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					                                   A THEORY OF PREFERRED STOCK
                                             William W. Bratton*
                                                       and
                                             Michael L. Wachter**
                                                     Abstract
Should preferred stock be treated under corporate law as an equity interest in the issuing corporation or
under contract law as a senior security? Should a preferred certificate of designation subsumed in the
corporate charter and treated as an incomplete contract filled out by fiduciary duty, or should it be
treated as a complete contract with drafting burden on the party asserting the right, as would occur with
a bond contract? Is preferred equity or debt? This article shows that preferred is both corporate and
contractual, neither all one nor all the other. It sits on a fault line between two great private law
paradigms, corporate and contract law, and draws on both. The overlap brings two competing
grundnorms to bear when interests of preferred and common stockholders come into conflict in decided
cases: on the one hand, managing to the common stock, as residual interest holder, maximizes value,
while on the other hand, holding parties to contractual risk allocations maximizes value. When
questions arise concerning the relative rights of preferred and common, the norms hold out conflicting
answers. Delaware courts have taken the lead in confronting these questions, seeking to synchronize the
law of preferred stock with the rest of corporate law, a project that leads to both innovation and stress.

This article examines recent preferred cases to show two facets of Delaware law coming to bear as the
synchronization process proceeds--first, reliance on independent directors for dispute resolution, and,
second, the common stock value maximization norm. There follows a tilt toward corporate norms that
disrupts risks allocated in heavily negotiated transactions, particularly in the venture capital sector.
Toward the end of restoring balance between the corporate and contract paradigms, the article makes
three recommendations. First, the meaning and scope of preferred contract rights should be determined
by courts rather than by issuer boards of directors. Second, conflicts between preferred and common
should not be decided by reference to a norm of common stock value maximization. Enterprise value
should be the referent, more particularly, maximization of the value of the equity as a whole. Third,
independent director determinations of conflicts between preferred and common should not be accorded
ordinary business judgment review. Instead, a door should be left open for good faith review tailored to
the context—a showing of bad faith treatment of the preferred where the integrity of a deal has been
undermined, burden of proof on the board.

Table of Contents


*
 Deputy Dean and Nicholas F. Gallicchio Professor of Law; Co-Director, Institute for Law & Economics, University
of Pennsylvania Law School
**
  William B. Johnson Prof. of Law and Economics and Co-Director, Institute for Law and Economics, University of
Pennsylvania Law School. Our thanks to Henry Hu, Travis Laster, Roberta Romano, Gordon Smith, Gil Sparks,
Leo Strine, Eric Wilensky, and participants at the Tilburg University Anton Philips Fund Conference on Institutional
Investors and the Penn Law Institute for Law & Economics Roundtable for their comments and questions.

                                                         1
                                                 INTRODUCTION
        Preferred stock is under theorized.1 The most recent comprehensive study appeared
almost six decades ago.2 Commentary since has been sporadic.3 Yet preferred stock’s economic
salience has increased notably in recent decades. The volume of new preferred offerings
outstrips that of initial public offerings (IPOs) of common stock or new public common offerings
by seasoned issuers.4 Preferred also is the favored mode of investment in the venture capital




1
  We suspect this follows from a judgment that preferred stock is unimportant, a judgment resting on three
assumptions: (1) The law governing preferred is highly technical and largely follows from documentation prepared
by capable corporate lawyers and therefore is unproblematic from a policy point of view. Restating, issues raised by
preferred stock are only tangentially connected to “corporate governance.” (2) Relatively speaking, the incidence
of preferred in corporate capital structures has declined steadily over the last seventy-five years. To the extent
preferred matters today, it matters as regards venture capital, so the relevant subject matter category is venture
capital, which is not under theorized. (3) The law of preferred is simple: the drafter of the charter determines the
outcomes. When there is a litigated case, the preferred almost always loses and for a good reason: It asks for some
sort of implied or fiduciary protection against opportunistic action by the common, action from which the preferred
could have been protected at the drafting stage. This Article will show that these assumptions are no longer safe.
2
  See Richard M. Buxbaum, Preferred Stock—Law and Draftsmanship, 42 Cal. L. Rev. 243 (1954). One of us
frequently consulted Professor Buxbaum’s article when practicing law during the 1970s. We have it on good
authority that corporate lawyers continue to refer to it.
3
  The leading subsequent papers are Victor Brudney, Standards of Fairness and the Limits of Preferred Stock
Modifications, 26 Rutgers L. Rev. 445 (1973), and Lawrence Mitchell, The Puzzling Problem of Preferred Stock
(And Why We Should Care About It), 51 Bus. Law. 443 (1996). There also has been legal scholarship on venture
capital preferred. See William W. Bratton, Venture Capital on the Downside: Preferred Stock and Corporate
Control, 100 Mich. L. Rev. 891 (2002); G. Gordon Smith, The Exit Structure of Venture Capital, 53 UCLA L. Rev.
315 (2005); Jesse M. Fried & Mira Ganor, Agency Costs of Venture Capital Control in Startups, 81 N.Y.U. L. Rev.
967 (2006); Douglas G. Baird & M. Todd Henderson, Other People’s Money, 60 Stan. L. Rev. 1309 (2008).
4
  From 1999 to 2005 U.S. firms issued over $868 billion in preferred stock while raising only $374 billion through
common equity IPOs and only $590 billion through seasoned equity offerings. Jarl G. Kallberg, et al., Preferred
Stock: Some Insights into Capital Structure, at 2, working paper (2008) available at
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1108673.
          Three quarters of the preferred took the form of trust preferred securities, id. at 8, implying that $217
billion was traditional preferred, which is the form discussed in this Article. Trust preferred issues employ a trust,
the common equity of which is owned by the issuer. The issuer sells a subordinated debt security to the trust, which
funds the purchase by selling its own preferred. The issuer thereby gets to deduct the payments as interest. At the
same time, bank issuers count the principal as equity capital for regulatory purposes. Id. Accounting treatments
vary. Id. at 8-9. Since the issuer’s direct obligation is debt, trust preferred does not implicate the sorts of legal
questions treated here. Issues concerning trust preferred payment provisions are treated in Bank of New York
Mellon v. Commerzbank Capital Funding Trust II, 2011 WL 3360024 (Del.Ch.), and QVT Fund LP v. Eurohypo
Capital Funding LLC I, 2011 WL 2672092 (Del.Ch.).

                                                          2
sector.5 Finally, it is much utilized in the financial sector6 —the United States Treasury
purchased more than $200 billion of preferred under the Troubled Asset Relief Program.7
         It is time for a new look. There are three reasons why, the first theoretical, the second
institutional, and the third normative.
A. Corporate Legal Theory
        The theoretical interest concerns the problem of defining the corporation’s boundaries,
asking the “who’s in and who’s out” question regarding the line dividing fiduciary beneficiaries
from contract counterparties. The problem has been traversed extensively in corporate legal
theory8 without anyone noticing the special case of preferred. Its holders are the only corporate
constituents with a participation that straddles the line, being both corporate and contractual. It
follows that resolutions of problems regarding preferred offer special information about the lay
of the corporation’s borderlands.
        The classic common stockholder surrenders capital to the company with no right to pull it
back out, taking the residual financial risk on both the downside and upside and giving up direct
input into business decisions in exchange for a vote at an annual board of directors’ election.
The interest can be viewed contractually, but the contract that emerges is almost entirely
incomplete, with open-ended fiduciary duties substituted for negotiated financial rights.
Whether viewed from within corporate law or through a contractual lens, common stockholders
are “insiders.” Lenders also contribute capital to corporations, often for long periods. But they
do so under contracts that create enforceable financial priorities. The contracts approach
completeness, and courts balk when asked to interpolate additional rights in cases where lenders
find themselves in vulnerable positions.9 Lenders sit “outside” of corporation, and look to
specific, bargained for rights for protection rather than the apparatuses of governance and
fiduciary duty.
        Stockholders are corporate, lenders are contractual, and a well-understood wall separates
their legal treatments. Preferred stock literally straddles the wall. The holder receives a share of
stock issued pursuant to the same corporate code and charter as a share of common stock. The
stock, viewed in isolation, carries the same vulnerabilities as a share of common stock and
subsists in the same regime of rights and duties. The issue then adds contract rights to the stock,

5
  Bratton, supra note 3, at 914-16.
6
  See J. Salutric & J. Wilcox, Emerging Issues Regarding Trust Preferred Securities, SRC Insights, Federal Reserve
Bank of Philadelphia, September 15, 2009.
7
  The Treasury purchased $205 billion in shares of preferred stock from 707 financials under the TARP Capital
Asset Purchase Plan. Additional purchases were made from Citibank, Bank of America, and AIG. Congressional
Budget Office, Report on the Troubled Asset Relief Program, Dec. 16, 2011, at 4-7. For a summary of TARP
disbursements and repayments, see Baird Webel, Troubled Asset Relief Program (TARP): Implementation and
Status, Congressional Research Service, Mar. 4, 2010, at 3-8.
8
  See, e.g., Jonathan R. Macey, Fiduciary Duties as Residual Claims: Obligations to Nonshareholder Constituencies
from a Theory of the Firm Perspective, 84 Cornell L. Rev. 1266 (1999)(stressing that the shareholders’ position as
exclusive beneficiaries is a default rule); Michael C. Jensen, Value Maximization, Stakeholder Theory, and the
Corporate Objective Function, 22 J. Applied Corp. Fin. 32 (2010)(explaining why shareholder value maximization
serves as the corporate objective function).
9
  See, e.g., Metropolitan Life Ins. Co. v. RJR Nabisco, Inc., 716 F. Supp. 1504 (S.D.N.Y. 1989). Employees also
are treated as contract counterparties. See, e.g., Merola v. Exogen, 423 Mass. 461, 668 N.E. 2d 351 (1996).

                                                         3
either financial preferences, or, depending on the case, a debt-like right to be paid sums certain
on set dates.10
       So which is it, equity or debt? Stock and corporate law or senior security and contract
law? Incomplete contract filled out by fiduciary duty or complete contract with drafting burden
on the party asserting the right? These are the central questions posed by the law of preferred
stock. Corporate legal theory holds out no answers. This Article fills the void.
        Preferred stock sits on a fault line between two great private law paradigms, corporate
law and contract law. It is neither one nor the other, but draws on both.11 The overlap catches
up two grundnorms and brings them into conflict—on the one hand, the corporate paradigm
instructs that managing to the common stock, as residual interest holder, maximizes value; on the
other hand, the contract paradigm instructs that holding parties to contractual risk allocations
maximizes value. When questions arise concerning the relative rights of preferred and common,
the paradigms can hold out conflicting different answers. Decision makers choose between the
two. The law vacillates.
       This does not go to say that lines never get drawn. Sometimes clear categorical
placements must be made and preferred is successfully pigeonholed on one or another side of the
debt/equity line. For example, bank capital rules treat preferred as equity; sometimes equity on a
par with common but not always. Generally Accepted Accounting Principles (GAAP) requires
some preferred to be booked as debt, even though formally it is stock, while other preferred is
booked as equity.
        Things get harder and neat results prove elusive when courts address cases in which the
economic interests of preferred and common stockholders come into conflict. Delaware law here
aspires to a clean paradigmatic split, referencing corporate law when the matter concerns a “right
shared equally with the common” and referencing contract law when the matter concerns special
rights and preferences.12 But the overlap is too thick to permit easy compartmentalization.
Decisions are not remitted to the law of debtor-creditor on the “rights and preferences” side of
the binary; rights shared with the common are not defined by exclusive reference to corporate
law. Preferred sits on the line; it is both. Therefore, coherence in treatment cannot follow from
black and white references back to contract or corporate law. Both paradigms come to bear and
decision makers need to look both ways and synchronize the two paradigms’ simultaneous
application.
       This is not easy to do. This Article clarifies the field with close looks at four recurring
points of dispute—equity recapitalizations, allocations of merger proceeds, enforcement of
10
   See Del. Gen. Corp. L. § 151(a)(permitting corporations to issue stock with “such designations, preferences and
relative, participating, optional or other special rights, qualifications, limitations or restrictions” as stated in the
charter).
11
   Contrast convertible bondholders, who are treated as creditors prior to conversion and take equity status only upon
conversion into common. See, e.g., Harff v. Kerkorian, 347 A.2d 133 (Del. 1975)(denying the right to bring a
derivative action). The same goes for a warrantholder, who is treated as a contract claimant prior to exercise despite
having made a species of equity investment in the corporate issuer. See Aspen Advisors LLC v. United Artists
Theatre Co., 861 A.2d 1251 (Del. 2004)(refusing appraisal rights to a warrantholder). Although we know of no law
or commentary on the question, our sense is that trust preferred stock also avoids overlap by separating the debt and
equity aspects of the interest into two securities. See supra note 4.
12
   See Jedwab v. MGM Grand Hotels, Inc., 509 A.2d 584, 594-95 (Del. Ch. 1986)(Allen, C).

                                                           4
payment mandates, and fundamental changes effected by preferred in control. We will show that
dispute resolution in all four categories requires negotiation between the two paradigms rather
than one hundred percent reference to one or the other.
B. Institutional Posture and Normative Concerns.
        The Delaware courts have emerged in the dominant role as deciders of preferred stock
disputes.13 What was once a disparate, multistate caselaw now is articulated by the Delaware
judiciary in a closed, self-referential context, a context highly sensitive not only to each case’s
facts but its implications for the overall framework of Delaware corporate law. That framework
has undergone notable developments over the past several decades. As ever, the Delaware courts
accord respect to business judgments made by boards of directors, but they now push boards to
remit dispute resolution to independent directors and temper their board centrism by recognizing
a norm of shareholder wealth maximization.
        Recent Delaware cases strive to integrate the law of preferred within this framework.
The integration project both inspires innovation and causes stresses and strains. Unfortunately,
the latter have been in ascendance recently as the courts have reset the balance between
corporate and contractual treatment. Although framed in contractual terms, the rebalancing has
the effect of pushing preferred deeper into corporate territory. Board decisionmaking primacy
has that effect: because courts review processes leading to outcomes rather than the outcomes
themselves, questions about substantive rights that a half century ago were seen as matters for
judicial determination now devolve on corporate boards. In addition, challenges to board
judgments now tend to be viewed through the lens of common stock value maximization. The
two frames, taken together, tend to assure that the preferred lose the case. Taken alone, that
would not present a problem, but destabilizing implications follow for the financial markets, the
venture capital sector in particular. Arm’s length deals are being undercut due to overemphasis
of preferred’s corporate character and under emphasis of transactional context.
        We propose a contrasting framework built on three principles. First, the meaning and
scope of preferred contract rights should be determined by courts rather than issuer boards of
directors. Second, conflicts between preferred and common should not be decided by reference
to a norm of common stock value maximization. Enterprise value should be the referent, more
particularly, maximization of the value of the equity as a whole. Third, independent director
determinations of conflicts between classes of preferred and common should not be accorded
ordinary business judgment review. Instead, a door should be left open for good faith review
tailored to the context—a showing of bad faith treatment of the preferred where the integrity of a
deal has been undermined.
C. This Article
        Part I describes the contract/corporate balance set during the first half of the twentieth
century. The courts confronted downside fact patterns on which preferred stockholder claims
interfered with corporate equity recapitalizations that enhanced enterprise value. Preferred

13
  Since 1980, sixty percent of the cases keyed by West as involving preferred stock (101 k1292 Preferred stock; 101
k1475 Preferred or Other Special Stock) were decided in Delaware. New York came second with twenty percent.
During the decade 1940-1950, Delaware cases made up 12.7 percent of the set. Buxbaum, supra note 2, cites a total
of 381 cases. New York leads that set with 20.7 percent (79); Delaware came second with 9.5 percent (36).

                                                        5
holders played the contract card, analogizing to the claims of bondholders. The companies
insisted that the preferred, as stock, be brought inside in the tent and be made to sacrifice for the
good of the enterprise. The companies won. Preferred henceforth would be stock irretrievably,
and the corporate law paradigm would delimit claims to contractual priority.
        Part II takes up problems arising from acquisitions of preferred stock issuers. Although a
corporate charter can fix an allocation of merger proceeds for a preferred class in advance, such a
term often is omitted. It follows that a merger creates an allocational issue for decision by the
issuer board of directors, a body elected by common stockholders. The preferred frequently
complain about the conflicted result. We show that a plausible case can be made for either of
corporate or contract treatment—the former meaning fiduciary scrutiny along majority to
minority lines and the latter delimiting preferred to rights explicitly reserved by contract and the
statutory appraisal remedy. We go on to show that both approaches influence Delaware
decisions—a classic case of mixed signals in mutual tension due to paradigmatic overlap. The
tensions recently came to a head in a Delaware Chancery decision, LC Capital Master Fund, Ltd.
v. James,14 which forcefully resolved them by treating the charter as a complete contract, in
effect expanding the board’s zone of allocational discretion. We read the contract in question
differently than did the Chancery Court and show more generally that preferred stock contracts
cannot presumptively be modeled as complete and that the common stock maximization norm
has no productive role to play in end-period pie slicing. At the same time, we share the
Chancery’s aversion to full dress fiduciary review and agree that statutory appraisal usually
affords an adequate remedy. We think some minor boardroom process adjustments and minimal
judicial scrutiny under the good faith rubric can accommodate both the paradigmatic ambiguity
and the interests at stake.
        Part III considers the paradigmatic overlap occasioned by preferred with mandatory
dividend and redemption rights—debt-like promises to pay. The promises take second order
status because their performance is conditioned on the presence of “legally available funds” as
defined by corporate legal capital rules, fraudulent conveyance law, and an open-ended and
conflicting body of old cases. The Delaware Chancery Court has taken a new look here as well,
and, in SV Investment Partners, LLC v. ThoughtWorks, Inc.,15 resolved ambiguities in favor of
corporate treatment, leaving the decision whether to pay to the business judgment of issuer
boards of directors. We agree that ambiguities need resolution, but suggest the modern legal
framework better accommodates resolution in the opposite, contractual direction.
       Part IV addresses the venture capital context, where preferred stockholders often control
the board of directors but also operate under pressure to monetize their equity investments. The
Chancery Court, at the behest of complaining minority common, recently reviewed a sale
engineered by exiting venture capitalists. In In re Trados Inc. Shareholder Litigation,16 the court
opened a wide door to intrinsic fairness review on the common’s behalf, too wide in our view.
Part IV takes a critical look at Trados, projecting a negative impact on the venture capital
business model. We trace the problem to the Court’s application of the common stock
maximization norm and recommend, first, that enterprise value maximization be substituted as


14
   990 A.2d 435 (Del. Ch. 2010).
15
   7 A.3d 973 (Del. Ch. 2010).
16
   2009 WL 2225958 (Del.Ch.).

                                                 6
the fiduciary yardstick and, second, that a door be opened to waiver by common of fiduciary
protection in venture deal documentation.
       Part V reviews the Article’s sequence of analyses, asking whether a more consistent
regime of across-the-board corporate or contract treatment would improve matters. We find that
a paradigmatic harmonization initiative would disturb both transactional risk allocations and
corporate governance. Preferred is dual and works only when both paradigms are consulted. A
conclusion follows.




                                              7
     I. THE PARADIGMATIC BACKDROP: CORPORATE TREATMENT IN DEPRESSION-ERA
                           EQUITY RECAPITALIZATIONS
        Courts confronted the choice between the corporate and contract paradigms in stark terms
during the first half of the twentieth century. In those days American industrials routinely
financed with priority, cumulative preferred.17 “Priority” means that a set preferred dividend
must be paid before a dividend may be paid to the common, but that the preferred dividend may
be skipped within the discretion of the board of directors. “Cumulative” means that past skipped
preferred dividends must be made up before the common can receive a dividend. Although there
is no promise to make a payment, the cumulative priority can constrain the issuer board’s
freedom of action.
        The priority arrangement works well in good times. The enterprise creates free cash
flows and the preferred gets its dividend at a rate of return higher than that on the same issuer’s
bonds. Things are different given moderate distress. The enterprise pays its bondholders and
even turns a small profit, but the board needs to reinvest every cent to keep the business going
and so skips preferred dividends. Under the cumulative feature, dividend arrearages build up
over time. The arrearages in turn prevent the company from making periodic payments on its
common, inhibiting sale of additional common to raise new equity capital. As more arrearages
cumulate, the issuer’s equity capital structure becomes more and more dysfunctional, with the
lion’s share of the marginal economic interest appended to the preferred even as the votes for the
board of directors stay appended to the common.18 Preferred rights look more and more like
barriers on the road to progress for the enterprise as a whole.19
        During the Great Depression the corporate landscape was crowded with such capital
structures.20 The project of clearing the wreckage triggered disputes that posed fundamental
choices between contract and corporate treatment. Contract privileged preferred fixed claims
and reinforced barriers, while corporate facilitated the barriers’ removal. The courts
emphatically endorsed corporate treatment, and the choice has stuck. The preferred’s curious
hybrid legal status results: contract rights, no matter how thickly laid on, are potentially subject
to diminution for the good of the enterprise.
        This Part recounts the Depression-era choice set. Section A describes the problem
confronting the issuer of preferred in arrears. Section B set out the solution of a cramdown
recapitalization and the resulting legal questions, going on to describe the courts’ move to
corporate treatment in resolving it. Section C summarizes.
A. The Recapitalization Problem

17
   See 1 Arthur Stone Dewing, The Financial Policy of Corporations 132-33 (5th ed. 1941)(describing industrial
preferred of the early twentieth century); Benjamin Graham, et al., Security Analysis: Principles and Technique 378
(4th ed. 1962)(describing early twentieth century corporate financing patterns).
18
   Arguably, this partial separation of the marginal economic gain and loss from the interests of the principals who
elect the board is inefficient. See Eliasen v. Itel Corp., 82 F.3d 731 (7 th Cir. 1996).
19
   Or, alternatively, a barrier to immediate profit sharing with the insiders holding the common. See 1 A. Dewing,
supra note 17, at 138-39.
20
   See Robert M. Blair-Smith & Leonard Helfenstein, A Death Sentence or a New Lease on Life? A Survey of
Corporate Adjustments under the Public Utility Holding Company Act, 94 U. Pa. L. Rev. 148, 149-53
(1946)(describing dysfunctional utility capital structures).

                                                         8
        Hypothesize ABC Corp. with a total market equity capitalization of $100,000,000. There
are 1,000,000 preferred shares outstanding and 2,000,000 common shares, with the preferred
trading for $80 per share and the common trading for $10 per share. The preferred carries a
cumulative dividend preference plus a liquidation preference under which it is to be paid a stated
amount of $100 in full along with all accrued dividends before the common receives any
liquidation proceeds. The liquidation preference plus dividend accruals come to $150 per share.
       An infusion of new capital into ABC will facilitate a turnaround. Money is tight and no
loans are available. A new equity offering makes sense but the preferred arrearages are in the
way, for a new common issue holding out no prospect of cash returns will not sell for much in
the market. Recapitalization makes sense: if the preferred can be transformed into common the
arrearages will disappear. A successful recapitalization to an all common structure will cause the
value of the company’s equity to rise to $120,000,000.
        An allocational question arises. To recapitalize is to increase the pie’s size to $120
million and then slice it, handing the pieces to the preferred and the common. There is a range of
possible splits. At one end, the entire gain could be allocated to the preferred, which would
follow if the preferred received eight common shares for each preferred share (8,000,000 to the
preferred = $100,000,000; 2,000,000 to the common = $20,000,000). At the other end, the entire
gain could be allocated to the common, which would follow from a four-to-one allocation to the
preferred (4,000,000 to the preferred = $80,000,000; 2,000,000 to the common = $40 million).
An exchange ratio of six-to-to-one splits the $20 million gain evenly (6,000,000 to the preferred
= $90,000,000; 2,000,000 to the common = $30,000,000).
      Assume the board decides to split the difference and recapitalize on a six-to-one basis.
How does it get from here to there?
        The board could set up a voluntary exchange offer, asking the preferred to tender back
their shares and receive six common back for each share tendered. Unfortunately, the offer
creates a hold out problem. Preferred holders can refuse to tender into the offer and insist on a
more favorable ratio. Even if a majority of the preferred holders turn out to be cooperative and
willing to accept, a minority can be expected to stand pat. If eighty percent of the preferred
holders accept, the twenty percent holding out retain their stock with liquidation preference and
arrearages intact at $150. If the ploy works, the holdouts eventually get their arrearages paid
down, coming out way ahead of the rest of the group. The hold out possibility destabilizes the
transaction.
B. Cram Down
       The ABC board needs a way to cram down a recapitalization. Under the contract
paradigm, strictly applied, cram down is impossible. To see why, compare an issue of bonds that
stands in the way of progress. To scale back the bondholders’ claims the issuer must either
procure their unanimous consent to a direct amendment of the bond contract21 or try to get a
supermajority to consent to an exchange offer.22 Either way, it confronts the hold out problem


21
   See Trust Indenture Act § 316, 15 U.S.C. § 77aaa (20__)(requiring unanimous consent to amendment of payment
terms).
22
   See William W. Bratton, Corporate Finance: Cases and Materials 462-63 (7th ed. 2012).

