A recent decision of the Delaware Court of Chancery (the “Court”) places certain fiduciary constraints on a company’s ability to satisfy its obligations to its preferred equity holders. While investors often seek to acquire preferred stock in return for their investments, the Court’s decision in The Frederick HSU Living Trust v. ODN Holding Corporation (“ODN”) et al., makes it clear that actions taken by a company in connection with the payment of such preference will be subject to the fiduciary duties that a company’s board owes to its holders of common stock.

Plaintiff, a founding stockholder of ODN Holding Corporation (the “Company”), brought an action against the Company’s board of directors (the “Board”) alleging, among other things, breach of fiduciary duty in connection with the redemption of preferred shares owned by the Company’s controlling stockholder, the venture capital firm Oak Hill Capital Partners (“Oak Hill”). As consideration for Oak Hills’s investment in the Company, Oak Hill received shares of preferred stock in the Company, carrying a mandatory redemption right exercisable by Oak Hill five (5) years after the investment (See id. at 6). In the event that the Company did not have sufficient funds to redeem the preferred stock at the time of exercise, the Company agreed to make redemption payments to Oak Hill as funds became available (See id. at 6-7). Plaintiff claimed that Oak Hill caused the Company to alter its business strategy prior to the time that the redemption right was able to be exercised, prioritizing the hoarding of cash to satisfy Oak Hill’s redemption demand rather than fostering the growth and development of the Company for the benefit of the common holders (See id. at 10-14). This included selling two (2) of the Company’s primary lines of business in an effort to raise capital to fund such redemption, and failing to use funds to pursue acquisitions, as was the Company’s prior practice (See id.). As a result of the foregoing, Plaintiff brought several claims against the Company, Oak Hill, and individual members of the Board, among which was a claim for contravention of the Board’s fiduciary duty of loyalty to the holders of the Company’s common stock (See id. at 21).

With respect to the fiduciary duty claim, the Court held in favor of Plaintiff, denying Defendants’ Motion to Dismiss. The Court’s rationale centered on the premise that a company’s board of directors has a fiduciary obligation to maximize the long-term value of the company for the benefit of holders of its “undifferentiated equity” (i.e. its common stock) (See id. at 36-37). The Court distinguished the rights of preferred holders as contractual in nature, entitling them to fiduciary duty protection only to the extent their interests align with the interests of the common holders (See id. at 41 and 44). While the Court readily acknowledged the contractual obligation to redeem the preferred shares held by Oak Hill, it emphasized that the Board took actions to satisfy the redemption obligation before there was any contractual obligation to redeem. In other words, the Board took actions to maximize the value of the redemption right rather than the value of the common stock, which the Court ultimately held to be a direct breach of the Board’s fiduciary duty of loyalty to the shareholders of the Company.

The Court’s holding in this case reminds investors that, at the end of the day, a board’s primary directive is to maximize the company’s value to its common stockholders, not its preferred holders. Because the rights of the preferred are contractually founded, they must ultimately be subject to the overall interests of the “undifferentiated equity” of a company. From an investor’s perspective, the Court’s decision will likely spur efforts to structure preferred equity obligations in a way that gives the preferred holders the ability to take direct action rather than going through the board, thereby making the fiduciary duty issue a moot point. This may be preferable from a company’s perspective as well, especially in the case of board members who are appointed by holders of preferred stock.

However, in structuring the rights of preferred holders, care should be taken to ensure that the protections do not inadvertently lead to other issues. For example, affording preferred stock too many protections could cause it to fall under the definition of “disqualified preferred stock,” or a similar term contained in a company’s senior credit agreement, if applicable, which could have adverse consequences on the company and all of its equity holders.

The full text of the case, The Frederick HSU Living Trust v. ODN Holding Corporation (“ODN”) et al., can be found here.

Delaware General Corporate Law § 226 (the “Custodian Statute”) bestows the Delaware Court of Chancery with the power to appoint a custodian for solvent companies and receivers for insolvent companies in certain circumstances. See 8 Del. C. § 226. Specifically, a custodian may be appointed where, inter alia, a company’s “stockholders are so divided that they have failed to elect successors to directors whose terms have expired”, and where the business is suffering or threatened with “irreparable injury because the directors are so divided respecting the management of affairs that the required vote for action by the board of directors cannot be obtained and the stockholders are unable to terminate this division.” 8 Del. C. § 226(a)(1), (2). Although a custodian appointed under § 226 shall “continue the business of the corporation and not . . . liquidate its affairs and distribute its assets,” the Chancery Court has wide discretion in how it addresses a deadlock, and may even authorize a custodian to sell a company. See id. The scope of the Chancery Court’s broad discretionary authority to address deadlocks under § 226 was addressed in a recent decision of the Delaware Supreme Court. See Shawe v. Elting, No. 423, 2016, 2017 WL 563963, at *1 (Del. Feb. 13, 2017). Some read that decision as expanding the power of the courts to order the sale of a solvent company’s stock over the objection of the company’s shareholders.

