A recent Delaware Chancery Court case provides further support for using "pay-toplay" techniques to reduce or remove the rights of preferred stock investors who fail to support a company in subsequent fundraisings. In Watchmark Corp. v. ARGO Global Capital, LLC, et. al., the court decided that Watchmark’s directors, five out of six of whom were representatives of the preferred stock investors, did not breach their fiduciary duties in approving a financing that converted preferred stock of nonparticipating investors into common stock.
Watchmark is a wireless network software company based in Bellevue, Washington. In early 2004, Watchmark sought to acquire the Metrica Service Assurance Software Group from ADC Telecommunications, an acquisition the board expected could double Watchmark’s revenues. Watchmark’s board (including the representative of ARGO Global Capital, a Watchmark investor and the eventual contesting party) was actively engaged in consideration and negotiation of the Metrica acquisition and, on October 22, 2004, approved the merger for a purchase price of $35 million. While the Metrica merger was being negotiated, Watchmark’s board also began negotiations for the sale of a new series of preferred stock to finance the acquisition. All of the company’s investors were invited to participate in the negotiations. By August, Watchmark’s investors had agreed on the key terms of the financing (including the conversion of the preferred stock of non-participants to common stock) and each of the investors was asked how much it would invest in the new round. ARGO informed Watchmark it would not participate.
Due to an apparent concern that ARGO might challenge the transaction, Watchmark sought a declaratory judgment validating the proposed financing and merger. ARGO counterclaimed against Watchmark and four members of its board alleging that Watchmark did not have the right to consummate the deal without ARGO’s consent under the terms of the preferred stock held by ARGO and that the board members had breached their fiduciary duties. However, the court upheld the actions of Watchmark and the board members on both counts.
The key factors leading to the court’s decision were:
- All of the company’s investors were invited to participate in the negotiations for the financing.
- There was no debate about whether the financing was needed or whether the Metrica acquisition would benefit Watchmark.
- Each investor could avoid having its preferred stock converted by participating in the financing.
- ARGO had indicated a willingness to participate if the terms were sweetened, undercutting its argument that it was being discriminated against.
Watchmark is the latest in a series of cases that have made it substantially easier in certain circumstances to eliminate the rights of preferred stock investors. Delaware courts have repeatedly construed preferred stock protective provisions narrowly, particularly to prevent a minority investor from blocking an important corporate transaction. Watchmark is an important addition to the landscape in this area for several reasons:
- The ruling suggests that offering proposed financings to all of a company’s investors provides substantial protection from claims of fiduciary breaches, even where the transaction is voted on by board members affiliated with participating investors, in part because there is no disparate treatment.
- The court, in directly addressing the so-called "no impairment" provision in the charter which is intended to provide broad protection for the preferred stock, ruled that it should be construed narrowly and did not give rise to any independent consent rights.
- Watchmark reaffirmed the use of a merger with a wholly-owned subsidiary as a technique for changing preferred stock terms and avoiding preferred stock consent rights without the approval of the affected preferred stock holders.
Watchmark represents yet another example of a trend toward aggressive and dilutive treatment of investors who cannot or will not continue to fund an enterprise. We would be happy to discuss the implications of this case in more detail and will continue to monitor developments in this area.
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