                                                       9
just described.23 An involuntary haircut can be imposed on debt claimant only in a bankruptcy
reorganization proceeding,24 and then only if every junior claimant is wiped out.25
        It was the same way with preferred during the Victorian era. The Victorians took
contract seriously and corporate charters could not be amended without unanimous consent.26
But the unanimity rule was relaxed during the early twentieth century when corporate codes were
revised to permit charter amendment by majority vote.27 This in turn opened a route to an
involuntary out-of-bankruptcy cram down against preferred.              Although the preferred’s
obstructive priorities are contract terms, they are embedded in the issuer’s charter rather than in a
free standing contract (as occurs with debt securities). Once corporate codes allowed charter
amendment by majority vote, it literally followed that the boards and common stockholders
could join together to impose mandatory exchanges on preferred issues.
        To see how, we return to ABC Corp. and note that the preferred holds only one-third of
the votes. It accordingly cannot block an amendment approved by the board and submitted for
shareholder ratification. At the same time, the common can be expected to vote in favor of the
amendment only if it holds out a clear cut gain. The board, concerned about this, takes a cold
look at the six-to-one exchange ratio, deciding that it so favors the preferred as trigger possible
resistance among the common. Just to be sure, it adjusts the ratio to five-to-one (71.5 percent or
$85.7 million to the preferred and 28.5 percent or $34.3 million to the common) and submits the
amendment to a vote.
        The contract versus corporate issue is joined at this point. Assume no preferred issuer
has ever before attempted such an amendment. The revised corporate code, read literally,
permits it, and, indeed, contains a reservation clause permitting legislative amendments to alter
existing rights.28 There will be a wall of conceptual resistance even so. Preferred rights are
widely assumed to be contractual and vested, just like the rights of bondholders. Viewing the
preferred contractually, the amendment makes no structural sense: What stops the company from
transferring value from the preferred to the common by cramming down a recap on a one-to-one
basis or a one-fourth-to-one basis? What is the value of a promise that can unilaterally be

23
    See William W. Bratton & Mitu Gulati, Sovereign Debt Reform and the Best Interest of Creditors, 57 Vand. L.
Rev. 1, 56-60 (2004); Mark J. Roe, The Voting Prohibition in Bond Workouts, 97 Yale L.J. 232, ___ (1987).
24
    See Bratton, supra note 22, at 529-31.
25
   Id.; 11 U.S.C. § 1129(b)(making absolute priority treatment of a reorganization plan available on a contingent
basis). There is a way to minimize the holdup problem in the context of a voluntary exchange offer, provided the
issuer’s charter permits the creation of a new issue of preferred having a priority over the existing issue in arrears.
The issuer creates such an issue and offers in exchange for the existing preferred on a one to one basis, plus the
sweetener of a small cash payment. To exchange is to have one’s arrearages disappear. But to hold out is to be
junior to the new issue and have no present expectation of dividends. See, e..g, Johnson v. Fuller, 36 F. Supp. 744
(D. Pa. 1940); Shanik v. White Sewing Machine Co., 15 A.2d 169 (Del. Ch. 1940).
26
    See John F. Meck, Jr., Accrued Dividends on Cumulative Preferred Stocks: The Legal Doctrine, 55 Harv. L. Rev.
71, 79 (1941). The unanimity rule originated in judicial opinions that filled gaps in corporate charters and state
codes. See Edward O. Curran, Minority Stockholders and the Amendment of Corporate Charters, 32 Mich. L. Rev.
743, 744-45 (1934).
27
   See E. Merrick Dodd, Jr., Statutory Developments in Business Corporation Law 50 Harv. L. Rev. 27, 46-48 (1936)
(describing the Illinois statute and comparing the Massachusetts and Delaware statutes). Earlier voting rules varied
depending on the subject. For example, in late nineteenth century Massachusetts, it took unanimous consent to
change the nature of the business, but additional stock could be issued on a majority vote basis. Id. at 33.
28
    See, e.g., MBCA § 1.02.

                                                          10
amended away by the promisor? Arguably, it is illusory and has no value. To allow the
amendment, then, is to undercut the financial transaction that created the preferred in the first
place, particularly given a class of preferred issued and sold before the amendment of the
corporate code.29
        A stark choice is posed to the reviewing court. Contract treatment means preferred
consent, hold up, and a dysfunctional capital structure. Corporate treatment undercuts the deal
but also applies the corporate code as written and facilitates a fresh start in the best interests of
the corporate community as a whole.
       Depression era courts split on the question. Some, including the Delaware Supreme
Court,30 held that the amended code’s majority vote provision could only be applied
29
   Note that the vested rights approach runs parallel to absolute priority in bankruptcy. Both follow from the notion
that a contract right cannot be impaired without its holder’s consent. We have seen that each debt claimant gets a
veto in an out-of-court recapitalization, creating a hold up problem. Bankruptcy takes away the veto and the hold up
by statute, organizing senior claimants into classes and remitting approval of a plan of reorganization to the classes’
majority votes. Absolute priority kicks in as a backstop: given that possibility of unconsented impairment of
contract rights toward the end of preserving the enterprise’s going concern value, a reorganization plan cannot be
crammed down against an unconsenting impaired class unless every junior class is wiped out. See Bankruptcy
Code, 11 U.S.C. §§1129(a)(8) & 1129(b)(2). Thus stated, absolute priority effects an accommodation between the
corporate and contract paradigms: even as the enterprise’s contractual capital structure has become dysfunctional,
necessitating a mandatory, judicially-supervised recapitalization, the shares in the new capital structure are to be
distributed in accordance with contracted-for priorities. Underwater common accordingly gets wiped out.
          Unfortunately for the preferred, an absolute priority objection is structurally ill-suited to the context of an
out-of-court equity recapitalization. The exercise requires a shareholder vote and a common stock majority has no
incentive to vote in favor of a recap that eliminates or reduces the value of its participation. The bottom line is
simple: no preferred haircut, no recap. Ruling the transaction unfair for traversing absolute priority in effect
reinstates the vested rights barrier.
          Adjudicated recapitalizations present a different case and the Securities and Exchange Commission effected
a series of them under the Public Utility Holding Company Act of 1935 (PUCHA). 49 Stat. 803, 15 USC §§ 79 et
seq. The PUCHA addressed “pyramided” utility company capital structures which had been constructed during the
first decades of the twentieth century to effect gains from high leverage outside of the purview of state public utility
commissions. Many such capital structures became dysfunctional during the Depression. The PUCHA ordered
their dismantling through SEC proceedings. PUCHA § 11(b)(2), 15 USC § 79k(b)(2). The absolute priority issue
was joined in Otis & Co. v. Securities and Exchange Commission, 323 U.S. 624 (1945), in which the Supreme Court
sanctioned an absolute priority violation in an SEC recapitalization proceeding.
30
   In Keller v. Wilson & Co., 190 A. 115 (Del. Supr. 1937), an issuer with two classes of preferred in arrears
conducted a recapitalization that transformed one of the issues into common at a five-to-one ratio. The transaction
was effected by a charter amendment that mandated the exchange, an amendment approved by overwhelming
majorities of all shareholder classes, preferred and common. The effect was to eliminate the subject preferred issue
along with the arrearages. Id. at 116-117. The charter amendment was effected in reliance on an amendment to the
Delaware code promulgated in 1927, after the issue of the preferred stock in question. See Norman D. Lattin, Lattin
on Corporations 578 (2d ed. 1971). Prior to the statutory change, dividend arrearages could not be eliminated by
charter amendment. 190 A. 115, at 117-118. The Court ruled the amendment invalid. The new statute could only be
applied prospectively:

         The rights of cumulative preferred shareholders to the stipulated dividends accrue to them by virtue of the
         contract. That right exists and persists. When the necessary corporate action, under the amended statute
         conferring the power is taken, the status of the shares may be changed, and the right thereafter to claim the
         dividends as originally stipulated may be cancelled, but the amended statute under the general rule of
         construction, ought not to have a retroactive effect. . . . It is one thing to confer a general power to
         accomplish a purpose in the future. It is quite another thing to say that the power may be exercised to
         destroy a right accrued and recognized as a vested right of property.

                                                           11
prospectively, that is, to preferred created after the enactment of majority amendment. Most
courts, including New York’s,31 held that no such “vested rights” existed.
        The vested rights era did not last long even in Delaware. A few years after deciding in
favor of vested rights, the Delaware Supreme Court encountered a case in which an issuer used a
different technique to the same end.32 This time, instead of directly amending its charter, the
issuer effected a “dummy” merger. The mechanics are simple. The issuer creates a wholly-
owned shell subsidiary and then enters into a merger agreement with the subsidiary pursuant to
which the subsidiary is the surviving corporation. The merger agreement provides that the
existing shares of the issuer, preferred and common, will be “converted” into common shares of
the surviving corporation. The conversion strips the arrearages. Significantly, mergers and
charter amendments were governed by different sections of Delaware’s corporate code (as
continues to be the case).33
        The Delaware Supreme Court, in Federal United v. Havender,34 ruled that statutory
difference to be determinative. The code’s merger section permitted the transaction in question
and had always done so.35 The preferred argued that the section’s employment in the present
case amounted to a formal ruse, accomplishing what the Court had forbidden by direct charter
amendment. Court rejected the argument, along with a “vested contract rights” claim to unpaid
dividends:36 transactional limitations obtaining under one section of the code would not be read
to constrain the use of another section of the code to reach the same substantive result. The point
survives as Delaware’s “bedrock” doctrine of independent legal significance.37
       Henceforth, recapitalizations would be easily effected with or without the voting support
of the preferred, so easily as to prompt the legislature to a give back. Now, in Delaware and
elsewhere,38 a charter amendment that alters or changes “the powers, preferences, or special

Id.at 125-126. The Court also ruled that the contract right was protected by the contract clause of the constitution.
Id. at 124. The court also interpreted the corporate code to be inapplicable to action in question—this was a
“cancellation” of accrued dividends, not a charter “amendment.” Id. at 124-25. The case was extended the
following year in consolidated Film Industries v. Johnson, 197 A. 489, 493 (Del. 1937)(holding that section 26 did
not apply to cancellation of arrearages of preferred stock created after its enactment).
31
   See Davison v. Parke, Austin & Lipscomb, 285 N.Y. 500, 509, 35 N.E.2d 618, 622 (1941)(rejecting vested rights
doctrine).
32
   The preferred in question had a $100 liquidation preference and a $6 cumulative dividend preference which was
$29 per share in arrears. Under the recapitalization, each preferred share was exchanged for one new preferred share
with a $3 cumulative dividend preference and $55 liquidation preference along with six common shares. Federal
United Corp. v. Havender, 11 A.2d 331, 334 (Del. 1940). The effect of the exchange was to put most of the common
shares in the recapitalized company into the hands of the preferred. The arrearages, of course, disappeared. The
votes in favor of the transaction amounted to 91.8 percent of the total outstanding shares. Id. at 334. The parties
stipulated that the financial allocation was “fair and equitable.” Id.
33
   Id. at 338-39. Today, charter amendments proceed under Del. Gen. Corp. L. § 242, and mergers proceed under
Del Gen. Corp. L. §§ 251 and 253.
34
   Federal United Corp. v. Havender, 11 A.2d 331 (Del. 1940).
35
   Id. at 338.
36
   Id. at 339.
37
   See Elliott Associates Inc. v. Avatex, Corp., 715 A.2d 843, 853 (Del. Supr. 1998); Warner Communications. Inc.
v. Cris-Craft Industries, Inc., 583 A.2d 962, 970 (Del.Ch. 1989).
38
   MBCA §10.04(a)(3). Delaware followed other states in making this concession. See Dodd, supra note 27, at 47
(describing a class vote provision modifying majoritarian amendment in the Illinois statute of 1935).

                                                         12
rights” of a given class must be approved by the vote of a majority of that class.39 The class vote
mandate holds out a veto of a one-sided amendment while substantially diminishing the hold out
problem. But we will see in Part II that the dummy merger route to cram down remains open.40
C. Summary
       To create an absolute contractual claim against a corporation in exchange for an infusion
of $1 million of capital all one needs to do is to get an authorized officer to write “The
corporation promises to pay you $1,000,000” on a piece of paper and sign it. Absent the holder’s
consent, the claim can be impaired only in the context of a bankruptcy proceeding. Resistance to
unconsented impairment persists even there, manifested in the absolute priority rule.41
        Preferred stock is stock issued under a corporate charter, and so is more vulnerable than
debt. The Depression-era courts removed the contract paradigm’s protection to make way for
enterprise value enhancement under the corporate paradigm. A question arises: Is there any way
to invoke contract and draft the preferred into same absolute contractual status enjoyed by debt?
We will see in Parts II and III that the answer is no. With preferred, corporate and contract
inevitably overlap.




39
   Del. Gen. Corp. L. § 242(b)(2).
40
    Many states have merger statutes that carry over a class vote in the merger by reference to the fact that it would
obtain given a charter amendment. See MBCA § 11.04(f).
41
   See 11 U.S.C. § 1129(b)(2)

                                                          13
               II. PREFERRED STOCK AS FIDUCIARY BENEFICIARY: MERGERS
        When a corporate bond issuer merges into another corporation, the bonds, by operation of
law, carry over to the surviving corporation’s capital structure with their rights untouched. 42 It is
different with preferred. When a preferred issuer merges into another company, the preferred
lies on the corporate side of the line and corporate law makes it possible for merging companies
to effect top-to-bottom rewrites of their equity capital structures. What comes into the merger as
a fixed interest security can come out the other end as cash, common stock, preferred with
different rights and preferences, or debt, and in any case in an amount with a value determined
by the issuer’s board of directors. A merger also can be structured to leave target company
preferred’s rights unaffected, as would occur with a bond. But nothing requires that treatment.
Mergers thus hold out special risks for preferred holders.43 It would seem to follow that the
preferred, as a minority voting class, should benefit from the same fiduciary protection extended
to common stock minorities cashed out in parent-subsidiary mergers.44

        It is not so simple, however. Preferred stock, as stock, does enjoy the protection of the
duties of care and loyalty. Given, for example, injurious management self-dealing, a preferred
holder has the same standing as a common holder to enforce the duty of loyalty in a derivative
action.45 But once we get past cases in which the preferred and common share an interest in
good, clean management, tensions between the contract and corporate paradigms undermine
preferred’s case for fiduciary beneficiary status. There are three countervailing considerations.
Two of them are corporate: first, the preferred’s financial interest is defined by contract rights
that conflict intrinsically with the interests of the common, and corporate law resists attempts to
bring adverse contract counterparties inside the fiduciary tent;46 and second, it is thought that a
singled-minded focus on the common interest keeps management better focused on value
maximization.47 The third consideration is contractual: protective contract terms are available to
preferred while publicly-traded common tends to be written against the background default
regime.

        The Delaware courts do entertain claims of unfair treatment of preferred as regards
divisions of merger proceeds. The line of cases dates back to the early twentieth century, but at
best can be described as tentative. So tentative that the Delaware Chancery Court recently
expressed second thoughts about the whole enterprise in LC Capital Master Fund, Ltd. v.
James.48

42
  See Del. Gen. Corp. § 252. Trust indentures customarily require the surviving corporation formally to assume the
bonds. See Model Simplified Indenture §§ 5.01-5.02. See also Dawson v. Pittco Capital Patners, L.P., 2012 WL
1564805, at 17-19 (Del.Ch.)(addressing the question whether a debt claim attached to a preferred stock interest or
should be considered separately).
43
   At least absent voting control.
44
   The line of majority-minority cash out merger cases begins with Weinberger v. UOP, Inc., 457 A.2d 701 (Del.
1983).
45
   See MCG Capital Corp. v. Maginn, 2010 WL 1782271 (Del. Ch.).
46
   See, e.g., Katz v. Oak Indus. Inc., 508 A.2d 873 (Del. Ch. 1986)(refusing fiduciary protection to bondholders
subject to an exchange offer); Simons v. Cogan, 542 A.2d 785 (del. Ch. 1987)(refusing to extend fiduciary
protection to convertible bondholders).
47
   See Equity-Linked Investors, L.P. v. Adams, 705 A.2d 1040, 1042 (Del.Ch.1997).
48
   LC Capital Master Fund, Ltd. v. James, 990 A.2d 435 (Del. Ch. 2010).

                                                        14
        This Part conducts a de novo review of the subject matter. Section A lays out the policy
alternatives: (1) fiduciary scrutiny and a difficult follow up question respecting the standard of
review, versus (2) complete rejection of fiduciary scrutiny on the grounds that the territory is
contractual and that the statutory appraisal remedy at all events provides adequate protection
against oppressive treatment. Section B reviews the Delaware precedent, showing that it draws
on both of the foregoing alternatives to emerge with internal contradictions. Section C considers
the James opinion, which pushes in the direction of the contractual alternative, looking
negatively at the fiduciary precedent without explicitly overruling it. We conclude that fiduciary
review remains a necessary part of the law, held in reserve for extreme cases. More particularly,
given a merger allocation effected by a preferred issuer’s independent directors, good faith
suffices as the standard of review, but the issuer’s board of directors should bear the burden of
proof on the good faith question. Our treatment follows from a critical legal conclusion: the
preferred has no corporate law right to share in merger gain.

A. The Problem and the Alternative Solutions

        Mergers of preferred issuers tend to create allocational problems on moderate downside
fact patterns. To see why, compare the downside and upside extremes. On the extreme
downside, the issuer’s debt load is unsustainable and any acquisition is likely to be effected
through a chapter 11 reorganization where the preferred’s contract rights will be transformed into
a matured claim with priority over the common.49 On the upside, there isn’t much to fight
about. The preferred’s dividends are paid up. If the preferred has a conversion privilege, it is in
the money and the holders can protect themselves by converting. If there is no conversion
privilege, the preferred’s share of the issuer’s value likely is capped at the stated liquidation
amount, and there will be no serious argument that the preferred is worth less.50 If the acquiring
corporation wants the preferred out of the surviving corporation’s capital structure, all it has to
do is redeem the issue at the principal amount stated in the charter. If the acquiring corporation
deems the preferred’s implicit terms to be favorable, it leaves the preferred in place.

        Things are less clear cut when a merger occurs on the moderate downside. To set up the
problem let us return to ABC Corp. and its $100,000,000 market capitalization comprised of
1,000,000 preferred shares trading for $80 and 2,000,000 common shares trading for $10, with
the preferred’s liquidation preference and dividend arrearages totaling $150. Assume that the
ABC board of directors has entered into a merger agreement with XYZ Corp. for a consideration
of $140,000,000. Further assume that the board has acquitted itself of its duty to get a good
merger price51 and the acquirer wishes to cash out the preferred along with the common. A
question arises regarding the preferred’s share of the merger proceeds, a share to be assigned by
the issuer’s board of directors.



49
   See Bratton supra note 22, at 544-45.
50
   The cases address the question whether the preferred is worth more, a matter of charter interpretation. See, e,g., In
re Appraisal of Ford Holdings, Inc. Preferred Stock, 698 A.2d 973 (Del. Ch. 1997). (interpreting charter to opt out of
appraisal and lock the preferred into a price).
51
   See Paramount Communications v. QVC Network Inc., 637 A.2d 34, 44 (Del. 1994)(describing a duty to search
for the best value reasonably available given a sale of control).

                                                          15
        We pose three possible results: Allocation (1) $100,000,000 preferred/$40,000,000
common, splitting the merger gain evenly (if not pro rata);52 Allocation (2) $80,000,000
preferred/$60,000,000 common, leaving the preferred where it was in the market before the
merger and allocating the entire gain to the common; and Allocation (3) $70,000,000
preferred/$70,000,000 common, taking the occasion of the merger to transfer $10,000,000 of the
preferred’s ex ante market value to the common.

        The corporate and contract paradigms suggest contrasting responses when the preferred
come to court arguing that a board’s allocation is unfair. Under the corporate paradigm, the
court entertains the fiduciary claim, which in turn means articulating a standard of review.
Under the contract paradigm, the court withholds fiduciary scrutiny on the ground that the
preferred could have contracted for protection; the preferred having failed to do so, it is remitted
to statutory appraisal remedy. We will see that both approaches are plausible but also hold out
problems.

        1. Fiduciary treatment and standards of review.

         Fiduciary review follows from a rough analogy to majority-minority duties among
common shareholders. Although the preferred stock contract might have specified a merger
payout in advance (for example, liquidation value or liquidation value plus arrearages), it does
not. This leaves the preferred in a vulnerable position—the value of its participation is fixed by
members of a board of directors who owe their positions to the votes of common stockholders.
The common thus in some sense “control” the board. If the board, instead of proceeding in an
even-handed way, skews the allocation of merger gain to the common, we arguably have a case
in which a majority stockholder has used its control power to exclude the “minority” preferred to
its detriment.53

        The claim is strongest under Allocation (3), with its negative sum wealth transfer, but
more speculative as regards Allocations (1) and (2). No action can be grounded on the fact that
an allocation falls short of the preferred’s $150 liquidation preference. The Depression-era courts
rejected such an absolute priority theory of fairness54 and the Delaware courts have maintained
that view in the cash out merger context.55 Beyond that, the law holds out no objective calculus
of fair allocation. Indeed, contemporary courts avoid such pie-slicing inquiries, instead
reviewing the boardroom process that resulted in the merger.

        With process as the focus, a standard of review must be determined. Corporate law
holds out a choice between strict and less strict—intrinsic fairness or good faith, with variations
within the categories. Formulating and then sticking with a given standard will prove difficult
because the analogy to majority-minority fiduciary duties is stronger or weaker depending on the
issuer’s shareholding configuration. We accordingly will interrogate the standard of review

52
   A pro rata split of the merger gain by number of shares would be $93,333,333 preferred/$$46,666,667 common.
A pro rata split by reference to pre-merger market value would be $112,000,000 preferred/$28,000,000 common.
53
   The classic Delaware case is Sinclair v. Levien, 280 A.2d 717 (Del. 1971)(finding slow liquidation through
dividend payments not to be unfair).
54
   See supra note 29.
55
   See Rothschild Int’l Corp. v. Liggett Group Inc., 474 A.2d 133 (Del. 1984).

                                                      16
question through two shareholding lenses, first, a blockholder-dominated board, and, second, an
independent director board elected by dispersed shareholders.

        (a) Blockholder domination. We begin with a board dominated by a blockholder. The
blockholder owns a majority of the common shares and its agents comprise a majority of the
company’s board of directors. The merger allocation thus deeply implicates the blockholder’s
financial interests. Indeed, there is a strong resemblance to the well-worn fact pattern of a
parent-subsidiary merger where the parent company merges the subsidiary into itself using its
control power to effect a lowball payment to the subsidiary’s minority shareholders. The best the
preferred can expect is Allocation (2) and it should be prepared for Allocation (3).

        If we carry out the analogy to parent-subsidiary mergers, intrinsic fairness is the standard
of review with the burden of proof on the controlled board. Under the parent-subsidiary merger
cases, the burden of proof on fairness can be shifted to the challenger if the subsidiary board
appoints a special committee of independent directors to negotiate the merger price on the
minority shareholders’ behalf, according the committee veto power into the bargain. 56 It would
seem to follow that the preferred here should have a veto-wielding special committee of
disinterested directors appointed to negotiate its merger allocation.

        But the analogy is imperfect. In the parent-subsidiary context, intrinsic fairness review
and the resulting special committee force a negotiation over a single point—the value of the
subsidiary. Once the value is set, the relative proportions of stock ownership determine its
allocation. The preferred merger is more complicated. The issuer, its majority stockholder, and
its board negotiate over the company’s value with a third party acquirer. A committee of
independent directors likely will be taking the lead in that process on the issuer’s behalf. A
second special committee representing the preferred addresses an ancillary allocational matter, a
matter unlikely to admit of a clear answer. Such a committee’s appearance in the merger process
is cumbersome at a minimum. It also is potentially disruptive where the primary negotiation
with the third party acquirer (or group of potential acquirers) is ongoing. Assume that a tentative
price is on the table, but that questions remain open about mode of payment (cash or stock) and
acquirer financing (borrow new money or issue new preferred). Initiation of a second
negotiation between the target issuer and its own preferred could raise value questions with
spillover effects regarding value questions at the primary negotiation.

       If the potential negative consequences are deemed salient, the second, preferred-only
negotiating committee is dispensed with and the preferred allocation is remitted to the special
committee charged with approving the terms of the merger. The concession is significant, for
independent director negotiation by itself shifts the burden of proving unfairness, whether as to
process or to price, to the complaining preferred.

        (b) Dispersed common standard of review. Contrast a case where both the common and
preferred are widely held and a majority of the board is independent, with the independent
directors owning some common, either awarded as incentive compensation or purchased as a
bonding exercise. Assume Allocation (2). One can still draw an inference of self-interest—the
preferred get no share of the merger gain—but one also can give the independent members of the
56
     See Kahn v. Lynch Communication Systems, Inc., 638 A.2d 1110, 1116-17 (Del.1994).

                                                       17
board the benefit of the doubt. Dispersion of the set of voting principals arguably relieves the
board of pressure to skew the distribution in the common’s favor. If the members’ holdings of
common do not comprise significant portions of their personal wealth, we can depict them as
credible independent decision makers constrained by a reputational interests. From this
perspective, these directors are no less able to dispose of this financial conflict than they are able
to dispose of a conflict posed by a self-dealing transaction between a top managers and the
company, a job they are routinely called on to perform. Leaving the decision to the business
judgment of independent directors therefore seems more reasonable and less expedient than in
the blockholder case.

        A question follows for the standard of review: perhaps the analogy to parent-subsidiary
mergers should be abandoned and an analogy made instead to independent director review of a
management self-dealing transaction. In recent years the standard of review for these
determinations has been relaxed. Under the former standard, the test is intrinsic fairness with the
burden of proof on the plaintiff.57 More particularly, a board defending its approval of a self-
dealing transaction would have the burden to prove its own disinterestedness and the fact of a
serious inquiry into the value questions at stake. If the board makes this proof, the plaintiff still
gets a shot at proving that that the value allocation is substantively unfair. This would seem easy
under Allocation (3), arguable under Allocation (2), and quite difficult under Allocation (1).
Under the relaxed standard, the business judgment standard of review applies once the board
satisfies the burden to show disinterestedness and serious inquiry.58 At this point the plaintiff
loses its direct shot at showing substantive unfairness and instead has to show that the board was
in bad faith.59

         2. Contract treatment.

        This subsection interrogates the possibility of foursquare contract treatment. Under this,
fiduciary review is refused absolutely and complaining preferred holders are remitted to the
statutory appraisal remedy.

