Private Equity

The recent Delaware Court of Chancery decision in Frederick Hsu Living Trust v. ODN Holding Corporation found that the defendants’ conduct in effecting a partial redemption of preferred stock was “entirely fair.” In the complaint, the plaintiff alleged that Oak Hill Capital and Oak Hill Capital’s board designees breached their fiduciary duties by focusing ODN’s efforts on cash accumulation through asset sales, for the purposes of redeeming Oak Hill’s preferred stock, rather than on the pursuit of investments to promote the long term growth of the business and create value for the holders of ODN’s common stock. After denying the motion to dismiss, the Court evaluated the actions of Oak Hill and its representatives under the “entire fairness” test and determined that they satisfied the test by demonstrating that ODN’s business declined due to industry changes, rather than actions taken by Oak Hill, and that the result for common stockholders under either an asset sale and cash accumulation plan or a growth-focused plan would have been the same—the common stockholders would have had no recovery on their investment. This decision, however, serves as a reminder to private equity sponsors that invest in preferred stock that in exercising their rights as holders of that preferred stock they or their board designees may have a fiduciary duty to common stockholders that will be judged with 20/20 hindsight and that a board may be entitled to consider breaching its obligations to preferred stockholders if necessary to satisfy that fiduciary duty.

Background

In 2008, funds sponsored by Oak Hill invested $150 million into shares of preferred stock of ODN Holding Corporation, a holding company for Oversee.net, an Internet company that operated primarily in the “domain monetization” space. Under the terms of the preferred stock, Oak Hill had a mandatory redemption right in 2013. Any redemptions by the company were to be made “out of funds legally available therefor.” If the funds legally available were insufficient, ODN was required to take all reasonable actions determined by the Board “in good faith and consistent with its fiduciary duties” to generate funds. In 2009, Oak Hill purchased shares of common stock in ODN and became its controlling stockholder.

In 2013, Oak Hill exercised its redemption right. ODN did not have sufficient funds to pay the full redemption price. It used as much of its cash as then possible for redemption, sold a line of business and developed a new business plan that involved various cost cuts and additional sales to fund additional redemption amounts. In 2016, Frederick Hsu—one of ODN’s founders and a holder of common equity—brought a suit against Oak Hill, ODN’s Board of Directors and certain officers, alleging that they breached their fiduciary duties by causing ODN to sell assets and stockpile cash to satisfy Oak Hill’s redemption right rather than seeking to maximize the value of ODN over the long-term. Previously, ODN had allegedly, at Oak Hill’s direction, changed its growth oriented business strategy and had sold two of its four lines of business, which caused a substantial decline in revenues for ODN.

The Court denied defendants’ motion to dismiss based on the facts in the record and concluded, among other things, that the board’s fiduciary duties generally run to the common stockholders of a corporation (as well as to the preferred where their interests are aligned) and that the board of ODN should have considered those duties in determining whether to honor the redemption obligation on its preferred stock or whether to breach those obligations and to potentially be liable for damages to Oak Hill. The trial focused on whether Oak Hill and its board designees breached their duty of loyalty to ODN given the conflict of interest created between their ownership of the preferred stock, the exercise of their redemption rights and the interests of the common stockholders. The Court concluded, following the trial, that the actions by Oak Hill and their board designees were entirely fair based on, among other things, that (i) ODN’s domain monetization business, which generated approximately 80% of ODN’s revenue, was already in steep decline due largely to broader industry trends in a rapidly evolving market which neutered ODN’s original growth and acquisitions-focused strategy, (ii) Oak Hill was the largest common stockholder and was therefore highly incentivized to make a growth strategy work and did try to make the strategy work but was not required to take long shot bets to grow ODN when they were unlikely to succeed and (iii) Oak Hill achieved fair value for the dispositions of ODN’s businesses.

Key Takeaways

The Court’s decisions on the motion to dismiss and following the trial provide some important takeaways for private equity sponsors investing in preferred stock, including the following:

• A redemption right contained in a preferred stock is not a guaranteed right of payment. A holder of preferred stock is not a creditor of a corporation, even after the redemption right is exercised. A board of a Delaware corporation owes fiduciary duties to its common stockholders when considering how to handle contractual obligation owed to other parties, including holders of preferred stock. Under the doctrine of “efficient breach,” a board may decide to breach a preferred stockholder’s redemption rights and pay damages if necessary to satisfy its fiduciary duties.
• If a holder of preferred stock is also the controlling stockholder of the company, the holder of the preferred stock and its board designees will need to consider if they can exercise their rights as a preferred stockholders’ consistent with their fiduciary duties to minority stockholders. 
• Procedural safeguards, such as special committees or actions taken by disinterested members of the board, should be put in place where there are conflicts of interest between the controlling stockholder and minority stockholders. Care should be taken that the directors on those committees are truly independent. The Court noted in this case that special committees can be ineffective because of, among other things, the network of relationships between the controlling stockholder and the special committee members.