Richards Layton & Finger

Fiduciary Duties to Preferred Stockholders in a Merger: LC Capital Master Fund, Ltd. v. James

May 3, 2010

In LC Capital Master Fund, Ltd. v. James, C.A. No. 5214-VCS (Del. Ch. Mar. 8, 2010), the Delaware Court of Chancery denied a preferred stockholder’s motion to enjoin the acquisition of QuadraMed Corporation by affiliates of Francisco Partners II, L.P., holding that the directors fulfilled the limited fiduciary duties owed to the preferred stockholders in approving the merger which cashed out the preferred stockholders at a price based upon the preferred stock’s conversion rate to common stock.

Under the terms of the proposed transaction, Francisco Partners would acquire QuadraMed at $8.50 per share of common stock, and the preferred stockholders would be cashed out on an as-if converted basis ($13.7097 per preferred share). The QuadraMed directors sought advice from counsel regarding the permissibility of such treatment of the preferred stockholders, and were advised that the board could adopt a merger agreement that cashed out the preferred stockholders, and that, so long as the board honored the contractual rights of the preferred stockholders in a merger, it did not have to allocate additional value to the preferred stockholders.

The certificate of designation that governed the preferred stockholders’ rights did not afford the preferred stockholders a right to vote on any merger. Though the certificate of designation provided for a liquidation preference of $25 for each share of preferred stock, the certificate expressly stated that a merger did not trigger the preferred stockholders’ liquidation preference. Instead, the certificate essentially provided that in a merger, the preferred stockholders either would receive the consideration determined by the board in a merger agreement or, if the preferred stockholders were not cashed out in the merger, the preferred stockholders had the right to convert their shares and receive (at any time in the future) the consideration received by the common stockholders.

LC Capital moved to enjoin preliminarily the stockholder vote on the merger, arguing that the QuadraMed board breached its duty to make a “fair” allocation of the merger consideration between the common and preferred stockholders. LC Capital argued that to ensure a fair allocation, the board had to designate an agent to negotiate on behalf of the preferred stockholders throughout the allocation process and also retain a financial advisor to value the preferred stock. The plaintiff claimed that these duties were particularly significant in this case because each QuadraMed director owned common stock or common stock options, but not preferred stock.

The Court denied the injunction motion, explaining, “When, by contract, the rights of the preferred in a particular transactional context are articulated, it is those rights that the board must honor. To the extent that the board does so, it need not go further and extend some unspecified fiduciary beneficence on the preferred at the expense of the common.” The Court also found that plaintiff had not advanced facts supporting a reasonable inference that any of the special committee members were materially interested in the transaction, noting, “To hold that independent directors are disabled from the protections of the business judgment rule when addressing a merger because they own common stock, and not the corporation’s preferred stock, is not . . . something that should be done lightly.” Further, the Court concluded that the special committee’s decision to treat the preferred stockholders on an as-if converted basis was made on a thoughtful basis informed by advice of counsel, with no hint of any lapse of care.

In addition to finding that LC Capital had not demonstrated a probability of success on the merits, the Court noted that LC Capital purported to represent 95 percent of the preferred stockholders, that the preferred stockholders had appraisal rights unfettered by an “appraisal out” in the merger agreement, and that the common stockholders would be harmed if the merger were enjoined. Thus, the Court held that the balance of harms also weighed against the issuance of a preliminary injunction.