Boards of Directors Owe Fiduciary Duties to Preferred Shareholders
Danielle C. Lesser
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The law with respect to duciary duties owed by boards of directors to preferred shareholders is far from settled. Many directors hold the mistaken view that corporate boards of directors owe no duciary duties to preferred shareholders and that the rights of preferred shareholders are governed entirely by the law of contracts. The rights of preferred shareholders, however, are not limited solely to those enumerated in the certicate of designations. It is thus important to closely examine the obligations owed by directors to preferred shareholders, especially in the structuring of corporate transactions that benet common shareholders at the expense of preferred shareholders. As discussed below, whether a given claim asserted by a preferred shareholder is governed by contract or duciary principles turns upon whether or not the dispute arises from a right articulated in the certicate of designations. If the claim is not a contractual preference, it could be a right shared equally by the common and preferred shareholders where duciary duties are owed. As the cases briey discussed herein will show, this determination is often highly factspecic and is not susceptible to any ‘‘bright line’’ test. All shares, including preferred shares, constitute an ownership interest in a corporation. Likewise, all shareholders own the corporation but surrender management to the board of directors. The directors, as the managers of corporate aairs, are charged with duciary duties both to the corporation and its shareholders. The directors thus must act in the best interests of the shareholders, and cannot engage in self-dealing. Typically, preferred shares do not have voting rights, except under limited circumstances, are senior to common shares in the
Danielle C. Lesser is a litigation partner at Morrison Cohen Singer & Weinstein, LLP in New York City and a co-author of Chapter 27, Insourcing Legal Resources in Successful Partnering Between Inside and Outside Counsel (West Group) and co-author of Chapter 28, Jury Selection, Commercial Litigation in New York State Courts (West Group). 131
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capital structure, generally have a stated coupon and may have certain conversion rights or other equity kickers. These share preferences are in derogation of the common law, thus, the certicate of designation which grants these rights to the preferred shareholders must be strictly construed. These rights are contractual. For those duties owed both to the common shareholder and preferred shareholder, for example, with respect to duties of care, loyalty and candor, the rights and remedies of the holders of preferred shares are found beyond the four corners of their ‘‘contract.’’ Unlike the preferences set forth in the certicate of designations, which are contractual, rights to which a preferred shareholder is entitled that are outside of the certicate of designation are governed by the laws of equity. In the most basic sense, courts recognize that the rights of preferred shareholders under Delaware law are ‘‘essentially contractual and the scope of the duty is appropriately dened by reference to the specic words evidencing that contract.’’2 Furthermore, for claims specically governed by the certicate of designations, no claim for breach of duciary duty will lie. Indeed, where the certicate of designation expressly contemplated the proposed transaction, and supplied a device to protect the preferred stockholders, the proposed transaction will not implicate the director’s duty of loyalty.3 However, Delaware case law expressly permits a preferred shareholder to maintain a breach of duciary duty claim based on a director’s failure to satisfy his/her duty of care, loyalty and/or disclosure, and courts observe that corporate directors are obligated to treat preferred shareholders fairly.4 The case of Jedwab v. MGM Grand Hotels, Inc.5 establishes that ‘‘when a right asserted is equally shared by preferred and common stockholders, the right and the scope of the correlative duty may be measured by equitable as well as legal standards.’’ Thus, the contractual rights of preferred shareholders exist alongside but independent from the duties of care, loyalty and disclosure which are owed to all shareholders of a
Jedwab v. MGM Grand Hotels, Inc., 509 A.2d 584, 594 (Del. Ch. 1986). HB Korenvaes Invs., L.P. v. Marriott Corp., Civ. A. No. 12922, 1993 WL 205040* (Del. Ch. June 9, 1993)
3 4 Jackson Nat’l Life Ins. Co. v. Kennedy, 741 A.2d 377, 391 (Del. Ch. 1999); In re FLS Shareholders Litig, 1993 WL 134087 (Del. Ch. Apr. 21, 1993). 5 509 A.2d 584, 594 (Del. Ch. 1986). 2
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corporation. Other courts have recognized that a corporation’s directors ‘‘are duciaries for the Preferred stockholders [sic], whose interests they have a duty to safeguard, consistent with the duciary duties owed by those directors to [the corporation’s] other shareholders and to [the corporation] itself.’’6 In Jedwab, a preferred stockholder failed in her attempt to enjoin completion of a merger. Although the plainti was unsuccessful, the Court stated that the claim that the preferred shareholders were not receiving a fair allocation of the merger proceeds could state a claim for breach of duciary duty:
