Corporate & Securities Alert
January 2012
Delaware Supreme Court Affirms
Decision on Funds Legally Available
for Redemption
By Samuel Mason
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.
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Corporate & Securities Alert
January 2012
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).
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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.
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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.
Lessons Learned
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.
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> 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:
(1) 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),
(2) a number of different valuation methodologies, requiring the board to use the one yielding the highest number,
(3) the phrase “property legally available,” and/or
(4) a favorable methodology for a cash flow analysis.
> Additional strategies for the investor might include:
(1) requiring a debt instrument instead of preferred stock, with a
conversion feature or warrants, and
(2) in the event mandatory redemption is not made when required,
providing for board representation and/or issuance of additional
stock.
For more information, please contact Samuel Mason at (215) 988-2642 or
[email protected].
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