       (a) The preferred contract as complete. Corporate fiduciary law can be defended from a
contractarian perspective on the ground that common stockholders invest pursuant to an
incomplete contract.60 The common takes the residual interest along with the right to elect the
board, but beyond that relies on the board’s capability and fidelity along with the backstop terms
of corporate law. It is thought more efficient to protect that reliance with fiduciary law than to



57
   See, e.g., Fliegler v. Lawrence 361 A.2d 218, 222 (Del. 1976).
58
   See Benihana of Tokyo, Inc. v. Benihana Inc., 906 A.2d 114, 120 (Del. 2006).
59
   If this approach seems too protective of the board, owing to the keenness of the underlying conflict, we could shift
the framework of reference to the cases on director duties respecting defensive tactics employed in response to
control threats. The standard of review would remain good faith, but the burden of proof would be allocated to the
defending board. See Cheff v. Mathes, 199 A.2d 548, 554 (del. 1964); Unocal Corp. v. Mesa Petroleum Co., 493
A.2d 946 (Del. 1985).
60
   See Marco Becht et al., Corporate Governance and Control at 8-9, ECGI Finance Working paper No. 02/2002
(August 2005) available at http://ssrn.com/abs=343461; Oliver Williamson, Corporate Governance, 93 Yale L. J.
1197, 1205-06, 1210-11 (1984).

                                                          18
force common stock investors to an ex ante contract negotiating table to specify their rights.61
Indeed, as the common hold the residual interest, it is thought that the set of possible
contingencies is so large as to make ex ante contractual specification unfeasible.62 The subject
matter being noncontractible, incompleteness is inevitable and fiduciary protection is
accordingly necessary.

        Preferred is arguably different because its preferences are contracted for and presumably
can be protected with explicit provisions. Indeed, there are well-known means of dealing with
the problem of skewed merger consideration. The charter can provide that a merger constitutes a
liquidation event and condition the transaction’s effectiveness on payment of the liquidation
preference or otherwise dictate a merger price.63 Alternatively, the charter can require that a
class vote of the preferred be obtained in the merger approval process, 64 according the preferred
a veto as a group. As a further alternative, the charter can require that the preferred be left
unimpaired in the issuer or merger survivor’s capital structure.65

       Given the availability of contractual protection, fiduciary review can be withheld on a
penalty default theory.66 Under this, a skewed outcome in the individual case is accepted on the
assumption that withholding scrutiny in the long run causes preferred to insist that merger
contingencies be dealt with in the charter; contractibility trumps fiduciary treatment.

        This approach arguably synchronizes well with the corporate paradigm of our
“shareholder value” era. As between the preferred and the common, today’s regime of value
enhancement signals the common as the appropriate fiduciary beneficiary because it holds the
residual interest. Managing to the common encourages managers to take risks and thereby to
create value. The preferred, with its fixed income features, is a more financially conservative
interest, so it is best to keep the preferred interest out of the boardroom and force it to make its
rights explicit on paper. In short, if the legal regime should stress maximizing for the common,
then any judicial intervention against a merger allocation in the common’s favor traverses a
grundnorm and invites inefficient results.



61
   Recent experience with other forms of business organization provides a basis for questioning this point. See, e.g.,
Myron T. Steele, Freedom of Contract and Default Contractual Duties in Delaware Limited Partnerships and
Limited Liability Companies, 46 Am. Bus. L.J. 221 (2009)(discussing Delaware’s policy of contractual treatment of
LLCs and LPs and contending that the default standard of conduct should be contract good faith rather than
fiduciary duty).
62
   Williamson, supra note 60, at 1205-06, 1210-11.
63
   See Matthews v. Groove Networks, 2005 WL 349423 (Del.Ch.); In re Appraisal of Ford Holdings, Inc. Preferred
Stock, 698 A.2d 973 (Del. Ch. 1997).
64
   See Del. Gen. Corp. L. § 151(a).
65
   Such a provision might allow a survivor other than original issuer to issue a substantively equivalent class of
stock. In the preferred stock contracts collected and reviewed in connection with this Article, the alternative of
leaving the preferred in the issuer capital structure showed up as a condition excusing application of a class vote
provision; that is, if the preferred is left untouched, the preferred holders get no class vote.
66
   See Ian Ayres, Ian Ayres & Robert Gertner, Filling Gaps in Incomplete Contracts: An Economic Theory of
Default Rules, 99 Yale L.J. 87, 97-99 (1989).



                                                         19
        A penalty default thus makes theoretical sense. It does not necessarily follow, however,
that it makes cost sense in the real world, even to a common stockholder. Penalty defaults, as
mooted in law and economics, do not force contracting for its own sake. The idea is that by
fixing the default at a result neither party is likely to want 67 the law forces parties to adjust by
negotiation, thereby causing them to disclose additional information or otherwise contract more
efficiently.68 The additional information facilitates a more efficient allocation of risk in the
contract. It is not clear that any efficiencies are on offer here. Nor is it clear that judicial
intervention respecting merger allocations somehow constrains boardroom discretion to take
risks. The duty applies only to end period decisions, and does not envision preferred stock value
maximization as a going concern fiduciary proposition.

        More importantly, penalty default treatment of the preferred could disserve the common
stock interest. To see why, consider the following question: Why don’t preferred stock charter
provisions always accord a merger class vote? We drew on the EDGAR database for new issues
of preferred registered for public offering since 2009 and surveyed their certificates of
designation. Fifty percent of the certificates provided for merger class votes (or otherwise
included effective protection in the event of a merger) and fifty percent left the preferred
unprotected.69 We also examined the certificates of preferred stock privately placed during the
second quarter of 2011 and filed in EDGAR as disclosure exhibits. Only twenty nine percent of
these certificates provided for merger class votes (or otherwise included effective protection in
the event of a merger).70 There are good reasons for issuers to resist their inclusion. Class votes
create hold up possibilities in moderate distress situations. Return to ABC Corp., where a class
vote would hand the preferred a chip with which to bargain for a premium price above $80. The
limit would be reached only when the allocation so favored the preferred as to cause the merger
to lose the common’s voting support. If the preferred lies in institutional hands, an aggressive
negotiation can be expected. Omitting the class vote makes it easier to sell the company and
avoids a possible allocational skew favoring the preferred.71

        The same analysis applies to clauses that treat mergers as liquidations. The issuer has
every reason to resist this concession. Let us return to ABC Corp., where the preferred’s
liquidation preference soaks up the entire merger proceeds. ABC would be forced to negotiate
with the preferred to pay less, using its privilege to walk away from the deal as a lever.72 From
the issuer’s point of view, then, a legal regime that pushes investors in the direction of insisting
on liquidation treatment makes little sense.

67
   Id. at 97.
68
   Id. at 98-99.
69
   The dataset contains 22 certificates of designation. See also Note, Arrearage Elimination and the Preferred Stock
Contract: A Survey and a Proposal for Reform, 9 Cardozo L. Rev. 1335, 1345-53 (1988)(surveying New York Stock
Exchange listed preferred found that only 14 percent of the issues had the benefit of a class vote in a merger).
70
   The dataset contains 68 certificates of designation.
71
   Now further assume that class votes are priced out at original issue—all other things equal, preferred with a class
vote returns 30 basis points less than preferred without a class vote, with the pricing parties assuming a backup
regime of fiduciary scrutiny. A shift to a no-scrutiny regime disrupts the price equilibrium, causing the issuer to
have to pay more to issue preferred without a class vote. On this scenario, the potential for fiduciary scrutiny
expands the issuer’s menu of contracting alternatives.
72
   If the preferred is dispersed, the issuer could attempt to get the votes to approve a charter amendment that removes
the liquidation payout. But, because the preferred get an automatic class vote on such an amendment, see Del. Gen.
Corp. L. § 242(b)(2), the bargaining context will not have changed.

                                                          20
        Alternatively, the preferred could contract into a right to be left in the capital structure of
the entity surviving the merger. But this ties the issuer’s hands too. A potential acquirer of ABC
Corp. is unlikely to favor retention of a preferred class $50 in arrears. If it acquires ABC
anyway, the price paid to the common will have been adjusted downward due to the cost of the
preferred’s cumulated contractual baggage.73

        The contractual back and forth bolsters the case for fiduciary review. The best
explanation for a preferred stock contract that omits to specify a merger price or provide for a
class vote is the issuer’s interest in avoiding a commitment to pay the preferred a premium over
pre-merger value on a moderate distress fact pattern. The omission expands the issuer’s zone of
freedom of action and so facilitates enterprise value enhancement. However, the omission is
rational for the preferred only on the assumption that merger allocations made by the issuer
board of directors lie in fiduciary territory.

         (b) Appraisal rights. The availability of statutory appraisal strengthens the case for
contract treatment.74 Dissatisfied shareholders can dissent from many mergers and demand a
judicial appraisal of the value of their shares. Let us take the ABC Corp. merger into appraisal.
The inquiry goes to the fair value of the shares exclusive of any value arising from the merger75
and so is not about getting a share of merger gain. Assuming that the $80 pre-merger market
price was reflective of the value of the preferred, appraisal looks attractive only given Allocation
(3). If, under Allocation (2), the preferred see the $80 market price as inaccurately low, they
must marshal experts who can plausibly project increasing future ABC cash flows in an effort to
get the preferred past the $80,000,000 payout. A shot at getting past Allocation (1) is highly
speculative, for the preferred’s $150,000,000 liquidation preference is relevant only to the extent
it contributed to its pre-merger fair value.76

        Appraisal exclusivity presents several problems. First, there is no recent caselaw on
judicial valuation of preferred,77 so the substantive parameters of the proceeding are a matter of

73
   We also note that the preferred could draft into across-the-board appraisal rights. See Del. Gen. Corp. L. § 162 (c).
This blunts but does not reverse the negative effects on preferred investors of a penalty default regime. That said, if
fiduciary scrutiny is to be withheld, across-the-board appraisal rights would be better effected as a legislative
adjustment. That way, the present generation of contracts gets the benefit.
74
   Appraisal’s availability does not generally pretermit fiduciary review at the instance of common stockholders. For
example, a Revlon complaint about the quality of the process pursuant to which a board set a merger price goes
forward despite the possibility of an appraisal. The same would go for a complaint that an interested director tie
between the target and the acquirer tainted the deal. But there also are exceptions. In a parent-subsidiary merger
case, the plaintiff secures fiduciary review only on a showing of process unfairness. If the complaint goes only to
price, it must be made in an appraisal. Weinberger v. UOP, Inc., 457 A.2d 701, 714-15 (Del. 1983). There is also a
statutory exception. Where the parent owns 90 percent or more of the subsidiary’s stock and takes advantage of a
special merger procedure created by section 253 of the Delaware General Corporation Law, appraisal has been held
to exclusive on a per se basis. See Glassman v. Unocal Exploration Corp., 777 A.2d 242 (Del. 2001).
75
   Del. Gen. Corp. L. § 262(h).
76
   The field of evidentiary possibilities opens up a bit if we change the facts and assume that the preferred was not
publicly traded.
77
   There a recent appraisal proceeding respecting preferred In re Appraisal of Metromedia Intern. Group, Inc.
971 A.2d 893 (Del.Ch.,2009). But the case was decided by reference to conversion value rather than by reference to
the expert reports. Id. at 901-02. See also Gearreald v. Just Care, Inc., 2012 WL 1569818 (Del.Ch.)(appraisal of a
venture capital investee in which the preferred stock is treated as converted pursuant to charter provision).

                                                          21
speculation. Preferred holds out daunting problems for appraisers. Not only must the company’s
future cash flows be projected under uncertainty, but the appraiser must also assess the
probability that the issuer board will exercise its discretion to direct the projected flows to a
future preferred dividend or redemption payment. Second, the process context in appraisal is not
plaintiff-friendly. Appraisals may not be framed as class actions. Appraisal plaintiffs
accordingly must be large stockholders acting for their own accounts. With preferred, this is less
of a problem than formerly due to the proliferation of hedge funds as strategic investors in
publicly traded equity and preferred’s position as the vehicle of choice in venture capital finance.
Preferred stockholders more and more tend to be large institutions with the wherewithal to
undertake expensive appraisal litigation.78 Third, the Delaware statute makes appraisal available
only for a subset of mergers. Appraisal rights obtain if the preferred is privately held, as would
be the case with venture capital financing or a rule 144A offering79 resulting in fewer than 2,000
holders of record.80 Appraisal also is available if the preferred is publicly traded and the merger
consideration is cash or debt securities. But there are no appraisal rights if the preferred is
publicly traded and the merger consideration is publicly traded stock.81

        To show how the three problems can combine to undermine the proposition that appraisal
is an “adequate remedy,” let us return to the dummy merger. Recall that dummy merger’s
provide a means to cram down an equity recapitalization against preferred and that the Delaware
courts sanctioned the technique in Havender.82

        We turn back the clock at ABC Corp. to the time of the preferred’s original public issue
for $100 per share, a total consideration of $100,000,000. Assume that times were good and that
the 2,000,000 shares of common trade for $100 per share. Two months pass. An investment
banker then approaches ABC with a recapitalization plan under which the board engineers such a
dummy merger on a one-for-two basis. This divides ABC’s market capitalization one-fifth to the
preferred ($60,000,000) and four-fifths to the common ($240,000,000). The merger is submitted
to the shareholders and the common uses its majority to cram down the deal. ABC’s preferred
will not have the right to seek appraisal—since the pre-merger preferred is publicly-traded and
the stockholders receive publicly traded stock as consideration in the merger, the appraisal
statute’s exceptions apply.83

        The ABC preferred’s goose is cooked unless it can persuade a court to enjoin the
transaction on fiduciary grounds. Although the hypothetical is fantastic, it makes an important
structural point regarding the vulnerability of preferred: the level of exposure is more severe than
often recognized, potentially permitting even this quasi-conversion of newly-raised capital.
Indeed, even if appraisal were available in this dummy merger it would be unreasonable to remit

Valuation of preferred was a litigated issue under the PUCHA. See, e.g., In re Eastern Gas & Fuels Assoc., 30
S.E.C. 834 (1950); Note, A Standard of fairness for Compensating Preferred Shareholders in Corporate
Recapitalizations, 33 U.Chi. L. Rev. 97 (1965).
78
   Mark J. Anson et al., The Handbook of Traditional and Alternative Investment Vehicles 328-29 (2010)
(discussing hedge fund strategies involving preferred)
79
   See generally, Bratton, supra note 22, at 297.
80
   Del. Gen. Corp. L. § 262(b)(1).
81
   Del. Gen. Corp. L. § 262(b)(1) & (2).
82
   See supra notes 33-37 and accompanying text.
83
   Del. Gen. Corp. L. § 262(b)(1) & (2).

                                                        22
the preferred to it as the exclusive remedy. The transaction is in manifest bad faith and an ex
ante injunction is the cleanest, most appropriate mode of intervention. Interestingly, an old line
of Delaware cases waives appraisal exclusivity to hold out an injunction against dummy mergers
following from “acts of bad faith, or a reckless indifference to the rights of others interested,
rather than from an honest error of judgment.”84 It bears noting that dummy mergers still
occur,85 if not in the particularly crude mode hypothesized here. We can attribute the restraint to
the prospect of judicial scrutiny.

         4. Summary.

        A plausible case can be made for each of corporate and contract treatment. At the same
time, each paradigm leads to excess when applied full dress. Intrinsic fairness review under the
corporate paradigm could throw a wrench into negotiations and in any event would occasion
hold up lawsuits by institutional preferred holders. Complete contract treatment coupled with
appraisal exclusivity is untenable in extreme cases. A door needs to be left open for judicial
scrutiny. This qualified conclusion confirms our point about the intrinsic legal instability of
preferred. Because it straddles the corporate/contract divide, every problem admits of a range of
solutions. The section that follows turns to Delaware law, showing conceptual instability in
action in decided cases.

        We note a point of contrast between the equity recapitalizations discussed in Part I and
the mergers under discussion in this Part. Both involve transactions that create gain and
implicate the slicing of corporate pies. In both cases the pie can be sliced either (1) to split the
gain between the preferred and the common, (2) to leave the preferred at its pre-transaction value
and allocate all the gain to the common, or (3) to transfer pre-transaction value from the
preferred to the common along with all of the gain. Assuming corporate treatment and fiduciary
scrutiny, two questions arise: first, whether the preferred has a right to gain-splitting in a
recapitalization, a merger, or both; and, second, whether a transfer of pre-transaction value from
the preferred to the common breaches a right owed to the preferred in a recapitalization, a
merger, or both. We think that as regards the first, gain sharing question, the two transactional
modes can be distinguished.



84
   Porges v. Vadsco Sales Corp., 27 Del.Ch. 127, 133, 32 A.2d 148, 151 (Del. Ch. 1943). The cases posed a narrow
question: whether appraisal rights, which were more widely available in those days, provided the exclusive remedy.
Ordinarily, they were held to be exclusive, but the cases held out the possibility of an injunction where the merger
amounted to a constructive fraud that “shocked the conscience.” Hottenstein v. York Ice Machinery Corporation,
45 F. Supp. 436 438 (D. Del. 1942), quoting MacFarlane v. North American Cement Corp. 16 Del.Ch. 172, 157 A.
396 (Del. Ch. 1928). See also Cole v. National Cash Credit Ass'n, 18 Del.Ch. 47, 156 A. 183 (Del. Ch. 1931). For
discussion see James Vorenberg, Exclusiveness of the Dissenting Stockholder’s Appraisal Right, 77 Harv. L. Rev.
1189 (1964). As it happened, no judicial consciences were shocked. The cases’ dummy mergers were effected in
order enhance enterprise value by cleaning up dysfunctional equity capital structures and administered pain to the
common as well as the preferred. The directors, rather than displaying reckless indifference to the rights of the
preferred, were muddling through on the downside trying to be fair to everybody. Moreover, the preferred plaintiffs
looked greedy. As in the public utility recapitalizations discussed supra note 29, the preferred insisted on absolute
priority treatment, framing their contract rights in the same mode as a bondholder’s. The courts took the corporate
view that relative priority and some sacrifice were not intrinsically unfair.
85
   See, e.g., Elliott Associates , L.P. v. Avatex Corp., 715 A.2d 843 (Del. 1998).

                                                         23
        A recap strips rights from the preferred for the purpose of enhancing enterprise value.
The transaction makes everybody better off only so long as the gain is shared; a class vote
imports a circumstantial guarantee that sharing occurs. Given no sharing of gain and absent the
consent of the class, the preferred makes a give up without any return. Leaving the preferred
with at its pre-transaction value differs from an affirmative transfer of value from the preferred to
the common only as a matter of degree. Pure exploitation occurs either way. Third party
mergers are different. The gain comes from an outside purchaser rather than from a sacrifice
made by the preferred. Moreover, there are fact patterns on which it is quite clear that the
preferred has no right to share the gain. On an upside scenario where the company has grown
and the preferred’s pre-merger value is higher than its face value (whether due to an attractive
dividend payout or a conversion privilege in the money), the merger parties will exercise their
option to take out the preferred at its redemption price before any question about gain sharing
arises. In other words, the preferred is treated as senior claim with a capped upside. On
downside patterns, where the preferred’s market value is below its liquidation value, it has a
right to its liquidation value only if contracted for explicitly. 86 To accord the preferred a right to
share merger gain on the downside fact pattern—an amount higher than pre-merger value but
lower than liquidation value—does follow from the analogy to minority common stock. But it is
not at all clear that the analogy should be drawn here. Nothing compels it, and reference to the
contract paradigm undercuts it: if the preferred want a premium, all it has to do is negotiate a
class vote.

B. Delaware Law

       In this Section we will put the ABC Corp. preferred through a modern cashout merger,
applying Delaware cases decided prior to the recent decision of LC Capital Master Fund, Ltd. v.
James. Section C will reconsider matters in light of James.

        We will take the ABC Corp. facts with one change—the preferred’s liquidation price plus
arrearages add up to only $110 per share. XYZ Corp. proposes a $140 million cash merger to
the ABC board, offering $110 per share for the preferred, and $15 per share for the common. As
has happened in litigated cases,87 XYZ makes its bid under the impression that the preferred
must be paid its liquidation preference in order to be cashed out in a merger. ABC’s investment
banker points out the error to XYZ, even as ABC’s CEO suggests that the bid should allocate
more to the common. The bid is reformulated accordingly. The new bid holds out the same total
consideration, but now the offer is $80 per share for the preferred and $30 per share for the
common. ABC’s top executives as a group hold 15 percent of the common and no preferred. A
majority of ABC’s directors are independent, and all of these directors hold trivial amounts of
the common and no preferred. After the reformulation of the bid, a committee of independent
directors is organized at ABC. It proceeds to negotiate the merger, securing $10 million
additional consideration. The added consideration is distributed between the common and the
preferred in proportion with the existing allocation so that the final price is $85.70 per share for
the preferred and $32.15 per share for the common. The special committee determines the
preferred/common allocation to be fair, with the concurrence of its investment banker. At no

86
 See Rothschild Int’l Corp. v. Liggett Group Inc., 474 A.2d 133, 137 (Del. 1984).
87
 See LC Capital Master Fund, Ltd. v. James, 990 A.2d 435, 441 (Del. Ch. 2010); Dalton v. American Investment
Co., 490 A.2d 574, 576 (Del. Ch. 1985).

                                                     24
point, however, does the committee consider the allocation’s etiology or inquire further into the
value of the preferred’s claim. Nor is a valuation report addressing the allocational question
requested from the investment banker. The preferred will not have a class vote because the
charter does not provide for one, but in this case it will have appraisal rights.88

       The preferred bring an action to enjoin the merger in the Delaware Chancery Court,
claiming a breach of fiduciary duty by the ABC board. The Delaware cases give the holders an
argument, an argument unlikely to succeed.

        We already have seen that old dummy merger cases express a preference for the appraisal
remedy but hold out the possibility of an injunction against a bad faith cram down. 89 The
modern precedent begins with a standard enunciated in 1986 by Chancellor Allen in Jedwab v.
MGM Grand Hotels90:
        [W]ith respect to matters relating to preferences or limitations that distinguish preferred
        stock from common, the duty of the corporation and its directors is essentially contractual
        and the scope of the duty is appropriately defined by reference to the specific words
        evidencing that contract; where however the right asserted is not to a preference as
        against the common stock but rather a right shared equally with the common, the
        existence of such right and the scope of the correlative duty may be measured by
        equitable as well as legal standards.91
This means, at a minimum, that the preferred will not be able to base a fiduciary case on the
merger’s failure to yield its $110 liquidation preference plus arrears.92 But it also stands for the
proposition that a merger allocation between preferred and common is subject to fiduciary
scrutiny.

        A question nonetheless arises regarding the standard’s division of the field into an
impermissible “contractual” zone and a fiduciary zone concerning “rights shared equally.” This
could operate as a filter, dividing merger fact patterns two groups, one subject to judicial scrutiny
and the other immune. More particularly, if the preferred receives at least what the common
receives has it been treated equally within Jebwab? That would mean taking the $150 million
consideration and distributing it pro rata to the common and preferred at $50 per share. If the
answer is yes, the reason is that any consideration paid to the preferred beyond $50 by definition
compensates for its “contractual” rights and preferences and lies outside of fiduciary territory.
As to those contract rights, the preferred can seek appraisal.

