Not so very long ago, a typical venture capital investment scenario involved a succession of investments at ever increasing valuations, a near-term liquidity event and realization of substantial returns. But as valuations have plummeted and companies seeking capital have fought to survive, provisions for protecting preferred stock investors have taken on new significance. The recent decision of the Delaware Court of Chancery in a case brought by Benchmark Capital against one of its portfolio companies and a host of other defendants illustrates the importance that technical provisions can have in distressed situations, and it demonstrates that investors in preferred stock may not have the protections they think they have bargained for1.
The Benchmark case involves a series of investments in Juniper Financial Corp., a financial services company focused primarily on issuing credit cards. Benchmark Capital initially acquired $20 million of Series A preferred stock in June of 2000. Two months later, Juniper followed with a $95.5 million Series B preferred round, with Benchmark contributing another $5 million. Nearly a year later, after negotiations relating to a possible acquisition stalled, Canadian Imperial Bank of Commerce (CIBC) invested $145 million in senior Series C preferred stock that gave CIBC majority control of Juniper, including the right to elect a majority of the board. The Series A and Series B investors, faced with the loss of control of the company, successfully negotiated for a series of protective provisions in exchange for their consent to the transaction. Among these were approval rights for (a) any amendment to Juniper’s charter that would “materially adversely change the rights, preferences or privileges” of the Series A and Series B preferred stock, (b) any sale of substantially all of Juniper’s assets, consolidation or merger (other than any merger with a wholly-owned subsidiary), and (c) any authorization or issuance of additional equity securities ranking senior to or on a parity with the Series A or Series B. CIBC in turn obtained the right to “trump” these Series A and Series B approval rights, but not if the transaction would diminish or alter the liquidation preference or the “other financial or economic rights” of the Series A or Series B preferred, increase the obligations, indemnities or liabilities of the Series A or Series B preferred, or give rise to a breach of any fiduciary duty owed by CIBC under Delaware law. Benchmark stated in its complaint that it agreed to the CIBC transaction only in reliance upon management’s representation that the Series C funding would enable Juniper to reach profitability.
Management’s projection was not realized. By the spring of 2002, Juniper again needed capital, this time to avoid running afoul of regulations applicable to its banking operations. Juniper offered the investment opportunity to its stockholders, as well as others. CIBC, however, was the only willing investor and proposed predictably harsh terms for a new Series D financing. Specifically, the Series D preferred stock to be issued to CIBC would be senior in virtually every respect to the Series A and Series B preferred stock, the liquidation preference of the Series A and Series B preferred stock would be reduced from $115 million to $15 million, the dividend rate for the Series A and Series B preferred stock would be cut, and the as-converted ownership of the Series A and Series B preferred stock would be reduced from 29% to 7%. Although Benchmark had the right to participate in the Series D financing, the investment only made economic sense for an investor-CIBC-that also held Series C preferred stock and its related “full ratchet” anti-dilution rights.
Juniper initially considered affecting the Series D financing by amending its corporate charter. After recognizing that the protective provisions of the Series A and Series B preferred stock could prevent that action, however, Juniper shifted the structure of the transaction to a merger, relying on an exception to the Series A and Series B approval rights for parent-subsidiary mergers (a provision often included to facilitate corporate housekeeping but a Trojan horse in this case). By making the substantial changes to the rights of the existing preferred stock through a merger with a wholly owned subsidiary, formed solely for purposes of the transaction, CIBC and Juniper were able to take the position that the Series A and Series B preferred had no right to veto the merger or the Series D financing.
A special committee of Juniper’s board formed to review the transaction made a number of proposals for alternative terms, including that CIBC waive its “full-ratchet” anti-dilution protection in connection with the investment. All of these were rejected by CIBC. With its back to the wall, the special committee then approved the transaction as originally proposed by CIBC.
Facing a loss of its investment, Benchmark fought back, seeking an order from the Delaware Court of Chancery to enjoin the transaction on the grounds that the merger/Series D issuance violated its separate approval rights. The Court denied Benchmark’s injunction request on all counts. Its stated basis for that rejection is noteworthy because it underscores the literal approach the Delaware courts take in interpreting preferred stock terms and suggests the implications of that approach.
Specifically, the Court of Chancery ruled that (a) no class vote was required to alter the rights and preferences of the Series A and Series B preferred stock, or the authorization of the new Series D senior preferred stock, because these changes were effected through a merger and not through a charter amendment, and (b) the issuance of the new senior preferred stock was permissible because the words “other financial or economic rights” were too broad and general to be given effect, at least in the context of Benchmark’s request for a preliminary injunction. Juniper’s need for funding and the absence of other willing investors also factored into the court’s decision to deny the preliminary injunction request.2 Juniper subsequently completed the subsidiary merger and closed the Series D financing. As of this writing, Benchmark has not appealed the Court of Chancery decision and the case remains pending.
On one level, the result in Benchmark may surprise observers, particularly venture capital investors. The economic outcomes Benchmark plainly sought to avoid-substantial reduction of its preference, subordination to new investments, significant dilution, and material impairment of its financial and economic rights-were permitted notwithstanding a detailed set of contractual provisions designed to prevent them. Yet when viewed in the context of prior Delaware cases, the decision was predictable because it followed established concepts of Delaware corporate law. The court particularly relied on the decision of the Delaware Supreme Court in Elliot Associates L.P. v. Avatex Corp., in which Avatex’ attempt to eliminate its investors’ preferred stock through a subsidiary-parent merger was thwarted by charter language barring any alteration of the investors’ rights or preferences “by merger, consolidation or otherwise.” Indeed, the Court of Chancery in Benchmark found it significant that the Benchmark preferred stock had been drafted after the Avatex decision, inferring that the drafters of Juniper’s charter must have intended to permit changes to the Series A and Series B preferred stock through mergers because they omitted these magic words. The court’s opinion reaffirmed that preferred stock rights in Delaware are contractual in nature, that any rights, preferences and limits of preferred stock must be “expressly and clearly stated” and will not be “presumed or implied,” and that extrinsic evidence of the parties’ intent will be considered only when the plain language of the preferred stock is ambiguous. The Benchmark decision is also consistent with a long-standing principle of Delaware corporate law in favor of uniformity and certainty in the provisions of financial instruments.
