United States: Redeemable Preferred Stock: When Is It Not Redeemable?

Investors typically do not finance an early stage or middle market company with the intent to ultimately call for a redemption of the preferred shares that it receives from the company in connection with the original financing.  Such a situation signals a failed investment, as the return of the original purchase price for the investor's preferred shares represents zero appreciation on the original investment.  However, there are circumstances where redemption is appropriate as a last option.

A recent Delaware Chancery Court decision in TCV v. TradingScreen provided some insights into Delaware's approach to determining the circumstances under which a corporation is legally permitted to fulfill a demand for redemption, meshing the statutory concept of "surplus", as such term is used in the Delaware General Corporation Law, and the common law concept of "funds legally available."  The Delaware courts had previously left unanswered the question of whether the statutory standard of "surplus" was somehow different than the common law standard of "funds legally available."  According to the Chancery Court in TCV v. TradingScreen, there is a difference.  While a calculation of "surplus" basically consists of net assets in excess of capital, "funds legally available" is to be determined on the basis of a "going concern/insolvency" analysis (i.e., would the company's payment of the redemption amount to the investor impair the company's ability to continue as a going concern and pay its debts when due?).  The risk to investors is that the viability of a contractual redemption right with respect to its preferred shares may be closely tied to the timing of the demand for redemption of those shares.

Final word on the matter will be provided by the Delaware Supreme Court, as the Chancery Court decision in TCV v. TradingScreen has been appealed.  In the meantime, companies and investors should be cognizant of the implications of the Chancery Court's decision when negotiating the terms of a redemption provision and the remedies available to the preferred stockholders if the company is not able to satisfy a mandatory right of redemption.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.