         Jedwab did not address this question,93 but Chancellor Allen himself impliedly rejected
this narrow reading in a later opinion, In re FLS Holdings Shareholders Litigation.94 There the

88
   Del. Gen. Corp. L. §262(b)(2).
89
   See supra note 84 and accompanying text.
90
   509 A.2d 584 (Del. Ch. 1986).
91
   Id. at 594.
92
   See Rothschild Int’l Corp. v. Liggett Group Inc., 474 A.2d 133, 137 (Del. 1984), which rejects a fairness claim
based on the preferred’s “expectation” that it would receive its liquidation preference in a cash out merger. The
case, invoking the doctrine of independent legal significance, also rejects a substance over form argument that a cash
out merger should be treated as if it were a liquidation. Id. at 136-37.
93
   509 A.2d at 594-95. It was a case were the preferred received less than the common A single shareholder owned
control blocks of both the preferred and the common. Chancellor Allen put the control shareholder’s presence

                                                         25
preferred received more than the common, but only slightly.95 The board of directors, dominated
by representatives of the common, had steadily carved out a larger share for the common in the
course of an extended negotiation.96 The directors, said Chancellor Allen, had a duty to both
classes and were “obligated to treat the preferred fairly,” even as the standard of review was
“somewhat opaque.”97

        Both opinions discuss boardroom process. Jedwab suggests a special negotiating
committee for the preferred comprised of independent directors98 while FLS Holdings holds out
“a truly independent agency on the behalf of the preferred,”99 adding that a valuation study
prepared by the board’s investment banker ex post the negotiation amounts to a “relatively
weak” protection.100 But a rule-based approach to process protections is rejected—while “such
factors typically constitute indicia of fairness; their absence, however, does not itself establish
any breach of duty.”101

        Jebwab and FLS therefore stand for the proposition that the preferred can get more per
share than the common and still get a hearing, but do little to add particulars. Chancellor Allen
later characterized the cases as a backstop: the preferred holders get the hearing when in an
“exposed and vulnerable position vis-à-vis the board of directors.”102 Just what makes for
exposure and vulnerability is unclear, although it bears noting that Jedwab and FLS involved
issuers and boards under the immediate control of majority blockholders. 103 ABC, in contrast,
has dispersed shareholders and a majority independent board.


together with the unequal payment outcome to invoke intrinsic fairness as the standard of review. He ruled that the
deal passed inspection, id. at 595-96, 600, and his reasons were persuasive. The preferred received less than the
common because its “preferences” limited its upside potential; the preferred accordingly was worth less than the
common. Id. at 596-98. The issuer was Kirk Kerkorian’s MGM Grand, which was in a fix after a catastrophic fire
at its Las Vegas hotel. The preferred was offered to the common in an exchange offer, with its dividend preference
set at the most recent MGM Grand dividend and its mandatory redemption payout set slightly above the current
stock price. The lowball preferences ultimately caused its market value to lag the common’s after the company
recovered.
94
   1993 WL 104562 (Del. Ch.).
95
   Id. at 3-4.
96
   Id. at 2-4.
97
   Id. at 4.
98
   509 A.2d at 599. A voluntarily conceded class vote also is suggested. Id.
99
   1993 WL 104562, at 5.
100
    Id.
101
    509 A.2d at 599.
102
    HB Korenvaes Investments, L.P. v. Marriott Corp., 1993 WL 205040 at *5 (Del.Ch. June 9, 1993).
103
    Another case, Dalton v. American Investment Co., 490 A.2d 574 (Del. Ch. 1985), is closer on the facts. There
an initial offeror proposed a merger that would have paid a class of perpetual preferred its liquidation value of $25
and $12 for the common. Unfortunately for the preferred, the offer came to naught for extraneous reasons. The
issuer’s CEO then shopped the company, stipulating that $13.50 would be an appropriate price for the common.
The eventual acquirer paid $13 for the common and suggested the preferred, which had a low dividend payout rate,
be left untouched in the issuer’s capital structure as “cheap debt.” (This is an option given a triangular merger
structure in which the target is technically the surviving corporation and no charter provision dictating some other
treatment for the preferred.) The CEO, however, thought that treatment unfair to the preferred and negotiated a step
up in the dividend rate from 5 percent to 7 ½ percent and a 20 year mandatory redemption schedule.
           The Chancery Court reviewed the case without articulating the standard of review being applied. The
question, said the Court, was whether the treatment of the preferred resulted from the CEO’s $13.50 solicitation or
was a function of the business preferences of the acquirer. The Court found that the acquirer’s interests were the

                                                         26
        Jedwab and FLS are not the only preferred cases in the Delaware canon. Chancellor
Allen later voiced a contractual view of preferred:
        [T]o a very large extent, to ask what are the rights of the preferred stock is to ask what are
        the rights and obligations created contractually by the certificate of designation. In most
        instances, given the nature of the acts alleged and the terms of the certificate, this
        contractual level of analysis will exhaust the judicial review of corporate action
        challenged as a wrong to preferred stock.104
Finally, in the last case in the series, Chancellor Allen gestured to common stock value
maximization:
        [G]enerally it will be the duty of the board, where discretionary judgment is to be
        exercised, to prefer the interests of common stock as the good faith judgment of the
        board sees them to be to the interests created by the special rights, preferences, etc., of
        preferred stock, where there is a conflict.105

        Restating, the applicable Delaware law includes five principles (1) fiduciary intervention
is possible where the preferred is an exposed and vulnerable position; (2) fiduciary duties are
owed regarding rights shared equally with the common but not regarding preferences; (3) boards
should prefer the common when exercising discretion; (4) preferred should look to appraisal for
a remedy; and (5) preferred should protect itself contractually.

        Thus summarized, Delaware law is more than usually open-ended. It touches both of the
hard-edged alternatives laid out in Section A—fiduciary scrutiny and complete contract plus
appraisal exclusivity. As such, the various components stand in mutual tension; they do not
“synthesize.” If the board’s duty is to favor the common when making discretionary decisions, it
is hard to see how a boardroom process could breach a duty to the preferred even on Allocation
(3). If the default rule is explicit contractual protection or appraisal is exclusive, it is hard to see
how vulnerability and exploitation ever can be actionable. The tension follows from preferred’s
dual corporate and contractual character. Given the long menu of choices, the judge in effect is
called on to make a menu choice, deciding which paradigm to stress on the facts of the case.

        Let us now state a case for the ABC preferred. It builds on four process points. First, the
allocational shift from the preferred to the common came at the instance of the ABC CEO, who
owned a significant chunk of common. Second, the subsequent deal management by ABC’s
independent directors failed to correct the allocational mishap because no inquiry was made into


determining factor. It followed that there was no breach of duty. Id. at ___. The emphasis on causation and
culpability implies not intrinsic fairness but a standard of review closer to the good faith standard invoked in dummy
merger cases, with its emphasis on bad faith and reckless indifference to the rights of others.
104
    HB Korenvaes Investments, L.P. v. Marriott Corp., 1993 WL 205040 at *5 (Del.Ch. June 9, 1993). See also In re
Appraisal of Metromedia Int'l Group, Inc., 971 A.2d 893, 899-900 (Del.Ch.2009) (“[R]ights of preferred
shareholders are contractual in nature and the ‘construction of preferred stock provisions are matter of contract
interpretation for the courts.’ ... Unlike common stock, the value of preferred stock is determined solely from the
contract rights conferred upon it in the certificate of designation.... In other words, the valuation of preferred stock
must be viewed through the defining lens of its certificate of designations, unless the certificate is ambiguous or
conflicts with positive law.”)
105
    Equity-Linked Investors v. Adams, 705 A.2d 1040, 1042 (Del. Ch. 1997).

                                                          27
the causal chain, the acquirer’s business interests, or the relative values at stake. Third, all of the
directors owned common, raising a question regarding their independence. And, fourth, the
process included no independent agent to negotiate for the preferred. The question will be
whether the four points add up to show that the preferred’s position was “exposed and
vulnerable.”

        ABC will note in response that Jedwab and FLS do not mandate a special committee. The
availability of appraisal remains a consideration when a party asks that a merger be enjoined: 106
To the extent the preferred seeks to show that its share of the merger price falls below the stock’s
intrinsic value, it should go to appraisal. More importantly, a class of preferred walking away
with a premium over market price has no cause to complain; if anyone has a complaint, it is the
common whose merger gain has been thereby diverted.

C. James

        Chancellor (then Vice-Chancellor) Strine tilted emphatically toward the contract
paradigm in LC Capital Master Fund, Ltd. v. James.107 The preferred in question had been
issued in a rule 144A offering for $25 per share, an amount equal to its liquidation preference.
The charter provided for a 5.5 percent discretionary but cumulative dividend.108 The stock was
convertible into common at a conversion price of $15.50.109 The conversion price was set at the
high end of the trading range of the issuer’s common stock at the time of issue.110 The price
promptly declined: during the life of the preferred issue, there were only two quarters in which
the stock price briefly and slightly exceeded the conversion price.111 In the merger, the common
were cashed out at $8.50 and the preferred at $13.71.112 The $13.71 was derived by applying
the conversion ratio (1.6129) to the merger consideration paid to the common113—as if the
charter provided (which it did not) that a merger triggered a mandatory conversion.

         The deal process had been tense. There were discussions with several suitors, one of
which started out at a $25 per share figure for the preferred. A committee of independent
directors took charge. All members of the committee owned common, three out of four in trivial
amounts, but with one holding an 8 percent block worth $5.4 million. The committee found
itself between a rock and a hard place. The preferred would sue if its price was not raised above

106
    See LC Capital Master Fund, Ltd. v. James, 990 A.2d 435, 454 (Del. Ch. 2010).
107
    Id.
108
    Id. at 440.
109
    The price was revised pursuant to the charter in the wake of a reverse stock split by the issuer. The original
conversion price was $3.10.
110
    See QuadraMed Corporation, Pre-Effective Amendment No. 2 to Form S-1 Registration Statement, p. 18, filed
June 14, 2004, available at http://www.sec.gov/Archives/edgar/data/1018833/000119312504102710/ds1a.htm. This
document reports that the stock price ranged from $2.70 to $3.05 on June 10, 2004.
111
    This follows from an inspection of the quarterly stock price charts in the issuers 10-K reports filed in 2009 and
2006. The quarters were the first quarter of 2007, when the price peaked at when the price peaked at $3.29 and the
second quarter of 2004, when the price peaked at $3.55. See QuadraMed Corporation, Form 10-K, filed March 11,
2009, at 20 available at http://www.sec.gov/Archives/edgar/data/1018833/000119312509049923/d10k.htm;
QuadraMed Corporation, Form 10-K, filed March 16, 2006, at 29 available at
http://www.sec.gov/Archives/edgar/data/1018833/000119312506056657/d10k.htm#tx55645_10.
112
    990 A.2d at 439.
113
    Id. at 444 & n. 36.

                                                         28
$13.71. But if the Committee raised the preferred payout it ran the risk that the deal would lose
the voting support of the common,114 83.4 percent of which was owned by five hedge funds.115
The committee also may have been wary of second lawsuit: counsel advised the Committee that
it needed to be “careful” about allocating more to the preferred, absent some “special reason.”116
As it navigated these shoals the Committee dragged its feet on cashing out the preferred and tried
to cut a deal that left the preferred in the issuer’s capital structure untouched, a result that
apparently would have satisfied both the common and the preferred. Unfortunately, the potential
merger partner wanted to replace the preferred with debt. In the end, the Committee approved
$13.71 without the support of a fairness opinion from its investment banker.117

        The preferred, whose discretionary dividends appear to have been paid up to date,118 took
the position that their financial rights entitled them to a good bit more than $13.71. Restating, an
allocation of $13.71 was the functional equivalent of Allocation (3). Chancellor Strine, however,
refused to enjoin the merger and remitted the preferred to appraisal.119

        The opinion stoutly resists invocation of Jedwab and FLS. The preferred’s claim to a
second special committee might have been rejected on the facts of the case—the deal was fragile
and a second special committee might have disrupted the negotiations. The opinion goes farther,
invoking both the complete contract and the common stock value norm. The preferred, having
passed up the opportunity to address merger pricing contingencies in the charter and negotiate a
class vote or liquidation treatment, cannot later call on the Chancery Court’s solicitude:120 “Our
law has not, to date, embraced the notion that Chancery should create economic value for
preferred stockholders that they failed to secure at the negotiating table.” 121 Indeed, fiduciary
law, far from requiring the board to make a fair allocation, disables the board from doing so: the
Court cautions that the duty to maximize for the common could lead to liability for a director
who intervenes to protect the preferred.122

      Thus does James work hard to erase Jebwab and FLS Holdings. But it does so in dicta,
and can be read more narrowly. More particularly, the Court, taking a cue from the board
committee, deems the conversion price to be a contractually designated merger payout. 123 Given

114
    Id. at 444.
115
    See QuadraMed Corporation, Schedule 14A, p. 85, filed Feb. 8, 2010, available at
http://www.sec.gov/Archives/edgar/data/1018833/000119312510024517/ddefm14a.htm.
116
    990 A.2d at 443.
117
    Id. at 444.
118
    The corporation made open market common stock repurchases, which would have been forbidden by the charter
provisions protecting the preferred. See QuadraMed 2009 Form 10-K, supra note 111, at 23; QuadraMed
Corporation, Certificate of the Designation, Powers, Preferences, and Rights of the Series Cumulative Mandatory
Convertible Preferred Shares, Par Value $.01 per Share, § 3(d), QuadraMed Corp. Form 8-K, filed June 17. 2004,
Exhibit 3.1, available at
http://www.sec.gov/Archives/edgar/data/1018833/000119312504104592/dex31.htm. Charter sec,. available at
119
    Id. at 454.
120
    Id. at 449. Even the discretionary dividend preference is questioned. Despite the facts that the dividend was
cumulative and in fact was paid and that the issue was deemed financially burdensome by potential acquirers, the
court suggests that given only a discretionary dividend there is no value to allocate. Id.
121
    Id.
122
    Id. at 447.
123
    Id. at 451.

                                                       29
a payout fixed in the charter there is no case for breach of fiduciary duty, for the board has no
allocational decision to make. Indeed, given a fixed merger payout, any board that allocated
more for the preferred would indeed be open to a lawsuit by the common.

       The court, however, does not indicate where and how the charter effects this result. Our
review of the charter shows that there is no express merger price designation. Mergers are
mentioned in the charter’s conversion provisions, but only so as to set conversion rights going
forward in a case where the preferred remains in the capital structure of the corporation surviving
the merger.124

        There being no express designation, the contractual allocation on which the court relies
must be implied. It is hard to fathom an economic basis for the implication. A conversion
privilege is an option that gives a fixed interest holder a shot at upside gain. It does not have the
converse effect of dragging the fixed interest holder down with the issuer—on the downside the
convertible holder relies on its fixed payment stream to preserve the value of its interest. 125 This
heads-I-win-tails-you-lose result is not a free lunch; it is priced out in the interest rate on the
security.126 Given this trade off, it makes no sense to have the convertible’s value in a merger
decline in lockstep with the issuer’s common stock.127 Indeed, it undercuts the deal. There is

124
    See QuadraMed Certificate of Designation, supra note 118. The charter’s section 7(f) reads as follows: “If the
Corporation shall be a party to any transaction (including without limitation a merger, consolidation, statutory share
exchange, self tender offer for all or substantially all Common Shares, sale of all or substantially all of the
Corporation’s assets or recapitalization of the Common Shares and excluding any transaction as to which
subparagraph (d)(ii) of this Section 7 applies) (each of the foregoing being referred to herein as a “Transaction”), in
each case as a result of which Common Shares shall be converted into the right to receive stock, securities or other
property (including cash or any combination thereof), each Series A Preferred Share that is not converted into the
right to receive stock, securities or other property in connection with such Transaction shall thereafter be convertible
into the kind and amount of shares of stock, securities and other property (including cash or any combination
thereof) receivable upon the consummation of such Transaction by a holder of that number of Common Shares into
which one Series A Preferred Share was convertible immediately prior to such Transaction, assuming such holder of
Common Shares (i) is not a Person with which the Corporation consolidated or into which the Corporation merged
or which merged into the Corporation or to which such sale or transfer was made, as the case may be (a “Constituent
Person”), or an affiliate of a Constituent Person and (ii) failed to exercise his or her rights of the election, if any, as
to the kind or amount of stock, securities and other property (including cash or any combination thereof) receivable
upon such Transaction (provided that if the kind or amount of stock, securities and other property (including cash or
any combination thereof) receivable upon such Transaction is not the same for each Common Share of the
Corporation held immediately prior to such Transaction by other than a Constituent Person or an affiliate thereof and
in respect of which such rights of election shall not have been exercised (“Non-Electing Share”), then for the
purpose of this subparagraph (f) the kind and amount of stock, securities and other property (including cash or any
combination thereof) receivable upon such Transaction by each Non-Electing Share shall be deemed to be the kind
and amount so receivable per share by a plurality of the Non-Electing Shares). The provisions of this subparagraph
(f) shall similarly apply to successive Transactions.”
125
    Bratton, supra note 22, at 684-87.
126
    Id. at 684.
127
    Because we read the QuadraMed conversion privilege in this conventional way, we are unpersuaded by
Chancellor Strine’s argument that James is consistent with Jedwab and FLS Holdings. He relies on HB Korenvaes
Investments, L.P. v. Marriott Corp. 1993 WL 205040 (Del. Ch.). Korenvaes points out that the existence of a
fiduciary duty to preferred is situational, id. at 6, and finds on the facts that the charter had allocated the risk in
question. Id. at 7. Vice Chancellor Strine draws the following conclusion, 990 A.2d at 448-49:

         The reasoning of Korenvaes reconciles the doctrine. 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

                                                            30
nothing in the charter in James that signals anything other than such a conventional arrangement.
Any implications in the charter go in the opposite direction: Mandatory conversion was provided
for, but only in the event the common stock sustained a price of $25.50,128 something it had
never done. Otherwise, this conversion privilege was drafted as an option paid for by the holder
to be held in reserve for the holder’s benefit.

        We do not read James to require this subversive reading of standard conversion
provisions as a matter of interpretation. There would be no reason for the Court to mention the
appraisal option if the charter in fact specified a merger payout, for such an appraisal would yield
$13.71 and not a penny more.129 We read the case’s insistence on an ex ante contractual
settlement the same way we read its rejection of Jedwab and FLS. The court, having determined
on the facts to go the contractual route, emphasizes contractual items in the doctrinal toolbox at
the expense of the fiduciary items. Jedwab and FLS are still there in the box even as the refusal
to bring them to bear in James makes their future use less likely.

       We have no quarrel with the result in the case,130 if only due to the risk that an injunction
might cause the acquirer to walk away from the deal and the availability of appraisal. We also
note that the preferred was not necessarily claiming a share of merger gain, only the economic
value of its participation. Roughly speaking, the James preferred allege Allocation (3). In this
posture, given the risk of deal disruption, appraisal sufficiently vindicates the claim. Finally, as
the Court notes, the struggling board was in good faith.131

D. Summary

        The overlapping paradigms come to bear on James with more than usual dysfunction.
This is because the law, in its present posture, poses a stark either/or, asking the court whether
the preferred’s vulnerability and the board’s exploitation of it combine to trigger intrinsic
fairness scrutiny. If the answer is yes, a heavy, potentially disruptive process burden crashes
down on the board; if the answer is no, contract and appraisal determine the result. In our view
this doctrinal sturm und drang can be avoided by reference to the good faith standard of review
employed in the old dummy merger cases.132 Under this the court asks whether board acted in
bad faith with reckless indifference to the rights of the preferred rather than making an honest

         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. When, however, as in Jedwab and FLS Holdings, there is no
         objective contractual basis for treatment of the preferred, then the board must act as a gap-filling agency
         and do its best to fairly reconcile the competing interests of the common and preferred.

We find the contract here every bit as incomplete as those in Jedwab and FLS Holdings. Meanwhile, Korenvaes did
not involve a merger. It was a straightforward application of an antidilution clause.
128
    See QuadraMed Certificate of Designation, supra note 118, § 8. The $5.10 figure therein provided has been
adjusted in the text for QuadraMed’s later reverse stock split.
129
    See In re Appraisal of Metromedia Int’l Group, Inc., 971 A.2d 893, 907-8 (Del. Ch. 2009)(fixing appraisal
recovery at price set in charter).
130
    We do wish that Chancellor Strine, after noting that he doubted that the that fourth director, the one with a $5.4
million stake in the common, would compromise his principles in order to pick up a few hundred thousand dollars
extra, 990 A.2d ar452-53, had signaled that he would in the future be less understanding.
131
    990 A.2d at 451-52.
132
    See supra note 84 and accompanying text.

                                                          31
business judgment. (We suspect that the court in James asked just this question sub silentio
when choosing among the competing paradigms.)

        The lesser good faith standard opens a big tent that accommodates the results of all of the
cases along with the overlapping paradigms. While James’ contractual aspirations are
understandable, a totally contractual posture is not sustainable. The pattern of incomplete
contracting remains embedded and leaves an open a door for conscience-shocking opportunism.
Boards, moreover, will do a better job when making these allocational decisions if counsel
advises of the possibility of judicial second guessing. Indeed, to assure scrupulous adherence to
the standard of independent director determination on a well-informed basis, we would specify
that the burden of proof on good faith fall on the board of directors.

        We have a suggestion as to how the board easily might meet that burden: the independent
committee should contain at least one director charged to represent the interest of the preferred.
This is potentially disruptive, for a dissenting vote by a representative would assure litigation.
We think that possibility would be minimized if the law were clarified on the basic distributional
point. We know of no principle according preferred a right to Allocation (1) and a share of the
gain in a third party merger.133 The corporate/contract paradigms would overlap more peacefully
if the point were made explicit: the preferred’s rights are capped at pre-merger value; to the
extent an issue of preferred wants a shot at gain, it should negotiate a class vote. Given the
clarification, the preferred’s representative would have a limited task, a task looming large only
in the absence of a market price establishing pre-merger value. Absent a price, the representative
should force the committee to confront evidence of pre-merger value in the form of a neutral
investment banker report, a confrontation that does not appear to have occurred in James.

       Good faith review, then would serve to direct the board to Allocation (2) and away from
the temptation of Allocation (3). Absent bad faith, objecting preferred should be remitted to
appraisal and statute amended to make appraisal universally available to preferred forced to take
anything other than their existing stock.

        We would make one additional change in the law. Common stock value maximization
needs to be taken out of this doctrinal toolbox. It is analytically unsuitable. To see why, return
to ABC Corp. and ask how a common stock maximizing board should make the allocation. The
answer is easy: it should employ Jedwab’s core equity versus contract rights distinction and
allocate the same $50 per share to everybody, transferring $20 million of pre-merger value from
the preferred to the common. Carrying the point to its logical conclusion, the ABC board never
should have allowed preferred arrearages to accumulate in the first place. It should have effected
a one-to-one dummy merger against the preferred immediately upon issuance. The board in
James should have done the same thing. With the preferred convertible into common at $15.50,
an immediate dummy merger after sale of the preferred for $25 would have created $9.50 of
shareholder value!



133
   We say “third party merger” intentionally. Given a gain yielded in an equity recapitalization through dummy
merger we would give the preferred a right to a share, for in that case the gain arises entirely as a function of the
preferred’s loss of its contracted for rights.

                                                           32
        These contracts can be incomplete in fact and make no business sense if their
performance is remitted to a common maximizing board without backstop judicial scrutiny.
Meanwhile, the intuition that motivates the common maximization principle will be fully
satisfied once the law clearly blocks any preferred claim to a share of merger gain.

        Finally, we note that an alternate route to fairness review arises in the zone of
paradigmatic overlap: the contractual duty of good faith. The analysis starts with Jedwab’s
paradigmatic division between contractual preferences and rights in common. As the value
impaired by the merger stems from the preference, the contract treatment arguably is appropriate.
The good faith constraint is triggered when a party exercises a contract right in such a way as to
as to deprive a counterparty of core expectations,134 which arguably is the case here. The case
can be framed objectively, looking to the degree of deprivation, or subjectively, looking to the
culpability of the actors who effected the injury.135 Thus framed, the contract case roughly
tracks the corporate good faith case. But there are some sticking points. There is a special
formulation of contract good faith applied to financial contracts governing senior securities,
under which good faith comes to bear only when the issuer traverses rights explicitly created in
the contract. In cases concerning bonds this tends to cut off good faith review.136 The preferred
can contend that the block does not apply because the merger has the effect of stripping its
contract rights, but the theory is untested. Delaware precedent raises an additional barrier,
holding that good faith implies a counterfactual finding that the parties would have drafted for
the right asserted by the preferred had they thought about it.137 If the right asserted is defined as
a class vote, then the counterfactual finding cannot be made. If the right is defined more broadly
as a right to have the preferreds’ going concern value considered in the merger allocation, then
the contract good faith case should lie.

        Thus sketched, the contract good faith case differs little from the corporate alternative but
for the sticking points. An issue arises as to which route is more “appropriate.” In our view the
corporate path makes more sense. The courts opted for corporate treatment of mergers and
charter amendments long ago, a jump shift to contract only confuses matters further.




134
    See, e.g., Kirke La Shelle Co. v. Paul Armstrong Co., 188 N.E. 163, 167 (N.Y. 1933).
135
    Quadrangle Offshore (Cayman) LLC v. Kenetech Corp., 1999 WL 893575 (Del Ch.), aff’d, 751 A.2d 878 (Del.
2000), is a Delaware preferred case that takes a step in this direction, entertaining the suggestion that a series of
actions taken by a distressed issuer might have been taken with an intent to frustrate the preferreds’ right to a
liquidation preference. The facts of the case did not bear out the suggestion of bad faith and the court denied the
claim.
136
    Broad v. Rockwell Int’l Corp., 642 F.2d 929, 957 (5th Cir. 1981)(en banc), cert denied, 454 U.S. 965 (1981), is
the leading case.
137
    See Katz v. Oak Indus., 508 A.2d 873, 880 (Del. Ch. 1986).

                                                          33
                                     III. THE PAYMENT STREAM
        Financial preferences, the basic rights making up the core of preferred stock’s value, can
be structured as priorities or as promises to pay. Either way, they subsist in an ambiguous,
unstable legal environment. We have seen that priority dividends in arrears can be stripped in a
dummy merger. This Part turns to mandatory preferred for a look at the strange, second order
status of an issuer’s promise to pay a preferred dividend or redeem a preferred issue at stated
value. Second order status follows from preferred’s dual nature. The promise to pay is, of
course, contractual. But, because it is attached to a corporate equity interest, the law refuses
enforcement if enforcement impairs the interests of contract creditors. The parameters of this
zone of constraint remain unclear, admitting of a narrow definition that enhances the promise’s
contractual power and a broad definition that emphasizes corporate status and makes
enforcement difficult. Meanwhile, the cases are old.

        Recently, in SV Investment Partners, LLC v. ThoughtWorks, Inc.,138 the Delaware
Chancery Court radically expanded the zone of enforcement constraint, stripping away the
promise’s contractual vitality by remitting the decision to perform the promise to pay to the
discretion of the issuer board and thereby subordinating the preferred’s payment rights not only
to the interests of the issuer’s creditors but to those of its common stockholders. This Part
explains the case as an updating exercise. The old cases are not only unclear but institutionally
dated, relying on judicial business judgments about ability to pay. ThoughtWorks, by remitting
the matter to board discretion, aligns the legal treatment with the modern approach. The case
also imports clarity by minimizing the old cases’ corporate/contract dualism and pushing the
treatment deep into corporate territory.

       The problem is that the promise itself gets erased in the course of the updating. So we
experiment with the converse approach, asking whether it is feasible to push the treatment deep
into contract territory by minimizing the enforcement constraint. We show that this approach
holds out no danger to corporate going concerns and protects transactional integrity.

       Section A describes the doctrinal inheritance. Section B turns to the ThoughtWorks
opinion. Section C accounts for the approach taken in the case and outlines an alternative.
Section D concludes.

