Summary and Facts
The Delaware Supreme Court has affirmed a Chancery Court holding that a corporation’s board of directors was entitled to conclude that it did not have “funds legally available” to redeem preferred stock within the meaning of the mandatory redemption provisions of its certificate of incorporation. The board’s conclusion was predicated upon the absence of cash availability, and was supportable even assuming net assets exceeded the redemption amount as required by Delaware General Corporation Law (“DGCL”) restrictions on redemptions.
In SV Investment Partners, LLC et al. v. ThoughtWorks, Inc. (Del. 2011), published by the court on November 15, 2011, SV Investment Partners and affiliated funds (SVIP) invested $26.6 million in the preferred stock of a Delaware corporation called ThoughtWorks, Inc., an information technology services firm. ThoughtWorks’ Certificate of Incorporation was amended to include a provision (the Redemption Provision) that on and after the fifth anniversary of the closing, SVIP would be entitled to require ThoughtWorks to redeem the preferred stock “for cash out of any funds legally available therefor.” Also, ThoughtWorks was required to value its assets at the highest amount permissible for purposes of calculating the amount it could legally pay under the DGCL.
Starting in 2005 SVIP sent a number of demand letters exercising its redemption rights. The board of ThoughtWorks determined from time to time the amount of “funds legally available” and made several redemptions to that extent, totaling $4.1 million. In 2007 SVIP filed suit in the Court of Chancery seeking a declaratory judgment to establish the meaning of the phrase “funds legally available.” During discovery and settlement negotiations, ThoughtWorks sought financing for a potential redemption but none was consummated. In 2010 the board obtained financial advice that ThoughtWorks’ net asset value was in the range of $6.2–22.3 million and its cash availability in the range of $1–3 million. The board, however, felt that cash availability was zero, taking into account certain adverse circumstances, and refused to make any further redemption at that time.
In November 2010, the Court of Chancery concluded that “funds legally available” meant cash funds on hand in an amount not exceeding “net assets,” as defined in Section 154 of the DGCL, and that Thoughtworks’ board was entitled to deference when it determined that the company did not have sufficient cash. The Delaware Supreme Court has now affirmed this holding.
Meaning of ‘Funds Legally Available Therefor’
The Redemption Provision stated that redemption was to be made out of “funds legally available therefor.” Section 160 of the DGCL prohibits a redemption of stock when the capital of the corporation is “impaired” (Section 170 does the same with respect to dividends). Capital is impaired if funds used to redeem stock exceed the amount of the corporation’s “surplus,” which is defined by Section 154 of the DGCL to mean the excess of net assets over the par value of the corporation’s issued stock. “Net assets” are the amount by which total assets exceed total liabilities.
SVIP argued that “funds legally available” means an amount equal to “net assets” as determined based on a financial valuation of the company, without regard to whether net assets consist of cash, property, plant and equipment, inventory, goodwill or some other asset. If net assets exceed the redemption amount, then the company has an obligation to pay, and if it cannot do so because of inadequate cash flow, then SVIP would be entitled to a judgment that it could attempt to enforce in the normal course, presumably in the bankruptcy arena.
The Chancery Court on the other hand used Black’s Law Dictionary and various other dictionaries to define “funds,” “legally” and “available,” and concluded that the phrase means cash that is obtainable and ready for use in conformity with applicable law. A corporation can have cash that is not legally available, or a corporation can lack cash yet have the legal capacity to make a redemption, using other corporate property, if it had a surplus.
Calculation of Net Assets
The Chancery Court, and in reviewing the Chancery Court holding, the Supreme Court, also analyzed the definition of “net assets” assuming for purposes of argument that SVIP was correct when it asserted that “funds legally available” means that net assets exceed the redemption amount without regard to the nature of the assets. SVIP’s expert used the discounted cash flow, comparable companies and comparable acquisition methods to show that ThoughtWorks’ net assets were in the range of $68-137 million, well above the amount necessary to redeem the preferred stock.
However, the Chancery Court said that the assets must be valued based on “real economic value that the corporation may borrow against or the creditors may claim or levy upon,” citing Klang v. Smith’s Food & Drug Centers, Inc., 702 A.2d 150, 154 (Del. 1997). Thus the court appears to use the kind of analysis that an asset based lender might use, wishing to ensure that a loan could be paid off by sale, within a reasonable time table, of equipment, inventory, receivables, and similar salable assets. In contrast, the expert’s methodologies are geared to a valuation of the company as a going concern (including goodwill).
Also, the expert’s testimony was held insufficient to show that “net assets” were sufficient for the redemption payment, because
- She did not consider the amount of funds ThoughtWorks could use for redemption while continuing as a going concern
- She did not consider how making the redemption would affect ThoughtWorks’ ability to achieve the projections on which her analysis relied
- She did not consider how Thoughtworks might raise the funds for the redemption
These criticisms might seem somewhat inconsistent with the court’s purported acceptance of SVIP’s position that the exercise requires only a calculation of net assets without regard to whether the assets included cash. The explanation may be that the valuation did not take the redemption into account on a pro forma basis, and doing so would have reduced the valuation.
