LC Capital Master Fund, Ltd. v. James, C.A. No. 5214-VCS (Del. Ch. Mar. 8, 2010) (Strine, V.C.).
In this opinion, the Delaware Court of Chancery, in denying a motion seeking to enjoin a merger, addressed the duties that corporate directors owe to preferred stockholders when allocating merger consideration between common and preferred stockholders.
The plaintiff, LC Capital Master Fund, Ltd. (“LC Capital”) was a preferred stockholder of QuadraMed Corporation (“QuadraMed”). Pursuant to the certificate of designation establishing the rights, powers and preferences of the preferred stock (the “Certificate”), preferred stockholders had the right to convert their preferred shares into common shares at a specified ratio. The Certificate also established other rights and preferences, such as dividend rights and liquidation preferences. The QuadraMed board formed a special committee of independent directors (the “Special Committee”) to evaluate acquisition bids. The Committee recommended the acquisition of QuadraMed by Francisco Partners II, L.P. (“Francisco Partners”) via a merger (the “Merger”). In the Merger, the holders of QuadraMed preferred stock were cashed out at the price the preferred stockholders would have received for their common stock had they exercised their conversion rights before the Merger.
LC Capital sought to enjoin the Merger, alleging that the QuadraMed directors breached their fiduciary duties of care and loyalty to the holders of preferred stock. LC Capital argued that the directors unfairly allocated the Merger consideration between the common and the preferred stockholders by allocating based solely on the conversion rights of the preferred stock and not according value to other contractual rights of the preferred stock, such as the dividend rights and liquidation preferences. LC Capital also contended that the board members, who owned shares of common but not preferred stock, were necessarily conflicted and could not fairly balance the interests of the preferred stockholders. The plaintiffs did not allege, however, that the directors breached their “Revlon” duty by failing to take reasonable efforts to secure the highest price reasonably available in the sale.
The Court explained that, although directors do owe fiduciary duties to preferred stockholders, preferred stockholders’ rights are largely contractual in nature and are governed by the specific rights and preferences set forth in the certificate of incorporation (including the certificate of designation). Once directors honor the contractual rights of the preferred stockholders, they are entitled to favor the interests of the common stockholders. The Court stated that a board of directors may owe a “gap-filling duty” to preferred stockholders if there is no objective contractual basis by which to allocate consideration between the common and the preferred stockholders in a merger. Without such a duty, the preferred stockholders may be subject to arbitrary treatment. But such “gap filling” duties are not implicated where the terms of the preferred stock provide an objective basis by which to allocate consideration. The plaintiff argued that prior decisions of the Court of Chancery had held that directors owe preferred stockholders a fiduciary duty to exercise care in fairly allocating merger proceeds among holders of common and preferred stock. The Court, however, explained that those cases were in sharp tension with the great weight of precedent, unless viewed in their proper factual contexts – in each, the Court explained, the preferred stockholders lacked specific contractual rights regarding appropriate treatment in a merger. Because the QuadraMed preferred holders received merger consideration based on their express conversion rights, the court found the directors owed no further duty vis-à-vis allocation. The Court explained that a board of directors must honor the contractual rights of preferred stockholders, but it need not go further and grant unspecified benefits to the preferred stockholders at the expense of the common stockholders.
The Court also explained that, although all members of the Special Committee owned QuadraMed common stock or options, the plaintiff did not present any evidence that the members were materially self-interested by reason of such ownership or otherwise. The Court noted that the plaintiff did not advance any reason to believe that losses arising out of a shift of merger consideration from the common to the preferred stockholders would have been material to the directors’ personal economic circumstances. From a policy perspective, the Court stated that independent directors should not lose business judgment rule protection because they own common but not preferred stock. Common stock ownership gives the directors an incentive to fulfill their fiduciary duties effectively.
For these reasons, the Court held that LC Capital had failed to show a reasonable probability of success on the merits of its breach of fiduciary duty claims. In declining to enjoin the merger, the Court also considered the balance of the equities, noting that it would be reluctant to grant injunctive relief harmful to the common stockholders where a preferred stockholder could pursue appraisal and an equitable damages case.