A. The Promise to Pay on Preferred

        We have seen that dividend and liquidation priorities remit considerable payment
discretion to issuer boards of directors. Board discretion can be further expanded by making a
preferred issue redeemable only at the board’s option. One-way redemption permits the board to
pay down the preferred at its stated value when an alternative means of financing becomes more
desirable or the issue otherwise becomes burdensome.139 The stated amount, even as it bears a
more than passing resemblance to the principal amount of a bond, does not otherwise “come
due” pursuant to a preset repayment schedule. The issuer can leave the preferred it in its capital

138
    7 A.3d 973 (Del. Ch. 2010), affirmed SV Investment Partners, LLC v. ThoughtWorks, Inc., 37 A.3d 205
(Del.Supr.).
139
    Buxbaum, supra note 2, at 265, quoting Ballantine, Corporations 509 (rev. ed. 1946).

                                                      34
structure indefinitely. The matter of payment being largely vested in the board’s business
judgment, the financial rights of priority preferred holders, while created contractually, very
much lay on the corporate side of the paradigmatic line.140

        Preferred also can be drafted to look like debt, with a promise to pay a fixed dividend
(paralleling the payment of interest) and a promise to redeem the issue on a fixed date or series
of dates (paralleling the repayment of principal). This discretion-constraining alternative has
long been open, but has been only sporadically taken up in practice.141 When it has been taken
up in history, there has been a residuum of legal hostility. Some state statutes threw up barriers to
fixed redemptions,142 and courts resolved interpretive doubts respecting constraints on boards’
payment discretion in issuers’ favor.143

        There also was (and remains) a doctrinal barrier to enforcement of preferred payment
mandates. Promises to pay dividends on stock or redeem stock for cash cannot be made absolute
in the same sense as can promises to pay interest and repay principal on a bond. Because
preferred is stock, the promise takes a second order status. It is enforceable as regards the
common144 but carries a claim junior to the claims of the corporation’s creditors. The law
embeds this junior status when it makes payments to preferred stockholders subject to state law
legal capital rules and fraudulent conveyance law, both of which protect creditors of distressed
corporations from opportunistic payouts to stockholders.145 The former prohibits dividend or
redemption payments that render the corporation’s balance sheet insolvent or reduce a stated
capital figure booked on the balance sheet as shareholder equity.146 The latter protects corporate
creditors on a going concern basis, blocking payments on stock that leave the corporation with an
asset base too small to sustain its business or disable the corporation from paying its debts as
they come due.147



140
    There are cases that find an “abuse of discretion” regarding withheld dividends. See W.Q. O’Neall Co. v.
O’Neall, 108 Ind. App. 116, 25 N.E.2d 656 (1940)(dividend ordered on preferred stock on ground of oppression of
legatees of shareholder of family corporation); Cf. Channon v. Channon Co., 218 Il. App. 397 (1920)(ordering
dividend on common in family corporation on ground of arbitrary refusal to pay).
141
    Buxbaum, supra note 2, at 265 (describing compulsory redemption clauses as “seldom used” and “somewhat
anomalous to the nature of preferred stock). Compare 1 Dewing, supra note 17, at 153-56, which notes that
mandatory redemption preferred was frequently issued during the boom of the 1920s, but fell out of favor after
mandatory terms resulted in some of the issuers’ financial distress during the Depression.
142
    See Cal. Corp. Code § 1101 (restricting redemption to sinking fund out of earnings).
143
    See Crocker v. Waltham Watch Co., 315 Mass. 397,402, 53 N.E.2d 230, 233 (Mass. 1944)( “The cases in this
Commonwealth as well as those of other jurisdictions reveal, in general, a reluctance on the part of the courts to
construe provisions relative to the declaration of dividends in such a way as to hold that it is mandatory upon the
directors in any circumstances to declare dividends. The courts prefer not to interfere thus with the sound financial
management of the corporation by its directors, but declare as a general rule that the declaration of dividends rests
within the sound discretion of the directors, refusing to interfere with their determination unless a plain abuse of
discretion is made to appear.”)
144
    See Ammon v. Cushman MotorWorks, 128 Neb. 357, 258 N.W. 649 (1935)(describing an undertaking between
the issuer and the holder).
145
    Thus is a preferred acceleration provision triggered by skipped dividends ineffective against creditors. See Allied
Magnet Wire Corp. v. Tuttle, 199 Ind. 166, 154 N.E. 480, 156 N.E. 558 (1926).
146
    See Del. Gen. Corp. L. §§ 154, 170; Bratton, supra note 22, at 498-500.
147
    See Uniform Fraudulent Transfer Act § 4(a); Bratton, supra note 22, at 518-21.

                                                          35
        The law of preferred could make a simple reference over to these well-articulated
doctrines, block payments that traverse them, and stop there. Some cases do just that, stating that
the payment may not render the issuer insolvent.148 Other cases, however, variously articulate
more open-ended limitations.149 These prohibit redemptions that “impair,”150 “prejudice”151 or
“injure”152 interests of creditors, suggesting a barrier higher than the legal capital rules and
fraudulent conveyance otherwise create. Whatever the phrasing, the burden of proof is on the
preferred153 seeking to enforce its promise. It is accordingly the drafting custom to condition
preferred payment mandates on the presence of “funds legally available therefor.”154

        The payment constraint’s meaning is clear only at the extremes. On one side stands an
issuer in severe financial distress. Here the promise to pay on preferred is clearly unenforceable.
On the other side stands an issuer in excellent financial health. Assume that a large mandatory
redemption is coming due and the company has the cash or sources of financing to fund it. If the
company nonetheless misses the payment, it’s easily verified wherewithal puts the preferred in a
position to meet the burden to show “legally available” funds and bring a successful enforcement
action. Things still can get awkward, however. If the preferred sues on the unperformed promise,
gets a judgment, and then levies execution on the judgment, it technically bootstraps itself to the
status a secured creditor,155 jumping over pre-existing unsecured creditors. Presumably, given a
healthy issuer no creditors will raise an objection.

        Between the two extremes, where the issuer is not in distress but does operate under
financial constraints, things are not clear at all. Board discretion starts to matter despite the
existence of an enforceable promise. To see why, consider two scenarios. Assume first that
board actually wants to make a promised payment to the preferred and that there would not be a
fraudulent conveyance, but the company’s balance sheet presents an obstacle under the legal
capital rules. The willing board can surmount the obstacle because the legal capital rules hold
out discretionary room to doctor the balance sheet numbers by revaluing assets, subject only to
good faith review of its decision.156 A heavy burden then falls on objecting creditors to show bad
faith.




148
    See In re Greenebaum Bros. & Co., 62 F.Supp. 769, 771 (E.D. Pa. 1945); Hurley v. Boston R.R. Holding Co., 54
N.E.2d 183 (Mass. 1944); McIntyre v. Bement's Sons, 109 N.W. 45, 46 (Mich. 1906); Booth v. Union Fibre Co.,
171 N.W. 307, 309 (Minn. 1919).
149
    Particulars respecting enforcement actions are sparse and confused. Thus does one case comment that a preferred
class cannot get an order putting the issuer into receivership, Rider v. John G. Delker & Sons Co., 145 Ky. 634, 140
S.W. 1011 (1911), while another from the same jurisdiction comments that a receivership obtains as against the
common. Westerfield-Bonfe Co. v. Burnett, 176 Ky. 188, 195 S.W. 477 (1917).
150
    See Koeppler v. Crocker Chair Co., 228 N.W. 130, 132 (Wis. 1929).
151
    See Cring v. Sheller Wood Rim Mfg. Co., 183 N.E. 674, 678 (Ind. App. 1932).
152
    See Westerfield-Bonte Co. v. Burnett, 195 S.W. 477, 478 (Ky. Ct. App. 1917)
153
    See cases cited supra notes 148-152.
154
    It is noted that without the limitation, a conscientious counsel would refuse an opinion on the issue’s validity.
155
    See, e.g., McKinney’s CPLR §5202 (granting priority the moment the judgment is delivered to the sheriff). See
generally, David Gray Carlson, Critique of Money Judgment (Part II Liens on New York Personal Property 83 St.
John's L. Rev. 43 (2009).
156
      See Klang v. Smith’s Food & Drug Centers, Inc., 702 A.2d 150 (Del. 1997).

                                                         36
        Now turn to the more likely case where a class of preferred comes due for redemption
and the board, which does not have the cash sitting in a sock under the bed, resists the payment.
As we have seen, the promise is conditional: payment comes due only if funds are “legally
available” and the board can defend on the open-ended ground that claim that payment would
“impair, prejudice, or injure” creditor interests. The standard leaves impairment to the eye of the
beholder—the standard can be applied tightly and contractually or loosely and corporately. On a
contractual reading, the enforcing court aggressively pushes the recalcitrant issuer to the limit of
fraudulent conveyance law, forcing it to liquidate assets to raise the cash. Alternatively, concern
for creditor interests can be dispensed corporately and expansively, with the court opening up a
discretionary envelope for the issuer’s board of directors and thereby relieving the common stock
interest of the payment burden. What started out as creditor protection turns into common
protection.

        Until recently, the leading case was Mueller v. Kraeuter & Co., decided by the New
Jersey Chancery in 1942.157 The court there took the contractual route, pushing the limits in
favor of a payment on the preferred against a board that had been stalling while reinvesting
earnings to expand the business.158 But the preferred did not get a judgment for the whole: the
issuer did not have the cash on hand and that an immediate payment might have injured
creditors. The court instead drew on its equitable powers and ordered counsel to prepare a
schedule of installment payments.159

       Other cases send a more corporate signal, however. At the extreme lies a Pennsylvania
case decided in 1879, which held that the preferred has no right to enforce the promise so as to
cripple the issuer’s business and impair the interests of not only creditors but common
stockholders.160

       Financial practice has changed since these cases were decided. Preferred dividends
remain discretionary in many contexts, particularly in venture capital deals.161 But mandatory
dividend provisions are not uncommon.162 Redemption provisions also depend on the deal.
Perpetual preferred still is issued, but mandatory redemption terms are not uncommon.163
Indeed, with venture capital, exit via mandatory redemption is hard-wired into the business
model.164

B. ThoughtWorks



157
    See Mueller v. Kraeuter & Co., 131 N.J. Eq. 475, 25 A.2d 874 (N.J.Ch. 1942).
158
    131 N.J.Eq. at 478-79, 25 A.2d at 876.
159
    131 N.J. Eq. at 479-80, 25 A.2d at 876.
160
    Culver v. Reno Estate Co., 91 Pa. 367 (1879). See also Warren v. Queen & Co., 240 Pa. 154, 87 A. 595
(1913)(conditioning redemption on an affirmative showing that no injustice be done to the existing rights of other
stockholders or creditors).
161
    Bratton, supra note 3, at 741.
162
    In our EDGAR-based survey of recent preferred issues, see supra notes 69-70, 23% of the registered issues had
mandatory dividend provisions, and 70% of the unregistered issues had mandatory dividend provisions.
163
    In our EDGAR-based survey of recent preferred issues, see supra notes69-70, 14% of the registered issues had
mandatory redemption provisions, and 36% of the unregistered issues had mandatory redemption provisions.
164
    See Bratton, supra note 3, at 742.

                                                        37
        Thus sat the law and the practice until 2010, when a hard fought litigation between a
venture capitalist seeking to enforce a redemption right against a recalcitrant, but not insolvent
investee reached the Delaware courts. There resulted a new and leading pronouncement on the
enforceability promises to pay preferred. The Chancery Court’s decision in SV Investment
Partners, LLC v. ThoughtWorks, Inc.,165 forcefully pushes the law in the corporate direction,
implying that the preferred will not be able to get a judgment unless the issuer has cash on hand
(or the equivalent).166

        The issuer in question sold $26.6 million of preferred to a venture capital firm at the peak
of the 1990s dot com bubble. The idea was to put the company in a position to go public at an
early date. The bubble’s bursting dashed those upside hopes.167 Meanwhile, the charter
provision creating the preferred contained a heavily-negotiated five-year redemption provision.
The provision contained the standard “out of funds legally available” clause, but otherwise took
steps to put the screws on the issuer. The issuer got a year of grace in the event its working
capital proved insufficient to redeem the preferred. Once the one-year period expired the charter
specified that redemption would be “continuous,” that is, that the issuer would divert cash to
preferred redemption on a going concern basis. The charter also provided that for the purpose of
determining funds legally available, the amount should be “highest amount permissible under
applicable law.”168

        The issuer, a services company with a volatile earnings stream, took advantage of the
grace year and thereafter took the position that there were no significant funds available.169 Its
board of directors took up the matter of redemption payment on a quarterly basis and, duly
prepped by counsel, took into account a list of factors, including the (a) the board’s
determination of the corporation's surplus, (b) avoidance of payments triggering insolvency, and
(c) avoidance of payments impairing the corporation’s ability to continue as a going concern and
“thereby eroding the value of any assets (such as work in process and accounts receivable) that
have materially lower values in liquidation than as part of a going concern, such that the value
assumptions underlying the initial computation of surplus are no longer sustainable and the long
term health of the Company is jeopardized.”170 In all, $4.1 million was redeemed over several
years, even as the total principal amount owing on the issue, including cumulated, unpaid
dividends, rose to $45 million. The board also looked for takeout financing but only found it in
the amount of $30 million, conditioned on repurchase of all of the preferred for no more than $25
million. The preferred rejected the haircut and went to court.

       The preferred took the position that redemption should be ordered so long as it implicated
no invasion of surplus within the meaning of the legal capital rules, and introduced valuation

165
   7 A.3d 973 (Del. Ch. 2010).
166
   The Supreme Court affirmed the Chancery’s ruling in SV Investment Partners, LLC v. ThoughtWorks, Inc., 37
A.3d 205 (Del.Supr.). The opinion confirms the standard of review applied but otherwise adds no new law.
167
    Id. at 978-79.
168
    Id.
169
    This included going to court with an interpretation that would have made the working capital carve out
permanent. The Delaware Chancery Court rejected this in ThoughtWorks, Inc. v. SV Inv. P'rs, LLC, 902 A.2d 745
(Del.Ch. 2006)
170
    7 A.3d at 980.

                                                      38
evidence showing more than enough balance sheet equity to sustain the payment. 171 Vice-
Chancellor Laster rejected this, reckoning that a balance sheet showing did not suffice to satisfy
the creditor impairment limitation, which at least required an additional showing addressed to
going concern insolvency.172 The Vice-Chancellor reckoned correctly. A ruling favoring the
plaintiff’s position implies the placement on the issuer of the burden to show negative going
concern effects of a judgment for plaintiffs. That has never been the law. The opinion, however,
goes on to pronounce more broadly.

        The Vice-Chancellor took the occasion to flesh out the legal standard with a two part
inquiry. The first part is substantive—a definition of “funds legally available.”173 This stresses
dictionary definitions of “funds” and “available”174 so that “funds legally available” emerges as
ready cash—“accessible, obtainable, and present or ready for immediate use” and “not
otherwise” subject to a legal block.175 The “not otherwise illegal” leg of the test subsumes the
long-standing creditor injury condition, which in turn is jacked up to a liquidation standard—the
preferred has no entitlement to “any part of the corporate assets until the corporate debts are fully
paid.”176 The result is significant: ready cash must be on the table first; that accomplished, one
asks whether its payment to a stockholder would impair the creditor interest, but impairment
seems possible even given a small outstanding piece of open-account debt.

        The second leg of ThoughtWorks sets out a standard of review keyed to boardroom
process:
      [T]the plaintiff must prove that in determining the amount of funds legally available, the
      board acted in bad faith, relied on methods and data that were unreliable, or made a
      determination so far off the mark as to constitute actual or constructive fraud.177
The good faith standard is drawn from Delaware’s legal capital cases. 178 As noted above, those
concern shareholder payouts that the board wants to make and accord wide discretion as regards
the asset valuations against which the rules’ balance sheet tests are applied.179 It is ironic (to say
the least) to see a standard pitched to facilitate payments to stockholders redeployed to protect a
board wishing to duck a contractually-undertaken stockholder payment. In any event, the
ThoughtWorks board’s process is found to have been “impeccable,” the board having undertaken
a “thorough investigation” and relied on detailed analyses developed by “well-qualified
experts.”180



171
    Id. at 982-83.
172
    Id. at 983-86.
173
    “Funds legally available” is a statutory constraint in Delaware. See Del. Gen. Corp. L. § 160.
174
    7 A.3d at 984.
175
    Id.
176
    Id. at 986.
177
    Id. at 988.
178
    The Court, id. at 988, cites Klang, supra note 156, 702 A.2d at 156 and Morris v. Standard Gas & Elec. Co., 63
A.2d 577, 584-85 (Del.Ch.1949).
179
    As the zone of board discretion widens, the creditor-protective properties of the rules diminish in tandem, and,
historically, the zone of discretion has set liberally. See Bayless Manning, A Concise Textbook on Legal Capital
61-64, 71-72, 84-90 (2d ed. 1981). There is an additional practical reason for liberality—directors who make
payouts in violation of the rules face personal liability. See Del. Gen. Corp. L. § 174(a).
180
    7 A.3d at 988-89.

                                                         39
        Add up the test’s two parts and you get a change in the law that takes giant step away
from contract into corporate territory. We started out with a contract enforcement case that calls
on the court to determine whether or not a promise has been breached.               The precedent
presupposes direct appraisal of the issuer’s ability to pay and in terms opens up no zone of
directorial discretion. Here, in contrast, we get a substantive test focused on ready cash which is
then filtered through a standard of review framed in good faith terms and focused on the board’s
informational base. The reference over to board process displaces the contract paradigm and
restates the issue in corporate terms: the question is no longer “can the issuer pay,” but “did the
issuer’s board do an adequate job of justifying its decision not to pay.” Thus does ThoughtWorks
undercut the promise: a promise to pay is not meaningful if its performance is left to the
promisor’s discretion.

C. An Explanation and an Alternative

       The court’s approach can be explained as an effort to integrate the law of preferred stock
with wider framework of corporate law, a framework that changed during the 70 years that
followed the decision of Mueller v. Kraeuter. Judicial review now goes to the quality of the
processes directors employ when making decisions rather than to the substance of the decisions
themselves.

        The old cases invite messy litigation. Suppose that the plaintiff here, instead of going for
a judgment for the whole hog of $45 million,181 had played it differently, seeking a decree that
holds the obligor’s feet to the fire without threatening the going concern. On this scenario, as in
Mueller v. Kraeuter, the court decides that the issuer has the ability to pay more than has been
forthcoming and sends the parties back to negotiate a payment schedule, in effect reallocating to
the preferred bargaining chips in an ongoing negotiation. Such an approach holds out a
cognizable threat of continuing judicial involvement with the defendant’s business operations,
just the sort of involvement that Delaware’s process-based standards seek to obviate. The
preferred’s second order promise cannot be enforced without somebody, presumably the court,
making a business judgment concerning the issuer’s ability to pay, and the Delaware courts are
allergic to such decisionmaking environments.

        And the ThoughtWorks standard could prove less liberal in application than its bare
statement suggests. The issuer, as depicted by the court, was asset and cash poor; it tried to
refinance but could come up with only $25 million. Let us hypothesize a harder case. Here the
preferred issuer has a large cash balance; debt finance is available to pay down the preferred.
The board determines, on an extensive record, that redemption would interfere with its business
plan, reasoning that the cash balance fortifies the company against its competitors and that credit
lines need to be husbanded in the interest of the enterprise. It accordingly redeems 20 percent of
the preferred, leaving the rest outstanding and awaiting a later exercise of board discretion.
Restating, payment is feasible, but inconvenient. Would this amount to bad faith within


181
   A $45 million judgment might indeed have injured creditors (although the opinion makes no reference to any
evidence on the issuer’s debt load). Judgment leads to levy and secured creditor status for the preferred, with
execution on the lien threatening the issuer’s producing capacity. The cases, with their creditor injury limitation, bar
that result, much as does the Bankruptcy Code with its automatic stay. See 11 U.S.C. § 362.

                                                          40
ThoughtWorks? One hopes so. Delaware courts are above-all fact sensitive and adept at
avoiding disruptive applications of their standards. But the matter is far from clear.

       ThoughtWorks imports coherence by pushing the treatment of the promise to pay out of
the awkward territory of paradigmatic overlap over to the corporate side. We wonder whether
the opposite adjustment might be feasible—a push over to contract. The old cases also predate
modern bankruptcy reorganization,182 and bespeak a fear of crippling levy and execution at the
behest of the preferred. That fear is no longer justified.

        If the ThoughtWorks preferred got a $45 million judgment the execution of which would
dismember the going concern, either the issuer or one of its creditors would solve the problem
with a bankruptcy filing. Bankruptcy’s automatic stay prevents destructive levy and execution.
Negotiations respecting the issuer’s ability to pay claims against it would be remitted to the
bankruptcy proceeding, where the preferred, as a junior claimant, would have to take its
chances.183 Admittedly, this counterfactual treatment cuts against the precedent every bit as
much as does the ThoughtWorks opinion. It treats the redemption as a first order promise and,
rather than attempting to thread the needle with a decree in the case, remits the issuer to the
machinery in place that obviates value-destructive effects of enforcement of first order promises.

        Interestingly, Vice-Chancellor Laster’s ThoughtWorks opinion makes a gesture in the
direction of our alternative scenario, suggesting that the whole problem would go away if the
preferred’s contract specified that on the redemption date the stock be made automatically
convertible into a note due in one year.184 The note, assuming that its issue survived fraudulent
conveyance scrutiny,185 would provide the preferred the enforcement cudgel it presently lacks,
triggering a liquidity crisis and a bankruptcy filing. A question arises: Is this formal ruse really
necessary? It certainly has no creditor protective properties, for it bootstraps the preferred to
pari passu status with pre-existing creditors. Nor does it import added certainty regarding the
parties’ intent that the preferred be paid. The charter provisions in ThoughtWorks already were
quite clear about that.

       The ruse would accomplish one thing—it would take the lawsuit out of a messy corporate
law framework into the more clearly outlined contractual context of debt versus equity; indeed, it

182
    The first statutory corporate reorganization procedure dates from 1934 with the enactment of §77B of the
Bankruptcy Act of 1934, which was replaced by chapter X under the Chandler Act, ch. 575, 52 Stat. 883 (1938).
183
    It bears noting that bankruptcy does not necessarily follow. The parties return to the negotiating table with the
preferred holding enforcement of the judgment and bankruptcy as a potential trump card. Whether or not the card is
played depends on a multitude of considerations. If, as seems to have been the case in ThoughtWorks, the
company’s business prospects are closely tied to the personality and talents of its CEO and largest stockholder, the
preferred may have good reasons for continued patience; the parties presumably work out a Mueller v. Kraeuter
payment schedule. Alternatively, external finance is procured, and the preferred is paid down in part, taking a lesser
haircut than earlier proposed or no haircut at all. If the CEO is dispensable the alternatives are different. The
judgment gives the preferred a lever to force a sale of the going concern, or, alternatively, to take control of the
board and find a new CEO. Bankruptcy will follow only if negotiations break down. If the company is heavily
levered and bankruptcy means creditor control, the preferred will have every incentive to avoid it.
184
    7 A.3d at 991. The source is the National Venture Capital Association, Model Term Sheet 6, n. 14, available at
http:// www.nvca. org/ index. php? option = com_ docman&task= doc_ download& gid= 75&
Itemid.
185
    See infra text accompanying note 187.

                                                         41
might even take the lawsuit out of the Delaware Chancery and into a bankruptcy court. Whether
it would work as advertised in practice is a more difficult question. Upstream conversion from
equity to debt is permitted by corporate codes.186 But the issue of the debt is constrained by legal
capital rules and fraudulent conveyance law just as is the payment of redemption cash.187
Presumably, the earlier the cash comes due on the debt, the greater the risk of invalidation as
transfer triggering insolvency; if the principal amount of the note were greater than the issuer’s
balance sheet shareholders’ equity, the conversion would trigger insolvency and be invalid as of
occurrence.

        If the parties themselves can lift the burden with an upstream stock-to-debt conversion,
then a proactive court can save them the trouble. All it has to do is resolve the ambiguities
created by the old cases on the contract side. The promise is presumptively enforceable and
creditor protection becomes an affirmative defense. The preferred get a judgment absent a legal
capital violation or a fraudulent conveyance, burden of proof on “legally available funds” on the
issuer with “legal availability” defined in terms of actual creditor interests rather than the
interests of the going concern. No roof would cave in as a result, for chapter 11 is there to pick
up any pieces. Meanwhile, uncertainty is avoided, uncertainty that the court aggravates when it
remits the preferred to the stock-to-debt drafting ploy. This is a late date on which to impose
such a formality as an enforcement requirement. So doing substantially diminishes the value of
the existing generation of mandatory redemption preferred stock and creates enforcement
uncertainty for the next generation.

D. Summary and Analysis

        ThoughtWorks takes a promise historically treated as second order and downgrades it to
third order. The historical treatment attempts to walk the corporate-contract divide with a foot in
each paradigm. The results are awkward, and, when ThoughtWorks rejoins the issue it is not
clear exactly what enforcement of a second order promise is supposed to mean. Clarity follows
only if one puts both feet on one side or the other. ThoughtWorks opts for the corporate side,
permitting the corporate board to tie up the preferred in the black box of business judgment. The
alternative of contractual enforcement maps onto the old cases no better than does corporate
treatment. But it is every bit as feasible. It would not, as a practical matter, turn the preferred
holder into a judgment creditor who tears the producing enterprise apart in the course of levy and
execution, compromising the interests of pre-existing creditors along the way. The practical
result instead is a negotiation at which the board of directors no longer controls the marginal
dollar and the preferred’s interest in repayment assumes a primary place in business planning.
Either choice is reasonable. Left to our own devices, we would err on the side of enforcement,
making it harder for the issuer to avoid its own promise to pay.

       We note two factors that are not implicated by the foregoing choice. First, contract
treatment does not traverse a meaningful norm of common shareholder value maximization.
Making a costly corporate obligation unenforceable always enhances shareholder value, at least


186
  See Del. Gen. Corp. L. §§151(b)-(e); N.Y. B.C.L. § 519(a)(1); MBCA § 6.01(c)(2).
187
  See Alexander J. Triantis & George G. Triantis, Conversion Rights and the Design of Financial Contracts, 72
Wash. U. L.Q. 1231, 1240-44 (1994).

