A Theory of Preferred Stock

Should preferred stock be treated under corporate law as an equity interest in the issuing corporation or under contract law as a senior security? Should a preferred certificate of designation subsumed in the corporate charter and treated as an incomplete contract filled out by fiduciary duty, or should it be treated as a complete contract with drafting burden on the party asserting the right, as would occur with a bond contract? Is preferred equity or debt? This article shows that preferred is both corporate and contractual, neither all one nor all the other. It sits on a fault line between two great private law paradigms, corporate and contract law, and draws on both. The overlap brings two competing grundnorms to bear when interests of preferred and common stockholders come into conflict in decided cases: on the one hand, managing to the common stock, as residual interest holder, maximizes value, while on the other hand, holding parties to contractual risk allocations maximizes value. When questions arise concerning the relative rights of preferred and common, the norms hold out conflicting answers. Delaware courts have taken the lead in confronting these questions, seeking to synchronize the law of preferred stock with the rest of corporate law, a project that leads to both innovation and stress.

This article examines recent preferred cases to show two facets of Delaware law coming to bear as the synchronization process proceeds - first, reliance on independent directors for dispute resolution, and, second, the common stock value maximization norm. There follows a tilt toward corporate norms that disrupts risks allocated in heavily negotiated transactions, particularly in the venture capital sector. Toward the end of restoring balance between the corporate and contract paradigms, the article makes three recommendations. First, the meaning and scope of preferred contract rights should be determined by courts rather than by issuer boards of directors. Second, conflicts between preferred and common should not be decided by reference to a norm of common stock value maximization. Enterprise value should be the referent, more particularly, maximization of the value of the equity as a whole. Third, independent director determinations of conflicts between preferred and common should not be accorded ordinary business judgment review. Instead, a door should be left open for good faith review tailored to the context — a showing of bad faith treatment of the preferred where the integrity of a deal has been undermined, burden of proof on the board.