In response to the decision, legislation has been proposed that would restrict the Chancery Court’s ability to dissolve or sell a solvent company by requiring that “alternative remedies prove insufficient after three years”, or the “necessary parties stipulate to such a sale.” Proposed Delaware Senate Bill No. 53.  The purpose of the proposed legislation is to “ensure the continued fair and equitable treatment of corporations in Delaware” by addressing “deficien[cies] in providing fair and equitable remedies in specific regards to deadlock situations.”  Id.  The Delaware Corporate Law Section plans to oppose the bill. The full text of the case, Shawe v. Elting, can be accessed here.

 

Updates and speculation regarding the forthcoming merger between AT&T and Time Warner have dominated the recent news cycle. Many pundits and business professionals have debated whether a vertical merger of such magnitude will survive regulatory scrutiny. The transaction will be reviewed by the Federal Trade Commission (“FTC”) and the Antitrust Division of the Department of Justice (“DOJ”) as per the Hart-Scott-Rodino (“HSR”) Antitrust Improvements Act of 1976 (the “Act”).

The Act requires that parties who are planning to complete certain mergers, acquisitions, and transfers of assets or securities make a comprehensive filing with the FTC and the DOJ. The parties may not finalize the transaction until a determination is made by the agencies as to whether the transaction will negatively influence United States commerce in violation of antitrust laws. Parties may complete due diligence and make plans for post-transaction activities during the agencies’ review.

Effective as of September 1, 2016, the FTC, with the concurrence of the DOJ, adopted new standards concerning HSR filings which are meant to make the process easier and more efficient for filers.

With the new changes, the FTC has authorized filers to make HSR filings by submitting a DVD containing the filing. Filers will retain the option to submit a paper filing, but may not file on any other format, including CDs, flash drives, or SD cards. The filer should submit two DVDs to the FTC and two DVDs to the DOJ for review. If the DVD contains a virus or is either encrypted or password-protected, the submission will be rejected. Any errors with the DVD or the files on the DVD will require a replacement DVD. The DVD filing must include paper copies of the cover letters, original affidavits, and certification pages. All other documentation must be submitted on the DVD if the filer wishes to file by DVD, as there is not an option to file a combination DVD/paper filing.

Additionally, the FTC updated the instructions that apply to the HSR form. While some of the updates relate to filing by DVD, most were implemented in order to streamline the instructions and make them less complicated for filers. The form itself is not affected by these amendments.

The FTC vote to publish the Federal Register Notice was unanimous at 3-0. The Federal Register Notice and the new instructions to the form may be viewed at the following link.

To expedite review, the FTC encourages filers to follow the recommendations located on the “Style Sheet.”

 

The SEC has adopted final rules to address intrastate and small offerings, further expanding and modernizing the manner in which start-ups and other small businesses are able to raise capital.  The final rules amend Rule 147 under the Securities Act of 1933, as amended (the “Securities Act”) to facilitate the continued application of intrastate offering exemptions under State securities laws, including States’ crowdfunding provisions. The rules also create a new exemption, Rule 147A, which will permit general solicitation (including via internet) and will permit sales to residents within a State where the issuer was formed or where such issuer has its principal place of business.  In addition, the final rules amend Rule 504 to increase the aggregate amount of securities that may be offered and sold in any 12-month period from $1 million to $5 million, while repealing Rule 505 that limited such offerings to accredited investors and to up to 35 other persons who do not satisfy the financial sophistication standards.

The new Rule 147A and the amended Rule 147 include the following provisions:

  • A requirement that the issuer either (a) is formed or (b) has its principal place of business within the State in which the securities are sold (without requiring that issuers be incorporated or organized in the State where they are making the exempt offering under the new rules), and that the issuer satisfy at least one “doing business” requirement;
  • A new “reasonable belief” standard for determining the residence of the purchaser at the time of the sale of securities;
  • A requirement that the issuer obtain a written representation from each purchaser regarding the purchaser’s residency;
  • A six-month limit on resales to persons residing within the State or territory of the offering only;
  • An integration safe harbor that would include any prior offers or sales of securities made by the issuer under another provision, as well as certain subsequent offers or resales of securities by the issuer after the completion of the offering; and
  • Disclosure requirements, including legend requirements, regarding limitations on resales.