                                                       42
short term. But there is no normative case to support a value bump from nonenforcement for the
contract paradigm comes to bear with full, trumping force. It is true that to the extent that
enforcement gets the preferred a seat at the table to share or take control its incentives may not
be consistent with enterprise value maximization. Alternatively, the preferred could end up
standing in the shoes of the residual interest holder with every incentive to maximize.

        Second, the enforcement question raised in ThoughtWorks cannot meaningfully be
resolved by allocating a drafting burden or conducting default rule analysis. Vice-Chancellor
Laster suggests the contrary when he faults the preferred for failing to protect itself with a built-
in promissory note exchange. By hypothesis, he reasons in the following four step sequence: (1)
both the corporate and the contract paradigms put the burden on the claimant to procure a
contract right expressly—“no right” is the default rule; (2) an express right could have been
procured here but was not; (3) therefore the claimant has no right; and (4) the claimant is forced
to procure the right explicitly next time, prompting information revelation or otherwise making
the transaction more certain. The logic is sensible in many situations, but it is unhelpful here.
The preferred holder here did negotiate for an express right—the right to be paid out of funds
legally available, and for ought that appears that is the highest payment right known to be
appropriate for preferred stock. The Chancellor, in imposing a contract burden to procure an
even higher right—the right to be paid unconditionally—simply restates the holding in chief,
which is the refusal to enforce the right actually bargained for. The ascription of fault on a
“could have/should have procured” basis has not bite, for the tables can be turned. If more
specificity would been useful at the drafting table, particularly given this negotiation’s emphasis
on the construction of a promise with teeth, the burden just as easily can be placed on the issuer’s
shoulders. That is, if the issuer’s board intended ex ante to make payment a matter of business
convenience, should not an express condition to that effect have been placed in the contract?

        Finally, it bears noting that ThoughtWorks is a venture capital case. Venture capital is a
high risk, high return corner of the world of finance with special characteristics. The financial
economists who explain its contractual outlines and productivity contribution teach that venture
capitalists contribute substantive discrimination and monitoring capability lacking in other
financiers. Such contributions are not made for free. The deal makes sense only if the venture
capitalist gets contingent control power.188 Redemption rights are a prominent means of

188
   See Masako Ueda, Banks Versus Venture Capital: Project Evaluation, Screening, and Expropriation, 59 J. Fin.
601 (2004), which compares financing by venture capital firms with financing by banks and describes a tradeoff.
The venture capitalists are specialists and do a better job of screening good and bad projects. At the same time they
position themselves to expropriate the project and use their position to extract rents. The upshot is that venture
projects have less collateral but higher risk, growth, and profitability. Andrew Winton & Vijay Yerramilli,
Entrepreneurial Finance: Banks Versus Venture Capital, 8 J. Fin. Econ. 51 (2008), focuses on monitoring after
investment to take us to more or less the same place. Venture capitalists monitor well and extract higher returns in
exchange, simultaneously imposing illiquidity on their investees. Bank financing costs less, but is ill-suited to risky
projects with skewed cash flows, low probability of success, and low liquidation value but high returns on the
upside. Summarizing, venture capital works with high risk, high return projects and comes with a strong arm.
Steven N. Kaplan, Berk A. Sensoy & Per Strömberg, Should Investors Bet on the Jockey or the Horse? Evidence
from the Evolution of Firms from Early Business Plans to Public Companies, 64 J. Fin. 75 (2009), amplifies this
characterization with survey of venture-backed firms that went the distance and achieved IPOs. It seems that
venture backs ideas rather than individuals. Managers are replaced frequently even as lines of business stay stable.
Roman Inderst & Holger M. Müller, Early-Stage Financing and Firm Growth in New Industries, 93 J. Fin. Econ.
276 (2009), adds a point: Venture capital is attracted to competitive industries and industries with network effects

                                                          43
exercising that power. A court that inhibits their enforcement not only diminishes the utility of
preferred, it disables a productive mode of financing.




and economies of scope. The idea is to select a well-positioned company and make a big infusion of capital in a
play for long-run domination. For empirical support of these pictures, see Michael Hannan et al., Inertia and
Change in the Early Years: Employment Relations in Young, High Technology Firms, 5 Indus. & Corp. Change 503
(1996)(showing that 40 percent of founder CEOs are replaced by the first 40 months and 80 percent by 80 months).

                                                      44
      IV. PREFERRED IN CONTROL: VENTURE CAPITAL UNDER CORPORATE FIDUCIARY
                                      LAW
       There is something hapless about the preferred stock plaintiffs we have seen so far.
They take minority stock positions in reliance on special contract rights only to find out that they
can’t enforce the rights because the contract is embedded in a stock issue. When for the same
reason the rights prove vulnerable to elimination by common stock majorities, the preferred
stockholders get little back up protection from the majority-minority stockholder branch of
corporate fiduciary law.

        A preferred stockholder in control doesn’t have these problems. Historically such an
actor was the exception. Preferred was about finance, not governance, and preferred rarely
controlled the board or held a majority of the votes.189 Modern venture capital financing changes
the pattern. Venture capital is about both finance and governance and preferred stock is the
investment vehicle of choice.190 Venture capitalists holding preferred frequently take voting
control and can dominate the boards of directors even when holding a minority of the votes.

       The controlling venture capitalist (VC) poses a new question for the law of preferred
stock: Does fiduciary law come to bear to protect a common stock minority when a preferred
stockholder in control exercises its contract rights to impair the common’s interest?

        The question, like others regarding preferred, tends to arise on the moderate downside,
where there the issuer is viable but has not generated enough value to go around. Things are
easier on the extreme downside: where there is no value there are no allocational issues worth
pressing. On the upside there isn’t much to fight over either, assuming a minimum of ex ante
planning. The venture impresses the market and proceeds to an initial public offering (IPO).
The VC converts its preferred into common, sells into the offering, and makes a killing. The
VC’s counterparty, the “entrepreneur,” shares the jackpot and resumes control of the company in
the wake of the VC’s sale.191

        On the moderate downside, in contrast, the interests of the VC and the entrepreneur can
sharply conflict. There is value in the enterprise but not enough to facilitate the VC’s exit by
IPO. The VC in control, under pressure to create cash returns for its investors, brings the conflict
to a head by either exercising its redemption rights or using its board seats and voting shares to
cram down a sale of the venture to a third party having no room for the entrepreneur. Having
placed the entrepreneur on the scrapheap, the VC claims a priority share of the merger proceeds.

       How should corporate law treat this transaction? Under the contract paradigm, there is
no basis for intervention. The entrepreneur makes its bed at the get go by selling control to the

189
    A few charters allocated a majority of board seats to preferred given a set number of missed dividends. See
Benjamin Graham, et al., Security Analysis: Principles and Techniques 380-81 (4th ed. 1962). For the exceptional
case on this fact pattern, see Baron v. Allied Artists Pictures Corp., 337 A.2d 653 (Del. Ch. 1975)(ordering
preferred in control due to missed dividends to restart the stream when consistent with health of enterprise).
190
    See Bratton, supra note 22, at 741-42.
191
    See Bernard S. Black & Ronald J. Gilson, Venture Capital and the Structure of Capital Markets: Banks Versus
Stock Markets, 47 J. Fin. Econ. 243, 253, 255-56, 260-61 (1998).

                                                       45
VC in exchange for needed capital and a shot at an IPO jackpot. Sale at the VC’s instance is an
eminently foreseeable consequence. The corporate paradigm, in contrast, invites fiduciary
review—this can be seen as a case of a majority shareholder using its control power to extract
value from a minority shareholder.

        The Delaware Chancery Court recently opted emphatically for corporate treatment and
fiduciary review in the common’s favor in a venture capital case, In re Trados Inc. Shareholder
Litigation.192 Trados contrasts starkly with James, where, on the converse fact pattern, the court
questioned the very availability of majority-minority scrutiny to protect minority preferred.
Trados not only proceeds to scrutinize but breaks the precedential mold in so doing. Under the
traditional doctrinal framework, a majority holder that uses its control power to self-deal at a
minority’s expense traverses a fiduciary duty in its capacity as a shareholder. 193 Trados
switches to a corporate-level framework, looking not at the VC and its voting control but at its
director designees, treating their boardroom action in the VC’s favor as a self-dealing transaction
and thereby expanding the intensity of fiduciary constraint. Taken together with other Delaware
precedent, Trados signals hostility to the interests of venture capitalists in the Delaware courts.

        This Part examines Trados critically, asserting that fiduciary scrutiny under the intrinsic
fairness standard and the common stock maximization norm are unsuited to this context. The
coupling allows the entrepreneur to recapture what it already bargained away; worse, it can
inhibit value maximization. At the same time, we do not think that preferred stockholders in
control should be immunized from fiduciary scrutiny per se, even though their control may be
vested by an elaborate, exhaustively negotiated contract structure. The moderate downside fact
pattern holds out incentives for preferred in control to sell the company for less than enterprise
value, and it is not clear that venture capital contracting structures contemplate that result. We
turn once again to good faith as the standard of review best suited to the zone of
corporate/contract overlap.

        Section A describes venture capital contracting, in particular control relationships
effected pursuant thereto. Section B turns to Trados, where controlling VCs effect an exit in
apparent good faith, doing their best to get a good price and settling for less than their liquidation
preference, only to be waylaid ex post by underwater common using fiduciary law to extract
holdup value. Section C addresses the case’s potential perverse effects. Read literally, Trados
requires venture capitalists to deploy their control to yield value for the common even where the
deployment impairs the value of the corporation. The case’s unmitigated rule of common stock
maximization accordingly chills value maximizing deals. We pose a narrower rule under which
fiduciary review for the common succeeds only where the venture capitalist deploys control to
sacrifice enterprise value, a formulation that easily can be read together with mainstream
fiduciary law. Section D confronts a follow up question: whether the contract paradigm should
be substituted in the venture capital context so as to block fiduciary review in a case where
enterprise value is sacrificed. There is strong case in favor of doing so: an entrepreneur who
transfers control in exchange for venture capital financing arguably waives the common
stockholder’s objection to a sales below enterprise value. Such a waiver should be effective, but
should not be express not implied. Finally, Section E considers the alternative of relaxed

192
      2009 WL 2225958 (Del.Ch.).
193
      See Sinclair Oil Corp. v. Levien, 280 A.2d 717 (Del. 1971).

                                                           46
scrutiny under the good faith standard of review. Although this imposes some process costs on
the VC, they are not nearly as onerous as those following from intrinsic fairness scrutiny. Given
the exhaustive background of contractual risk allocation in VC cases, relaxed scrutiny is the best
fit.

A. Venture Capital Financing

         Venture capital deals are sealed with a thick stack of documents. 194 The contracts’
primary job is to align the incentives of both the entrepreneur and the VC toward success and, in
the event of success, to provide for gain sharing and liquidity for the VC while simultaneously
assuring the entrepreneur of control going forward. The contracts also provide for the event of
failure, allocating such value as has been created to the VC. As noted above,195 this is a singular
mode of financing. It contemplates intense involvement in the business by the senior security
holder, along with actual or contingent control rights hold outing potential destruction of the
common stock interest. Convertible preferred stock is the dominant financial contract in the
sector.196

         1. The upside and the downside.

         The expectation is that if the project is successful, the VC will realize its investment yield
by cashing out in an IPO of the investee company’s common stock. Thereafter the entrepreneur
is left in control of the firm. The contract secures the VC its share of IPO proceeds through the
conversion privilege attached to the preferred and facilitates later exit via the public trading
market by providing registration rights. Conversion can be made mandatory where an IPO meets
specified financial qualifications197 keyed to stock price, amount of proceeds, or resulting market
capitalization. Mandatory conversion assures that the VC does indeed exit and leave the
entrepreneur in unchallenged control.

       Concerns about the entrepreneur's incentives also loom large on the upside. These are
addressed by allocating the entrepreneur’s equity interest in the firm's growth in the form of
common stock options that vest over time.198 Sequential option vesting diminishes any
temptation to abandon the project prior to the IPO phase.199 Where the entrepreneur has traded


194
    See Bratton, supra note 22, at 741-42.
195
    See supra text accompanying notes 189-190.
196
    See, e,g., J.J. Trester, Venture Capital Contracting Under Asymmetric Information, 22 J. Banking & Fin. 675
(1998); W.A. Sahlman, The Structure and Governance of Venture Capital Organizations, 27 J. Fin. Econ. 473
(1990). There is a tax reason. See Ronald J. Gilson & David M. Schizer, Understanding Venture Capital Structure:
A Tax Explanation for Convertible Preferred Stock, 116 Harv. L. Rev. 874, 901 (2003) (showing that use of
common stock could result in employee compensation being taxed at a higher rate).
197
    Bernard S. Black & Ronald J. Gilson, Venture Capital and the Structure of Capital Markets: Banks Versus Stock
Markets, 47 J. Fin. Econ. 243, 253, 255–64 (1998), discusses the resulting contracting problems. The primary
problem for solution is the entrepreneur's lack of assurance against opportunistic retention of control by venture
capitalist through undue delay of the IPO. They suggest that an "implicit contract" backed by reputational
constraints and financial incentives assures the entrepreneur that the venture capitalist will voluntarily surrender the
reins. See also Hellman, The Allocation of Control Rights in Venture Capital Contracts, 29 Rand J. Econ. 57 (1998).
198
    See Paul Gompers & Josh Lerner, The Venture Capital Cycle 131 (2000).
199
    Id.

                                                          47
away boardroom control, the contingent payoff arrangement also imports a high-powered
incentive to remain in the good graces of the venture capitalist and any outside directors.

        Venture capital contracts treat downside scenarios by shaping priorities. A startup that
creates no value and runs out of capital goes into bankruptcy, probably to be liquidated once
there. Alternatively, if the startup has no significant debt, liquidation can be conducted privately.
Either way, contractual priorities will allocate any crumbs left on the table to the venture
capitalist. But these need not amount to much. Indeed, the risk of complete failure is intrinsic to
venture capital investment.200 Venture capital firms moderate it by staging the entrepreneur's
drawdowns of capital, by diversifying their portfolios of investments in startup firms, by
syndicating investments in particular firms, and by closely monitoring their positions.201

         Poor or mediocre performance short of complete failure—the moderate downside—is not
unusual. 202 It also presents a less tractable problem.203 Here the IPO route fails to open due to
indifferent venture performance or adverse market conditions204 and the venture capital
preferred remains unconverted. The preferred issue’s duration looms large. When redemption
rights become exercisable, the mediocre performer still limping along either finds replacement
capital, is sold to a third party, or is liquidated. (Alternatively, it defends itself in court, as we
saw with ThoughtWorks.) Whichever the case, the interests of the entrepreneur and the VC can
conflict sharply, with the former desiring continuation and a chance for an upside recovery and
the latter desiring termination and the present realization of any value on the table.205

         2. Control arrangements.

        Control in a venture capital relationship need not directly follow from ownership of a
majority of the voting shares. Assume the VC owns 55 percent of the voting stock and the
entrepreneur owns 45 percent. Parties in this posture often agree to share control of the board.
Each party designates a director for a seat or seats and agrees to agree on a candidate to fill the
remaining seat or seats. The third party director takes the arbitrator's role in the event of disputes.
Given shared control, share ownership proportions can break in either direction with the VC or
the entrepreneur holding a majority.206 Relative stock ownership proportions also can vary over

200
    Id. at 5-6.
201
    Id. at 130, 132-34.
202
    Under a rule of thumb, one-third of venture capital issuers end up insolvent. Another third limps along,
generating enough cash to pay expenses, especially the insiders' salaries, but never generating enough profit to
support a public offering of common stock. Another third succeeds, reaching the initial public offering stage and
generating substantial returns for venture capital investors—enough to compensate them for the high risk and
illiquidity of their overall venture capital portfolios. See George Dent, Venture Capital and the Future of Corporate
Finance, 70 Wash. U.L.Q. 1029, 1034 (1992). See also Gompers & Lerner, supra note 198, at 150 (Table 7.3).
203
    Poor results can mean that new capital is cut off due to staged investment. Cite
204
    It is more likely to be the eventual path taken. The National Venture Capital Association reports that from 1996
to 2004 there were more exits by sale than by IPO in 7 of 9 years. See Hellman, IPOs, Acquisitions, and the Use of
Convertible Securities in Venture Capital, 81 J. Fin. Econ. 649 (2006).
205
    Fried & Ganor, supra note 3, at 994-99 sketch a picture of distorted incentives on the part of the VC.
206
    Stephen Kaplan & Per Strömberg, Financial Contracting Theory Meets the Real World: An Empirical Study of
Venture Capital Contracts, 70 Rev. Econ. Stud. 281 (2003), ), gathers contracting data from venture capital
investments in 118 start ups made by 14 venture capital firms, finding that one party, VC or entrepreneur, controls
the board in only 38 percent of the cases; control is shared in the remaining 62 percent. In the one-party-in-control

                                                         48
time. For example, the VC can take a minority shareholding upon the first drawdown with its
share growing to a majority as drawdowns proceed. Contrariwise, the entrepreneur’s share can
grow as performance-based stock allocations come to vest. One study finds that the VC has a
majority of the votes most of the cases.207

        There is accordingly no one-size-fits-all control pattern. Sometimes the VC controls both
the board and majority of the stock; the entrepreneur clearly controls in a smaller number of
cases; control is shared in many cases.208    Overall, the implication is that entrepreneurs and
VCs are quite sensitive to control, its value, and the way in which its allocation interplays with
the other terms of their financings.

        It should be noted that the VC-entrepreneur bargaining dynamic just described is a
simplification. Startup funding comes in different modes and from different sources. Venture
capital funds also invest later on, after an IPO, with the degree of control depending on the
situation.209 Nor are venture capital firms the only source of startup capital. “Angel”
investors210 provide funding to startups at earlier stages.211 Angels are wealthy (often retired)
individuals who invest personal funds in near-by companies involved in familiar lines of
business. Like VCs, angels provide entrepreneurs with advice and the benefit of their

subset, the venture capitalist takes control in two thirds of the cases and the entrepreneur takes control in one third of
the cases.
207
    Kaplan & Strömberg, supra note 206, at 290. The VC has the majority in 69 percent of the cases assuming no
vesting of the entrepreneur’s performance-based stock allocations; assuming full vesting, the VC has most of the
votes 53 percent of the time. The entrepreneur has a majority in 12 percent of the cases, rising to 23 percent given
full vesting. Neither party controls in 18 percent of the cases, rising to 21 given full vesting. Id. at 288. For figures
derived from a second database of 50 companies, see Brian Broughman & Jesse Fried, Renegotiation of Cash Flow
Rights in the Sale of VC-Backed Firms, 95 J. Fin. Econ. 384, 388 (2010)(showing that 56.5 percent of all directors
appointed by VCs, 22.8 percent appointed by common, VC board control in 58 percent of the companies, and the
possibility that common directors and independent directors can block a VC initiative in the boardroom at42 percent
of the companies). G. Gordon Smith, The Exit Structure of Venture Capital, 53 UCLA L. Rev. 315 (2005), reviews
the documents governing 367 startups that made SEC filings in connection with IPOs. He finds that the charter vests
sole control in one party in 38 percent of the cases, with the venture capitalist receiving control in 77 percent of the
sole control subset. These results more or less track those of Kaplan and Stromberg. But, as to the other cases, Smith
produces a contrasting picture of the practice. According to Smith, entrepreneurs tend to start out in control of the
board of directors, with venture capitalists taking voting control as they contribute more and more capital through
staged drawdowns during the startup process. He also finds no evidence of shared control arrangements, even
though the documents do tend to expressly allocate one set of board seats to the venture capitalist, a second set of
board seats to the entrepreneur, and leave open the allocation of a third seat or set of seats occupying a tie breaking
position. According to Smith, the documents provide for voting by all shareholders voting as a single class on the
open seat or seats. Given a conflict, it follows that control in the end goes to party possessing the voting majority.
208
    We note some tendencies. Although the VC usually holds most of the votes, it also often shares control in the
boardroom. Shared control, however, does not necessarily imply equal power. If the VC has the greater influence
over the tiebreaker director, the VC can dominate the board without outright control. D. Gordon Smith, The Exit
Structure of Venture Capital, 53 UCLA L. Rev. 315, 320 & n.21 (2005) (suggesting a predisposition to favor the
VC); Bratton supra note 3, at 921 (same). For evidence that the tiebreaker director can opt to support the common
as regards the allocation of sale consideration on fairness grounds, see Broughman & Fried, supra, at 392-95.
209
    See Equity-Linked Investors v. Adams, 705 A.2d 1040 (Del.Ch. 1997), discussed infra note 217.
210
    The term originally described affluent individuals who finance Broadway plays. Colleen Debaise, What’s an
Angel Investor?, Wall Street J., Apr. 18, 2010 available at
http://online.wsj.com/article/SB10001424052702303491304575188420191459904.html.
211
    See Darian M. Ibrahim, The (Not So) Puzzling Behavior of Angel Investors, 61 Vand. L. Rev. 1405, 1406
(2008).

                                                           49
experience.212 Amounts invested in “angel rounds” are smaller than in VC rounds, ranging only
from $100,000 to $2 million, but the number of companies receiving angel capital is much larger
than the number of VC investees. Aggregate annual angel investment now equals that of venture
capital.213 Significantly, angels tend to take common stock stakes, foregoing board seats,
negative covenants, vetoes, and exit rights.214 This is in part because angel-funded startups want
to hold open a door for later venture capital financing. An all common capital structure amounts
to a clean slate open to the addition of layers of venture preferred.215

B. Trados

        The leading Delaware case on VC preferred, Equity-Linked Investors v. Adams,216 sends
a stark message: the common stock maximization norm comes to bear to protect the discretion of
boards of directors that take action inimical to the interests of noncontrolling VCs. 217 In re

212
    Id. at 1419, 1431, 1439.
213
    Id. at 1419.
214
    Id. at 1422-23.
215
    Id. at 1429.
216
    705 A.2d 1040 (Del.Ch. 1997).
217
    The Chancery Court there declined to come to the aid of a VC investor seeking to block a low-ball control sale by
an entrepreneur in control willing to do just about anything to prevent a control transfer to the VC. 750 A.2d at
1050-1052. The entrepreneur was running out of cash even as the VC demanded that the company liquidate and
forward the proceeds. Id. at 1043-1044. The VC, however, needed a matured cash redemption right to force the
issue. The company had already gone public and the charter did provide for cash redemption of the VC preferred in
the event of Nasdaq delisting, and the Nasdaq was threatening to delist the common. The entrepreneur begged
Nasdaq for more time as he looked for new financing to keep the game going. It was a race against the clock—
Nasdaq delisting and victory for the VC or new financing and victory for the entreprenuer. Id. at 1045-1052. The
entrepreneur won the race, closing a $3 million secured loan and giving the lender rights to buy enough stock to
attain voting control. The VC tried to checkmate the entrepreneur by making a higher offer and then going to court
arguing that the company’s board, in accepting a lower offer favored by the entrepreneur, had violated the board’s
Revlon duty to maximize the proceeds of a sale of the company. But the Court, per Chancellor Allen, brushed off
the theory in turn. It acknowledged that in an open auction of the firm the VC would have been the highest bidder.
Since the value of the firm was less than the redemption price of the preferred, the VC would bid up to the
redemption price in order take control and access the liquidation value of the firm’s assets. Id. at 1057. But that,
said the court, was irrelevant. The duty of the board was not to maximize the value of the company, as an economist
might insist. The legal duty was to maximize the value of the common stock, and putting the assets to the preferred
would wipe out the common. Id. at 1058-1059.

          Corporate fiduciary law did not dictate this result, but it certainly allowed it. It tends to avoid foursquare
maximization dictates and remit decisions, however critical, to the black box of directorial business judgment. The
Revlon cases are an exception keyed to control transfers where the common’s interest diverges from that of the
board of directors. They are not about the arbitration of disputes between VCs and their investees, where the
question concerns control going forward among existing equity claimants rather than the extraction of a best price in
a third party sale. Revlon’s interpolation would have tilted the playing field in the VC’s favor without vindicating
the case’s motivating principles. Chancellor Allen’s refusal to intervene under Revlon remits VCs and entrepreneurs
to deal with control allocation at the ex ante negotiating table. It was the correct move. But it also has awkward
implications. Refusing to order the common to turn the company over to the preferred under Revlon is one thing.
Laying down a general rule of common stock maximization is quite another. Such a rule was not, strictly speaking,
necessary to the case’s decision. And it potentially conflicts with the economic notion that the residual equity
interest should be the fiduciary beneficiary because it has a value-maximizing incentive in going-concern situations
outside of the vicinity of insolvency.



                                                          50
Trados Inc. Shareholder Litigation218 presents a group of VCs who got the message. They
controlled the board and drafted a liquidation preference triggered by a control transfer. But
board control in a majority shareholder implies fiduciary responsibilities to the minority. And so
comes the question: Which is the trump, the contract paradigm and the allocation of risk bound
up in venture capital contracting arrangements, or the corporate paradigm and the duty selflessly
to treat the interests of the minority common stockholders?

         The company in the case had been building itself up for an IPO for a number of years
without success, in the process issuing no less than five series of venture capital preferred.
Control had been surrendered to the VCs, whose designees occupied four of seven board seats.
Two other seats went to the two top officers. An independent director occupied the seventh
seat.219

        The VCs, having had no return on their investments, lost patience and decided to shop the
company. They got a $40 million offer but deemed it too low. 220 So they brought in a new CEO
to put the company in salable condition, and, at their investment banker’s suggestion, instituted a
management incentive scheme designed to cut the three top officers into any merger proceeds.221

        This got results. Within a year costs were cut, debt financing secured, and the company’s
prospects much improved.222 The company was shopped again and the board approved a
merger yielding $60 million. The proceeds were allocated $7.8 million to the executives under
the incentive plan and the rest to the preferred, with nothing to the common. The preferred took
the entire remainder because the charter provided that a merger be deemed a liquidation and the
preferred’s $57.9 million liquidation preference soaked up the remaining consideration without
being satisfied.