I conclude that her claim (a) to a ‘‘fair’’ allocation of the proceeds of the merger; (b) to have the defendants exercise appropriate care in negotiating the proposed merger and (c) to be free of overreaching by Mr. Kerkorian (as to the timing of the merger for his benet) fairly implicate duciary duties and ought not be evaluated wholly from the point of view of the contractual terms of the preferred stock designations. Id. at 594.7
Generally, in transactions involving issues of corporate control like mergers, reorganizations and other signicant transactions, directors cannot overlook the duciary duties owed to preferred shareholders, particularly where the transaction involves an insider or an aliate and benets the common shareholders to the detriment of preferred shareholders. Directors often rely on the notion that the rights of preferred shareholders are entirely governed by contract and the rights of common shareholders are governed by equitable principles, and thus, it is often the interest of the preferred shareholders that suer. It is in these types of transactions that courts will examine whether duciary duties owed to preferred shareholders have
Eisenberg v. Chicago Milwaukee Corp., 537 A.2d 1051, 1062 (Del. Ch. 1987). See also Jackson Nat’l Life Ins. Co. v. Kennedy, 741 A.2d 377, 387 (Del. Ch. 1999) (court rejected that duty to preferred shareholders was contractual only and recognized preferred shareholders’ right to fair allocation of merger proceeds’’). 7 509 A.2d at 594. See also In re FLS Shareholders Litig., 1993 WL 134087 (Del. Ch. Apr. 21, 1993) (‘‘In allocating the consideration of this merger, the directors, although they were elected by the common stock, owed duciary duties to both the preferred and common stockholders, and were obligated to treat the preferred fairly.’’ ‘‘If this case proceeds to an adjudication of the merits of plaintis’ claims, defendants will bear the burden of proving that the allocation was fair to the preferred.’’)
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been compromised. In Dalton v. American Inv. Co.,8 the court held that placing too high a price on an oer to sell the common stock could be a breach of management’s duty to preferred shareholders, if the consequences were a lower oer for the preferred shares. In Judah v. Delaware Trust Co.,9 the court found that the manner in which the board exercised the choice given it by the charter to redeem preferred shares either in silver or in a currency which had become worthless raised triable issues as to the board’s proper exercise of duciary responsibilities. In Zahn v. Transamerica Corp.,10 the exercise of redemption rights on the eve of liquidation by the board constituted a breach of duciary duty to preferred shareholders where, but for redemption, the preferred shareholders would have received a larger payment. In Quadrangle Oshore (Cayman) LLC v. Kenetech Corp.,11 the court denied a motion to dismiss where the complaint alleged that defendant had wrongfully delayed liquidation until after the preferred shareholders’ liquidation right had expired. In Dart v. Kohlberg, Kravis, Roberts & Co.,12 the court found that a breach of duciary duty was properly alleged where the claim was that a management buy-out ‘‘may result in a lessened ability of the surviving corporation to pay preferred dividends.’’13 With respect to signicant corporate transactions, including mergers and transactions that involve a change of control, the rule regarding what duties are owed to preferred shareholders sounds simple – preferential rights are contractual and rights shared by the common and preferred shareholders are equitable. The application
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490 A.2d 574 (Del. Ch.) a’d, 501 A.2d 1238 (1985)
378 A.2d 624, 628, 631 (Del. 1977) 162 F.2d 36, 42, 46–47 (3d Cir. 1947) 11 24 Del. J. Corp. L. 748, 1998 WL 778359 (Del. Ch. Oct. 21, 1998), appeal refused by Kentech Corp. v. Quadrangle Oshore (Cayman) LLC, 723 A.2d 839 (Del. Supr. 1998). 12 11 Del. J. Corp. L. 602, 1985 WL 11566 (Del. Ch. June 25, 1985) 13 See also Kimeldorf v. First Union Real Estate Equity and Mortgage Investments, 309 A.2d 151, 754 N.Y.S.2d 73 (1st Dep’t 2003). In Kimeldorf, the trial court preliminarily enjoined a proposed merger between First Union Real Estate Equity and Mortgage Investments and a party that was an aliate of the Chairman of the Board, a signicant shareholder. After the decision, the defendants terminated the deal. Thereafter, the Appellate Division vacated the injunction on the ground that the business judgment rule insulated the directors’ actions. Both the trial court and the appellate court recognized, however, that duciary duties are owed to preferred shareholders.
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of this rule, however, has not been so clear-cut. Corporate directors and their legal advisors must closely examine the origin of the right asserted by the preferred shareholders in order to determine whether the obligations owed to the preferred shareholders are governed by contract law or are duciary in nature.