Preferred stock—whether straight or convertible, perpetual or mandatorily redeemable—is a hybrid, having features both of equity and of debt. This alloyed nature can lead to unexpected results from the point of view of an investor. Understanding precisely when preferred stock is treated like equity and when it is treated like debt—and how to protect one’s interests in light of that treatment—is critical for any private equity firm that includes preferred stock in its repertoire of investment tools.
Preferred Stock Is Not Always Treated Like Equity
While preferred stock is technically equity, its particular terms may lead it to be treated more like debt for regulatory capital or tax purposes. For example, rating agencies often decline to give full equity credit for preferred stock that is mandatorily redeemable or the dividend obligation of which is cumulative. Similarly, preferred stock with accumulating dividends will often be currently taxable to the holder (similar to PIK interest on debt) unless the preferred stock (1) is not redeemable by the holder or (2) otherwise “participates” in the growth of the business by sharing in common dividends (to the extent in excess of the preferred coupon) and in the value attributable to the common stock upon liquidation (to the extent in excess of the preferred liquidation preference).
Holders of Preferred Have Only Equity, Not Creditor, Rights
On the other hand, despite often having debt-like features, a holder of preferred stock is in a fundamentally different position than a lender when it comes to enforcing the specific terms of the preferred instrument. Put simply, preferred stockholders have only equity, not creditor, rights.
Mandatory Redemption. Consider, for example, mandatory redemption requirements. Under Delaware law, equity cannot be redeemed if it would impair the capital of the company. A board’s determination as to whether a redemption would result in an impairment will be respected by the Delaware courts so long as that decision is made in good faith and is not so off the mark as to constitute constructive fraud. Where an issuer fails to honor a redemption right on the grounds that the redemption would leave the issuer with insufficient funds, the preferred holder has very limited recourse. It can’t attach the issuer’s assets, can't force the issuer into bankruptcy, and—unless it can show that the board’s decision was not made in good faith—probably can’t get a court to specifically enforce the issuer’s redemption obligation.
Dividends. Similarly, while preferred stock investors bargain hard over the applicable dividend rate, they can do little to guarantee that the issuer will in fact pay those dividends. Whether preferred or common, dividends are payable “if, as and when” declared by the board. In most cases, the investor’s only remedy for the issuer’s failure to pay preferred dividends is the right to additional board seats. For example, holders of publicly traded preferred stock are typically entitled to elect two directors (who would be additive to the existing board, and would not replace existing directors) if quarterly dividends on the preferred have not been paid for six quarterly dividend periods. Moreover, although the preferred terms invariably provide that no dividends may be paid on the common stock while preferred dividends are in arrears, unless unpaid preferred dividends accumulate the issuer only has to pay the current preferred dividend, and not make up dividends unpaid in prior periods, in order to pay common stock dividends.
Protective Covenants. It is often no easier for a holder to enforce protective covenants. Privately placed preferred stock in particular often contains prohibitions on the taking of certain actions without the consent of the preferred holders. These covenants look similar to, and are often modeled on, covenants that appear in loan agreements. However, the remedies available to a preferred stockholder for the breach of those covenants are significantly more limited than those available to debt-holders.
The difficulty in enforcing preferred stock protective covenants can be seen in a recent Delaware case involving a financially-challenged preferred stock issuer. The terms of the preferred stock issued by Abbey Financial LLC prohibited the company from selling certain assets without the consent of the preferred stockholder. Abbey Financial solicited such consent, the preferred holder refused to give it, and the company proceeded to sell the assets regardless. When the preferred stockholder brought suit following the consummation of the sale, the court dismissed the claim on the ground that the preferred holder could not demonstrate that it suffered any injury as a result of the sale of the property. Had the preferred holder owned subordinated debt rather than equity, the breach of covenant would have undoubtedly given it the right to accelerate its debt claim. The Abbey preferred holder sought a similar remedy, asserting that its damages could be measured by its redemption right. The court rejected that position, holding that to give a preferred holder the right to force redemption in these circumstances would improperly elevate an equity claim to a debt claim.
The Primary Duty of Directors Is to Common Stockholders
Despite the fact that preferred stockholders have—in respect of the dividend rights, redemption rights and protective covenants—equity rights rather than creditor rights, directors do not owe preferred stockholders fiduciary duties in respect of those rights. Delaware courts have consistently held that directors owe fiduciary duties to preferred stockholders only to the extent that their interests overlap the interests of the common stockholders. Where the interests of the preferred stockholders and the common stockholders diverge, the primary duty of the directors is to the common. Because the terms of the preferred stock—fixed dividend rights, liquidation preference, conversion rights, etc.—that create that divergence are by nature contractual, the board owes only contractual, and not fiduciary, duties to the preferred holders in respect of those terms.
The primacy of the directors’ duties to the common stockholders may lead the board to determine that there are better uses for the company’s funds than paying dividends on the preferred, or to take actions that risk diluting the ability of the company to pay the liquidation value of the preferred or to be able to redeem the preferred upon maturity. Indeed, directors—including those directors elected by the preferred stockholders—risk liability if they fail to manage the company to maximize long term value for the benefit of the common stockholders.