        A common stockholder responded with an appraisal action, but, apparently disappointed
with its prospects, switched over to a complaint for breach of fiduciary duty. 223 Things at the
company had been looking up, alleged the complaint; had the board waited there might have
been proceeds for the common. The board had failed to take the common’s interest into account,
and under Equity-Linked Investors the common has priority fiduciary status.224

        The Chancery Court, per Chancellor Chandler, denied the defendants’ motion to dismiss.
It analyzed the case as one of director self-dealing. The VCs’ director designees were interested
in the outcome of the transaction by virtue of their positions at the various venture firms; the two
officer directors were interested under the bonus arrangement. The interest having been shown,
the business judgment presumption was overcome and, under the duty of loyalty, the burden



218
    2009 WL 2225958 (Del.Ch.).
219
    Id. at 1-2.
220
    Id. at 2.
221
    More particularly, six percent of a $30 to $40 million dollar deal, eleven percent of a $40 to $50 million dollar
deal, and so on up to a fifteen percent cut of a deal over $120 million. Id. at 3 & n.5.
222
    Id. at 3.
223
    Id. at 4.
224
    Id.at 6.

                                                          51
shifted to the defendants to show entire fairness.225 Cites to Jebwab and Equity-Linked Investors
figured into the analysis as follows:
        Generally, the rights and preferences of preferred stock are contractual in nature. This
        Court has held that directors owe fiduciary duties to preferred stockholders as well as
        common stockholders where the right claimed by the preferred “is not to a preference as
        against the common stock but rather a right shared equally with the common.” Where this
        is not the case, however, “generally it will be the duty of the board, where discretionary
        judgment is to be exercised, to prefer the interests of common stock-as the good faith
        judgment of the board sees them to be-to the interests created by the special rights,
        preferences, etc., of preferred stock, where there is a conflict.” Thus, in circumstances
        where the interests of the common stockholders diverge from those of the preferred
        stockholders, it is possible that a director could breach her duty by improperly favoring
        the interests of the preferred stockholders over those of the common stockholders. As
        explained above, the factual allegations in the Complaint support a reasonable inference
        that the interests of the preferred and common stockholders diverged with respect to the
        decision of whether to pursue the merger. Given this reasonable inference, plaintiff can
        avoid dismissal if the Complaint contains well pleaded facts that demonstrate that the
        director defendants were interested or lacked independence with respect to this
        decision.226
Restating, when preferred holders in control cause the corporation to enter into a transaction that
realizes on their contractual preferences on the moderate downside, approval by controlled board
members will be treated as a self-dealing transaction at the behest of a complaining common
stockholder. The preferred’s rights get no recognition under fiduciary law because they are
contractual; the interest of the common, in contrast, does get recognition.227

        Apparently, the corporate paradigm trumps the contract paradigm even where the
resulting fiduciary intervention disrupts a power allocation effected in a heavily negotiated deal
between sophisticated parties. This is a questionable result. Venture capital investment is a high
risk/high return proposition for all participants. The deal structure often allocates to the VC the
power to detach the entrepreneur from the assets and deploy the assets somewhere (or with
someone) else.228 Infinite patience is not expected from the VC—it has investors of its own and
is under pressures to yield in a competitive market. This all-or-nothing governance framework
presumably yields a highly incented entrepreneur. Trados hobbles the incentive structure by
handing the entrepreneur a fiduciary backstop in the teeth of the deal’s allocation of risk.



225
    Id. at 6, 9.
226
    Id. at 7.
227
    This is a radical extension of Jebwab and Equity-Linked Investors. Both cases arose on the converse fact pattern
where a preferred stockholder claims of fiduciary protection against common in control. Both courts refused to
extend the corporate paradigm’s protection to the complaining preferred. Both cases remitted the preferred, to the
extent it found its level of protection unsatisfactory, to the contract drafting table to bargain for more protection next
time around. Trados is a case where the preferred has done exactly that. It has bargained into control only to find
the same cases invoked to turn exercise of the rights bargained for into a breach of fiduciary duty. Significantly, the
precedent had been thought to direct fiduciary duties in accordance with control. See Fried & Ganor, supra note 3,
at 990-93 (attributing a “contingent control” approach to the Delaware courts).
228
    See supra note 188.

                                                           52
        The Sections that follow take up the problems Trados leaves behind in two phases.
Section C assumes fiduciary review under an intrinsic fairness standard and demonstrates the
case’s potential perverse effects. Section D takes up the question whether the contract paradigm
should be invoked to block fairness scrutiny altogether.

C. Trados and the Value Maximizing Merger

        Trados is troublesome in four respects. First, its directive to maximize common stock
value makes economic sense in some situations but not in others. Second, read literally, the case
makes it impossible for preferred in control to effect a maximizing sale without surrendering
hold up value to the common. Third, the case slaps down fairness scrutiny in the teeth of the risk
allocation bound up in an antecedent bargain. Fourth, it fails to leave open a door through which
parties negotiating future deals can contract out from under the scrutiny it imposes. This Section
takes up these problems.

            1.   Common stock maximization versus enterprise value maximization.

        Sometimes preferred in control has an incentive to sacrifice enterprise value. Trados
scrutiny can make economic sense in such a case. In other situations maximization of the value
of preferred in control also maximizes enterprise value while common stock maximization
makes the enterprise less valuable. Here Trados scrutiny creates problems.

        Preferred, as a senior claim, can avoid taking value-enhancing risk where common, as the
at-the-margin residual interest, would assume the risk. This standard incentive incompatibility
story can be told by tweaking the Trados fact pattern.229 Assume that the VCs’ liquidation
preference is $40 million and wind back the clock to the beginning of the sale effort. There is a
$40 million offer on the table. The preferred can take it or hire a turnaround expert and try again
the next year. There is a 75 percent chance that a turnaround will produce an offer of $60
million and a 25 percent chance that the turnaround will fail and market conditions worsen so
that the best offer will be $30 million. The expected value of the company given the turnaround
attempt is $52.5 million ($60 million x .75 + $30 million x .25). The VC, however, has no
incentive to take the risk because its upside is capped at $40 million. It takes the bird-in-the-
hand because the turnaround carries a $10 million downside risk—a classic case of a sacrifice of
enterprise value stemming from a senior security holder’s aversion to risk. Maximizing for the
common also maximizes value.

        But that is not always the case. Trados, by insisting on common stock maximization,
holds out perverse incentives where maximizing for the common sacrifices enterprise value. To
see why, go back to the case and assume that the $60 million offer is on the table and that there
are two possible outcomes if the offer is not accepted. There is a 25 percent chance that a $70
million offer can be realized in the intermediate term and a 75 percent chance that the markets
will turn down and $50 million will be the best offer available. The expected value of delay is
$55 million ($70 million x .25 + $50 million x .75). Delay sacrifices $5 million of enterprise
value in exchange for a chance to realize an expected $750,000 ($3 million x .25) for the
common.
229
      For another telling, see Fried & Ganor, supra note 3, at 994-97.

                                                            53
        The second set of numbers replays the familiar problem of debt and equity on the
downside. In Credit Lyonnais Bank Nederland v. Pathe Communications Corp.,230 Chancellor
Allen famously suggested that fiduciary law should favor enterprise value maximization (and the
creditor interest) over shareholder value maximization where extreme financial distress inclines
the common interest to low return, speculative investment. The suggestion opened up the
possibility of liability for directors pursuing common stock returns in the “zone of insolvency,” a
possibility minimized by subsequent decisions.231

        Trados reminds us that common stock/enterprise value conflicts can arise incident to any
priority claim—senior equity claims as well as debt—and can arise on the moderate downside as
well as in the zone of insolvency. Trados, however, implicates the converse problem. Credit
Lyonnais opens a door to a creditor action against common-maximizing directors who sacrifice
enterprise value. Trados imposes potential fiduciary liability on directors who pursue enterprise
value over suboptimal speculation for the common’s benefit.

        It follows that, depending on the facts of the case, Trados can push a preferred-controlled
board away from an optimal result. Were that the only problem we could stop here and
recommend that the duty be reframed in terms of enterprise value—the common stockholder
plaintiff would be required to plead and prove that the preferred holder’s sale sacrificed
enterprise value (as opposed to common stock value). But it is more complicated than that.
Trados makes it harder for a VC in control to realize on its investment whatever a particular
case’s value posture, creating hold up value for the common.232 Worse, Trados leaves no
opening through which a VC can completely contract around the problem in advance.

        2.    Selling the company under Trados.

       For purposes of this discussion, assume the second situation described above—preferred
in control where a $60 million deal maximizes enterprise value, while common stock
maximization dictates delay in search of a $70 million offer.233 Immediate sale maximizes
value. But how, given Trados can the VC in control get the company sold? The case leaves the
VC with a Hobson’s choice—either sell into litigation risk or make a side payment directly to the
underwater common in exchange for the holdup value the case creates.



230
    1991 WL 277613, at 34 (Del.Ch.)
231
    See North American Catholic Educational Programming Foundation v. Gheewalla, 2007 WL 1453705
(Del.)(closing off a direct action and limiting creditors to a derivative action).
232
    Broughman & Fried, supra note 207, shows that the common stock hold up is a fact of life in VC sales situation
even absent a fiduciary leg up from Trados. Across their sample of 50 sales, deviations from contracted for
allocations in favor of the common occur in 11 cases such that the VCs in those cases realize on 89 cents on the
dollar. Id.at 391. They attribute the phenomenon to independent director presence in the boardroom and California’s
provision of a mandatory class vote for the common, which is respected at some Delaware corporations the assets
and shareholders of which are sited in California. Id. at 388-90, 392-95.
233
    The case also assumes that the common has no bargaining power. Sometimes it will, even given underwater
stock. Assume a simple two-party VC and entrepreneur case where the acquirer desires that the entrepreneur stay
with the business. If the entrepreneur is to stay, it has bargaining power despite the fact that its stock is
underwater—there will be no deal without the entrepreneur on board. Hence, there is no lawsuit.

                                                        54
        Let us first try to process our way out of the problem. As a first step we will have the VC
engage an investment banker to opine on the fairness of the sale price. Unfortunately, an opinion
as to the fairness of $60 million will afford little comfort given the threat of intrinsic fairness
scrutiny under a common stock maximand. Indeed, a fairness opinion that reports the numbers
in the hypothetical and admits a 25 percent chance of a $70 million sale makes the plaintiff’s
case under a literal reading of Trados.

        Let us accordingly process further and have independent directors stage manage the
merger. Independent directors are, of course, a normal incident of today’s fiduciary regime,
especially when a company is being sold. Even so, we make a considerable concession. The
independent board regime was designed with public companies in mind, not start ups unable to
reach the IPO stage. The cost burden of a constructed negotiation accordingly is not de minimis
for a company like the one in Trados, with its one independent director out of seven.

        Let us recruit a couple of new directors for the occasion. That accomplished, a question
will arise as to whether a special negotiating committee representing only the common interest is
necessary, by analogy to the parent-subsidiary cashout merger cases. If it is, we potentially
arrive at the tripartite negotiation that so troubled the Chancery Court in James, with the VCs
and their designees negotiating the sale price with the third party buyer and the common’s
directors interposing themselves to look for more money however they can get it. Such a
committee will be in an awkward position in our case: in order to satisfy the VC’s liquidation
preference and bring anything home for the common, it would have to hold out for a deal priced
higher than $66.57 million; failing that, it would be negotiating for hold up value.

        Any result negotiated by a special committee entails a residuum of litigation risk, even a
high-end settlement. Say, for example, that the merger is priced at $70 million after much
pushing by the independent committee. This yields the common $3 million. The committee,
advised by its own investment banker, finds the price fair. Yet nothing prevents a lawyer from
drafting the same “might have waited” complaint that survived motion to dismiss in Trados—
maybe waiting a year would have yielded $75 million. Such a claim is as hard to falsify as it is
easy to draft. Even so, the process precautions strengthen the VC’s hand—given an independent
special committee with veto power representing the common interest, the common are deprived
of the self-dealing fact pattern that proved actionable in Trados. It would seem to follow that
the burden of proof regarding fairness shifts to the plaintiff. 234 Such a shift may suffice to baffle
a “might have waited” pleading.

        The foregoing amounts to cold comfort for the VC for all sale prices under $66.57
million. Under a common stock maximization norm, any result that wipes out the common is
vulnerable to a “might have waited” complaint. It follows that the “fair” return negotiated by the
special committee comes out of the VC’s liquidation preference; in other words, hold up value.

        Having gotten to this point, it makes sense to ask whether we should dispense with the
special negotiating committee and negotiate directly with the holder of the common. This seems
sensible given a simple two-party case with a VC and an entrepreneur. A successful direct
negotiation leads to a surrender of the fiduciary claim in connection with the payment,
234
      This follows by analogy to the cash out merger cases. See supra text accompanying note 56.

                                                          55
eliminating litigation risk. But suppose the company’s buyer has no further use for the
entrepreneur and the entrepreneur is looking for compensation for loss of position and is a happy
to kill the deal for any return under $20 million. Here constructed negotiation through a special
committee might be cheaper for the VC, even given litigation risk. Alternatively, suppose that
the company has gone through numerous rounds of angel financing and that a collection of
wealthy individuals holds common in addition to the entrepreneur. The only way to eliminate
litigation risk is to get them all on board. A secondary hold up problem results: less than angelic
common holders may ask for more than a pro rata share of the settlement. Finally, it bears
noting that common holders have an incentive to negotiate for more than their due even when not
underwater. For example, although a merger priced at $70 million yields the common $3 million
net of the VC’s liquidation preference, nothing stops the common from negotiating for a higher
figure.

        In sum, the VC in control can succeed in selling the investee company post-Trados, but
only at considerable additional cost.

        3. Contracting out of fairness scrutiny—drag-along rights.

         There is a standard response to the complaint just registered. To the extent the VC is
averse to litigation risk or otherwise dissatisfied with the incentive effects of Trados, it can
deflect the risk at the contracting stage. The fiduciary common stock maximand purports only to
fill in a gap in an incomplete contract. And, as is usually is the case, the burden to contract
around the corporate law default falls on the preferred.

        The response has superficial credibility, for there is a standard contract that addresses this
problem—a shareholders’ agreement containing “drag along rights.”                 The credibility is
superficial because Trados disrupted the contracting field, impairing the operation of drag along
rights. Indeed, on the facts of Trados, there is no available contractual circumlocution.

       Drag-along rights appear in shareholder voting agreements. Voting agreements are a
standard feature of VC term sheets. We have seen, for example, that a shared control boardroom
might be made up of two VC designees, two entrepreneur designees and a fifth tie-breaker. A
contract between the VC and the entrepreneur, entered into by both in their capacity as voting
shareholders, assures the contemplated result.235

        Drag-along rights similarly seek to assure fulfillment of expectations respecting a future
sale of the company by allocating the right to force a sale of the company to a stated threshold
percentage of a class (or classes) of shareholders. Assume by way of example a five seat board
with a tie breaker director, a VC with 49 percent of the voting shares, and an entrepreneur with
51 percent of the voting shares. Assume that the VC’s two directors plus the tie-breaker vote in
favor of a merger. The merger, once approved by the board of directors, requires the confirming
vote of a shareholder majority. Absent a contract, the entrepreneur can use its votes to veto the
deal. The voting agreement avoids that result by extracting the entrepreneur’s advance promise


235
   See National Venture Capital Association Voting Agreement, section 1, available at
http://www.nvca.org/index.php?option=com_content&view=article&id=108&Itemid=136.

                                                     56
to vote in a favor of a merger having the preferred’s support. 236 A promise not to seek appraisal
will be included.237

        A caveat needs to be entered at this point. A shareholders’ agreement only binds its
signatories. It accordingly best suits a simple VC-entrepreneur fact pattern. Given layers of
angel investors in the shareholder group, things might be more complicated. Assume that a VC
sensibly conditions its provision of funds on 100 percent common assent to the shareholders’
agreement. A less than angelic common holder might say no and ask to be taken out with some
of the proceeds of the financing. Once again, then, avoiding Trados means confronting hold
outs.

        Let us assume that all common shareholders are ready to sign on. A question arises:
Does the drag-along just described, completely solve the Trados problem for the VC? The
question is whether the shareholders’ advance consent somehow obviates or excuses the self-
interested breach of the duty of loyalty that occurs in the boardroom when the VC’s director
designees approve a later deal. Arguably, no excuse follows because Trados situates the breach
in the boardroom rather framing the matter as a shareholder level breach by a controller against a
minority.

         The National Venture Capital Association (NVCA), which makes available a model
version of a venture capital shareholders’ agreement,238 undertook a revision in response to
Trados.239 The revision seeks to square the circle by forcing the sale while simultaneously
getting the self-interested approving directors off the Trados hook. The vehicle is a promise
made by the issuer corporate entity to the shareholder parties. Under the promise, a designated
threshold percentage of shareholders can direct the corporation to sell itself. The drafter outlines
a series of processes to be undertaken by the company to the end of effecting the sale. 240 Thus
does the initiation of a sale process trigger corporate level contractual duties to take actions that
facilitate the deal. Actual performance of these functions in theory cannot be characterized as a
“self-dealing transaction.”

       But there is only so much a contract can do in advance to get a company sold. A merger
ultimately requires the approval of the transferor’s board of directors. 241 The new NCVA drag-
along rights contemplate that this step be taken. But they provide in the alterative for a case
where the board approval is refused, as might happen with directors unwilling to stick out their
necks and approve a merger threatened by a Trados claim holding out potential personal liability.
Given a refusal, the agreement provides for redemption of the VC preferred at price equal to the
amount that would have been allocated to the preferred had the rejected transaction been



236
    Id., section 3.2.
237
    Id., section 3.2(e).
238
    Id.
239
    Id., Addendum & n.29.
240
    Id., Addendum, section __.
241
    251 Absent a charter amendment that remits merger approval to shareholder governance, section 141(a) of the
Delaware Code still requires a board decision. 141(a). The merger statute, section 251, also contemplates action by
the board.

                                                        57
consummated. 242 The idea is either to get the company sold with the board’s approval or, failing
that, to substitute an automatic redemption obviating the need for board approval.

        It is all very convoluted and clever. Unfortunately, it does not solve the Trados problem.
Redemption in lieu of a merger is not the same thing as a merger, for absent the acquirer’s cash
there is unlikely to be money on the table with which to redeem the preferred. The trigger does
give the VC a threat, and the redemption threat presumably makes the board members’ action in
approving the merger more reasonable. But it is hard to see how this background contractual
maneuvering either makes the merger any less “interested” if the approving board members also
are VC designees or makes the merger price intrinsically fair under Trados. If, in the alternative,
the board just says no to the VC’s deal and redemption rights are triggered and exercised, we
find ourselves back at ThoughtWorks, which, read together with Trados, implies a duty on the
board’s part to drag its feet about paying the redemption price!

        4.   Summary

        Trados burdens venture capital finance. The burden is especially heavy on deals in place
at the time of decision, none of which have the benefit of the NVCA’s redrafted shareholders’
agreement. Given a merger that maximizes enterprise value, there are no cognizable
countervailing economic benefits to justify the costs imposed. Nor does such a lawsuit vindicate
any serious notion of fairness.

        “Fairness” in the VC context cannot be determined by taking snapshot of the board that
approved the merger, as happened in Trados. The causal chain needs to be considered in the
wider transactional context. The common in the case came away with nothing because (a) VC
designees dominated the board, (b) the company earlier had surrendered a majority of voting
shares to the VCs in exchange for VC capital, and (c) the company gave up a $57.9 million
liquidation preference to the VCs in exchange for their capital. A reference to the doctrinal
framework that formerly came to bear on this fact pattern, majority-minority fiduciary duty as
articulated in Sinclair v. Levien,243 draws out the implications of the second and third links in the
causal chain. Under Levien, self-dealing by a majority shareholder gives rise to intrinsic fairness
scrutiny, burden of proof on the majority shareholder; self-dealing obtains if the majority takes
value to the minority’s exclusion and detriment.244 Value was taken in Trados, but only pursuant
to the ex ante contract. There was no failure to share and no breach up to $57.9 million. Any
failure to share implicates only the timing—the board gave up the value of the option to delay.
But, as we have seen, the option probably had no value from an enterprise perspective.

        The only value protected is doctrinal—the positive (as opposed to normative) place held
by the common stock maximization directive. That is not enough. A common stock maximand
not only encourages sacrifices of enterprise value, but adds costs by encouraging underwater
common to disrupt ex ante bargains in search of hold up value. An enterprise value maximand
presents a much stronger case for fiduciary scrutiny with a more balanced trade off of costs and


242
    National Venture Capital Association Voting Agreement, supra note 235, Addendum section __.1.3.
243
    Sinclair Oil Corp. v. Levien, 280 A.2d 717 (Del. 1971).
244
    Id. at 720.

                                                      58
benefits. It follows that a common stockholder challenging a sale effected by a preferred holder
in control should be required to plead and prove a sacrifice of enterprise value.

D. Trados and the Suboptimal Merger

        We return to the first merger described in the preceding section—a $40 million deal that
pays the VC its liquidation preference but foregoes the opportunity to realize an expected value
of $52.5 million, with the entire $12.5 differential coming out of the pockets of the common.
Here the litigation threat performs an efficiency function, ameliorating the structural tendency of
senior security holders to make low-ball deals. Investment banker opinions and independent
directors now serve a function, and even a special committee charged with the common’s interest
makes sense—one is less worried about disrupting a deal that should be killed in any event.

        The fairness posture also reverses. A merger below enterprise value is the archetypical
appraisal case. But, by analogy to parent-subsidiary mergers, appraisal should not be the
exclusive remedy and a door should be held open for a process complaint. And, given a sale
below enterprise value engineered by interested directors, there is a serious process complaint.
Traditional majority-majority fiduciary duty applies with full force.

         A question arises nonetheless: whether Trados scrutiny is undesirable here as well
because it disrupts a settled contractual risk allocation. Professors Baird and Henderson, in an
article that anticipated Trados, opine that scrutiny is undesirable.245 They advocate a contractual
barrier to fiduciary review, arguing that fiduciary law should demand neither common stock
value maximization nor enterprise value maximization in VC contexts. Their theory rests on the
assumption that parties can opt of the applicable fiduciary duty, an assumption backed by
reference to close corporation cases on the majority-minority shareholder duty.246 Trados, by
resituating the fiduciary breach in the boardroom, blocks the opt out possibility. In Delaware,
charters can opt out of the board’s duty of care, but not the board’s duty of loyalty.247

245
    Baird & Henderson, supra note 3, at 1328-33. Baird and Henderson are discussing Orban v. Field, 1997 WL
153831 (Del. Ch.).
246
    They cite. Baird & Henderson, supra note 3, at 1319, Ingle v. Glamore Motor Sales, Inc., 535 N.E.2d 1311,
1312-13 (N.Y. 1989)(holding that an employee-shareholder waived fiduciary duties in employment contract);
Gallagher v. Lambert, 549 N.E.2d 136, 137 (N.Y. 1989)(holding that employee-shareholder waived fiduciary duties
in shareholders’ agreement).
247
    Del. Gen. Corp. L. § 102(b)(7). Opting out is a topic of controversy in Delaware law today, but as regards a
provisions of the Delaware Limited Liability Company Act that favor freedom of contract, Del. Code Ann. tit. 6, §
18-1101(b) (“It is the policy of this chapter to give the maximum effect to the principle of freedom of contract and to
the enforceability of limited liability company agreements.”), and make fiduciary duties a function of the parties’
choices. Del. Code Ann. tit. 6, §§ 17-1101(d) & 18-1101(c).( “[t]o the extent that, at law or in equity, a member or
manager or other person has duties (including fiduciary duties”). See Edward P. Welch & Robert Saunders,
Freedom and Its Limits in the Delaware General Corporation Law, 33 Del. J. Corp. L. 845, 859, 864 (2008).
The Delaware courts continue to imply fiduciary duties. See Kelly v. Blum, 2010 WL 629850, at *10 nn.69-70 (Del.
Ch.) (noting fiduciary duties can be altered in LLC agreements with "clear and unambiguous" provisions); Twin
Bridges LP v. Draper, 2007 WL 2744609, at *20 (Del. Ch.) (“Unless the partnership agreement preempts
fundamental fiduciary duties, a general partner is obligated to act fairly and prove fairness when making self-
interested decisions.”). An opt in requirement has been suggested. See Fisk Ventures, LLC v. Segal, 2008 Del. Ch.
LEXIS 158, at *28 (Del. Ch. May 7, 2008) (“In the context of limited liability companies, which are creatures not of
the state but of contract, those duties or obligations must be found in the LLC agreement or some other contract.”).
Steele, supra note 61, at 223-24, argues that the drafting burden should lie on the LLC agreement to opt into

                                                          59
        It is not clear to us that an opt out would have worked in Delaware even if Trados had not
moved the dutry into the boardroom. Baird and Henderson’s proposition is important
nonetheless as a theoretical exercise pushing VC preferred to a contractual extreme. We
consider it in this Section, finding ourselves in partial disagreement. We recommend that
common stock complaints alleging sacrifices of enterprise value be entertained, but, in order to
reduce costs to the VC and diminish the holdup threat, we would substitute good faith for
intrinsic fairness as the standard of review. In addition, VC deals that expressly contract out
from under the duty should be respected.

