Changes to Corporate Capital in Equity Financing Transactions
If the rule isn’t that anything goes with enough votes, what is it?
Experienced entrepreneurs and investors alike understand that equity dilution is a fundamental aspect of investing in corporations. This is especially true when companies anticipate needing additional capital prior to their prospective profitability. But investors do not always trust management to act fairly and wisely when they sell additional stock or restructure shareholder rights.
This is the first part in a series of blogs focusing on modifications to corporate capital in equity financings. In this first part, I evaluate the law applicable to charter amendments in both Texas and Delaware. As many readers know, Delaware is the leading U.S. jurisdiction for domiciling corporations and has a highly developed body of corporate decisional law. Texas does not benefit from the same depth or breadth of case law. Accordingly, Texas courts—like those of other states—frequently look to Delaware precedent when making determinations in connection with Texas corporate law. Nevertheless, both statutory and judge-made law in Texas and Delaware are different in important aspects.
Charter Amendments [i]
Equity financings often require charter amendments to modify corporate capital. This could be for a variety of reasons. A team of founders may have issued all of the corporation’s authorized capital. Alternatively, an investor may have required that the charter limit authorized capital to existing holdings. In another scenario, investors may have sought anti-dilution protection by demanding the insertion of certain “preferred” rights in the corporate charter. These rights might include agreed ratios for converting their preferred stock to common stock upon an IPO or other event, with the conversion ratios protected by adjustments for certain dilutive stock issuances.
Because unreasonably restricting changes to capital structure can hamstring corporations in desperate need of capital and change, these provisions are subject to amendment. But what laws govern the amendment of corporate charters? If they are essentially contracts as maintained by Delaware courts, who gets to modify the contract if not everyone agrees?
Delaware Corporate Statute
Section 242 of the Delaware General Corporation Law (DGCL) authorizes corporations to amend the structure of equity ownership established in their charters (to “recapitalize”) upon approval of a simple majority. In relevant part, Section § 242(a) of the Delaware General Corporation Law (DGCL) allows amendments:
“To increase or decrease its authorized capital stock or to reclassify the same, by changing the number, par value, designations, preferences, or relative, participating, optional, or other special rights of the shares, or the qualifications, limitations or restrictions of such rights, or by changing shares with par value into shares without par value, or shares without par value into shares with par value either with or without increasing or decreasing the number of shares, or by subdividing or combining the outstanding shares of any class or series of a class of shares into a greater or lesser number of outstanding shares[.]”
Further, Delaware law provides that measures affecting a class or series must be approved by a majority of the affected class or series. DGCL § 242(b)(2).
Texas Corporate Statutes
Texas law qualifies charter amendments as fundamental transactions which require approval of two-thirds of shareholders entitled to vote, except in limited circumstances. Tex. Bus. Org. Code § 21.364(1); see Tex. Bus. Org. Code § 21.053. If a charter sets forth separate classes or series of shares, approval of an amendment that would affect the charter’s capital or the rights of any class or series requires approval by each separate class or series. Tex. Bus. Org. Code § 21.364(d). In contrast to Delaware, for class approval of an amendment (and any other fundamental transaction), Texas requires approval by at least two-thirds of the voting shares of the class or series. Tex. Bus. Org. Code § 21.364(c).
No Breach of Contract Claim for an Appropriately Approved Charter Amendment
Delaware courts have held that, by virtue of statutory authorization, corporations are contractually authorized to restructure their capital by amending their charters. See Hartford A. I. Co. v. W.S. Dickey C.M. Co., 24 A.2d 315 (Del. 1942). Similarly, Section 21.051 of the Texas Business Organizations Code states that “[a] shareholder of a corporation does not have a vested property right resulting from the certificate of formation, including a provision […] relating to the management, control, capital structure, dividend entitlement, purpose, or duration of the corporation.”
But this begs a question. Is any validly approved charter amendment affecting corporate capital lawful just because it is authorized by statute?
What can I do if a Corporate Action Impairs or Permits Dilution of my Voting Rights or Economic Ownership?
Imagine a corporation in need of capital whose charter offers significant anti-dilution protections to preferred investors. To reward investors willing to provide capital, and to create pressure on others, a corporation amends its charter to allow for a “pay-to-play” system. Under such a system, any investor that declines or is denied the right to participate in a future equity financing would see her percentage of equity in the company diluted, including voting and economic rights. If a fair price or better is paid for the share, existing stockholders’ will see their share value stay the same or increase. If lower than fair value is paid, share value will be impaired.
In such circumstances, is there anything a diluted shareholder can do to challenge this type of action? Or will they be relegated to shouting, “we’re not gonna take it” as they’re shoved down the front steps of the courthouse?
I found the answer somewhat surprising: it depends. Perhaps after years in this profession I should not have (haha).
Twice-Testing of Corporate Actions
In the words of Delaware courts, corporate actions are “twice-tested.” See, e.g.., Carsanaro v. Bloodhound Techs., Inc., 65 A.3d 618, 641 (Del. Ch. 2013). In both Delaware and Texas, in addition to being subject to review under “principles of law” (i.e., for statutory and contractual compliance), courts review corporate actions under “principles of equity.” Review for compliance with principles of equity equates to scrutiny of director actions for breach of fiduciary duty.
Although the law of contract does not supply a method for challenging charter amendments that are approved consistent with statutory requirements, suits for breach of fiduciary duty can sometimes provide a remedy when actions are taken that dilute shareholder equity. Whether a remedy will be provided depends on a silent factor and, principally, on two stated factors: (1) whether the board is independent of the stockholders participating in the transaction; and (2) whether the transaction is fair.
The silent factor? The finder-of-fact. Fairness and independence are fair and independent in the eye of the beholder. Absent an arbitration clause, in Delaware this means a judge specialized in corporate matters. In Texas, it means a jury unless the parties waive their right to a jury trial, or they have contractually agreed to a bench trial.
The next post in this series will address, under both Delaware and Texas law, the scope of fiduciary duties owed to common and preferred shareholders by corporate directors and certain shareholders. Later posts will address potential shareholder claims for breach of fiduciary duty, standards of review applied to evaluating shareholder claims in different context, and actions that can be taken to mitigate the risk of shareholder claims.
[i] Corporate charters are referred in Texas statutes as a Certificates of Formation. In Delaware, they are referred to as Certificates of Incorporation.