The amended Rule 504 retains the existing requirements, with the following changes:

  • An increase in the aggregate amount of securities that may be offered and sold in any 12-month period from $1 million to $5 million; and
  • A disqualification of bad actors from participating in an offering (consistent with the requirement of Rule 506).

The final rules also repealed the exemption previously provided under Rule 505. The amended Rule 147 and new Rule 147A will be effective 150 days after publication in the Federal Register.  The amended Rule 504 will be effective 60 days after publication in the Federal Register.  The repeal of Rule 505 will be effective 180 days after publication in the Federal Register.

The final rules are available here.

The recently enacted Fixing America’s Surface Transportation Act (the “Fast Act”) creates a new exemption from the registration requirements of the Securities Act of 1933, for resales of restricted securities, charges the Securities and Exchange Commission (the “SEC”) to study and simplify specified securities laws and amends certain regulations to facilitate capital-raising by emerging growth companies. Provisions of the FAST ACT modify or supplement the Jumpstart Our Business Startups Act of 2012, to further ease certain securities regulation requirements.  Some of the new provisions are effective immediately, while others require further rulemaking or action by the SEC.

Below is a summary of the key securities laws provisions included in the Fast Act:

New Resale Exemption

The Fast Act adds a new Section 4(a)(7) to the Securities Act, effective upon enactment, for secondary sales of restricted securities, subject, among other requirements, to the following conditions:

  • each purchaser is required to be an “accredited investor”, as defined in Rule 501(a) under the Securities Act;
  • the seller, or any person acting on the seller’s behalf, may not engage in any form of general solicitation or general advertising; and
  • unless the issuer is a reporting company under the Securities Exchange Act of 1934, the seller must make available to a prospective purchaser information concerning the issuer, its officers and directors, names of persons receiving commissions for the sale of securities in the offering, recent and prior financial statements, and information on any control persons who are sellers.

Section 4(a)(7) is similar to the exemption developed through SEC guidance and case law, and known as the “Section 4(a)(1 ½)” exemption.  Securities acquired in accordance with the Section 4(a)(7) exemption will continue to be “restricted securities” under the Securities Act and “covered securities” for preemption purposes of State Blue Sky laws. The new Section 4(a)(7) exemption is not exclusive of other available exemptions (including resales under Rule 144).

Easing Smaller Company Registration

The Fast Act mandates the SEC to amend Form S-1 to allow smaller reporting companies to incorporate by reference in a registration statement filings after the effective date of the registration statement.

Simplification of Disclosure Requirements

The Fast Act requires the SEC to study and/or issue rules to:

– to modernize and simplify disclosure requirements;

– revise Regulation S-K to eliminate provisions that are “duplicative, overlapped, outdated, or unnecessary”; and

– permit issues to include a summary page in their annual reports filed on Form 10-K so long as each item in the summary include a cross-reference to material contained in the Form 10-K.

Some Lenience for Emerging Growth Companies

The Fast Act includes provisions related to emerging growth companies  (generally companies with annual revenues of less than $1 billion (“EGCs”)), to:

  • permit EGCs to file a registration statement with the SEC within 15 days (in lieu of 21 days) before the date on which the issuer commences a road show in connection with a public offering;
  • allow an EGC that qualified as an EGC when it commenced the registration process, which subsequently ceases to be EGC, to continue to be treated as an EGC until the earlier of the date on which the issuer consummates its initial public offering or the end of the 1-year period beginning on the date the company ceases to be an EGC, regardless of whether it is no longer an EGC during the registration process; and
  • allow EGCs to omit certain financial information in a registration statement for historical periods otherwise required by Regulation S-X so long as at the time of the filing, the issuer does not believe such information will be required at the time of the offering; provided, that, at the time of distribution, the preliminary prospectus includes all required financial information.

These provisions are either effective immediately or the SEC has advised that it will not object if EGCs apply these provisions immediately.

To discuss these provisions of the Fast Act, please contact either of the authors at:

mpress@coleschotz.com

jhorowitz@coleschotz.com

The Fast Act is available at: https://www.govtrack.us/congress/bills/114/hr22/text.

The SEC’s announcement is available at : http://www.sec.gov/corpfin/announcement/cf-announcement—fast-act.htm and its Compliance and Disclosure Interpretation is available at: http://www.sec.gov/divisions/corpfin/guidance/fast-act-interps.htm.