The Frederick Hsu Living Trust v. ODN Holding Corp.: The Court of Chancery Addresses the Legality and Equity of Preferred Stock Redemption
May 25, 2017
In The Frederick Hsu Living Trust v. ODN Holding Corp., 2017 WL 1437308 (Del. Ch. Apr. 25, 2017), the Court of Chancery dismissed claims of unlawful redemption of preferred stock by ODN Holding Corporation (“ODN” or the “Company”), but denied a motion to dismiss claims that ODN’s directors and officers improperly favored the interest of the Company’s controlling stockholder in connection with the Company’s redemption of preferred stock to the detriment of the long-term interests of ODN’s stockholders.
In 2008, funds sponsored by venture capital firm Oak Hill Capital Partners (“Oak Hill”) invested $150 million in internet technology company Oversee.net, which formed ODN as a holding company to facilitate the investment. Oak Hill received shares of Series A Preferred Stock from the Company in return for its investment. The terms of the preferred stock included a mandatory redemption right after five years—provided that ODN had sufficient surplus, calculated in accordance with Section 160 of the Delaware General Corporation Law (the “DGCL”), and “funds legally available” to effect the redemptions. The Company had an obligation to generate funds for redemptions through “‘reasonable actions (as determined by [ODN’s] Board of Directors in good faith and consistent with its fiduciary duties).’”
Plaintiff alleged that, beginning in 2011, Oak Hill caused the Company to shift from a growth-oriented strategy to a single-minded focus on amassing cash reserves that could be used for redemptions, beginning with selling two of ODN’s four lines of business for a third of the price it had paid for them. By the end of 2012, the Company had accumulated a $50 million reserve. Shortly before Oak Hill’s redemption rights became exercisable, ODN appointed a special committee tasked with evaluating the Company’s options for raising capital and negotiating the terms of any redemptions. In turn, the special committee tasked three ODN officers with creating a proposal for Oak Hill. The officers, whose employment agreements granted them special payments if the Company redeemed at least $75 million of the preferred stock, advised the special committee that the Company required a cash reserve of only $10 million. They proposed that the Company use the remaining $40 million of accumulated cash and borrow an additional $35 million in order to redeem $75 million worth of the preferred stock, conditioned upon Oak Hill’s agreement not to seek redemption of the rest of its preferred stock until 2017. This proposal was unacceptable to Oak Hill, and the Company and Oak Hill were unable to reach an agreement before the redemption right matured.
On February 1, 2013, Oak Hill informed the special committee that it intended to exercise its redemption right on February 13, the earliest possible date. Knowing that the Company did not have sufficient funds to redeem the preferred stock in full, Oak Hill proposed that the Company make a redemption payment of $45 million. In exchange for this payment, Oak Hill would agree to delay additional redemption payments until year-end 2013, but would have the right to cancel the forbearance agreement and demand additional redemptions on thirty days’ notice. Despite the fact that Oak Hill had no ability to compel the Company to make redemptions except out of legally available funds, the accrual of which was subject to the board’s business judgment, the special committee resolved to recommend that the board accept Oak Hill’s terms. The special committee realized that redeeming $45 million would leave the Company with a reserve of only $5 million, but the officers had revised their assessment of the necessary cash reserve down to $2 million.
On February 13, 2013, Oak Hill demanded redemption in full. The Company reclassified Oak Hill’s preferred stock as a current liability on its balance sheet in the amount of $150 million in accordance with generally accepted accounting principles (“GAAP”). When the board met to consider Oak Hill’s redemption demand on February 27, 2013, however, it did not treat the preferred stock as a current liability, which would have resulted in the Company having a deficit of $60 million and being unable to redeem any of the preferred stock. The board instead concluded that the Company had sufficient surplus as required by Section 160 of the DGCL to redeem $45 million of preferred stock. ODN made the $45 million payment to Oak Hill on March 18, 2013. Over the next year and a half, the Company implemented a restructuring and sold all but two segments of its business, and used the funds generated by these actions to complete a second redemption of $40 million in September 2014. The aggregate $85 million in redemption payments triggered the officers’ bonuses.
On March 15, 2016, plaintiff sued, alleging that the Company unlawfully redeemed the preferred stock and that by deliberately selling 92% of the income-generating assets of ODN to amass enough cash to effect the redemptions, various defendants breached their duty of loyalty, aided and abetted those breaches, or were unjustly enriched.
The Court rejected the claim that the redemptions violated Section 160 of the DGCL. Notwithstanding the Company’s GAAP-driven reclassification of the preferred stock as a current liability, the Court determined that ODN had sufficient surplus at the time of the redemption. The Court explained that Delaware law treats preferred stock as equity rather than debt, and even a matured redemption right does not convert the holder of preferred stock into a creditor. The Court also held that the complaint failed to plead facts supporting a reasonable inference that the Company would become insolvent as a result of the redemptions, noting that the Company still had $23 million in net assets following the redemptions and a reduced need for cash given its reduced operational footprint.
However, the Court denied the motion to dismiss the claims of breach of fiduciary duty, except as to one director who had resigned in 2011. The Court allowed claims to proceed against the directors (including Oak Hill’s designees on the board, who had abstained from the votes to redeem Oak Hill’s preferred stock), the officers, and Oak Hill itself (both as controlling stockholder and as an alleged aider and abettor).
The Court discussed at length the interplay between the directors’ fiduciary obligations—which generally oblige them to strive to maximize value for the benefit of residual claimants, and do not oblige them to protect preferred stockholders’ special contractual rights—with the Company’s contractual obligation to “take all reasonable actions (as determined by the [ODN] Board of Directors in good faith and consistent with its fiduciary duties)” to generate sufficient legally available funds to redeem the preferred stock. The Court rejected the claim that the Company’s contractual obligation to Oak Hill superseded the directors’ fiduciary duty to the stockholders, writing that “[e]ven with an iron-clad contractual obligation, there remains room for fiduciary discretion because of the doctrine of efficient breach.” The Court observed that plaintiff alleged that the directors acted disloyally by selling off ODN’s businesses to raise cash to satisfy a future redemption obligation before any contractual obligation to redeem Oak Hill’s preferred stock existed, an allegation that was strengthened by the fact that the redemption provisions contained a fiduciary out to the board’s obligation to raise funds to pay for the redemption.
The Court also discussed the standard of review applicable to a transaction involving a controlling stockholder. Noting that the complaint alleged that Oak Hill exercised control over several of the challenged decisions and that the members of the special committee were subject to well-pleaded allegations of breach of the duty of loyalty, the Court determined that the use of a special committee, without a separate majority-of-the-minority stockholder vote, would not suffice to reduce the standard of review from entire fairness to business judgment. The Court further held that the allegations of misconduct against the special committee members were sufficient to preclude the Court from determining at the pleading stage that the use of the special committee shifted the burden of proof under the entire fairness standard from the defendants to the plaintiffs.