Benchmark has significant implications for emerging growth companies and investors alike. The decision could represent the tip of an iceberg with respect to certain “standard” preferred stock terms that, in light of the Delaware cases, may be found to be ambiguous or imprecise. For example, many preferred stock provisions give investors a preference-sometimes on a “double dip” basis-not only in liquidation (a relatively rare occurrence) but also in the event of a merger (a common exit event). The charter language used to affect this concept often is a simple statement to the effect that “a merger shall be regarded as a liquidation.” Some attorneys believe that this phrase may not be sufficiently precise to give effect to the preference if challenged.
Benchmark may also portend other shifts, particularly in the current investment environment. First, it may signal an increased willingness of private equity investors to resort to litigation to resolve disputes rather than resolving them through private, behind-the-scenes negotiation. If that were to occur, it would parallel the increasing incidence of litigation between limited and general partners. Second, as judicial decisions focus investors on the literal construction afforded preferred stock rights, new “standard language” may emerge that seeks to define ever more precisely the rights to which preferred stock investors are entitled and to close every avenue new investors might pursue in seeking to sidestep those rights. Finally, it is conceivable (but probably not likely) that investors may consider whether states other than Delaware-the historic jurisdiction of choice for many emerging company incorporations-might afford better protection for their investments. Massachusetts’ corporate statute, for example, requires a class vote from any class of stock that is adversely affected in a merger (as defined) unless the company’s charter otherwise provides.
What lessons does the Benchmark case offer investors? With due recognition of the difficulty of drafting contractual provisions that anticipate every future contingency, and of the fact that early investors are likely to suffer dilution and loss of rights in down rounds unless they continue funding, the court’s decision in Benchmark suggests several practical steps for investors to take.
* Include specific references to mergers. Preferred stock covenants, whether comprehensive or narrow in scope, should preclude action by “merger, consolidation or otherwise” to assure that an issuer cannot avoid the charter amendment process via a merger, at least in the absence of a merger that involves an actual sale of the company.
* Use anti-impairment clauses. In addition to a clearly stated (and comprehensive) list of prohibited actions, preferred stock terms in some cases include a general anti-impairment clause and/or statement of intent. Under such a clause, holders of preferred stock must approve any action that adversely affects or harms the interests of the preferred stock (as opposed to simply altering its privileges, rights or preferences, a narrower concept). Benchmark’s preferred stock contained such an anti-impairment clause, but it only applied to the anti-dilution rights.
* Clearly state merger/sale preferences. To avoid disputes and possible challenges, merger preference provisions should be very clearly stated and should set forth how the preference actually will operate in a merger (a required preferential exchange rate, for example) or an asset sale (redemption of the preferred stock for the greater of its preferential amount or the as-converted value, for example), rather than simply referring to provisions that govern liquidations. Investors should also consider protecting their preferred position in other types of transactions that effectively constitute liquidity events, such as recapitalization/redemption transactions, founder sales and other changes of control.
* Include examples. Inclusion of mutually acknowledged examples illustrating the operation of economic concepts and formulas, particularly in situations involving adjustable preferences and/or conversion rates or complex, multi-class capital structures, can further reduce the potential for disputes at the time of a liquidity event.
* Consider “qualified sale” provisions. The Benchmark decision may encourage investors to seek the right to approve any merger or charter amendment, without exception. In cases where an absolute block on charter amendments or mergers is not appropriate, investors can use a “qualified sale” provision, in which investor consent to a sale is not required as long as a specified return is achieved, the consideration consists of cash and/or liquid securities, and escrow/indemnity obligations are limited.
* Be careful of “innocuous” exceptions. Preferred stock investors should be careful about accepting apparently innocuous covenant exceptions that permit transactions such as internal reorganizations, parent-subsidiary mergers and reincorporations. For example, if a corporate issuer were to reorganize to an LLC form of organization, tax exempt and foreign investors would suffer adverse U.S. tax consequences. Similarly, reincorporation to another state can result in erosion of an investors’ rights.
* Focus on board process. Issuers and investors must continue to focus on the process by which their boards approve transactions, particularly in the case of dilutive down rounds. The Benchmark decision, as noted, did not address the plaintiffs’ allegations of conflict of interest and breach of fiduciary duty. Future investors in Benchmark’s position may rely on fiduciary duty claims as well as contractual charter provisions in seeking to protect their investments, particularly given the Delaware courts’ relatively strict interpretation of preferred stock terms.
Issuers and investors alike have a common interest in crafting preferred stock terms that are clear and understandable and that produce predictable results. Preferred stock, after all, is the most widely used financial instrument in the emerging company context and many fortunes depend on its validity. Benchmark and Avatex stand as reminders of the importance that the fine print in preferred stock can have. As a result, next-generation transaction terms, drafted in an environment where the risks of dilution and subordination are readily apparent, are likely to be sharpened. Of course, on a rising tide these improved protections will be irrelevant, but in turbulent seas when they are needed most they will provide shelter from the storm.
Michael Kendall and John LeClaire are partners of Goodwin Procter LLP and members of its Private Equity Group. LeClaire is co-chairman of the Private Equity Group.