        Baird and Henderson acknowledge that senior security holders in control have imperfect
incentives, and can be expected not only to fail to maximize the value of the common but
rationally to sacrifice enterprise value.248 Even so, Baird and Henderson, analogizing to an
enforcing lender,249 would have the contract paradigm trump the corporate paradigm as a



traditional fiduciary duties. For the view that fiduciary duties are hard-wired into all Delaware business forms as a
function of the constitutional vesting of Chancery Court jurisdiction, see Lyman Johnson, Delaware’s Nonwaivable
Duties, 91 B.U. L. Rev. 701, 702-04 (2011).
248
    Baird & Henderson, supra note 3, at 1329-30, 1330-32.
249
    Id. at 1332-33. The analogy is imperfect as a doctrinal matter. Assume that the Trados issuer has no preferred
stock outstanding but owes $40 million on a loan that is coming due. The lender demands its money. The company
has two choices, to sell itself for $50 million and pay off the loan with the proceeds or file a bankruptcy petition.
The board decides in good faith and upon due diligence that sale is the better alternative, even though $50 million is
a low price. Indeed, if the lender leaves the company alone for an additional year, its value will exceed $70 million.
The lender’s exercise of its contract right thus sacrifices enterprise value, all of which comes out of the common’s
pocket. But there is no fiduciary claim, for we are under contract absolutely. The lender owes no duty to the
common, who have bargained away their right to control the company in the event of default. The fact that that the
lender’s action sacrifices more than $10 million of enterprise value is neither here nor there.

          Now let us change the facts. The lender, in exchange for earlier waivers of a business covenant and
forgiveness of late payments, has gained the right to nominate a majority of the issuer’s board of directors and has
the benefit of a shareholders’ agreement with a majority of the common holders pursuant to which it directs the
voting of their stock. When default looms, the board determines that a bankruptcy petition will return greater
enterprise value than a sale at $50 million. Yet the lender’s designees determine that the sale serves the lenders’
interests by putting the money on the table more quickly and surely. They force the sale, using the lender’s voting
power under the shareholders’ agreement to push through shareholder approval.

         This is a different case. In the original version, the lender acted from outside of the corporate entity when
imposing a value-diminishing choice on the common-controlled board. Now the lender is inside, controlling the
board, and its designees owe fiduciary duties to the company. By undertaking to manage the entity, the lender has
assumed legal duties, compromising its ability to take an adverse posture as a contract counterparty.

         Let us now try the case a third way. Assume a small number of common stockholders. At the time the
lender takes control of the board, each executes a shareholders’ agreement containing an exhaustively drafted waiver
of the benefit of corporate fiduciary duties, including the duty to maximize enterprise value in connection with a sale
of the company. Each also grants the lender a proxy to vote its stock. The issue is whether stockholders can opt out
of the duty of loyalty by contract.

         Now put the three hypotheticals together and return to Trados. We see that the contract paradigm’s
protection of self-interested, value-destroying conduct yields when the lender takes control. Preferred in control can
ask for no greater solicitude.


                                                          60
structural proposition.250 The common have given up contingent control rights to the VC, rights
with the potential to destroy firm value. Meanwhile, the common and their managers emerge
with “just the right incentives . . . to operate the firm efficiently in the first place.”251

        Significantly, Baird and Henderson neither invoke the contract paradigm absolutely nor
advocate a complete retreat from fiduciary scrutiny. Although they would block intrinsic
fairness scrutiny on the Trados fact pattern, they pose a hypothetical on which scrutiny should
proceed.252 Here the VC dominates without controlling the board. It encourages profligate
spending even as the company turns down opportunities for additional funding, assuring the
other board members that additional finance on better terms is readily available. When the
company runs out of cash and is desperate the VC finds it a bridge loan, for its pains taking
bargain warrants that the almost dilute the common out of existence. If, say Baird and
Henderson, the common can show that the board turned down legitimate deals on an insufficient
process basis while dominated by a conflicted director, a fiduciary action should lie253

        Comes the question, wherein lies the distinction? Baird and Henderson do not elaborate
further. But there are two possible ways to distinguish the cases, good faith or implied waiver.

        Let us try good faith first. The hypothetical poses a bad faith VC who, motivated by the
chance of personal gain, sacrifices enterprise value at the expense of the other claimants. If we
take the value maximizing $60 million version of Trados, stipulating that the VCs believe
themselves to have made the best possible deal, it is a case of good faith and distinct from Baird
and Henderson’s hypothetical. Unfortunately, however, the distinction lacks traction. If we
switch to the $40 million version of Trados and stipulate that the VCs are aware of a better deal
or recklessly disregard chances to get a better deal, then the VCs are no more in good faith than
the VCs in the hypothetical. Yet Baird and Henderson would block scrutiny.

        Waiver holds out the better distinction. A below enterprise value sale by a VC in control
looking for an exit route is foreseeable by the common at the time the deal is made. We
accordingly could imply a waiver of scrutiny in the deal structure. Underhanded domination of
the board on a going concern basis for the purpose beating down the company to a fire sale price
is sneakier and more contrived and accordingly less easily foreseen. A waiver of scrutiny is less
easily implied. Scrutiny is blocked in the first, foreseeable case, but not in the second,
unforeseeable case.

        Waiver being the theory, we must confront the resulting problem of contract
interpretation. Baird and Henderson would imply a waiver as regards sale as a structural
proposition. The implication completes the contract as regards sale, and, given a complete
contract, fiduciary duty has no place.



250
    Id. at 1332-33.
251
    Id. at 1333.
252
    Id. at 1332-33 & n. 106.
253
    Id. They cite Orban v. Field, 1997 WL 153831 (Del. Ch.), a case not followed in Trados. See 2009 WL 2225958
at 8.

                                                      61
        This goes against the doctrinal grain. In the LLC context, where opting out of fiduciary
duties is an active possibility, the opt out must be explicit.254 A question arises at this point:
whether drag-along rights, in their pre-Trados form, should be read to effect the waiver. Here is
the relevant language form the AVCA form. The shareholder agrees
        to execute and deliver all related documentation and take such other action in support of
        the Sale of the Company as shall reasonably be requested by the Company or the Selling
        Investors in order to carry out the terms and provision of this [section], including without
        limitation executing and delivering instruments of conveyance and transfer, and any
        purchase agreement, merger agreement, indemnity agreement, escrow agreement,
        consent, waiver, governmental filing, share certificates duly endorsed for transfer (free
        and clear of impermissible liens, claims and encumbrances) and any similar or related
        documents . . . . 255
Read literally, the waiver is there; indeed, the signatory agrees to deliver a waiver tailored to the
occasion. If we ratchet up the drafting burden, however, the waiver does not succeed because
the signatory gets no special notification of a give up of fiduciary protection, a notice that
arguably should be enshrined in block capitals and initialed in the margin.

        It is a judgment call. For very much the same reasons articulated by Baird and
Henderson at a structural level, we would hold the AVCA language to effect the waiver and
block a fiduciary action by a drag along signatory, even in the $40 million case. Absent a
shareholder agreement, however, we would not block a Trados claim respecting a merger below
enterprise value. We would, however, adjust the standard of review.

      E. Standards of Review

        We agree with Baird and Henderson that the Trados fact pattern calls for a considered
accommodation between the corporate and contract paradigms. We have seen that foursquare
corporate treatment facilitates hold ups by underwater common and destabilizes heavily
negotiated transactions. Control having been given up at arm’s length, interested director
approval should not by itself trigger intrinsic fairness review. At the same time, absent a drag-
along, it is not clear that the common in a VC-controlled investee has bargained away its right to
complain of a sacrifice of enterprise value.

       We seek a point of accommodation on the corporate side of the paradigmatic divide. In
our view, an adjustment of the standard of review will work better than an across-the-board
contractual bar to suit.

        There are four possible standards of review when a Trados plaintiff complains of a below
enterprise value sale: (1) intrinsic fairness, burden of proof on defendant; (2) intrinsic fairness,
burden of proof on plaintiff; (3) good faith, burden of proof on defendant; and (4) good faith,
burden of proof on plaintiff. Trados appears to apply standard (1), allowing the plaintiff’s
allegations by themselves to put the burden to prove intrinsic fairness on the defendant.256

254
    Kelly v. Blum, 2010 WL 629850, at *10 nn.69-70 (Del. Ch.) (noting fiduciary duties can be altered in LLC
agreements with "clear and unambiguous" provisions).
255
    See National Venture Capital Association Voting Agreement, supra note 235, section 3(c).
256
    2009 WL 2225958 at 9. We say “appears” because the matter was decided on a motion to dismiss.

                                                       62
Standard (2) applies when defendants take procedural steps to qualify the transaction in
question—independent director approval in the case of a manager self-dealing transaction,
negotiation by an independent directors’ special committee in the case of a parent-subsidiary
merger. Standard (3) asks for less than fairness, reviewing only for reckless disregard for the
interests of the corporation. We have noted here its invocation in preferred stock cases,
reformulated as a reckless disregard for the interests of the preferred stockholders, and
recommended its employment when a common majority imposes a merger allocation on a class
of preferred. Standard (4) is the business judgment rule, which always yields to a plaintiff
meeting the burden to show bad faith. It might at first blush seem that business judgment
treatment in a Trados case amounts to rejection of fiduciary scrutiny and corporate treatment.
But that is not the case. To impose standard (4) is to reject the contract paradigm: Given an
effective waiver of fiduciary duty, none of the standards would apply.

       For us the choice lies between (3) and (4). Putting the burden of proof on defendant
under (3) puts procedural pressure on the VC to examine alternatives and justify its choice.
Switching the burden of proof to the plaintiff eases the pressure but enhances the chance that a
value destructive merger could get past motion to dismiss, subject to an appraisal.

        The precedent favors (3), which was employed in the leading Delaware preferred-in-
control case prior to Trados. This was Chancellor Allen’s decision of Orban v. Field.257 As in
Trados, VCs in control of a company in moderate distress arranged a sale.258 The acquirer, for
tax reasons, insisted on ratification by 90 percent of the common stockholders. 259 Unfortunately,
an entrepreneur on the scrapheap had more than 10 percent of the common votes and attempted
to turn those votes into a substantial hold up payment.260 The VC-controlled board responded
with a series of transactions that diluted the entrepreneur to less than 10 percent of the stock. 261
The entrepreneur sued for breach of the duty to maximize for the common, but made no claim
that merger sacrificed enterprise value.262

         Chancellor Allen rejected the claim. A board seeking to realize enterprise value could act
against its common stockholders provided it could show that it acted reasonably and in good
faith.263 As the merger “appeared reasonably to be the best available transaction,” the plaintiff
had no claim.

       Orban is easier than Trados, for there was no claim that enterprise value was sacrificed.
We think it could be extended to cover Trados by reference to Lyondell Chemical v. Ryan.264
Lyondell was a public company Revlon case. The Delaware Supreme Court, citing the
company’s 102(b)(7) provision opting out of the duty of care, took the occasion to interpose
good faith as the standard of review of the board’s fulfillment of its Revlon duty to maximize the
merger price. As a result:

257
    1997 WL 153831 (Del. Ch.).
258
    Id. at 3-4.
259
    Id. at 5.
260
    Id. at 6 & n. 5.
261
    Id. at 7.
262
    Id. at 8.
263
    Id.
264
    970 A.2d 235 (Del. 2009).

                                                 63
            Only if they knowingly and completely failed to undertake their responsibilities would
            [the directors] breach their duty of loyalty. The trial court approached the record from the
            wrong perspective. Instead of questioning whether disinterested, independent directors
            did everything that they (arguably) should have done to obtain the best sale price, the
            inquiry should have been whether those directors utterly failed to attempt to obtain the
            best sale price.265

        We are not asserting that Trados is Lyondell. The Lyondell board was disinterested.266
Even so, the “utter failure” standard resonates well in the venture capital context. The possibility
of review, even relaxed review, puts the controlled board on notice that the company must be
shopped and that outside confirmation respecting the quality of the price is needed. A board that
must meet the burden to show that it did not “utterly fail” to obtain the best price will take
enterprise value into account. Thus armed, it will sustain its burden on summary judgment.




265
      Id. at 243-44.
266
      Id. at 239.

                                                    64
                           V. TRAVERSING THE PARADIGMATIC DIVIDE
        The law of preferred stock emerges much changed in the wake of James, ThoughtWorks,
and Trados. Promises to preferred are harder to enforce. Fiduciary protection in situations of
vulnerability, elusive before, now retreats a step. At the same time, bargained for control rights
are less effective than before. Always ambiguous, preferred stock emerges more problematic
than ever.

        We have described and analyzed the issues the cases raise in terms a paradigmatic choice
between contractual and corporate treatment. This Section expands on our theme, highlighting
patterns in the courts’ choices along with possible alternatives and considering normative stakes.

A. Doctrinal Overlap

       We start with some doctrinal observations.           Disputes about preferred involve
paradigmatic overlap and paradigmatic overlap imports conceptual instability. To resolve the
dispute is to make a reference to one or the other paradigm. A court explaining and justifying a
decision tends to make exclusive reference to the paradigm chosen. The one-sided explanation
imports coherence in the context of a single opinion. But the opinions should be read and
applied with caution.

         We demonstrate the need for caution by pushing the approach taken in each of the cases
to its logical conclusion. The James move to contract, applied literally, implies an open field for
dummy mergers that opportunistically recapture financial rights sold to preferred stockholders.
We do not think Delaware law contemplates that result, and accordingly infer a good faith
limitation regarding mergers and merger allocations. The ThoughtWorks move to corporate
treatment, applied literally, implies that a preferred issuer of means can indefinitely forestall a
payment obligation. We do not think Delaware law contemplates that result either. The
corporate treatment in Trados, applied literally, invites hold outs and value-sacrificing decisions
and overrides existing drag-along rights. We think the Delaware courts, squarely faced with
such results, would contain the reach of the case. In the long run preferred stock always reverts
to the overlap. It is structurally unavoidable.

B. Delaware’s Approach

       The score in our three cases is corporate two (ThoughtWorks; Trados) to contract one
(James). Any apparent inconsistency is dispelled by reference to the results—the preferred
always loses.

       The disposition to favor the common is unsurprising. Delaware sells a product and the
buyers tend to be holders of common stock or their management representatives. Senior security
holders have historically done badly in the Delaware courts;267 drafters of debt contracts

267
    See, e.g., Shenandoah Life Ins. Co. v. Valero Energy Corp., 1988 WL 64391 (Del.Ch.)(ruling that a refunding
limitation covering indirect cheaper borrowing not to apply to a simultaneous borrowing); Katz v. Oak Indus. Inc.,
508 A.2d 873 (Del.Ch. 1986)(refusing contract good faith scrutiny to a debt exchange offer with an exit consent
attached).

                                                        65
overwhelmingly choose New York law.268 With preferred there is no option to split
jurisdictions, Delaware for governance, New York for financial promises. The financial terms
must go into the charter and take the law of the state of incorporation as it comes.

        There are also important mitigating points. A general disposition to favor the common
long antedates the Delaware courts’ emergence as the focal point bench for the law of preferred
stock. At the same time, preferred stockholders do not always lose in Delaware. 269 Nor is
Delaware singling out the preferred for rough treatment. A case like ThoughtWorks at bottom is
a control contest, and when control is contested Delaware courts also tend to presume in favor of
the discretion of the incumbent board of directors.270 While we contest the result in Trados, we
must acknowledge that the Court’s application of intrinsic fairness scrutiny is in line with
Delaware’s treatment of minority stockholders more generally. The Delaware merger cases
conduct an experiment in fiduciary protection for preferred that is unique among the states, and
the door to fiduciary scrutiny remains open post James.

        That said, we are left with corporate treatment when corporate treatment benefits the
common (board discretion to refuse payment and fiduciary constraint of majority preferred) and
contract treatment when contract treatment benefits the common (refusal of fiduciary protection
against a crammed down merger price). Inconsistencies are apparent. Why in particular the
refusal of majority-minority protection to the preferred minority against an imposed merger price
in James and the imposition of protection on a preferred majority imposing a merger price in
Trados?

         We can suggest a couple of answers. First, the Delaware courts are unlikely to view
themselves as going back and forth between contract and corporate treatment from case to case.
They see themselves as consistently contractual in preferred cases: If the preferred want a given
result, they should contract for it specifically; if they fail to do so, the default corporate paradigm
dictates the result. The preferred in ThoughtWorks could have procured upstream convertibility
into a note; in James either of a class vote or liquidation treatment would have done the trick; in
Trados drag-along rights seemed to have been lacking. Second, the difference between James


268
  See Theodore Eisenberg & Geoffrey Miller, The Flight from Arbitration: An Empirical Study of Ex Ante
Arbitration Clauses in the Contracts of Publicly Held Companies, 56 DePaul L. Rev. 335, 372 (2007).
269
    See, e.g., Protas v. Cavanagh 2012 WL 1580969 (Del.Ch.)(rejecting waste claim stemming from closed-end fund
redemption of auction preferred stock); Shiftan v. Morgan Joseph Holdings, Inc., 2012 WL 120196 (Del.Ch.)(
reading charter to require mandatory redemption and holding that in an appraisal action a court may properly
consider a non-speculative, contractually mandated redemption set to occur six months after the merger when
determining the fair value of preferred); Fletcher Int'l, Ltd. v. ION Geophysical Corp., 2010 WL 2173838 (Del. Ch.
May 28, 2010) (applying covenant requiring preferred consent to issue of security by subsidiary of issuer); MCG
Capital Corp. v. Maginn, 2010 WL 1782271 (Del.Ch.) (according standing to sue derivatively); Matthews v.
Groove Networks, 2005 WL 3498423 (Del.Ch.)(sustaining application of a liquidation provision directing merger
proceeds to the preferred); " Elliott Associates, L.P. v. Avatex Corp., 715 A.2d 843 (Del. 1998)(sustaining
application of a merger class vote provision against a dummy merger); In re FLS Holdings, Inc. Shareholders
Litigation, 1993 WL 104562 (Del.Ch.)(rejecting a nonpecuniary settlement of preferred rights respecting a merger
payout); Dart v. Kohlberg, Kravis, Roberts & Co., 1985 WL 21145 (Del.Ch.1985)(denying dismissal of a preferred
fairness claim respecting a leveraged restructuring); Baron v. Allied Artists Pictures Corp., 337 A.2d 653
(Del.Ch.1975)(rejecting a common stock challenge to the incumbency of a preferred controlled board).
270
    See Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946, 954-56 (Del. 1985).

                                                       66
and Trados is the difference between a merger allocation made by a disinterested board (James)
and an interested board (Trados).

        The drafting burden response resonates nicely with prevalent views respecting the
application and interpretation of financial contracts. But we have some concerns. As applied in
ThoughtWorks and Trados it looks like a game played by secret rules. The drafter in
ThoughtWorks tried hard to achieve enforceability, but, despite the manifest intent of the parties,
missed the technical trick, a trick not without enforceability problems of its own. Trados made
drag-along rights intrinsically ineffective. As for James, the contractual alternatives are well-
established, but come at a price to preferred issuers. To insist on them as the exclusive means of
protection against opportunism is to skew the bargaining space. It is accordingly not at all clear
that preferred stock contracts should be assumed to be complete. A presumption remitting
preferred to explicit contractual protection is normatively robust, but should be applied
reasonably (without the “gotcha” aspect) and with fact sensitivity.

        A distinction keyed to the independence of the directors on the cases’ respective boards
also has normative traction. The disinterested, independent director has risen to such prominence
as a solver of corporate problems as to become the universal solvent in conflict interest cases,
and that is a good thing. But there is also structural problem. In Trados we see the disinterested
director in a new, quasi-mandatory role. Formerly, a controlled board was assumed in majority-
minority cases. The question was whether control and differential results turned an otherwise
unobjectionable decision into a shareholder level breach of duty. If the controlled outcome was
uneven, intrinsic fairness scrutiny followed. Trados skips a step in the sequence. The controlled
board’s decision, not being disinterested, by itself triggers fairness scrutiny without a preliminary
inquiry into the evenness of the outcome, an exercise in which the minority shareholder bore the
burden of proof. The result is an easy complaint, too easy. At the same time, insistence on a
majority disinterested board cuts against the practice. The VC template incorporates a different
solution to the problem—the five seat board with a tiebreaker fifth director. Were the Trados
sale approved by a board thus constituted, the tiebreaker’s approval should suffice as a process
matter.

C. Consistency as an Alternative

        Perhaps consistency has a virtue here. Let us compare regimes that strive for consistent
treatments, all corporate or all contract. A corporate regime would give us ThoughtWorks and
Trados as decided but change the result in James, demanding a veto-bearing committee for the
preferred on pain of intrinsic fairness scrutiny. A contract regime would enforce the promise in
ThoughtWorks and dismiss the complaint in Trados, leaving James in place.

       We aren’t entirely satisfied with either set of results. Across the board corporate
treatment changes the Delaware outcomes to yield intrinsic fairness scrutiny in James, but
overrides the risk allocation in two VC deals. We think that fairness review in Trados is overkill
and see no need for intrinsic fairness scrutiny in James. Forced to choose, we would weight
respect for considered risk allocations higher than solicitude for the convenience of the going
concern or the interests of underwater common stockholders, enforcing in ThoughtWorks and



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dismissing in Trados. Meanwhile, the preferred in James had an appraisal option and so was not
remediless.

        In the end, however, we do not think that paradigmatic consistency is a viable alternative
given a subject matter on which two paradigms come to bear. Nuanced mediation across the
paradigmatic divide will work better. Consistency here lies in taking a considered look in both
directions when difficult conflicts arise. Contract should be the major theme, but only on the
understanding that completeness should not be assumed.

D. Value Maximization and Paradigmatic Conflict

        When contract trumps corporate, notions about value maximization motivate the choice.
Transactions embody maximizing trades. The issuer gets capital to invest based on a stated
return on stated terms, trading off future financial and control risks for a reduced level of present
financial obligation. Legal interventions that undercut these bargained for risk allocations chill
capital raising and in the long run raise the cost of equity capital at the shareholders’ expense.
Legal interventions that extend fairness protections to contract counterparties can do the same
thing: when the relationship is contractual, the contract itself is the best vehicle for protecting
counterparty interests.

       Concerns about value also motivate the choice when corporate trumps contract.
Generally, senior security holders don’t maximize enterprise value, residual interest holders do.
When self-interested seniors liquidate their investment, extracting returns of invested capital,
they can injure the going concern. When seniors take control with a view to capital extraction
they disrupt productive relationships amongst managers, employees, and firm specific capital.
The corporate legal system owes them no special assistance in these pursuits.

        The two paradigm’s normative associations, thus stated as binary opposites, are
descriptive of the conflicts presented in the cases. But the conflict description tends to be
unhelpful as regards their resolution. The simple incentive depiction of seniors as conservative
and risk averse and common stockholders as productive risk takers does not necessarily apply to
the venture capital investments at issue in ThoughtWorks and Trados. Here both the preferred
and the common holder are risk takers and, given a conflict, there is no basis for an ex ante
presumption that one or the other possesses the “correct” incentives. Where the VC has control
and power to remove the entrepreneur we get something approaching the incentive picture
idealized in agency theory—a manager forced by the stick of fear of removal and incented to
produce by the carrot of a huge equity upside. At the same time, the transaction that creates the
incentive arrangement has a claim to the solicitude of the contract norm.271 In other words, the
norms can be aligned to favor the preferred. The norms also can be seen in alignment in James,
but their direction can be reversed depending on the characterization of the facts. At first glance

271
   Associations with corporate legal theory’s back and forth over a contractarian corporate law paradigm also are
noted. The contractarians, armed with agency theory, sought to contractualize corporate legal theory, subordinating
the fiduciary and encouraging universal opting out of mandatory fiduciary duties. See, e.g., Henry N. Butler &
Larry E. Ribstein, Opting Out of Fiduciary Duties: A Response to the Anti-Contractarians, 65 Wash. L. Rev. 1, 29-
30 (1990). It not surprising that two Chicagoans, Professors Baird and Henderson, weighed in on the Trados issue
even before the case arose to argue against fiduciary constraints on VCs in control.

                                                        68
both norms point to the result in the case—the explicit contract holds out no protection for the
plaintiff and the corporate paradigm does not hold out clear cut fiduciary protection. The
normative posture changes once the contract is seen as incomplete—now judicial intervention on
the preferred’s behalf supports both the deal and the long term interests of common stockholders.

       The complications bring us back to the overlap point. Neither notion of value
maximization works well as a universal trump. The implications of both need to be kept in
mind, case by case. It follows that the common stock value maximization norm needs to be
contained in this context. Given two classes of equity whose interests conflict, enterprise value
maximization works better as the default norm.

                                            CONCLUSION

       We would modify the rules of each of James, ThoughtWorks and Trados. Each of our
modifications draws on both paradigms.

        Merger allocations to minority preferred should be subject to minimal scrutiny under the
good faith rubric, with the burden of proof on the defending board. Approval by genuinely
disinterested directors acting in absence of any threat of lawsuits from the common should
satisfy the burden. We would entertain appraisal exclusivity as an alternative approach if
Delaware’s corporate code offered held out appraisal to preferred issues on a per se basis.
Where appraisal is available, exclusivity should be the presumptive choice, absent a showing of
bad faith.

        Payment enforcement is intrinsically problematic due to legal capital and fraudulent
conveyance constraints, constraints that can be ameliorated but not avoided through the ruse of
upstream conversion to a promissory note. These legal barriers should be etched clearly and
narrowly or the promise to pay is negated. We accordingly would delimit the meaning of “funds
legally available” to the literal terms of the background regime and put the burden on the issuer
to show that payment would cause a violation.

         Cases where preferred in control sells the company are as a practical matter venture
capital cases. We think the treatment should be tailored to the transactional context with a view
to the risk allocation effected and the resulting incentive structure. It follows that scrutiny should
be blocked where the entire class of common has waived the objection in a shareholders’
agreement. Scrutiny should be available at the behest of non-waiving common holders given a
plausible allegation of a sacrifice of enterprise value. The standard of review should be good
faith, with the burden of proof on the board.




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