (quoting MCG Capital Corp., 2010 WL 1782271, at *15).

38 See Equity-Linked, 705 A.2d 1040.

39 2009 WL 2225958, at *7 (Del. Ch. July 24, 2009) (quoting Equity-Linked, 705 A.2d at 1042).

40 Id. (citing Blackmore Partners, L.P. v. Link Energy, LLC, 864 A.2d 80, 85-86 (Del. Ch. 2004)). In transactions that require the approval of preferred stockholders, where the preferred seek to negotiate certain benefits in exchange for such approval, if a better transaction becomes available that favors the interests of the common stockholders, and does not interfere with the rights of the preferred, the board may therefore be required to take a position directly hostile to the interests of such preferred stockholders.

First Principles for Addressing the Competing Interests of Common and Preferred Stockholders in an M&A Transaction █ 8

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In ruling in favor of QuadraMed’s directors, the Court of Chancery denied the injunction on the grounds that the preferred stockholders could not demonstrate that the board likely breached its fiduciary duties to the preferred stockholders.63 According to Vice Chancellor Strine, once a board of directors honors the preferred stockholders’ contractual rights, “it

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69 LC Capital Master Fund, 990 A.2d at 452 (Del. Ch. 2010).

70 Id. at 453. The Court in In re Trados stated with regard to such material self-interest that “the benefit received by the director and not shared with stockholders must be ‘of a sufficiently material importance, in the context of the director’s economic circumstances, as to have made it improbable that the director could perform her fiduciary duties … without being influenced by her overriding personal interests.’” In re Trados, 2009 WL 2225958, at *6 (citations omitted).

71 See LC Capital Master Fund, 990 A.2d at 448-49; see also HB Korenvaes, 1993 WL 205040, at *7.

72 See MCG Capital Corp., 2010 WL 1782271, at *15; In re Trados, 2009 WL 2225958, at *7.

73 See LC Capital Master Fund, 990 A.2d at 438; Equity-Linked, 705 A.2d at 1057.

First Principles for Addressing the Competing Interests of Common and Preferred Stockholders in an M&A Transaction █ 13 committee comprised of independent directors,74 securing a majority of the minority stockholder vote or, in the appropriate case, hiring an independent financial advisor to opine on the fairness of the allocation of merger consideration between a majority and minority interest, or permitting a representative of the minority interest to participate directly in negotiations concerning the allocation of merger consideration.75 In the case of a private equity firm making an initial investment in a portfolio company, In re Trados further suggests that preferred stockholders should consider negotiating “dragalong” rights that would allow such stockholders to force through a sale of the company, particularly if the firm secures designated board representation as a condition of its investment.76 Finally, the recent jurisprudence emphasizes the difficulty directors face if they are asked to support a sales transaction that favors the contractual interests of preferred stockholders over the residual interests of common stockholders.

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In Kennedy, two letters sent to a preferred stockholder failed to mention an impending sale of assets that would have rendered the preferred stockholder’s shares valueless.80 According to the Court, the omitted information would have significantly affected the plaintiff’s exercise of its contractual rights.81 Similarly, in Eisenberg, the Court found the board’s disclosures misleading because they listed business and cost-saving rationales as the purposes for the corporation’s self-tender offer, when the record showed that the true purpose was to take advantage of the unusually low price of the preferred stock.82 While

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83 Id. at 1060.

84 Id. at 1057.

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