Deference Due to Board Decisions
Both the lower and higher SVIP courts held that Thoughtworks’ board was entitled to deference in making the decision as to whether it had funds legally available, unless it acted in bad faith, relied upon unreliable methods or made a decision constituting fraud.
This point is underscored by comparing the situations in SVIP and the Klang case cited in SVIP. In SVIP the board decided not to make the required redemption, and in Klang the board wanted to make the redemption as part of a larger transaction. The Klang decision permits corporations to revalue their book assets and liabilities for purposes of the DGCL Sections 154 and 160 restriction on redemptions. If a corporation has not yet realized or reflected on its balance sheet an appreciation of assets, it may do so prior to redeeming stock. In the Klang case, the corporation’s investment adviser valued the assets under the “market multiple” approach and subtracted long term debt. The plaintiff argued that had $372 million in current liabilities been taken into account, the corporation would have had a negative net worth and would not have been able to make the redemption. The Klang court said that Section 154 “simply” defines net assets and does not mandate a “facts and figures balancing of assets and liabilities” to determine by what amount total assets exceeds total liabilities. The statute is “merely definitional” and “does not require any particular method of calculating surplus but simply prescribes factors that any such calculation must include.”
So, the Klang board was permitted to make a redemption by revaluing its book net assets and going to a market multiple approach instead of a line-by-line review and adjustment of its balance sheet. For the Klang court, this was “real economic value.”
The Chancery Court in SVIP used the phrase “real economic value” to require an assetbased method, and while rejecting the expert’s valuation methodologies used the phrases “speculative figures” and “highest valuation possible with a straight face” — even though the Redemption Provision required the SVIP Board to use the highest permissible valuation, and Klang, upon which SVIP relied, permitted a market multiple approach.
The common thread here is judicial support for the determinations of the boards of directors.
Common Law Restriction on Redemptions
Based on the SVIP court’s view that that phase “funds legally available” means “cash legally available,” one might think that a different outcome might have resulted had the Redemption Provision read “property legally available” or simply required the redemption to be made unless contrary to Section 154 and 160.
However, the Chancery Court cited a number of cases for the proposition that the common law restricts a corporation from redeeming its shares when “insolvent.” The court explained that the common law restriction and the DGCL restriction are separate, the DGCL does not codify the common law restriction, and a proposed redemption must be permissible under each. Even if assets exceed liabilities so that a corporation is solvent in a balance sheet sense and could make a redemption under the DGCL, a corporation may still be prohibited from a redemption unless a cash flow analysis shows that thereafter it would be able to pay its debts as they come due, which the Chancery Court said is a component of the common law restriction.
Thus, in effect a corporation must have available cash to make a redemption even if that concept is not part of the document providing for mandatory redemption or if the board wishes to make the redemption in the absence of a written requirement to do so.
Comparison of Redemption Restrictions and Uniform Fraudulent Transfer Act
The two SVIP standards for making redemptions are similar to those embodied in the Delaware Uniform Fraudulent Transfer Act, which applies to transfers of property other than redemptions, whether made by a person or a business entity. Any transfer is voidable if made without fair consideration and if either “the sum of the [transferor’s] debts is greater than all of the [transferor’s] assets, at a fair valuation,” or the transferor “intended to incur, or believed or reasonably should have believed that the [transferor] would incur, debts beyond the [transferor’s ability to pay as they became due.” The federal bankruptcy code also has similar provisions.
The basic lessons to be learned from the SVIP case, where Delaware is the controlling law, are:
- The “funds legally available” language often seen in redemption provisions means “cash legally available,” and even in the absence of such language a board may not authorize a redemption unless the corporation’s net assets exceed the redemption amount, and the corporation will be able to pay its debts as they come due. A corporation must comply with both the DGCL and the common law.
- The board of directors has considerable leeway in how it calculates net assets. It may use an asset-based method if it wants to avoid a redemption, or a multiple of earnings or other valuation if it wants to justify a redemption.
- A valuation of net assets should take into account the effect of making the redemption.
To maximize the chance that mandatory redemption will in fact be paid, an investor could seek to include in the redemption provision one or more of the following:
- a requirement to raise cash by selling assets or to make the redemption by transferring specified non-cash assets (however if the assets are valued at more than the redemption obligation, such a transaction could be voided as a fraudulent conveyance),
- a number of different valuation methodologies, requiring the board to use the one yielding the highest number,
- the phrase “property legally available,” and/or
- a favorable methodology for a cash flow analysis.
Additional strategies for the investor might include:
- requiring a debt instrument instead of preferred stock, with a conversion feature or warrants, and
- in the event mandatory redemption is not made when required, providing for board representation and/or issuance of additional stock.