The 2005 sale of Trados Inc. illustrates the difficult position in which directors may find themselves if they focus their attention on the preferred rather than the common stockholders. Trados had been funded by venture capital investors who held typical venture capital-style preferred stock and the principals of which constituted three of the seven members of the company’s board. The company was sold at a price that left nothing for the common stockholders. In the suit by the common stockholders that inevitably followed, the court found that the board breached their fiduciary duties to the common by failing to take the interests of the common stockholders into account in designing and managing the sales process. The board did not form a special committee; it apparently never considered the interests of the common stock holders as distinct from the interests of the preferred holders; it adopted a management incentive plan that detracted from the value of the common stock at any deal price above the liquidation preference of the preferred; it made no effort to negotiate a merger price that would result in a payment to the common stockholders; it did not obtain a fairness opinion; and it never considered conditioning the merger on the vote of the disinterested common stockholders. Although the court in the Trados case declined to award damages—finding that the common stock was in fact worthless at the time of the sale and thus that the price was ultimately fair to the common stockholders despite the board’s process failures—the decision is a cautionary note for any directors appointed by preferred stockholders.
The conflict between preferred and common stockholders becomes most acute where the issuer is neither a rousing success nor a complete failure. In those circumstances, the preferred stock issuer may find that the liquidation preference of its preferred stock exceeds not only the preferred stock’s conversion value but the entire equity value of the company. If a buyer proposes a merger in which the common stockholders receive value and the preferred holders are either left in place or are cashed out at a price less than their liquidation preference, maximizing the value of the common at the expense of the preferred, it would be entirely consistent with the fiduciary duty of the board to accept that offer. The preferred stockholders may exercise appraisal rights, but that will not necessarily provide them with much satisfaction.
Holders of convertible preferred stock should keep in mind that a merger that cashes out the common stock but leaves the convertible preferred in place can deprive the preferred stockholders of a significant portion of the value of their investment. That is because most convertible instruments provide that following a merger, the instrument becomes convertible into the consideration—whether stock, cash or other property—that would have been received if the holder had converted immediately prior to the merger. Thus, where that consideration is cash, the merger eliminated any further option value inherent in the instrument. In the case of convertible preferred stock, the conversion right of which is out of the money, that scenario leaves the holder with the Hobson’s choice of converting, continuing to hold the less-valuable preferred stock, or seeking appraisal.
The potential weakness of the appraisal remedy in these circumstances was demonstrated in the 2009 appraisal case involving the preferred stock of Metromedia International Group Inc. Metromedia was acquired in a merger in which all of its common stock was cashed out and its publicly-traded preferred stock left outstanding. The per share consideration to the common holders was a fraction of the conversion price of the preferred shares and the aggregate amount paid to the common was significantly less than the preferred stock liquidation preference. The preferred stockholders sought appraisal claiming, among other things, that they were entitled to receive at least their liquidation preference. The Delaware Chancery Court, in a case subsequently affirmed by the Delaware Supreme Court, disagreed. The court held that the ability of the preferred holders to access the liquidation value of the preferred stock was speculative and that the proper measure of the preferred stock for appraisal purposes was its as-converted value.
How Can a Preferred Stockholder Improve Its Position?
It may seem from the perspective of a preferred stock investor that the terms of the preferred are treated as equity precisely when you want them to be treated like debt, and treated like debt precisely when you want them to be treated as equity. Nonetheless, there are a number of things that a preferred stockholder can do to improve its position when its rights are most vulnerable. These include:
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- Make sure that the preferred stock has a voice in mergers, ideally by a class vote. While a veto over all mergers may in many cases not be commercially achievable, at the least the preferred should be able to block a transaction that cashes out the preferred at less than its liquidation preference or that impairs the economic rights of the preferred stock where it remains outstanding.
- Alternatively, provide that the preferred stock must be paid at least its liquidation preference upon any change of control. Without either the right to get liquidation value or the right to approve the merger, a preferred stockholder in a company whose common stock is acquired for cash at a price less than both the conversion price and liquidation value risks finding itself in the same position as the holders of the Metromedia preferred stock.
- Ensure that the issuer remains properly incentivized to pay dividends. This is typically done by providing that unpaid dividends accumulate and compound. However, where regulatory requirements make cumulative dividends unavailable, a preferred stockholder may still be able to provide that forgone dividends are taken into account at the time of conversion. Rating agencies and financial regulators tend to care less about how the total common equity pie is divided between common and preferred stockholders upon conversion than they do about contingent obligations of the regulated company to pay funds to its preferred stockholders.
- Provide remedies for breach other than the right to seek redemption. For example, failure to comply with protective covenants could give the preferred holder additional governance rights, such as the right to appoint additional directors or the right to compel the company to pursue a sale process (keeping in mind that the ultimate decision as to whether to sell the company must remain with the directors). Other remedies could include adjustments to the conversion price (thus diluting the common stockholders) or an obligation to put in place a sinking fund to which free cash flow would be deposited for use solely to redeem (or make dividend payments on) the preferred stock.
Preferred stock is a highly flexible tool that can provide significant benefits to both issuers and investors. However, investors that lose sight of the fundamental fact that—despite the debt-like features of many preferred stock instruments—they remain equity investors, risk getting less than they think they have bargained for, particularly when the issuer is facing economic distress.