Hsu v. ODN (April 25, 2017) is the second decision by the Delaware Court of Chancery in recent years that highlights the potential liability for the directors of a portfolio company, and the private equity sponsor-controller, when the company redeems preferred stock held by the sponsor. At the pleading stage of the litigation, the court declined to dismiss the plaintiff's claims of breach of fiduciary duty by the directors, and aiding and abetting by the sponsor, in connection with the company's redemptions. Rather than effecting a “de facto liquidation” of the company at “seemingly fire-sale prices” and “stockpiling cash,” the court wrote, the board “could have grown [the company's] business, gradually redeemed all of the preferred stock, and then generated returns for its common stockholders.” The court also held that the directors' abstaining from the formal vote on the two redemptions did not necessarily shield them from liability because they had been involved in the various steps underlying the redemptions.
In our view, the key distinguishing features in Hsu that underlie the court's decision are that the court deemed the preferred stockholder to be a controller; the court viewed the board as meaningfully influenced by the controller and not independent and disinterested; and, critically, the board apparently neither engaged in an adequate process to consider the interests of the common stockholders nor established a contemporaneous record indicating the bases for its actions.
In the attached Briefing, we discuss the case and offer related practice points. We outline certain terms that should be included in preferred stock to mitigate the risk of a breach of directors' fiduciary duties to the common stockholders when the preferred stock is redeemed. We also discuss the possibility of alternative investment structures that potentially could limit or eliminate fiduciary duties to the non-sponsor investors.