A Benchmark Case

Corey A. Levens

Rarely do venture capitalists bring lawsuits against the companies in which they have invested. Probably just as rare is a lawsuit by a venture capitalist against a fellow investor, especially when that investor is the only one willing to provide the additional financing which is arguably necessary for the company to survive. So when Benchmark Capital Partners IV, L.P., did precisely both of those things in Benchmark Capital Partners IV, L.P. v. Vague, et al., one might have expected that they had a novel legal theory or an egregious set of facts which would motivate the court to find in their favor. In fact, however, the Delaware Chancery Court had little difficulty dismissing Benchmark's claims based on established law going back to Warner Communications Inc. v. Chris-Craft Industries, Inc. (1989).

The facts of the case are fairly straightforward. Benchmark owned shares of the Series A and B preferred stock of Juniper Financial Corp. (the "Company"). Canadian Imperial Bank of Commerce ("CIBC") owned the majority of the Series C preferred stock of the Company and, based on its Series C preferred stock holdings, held a majority of the voting power of the Company on an as-converted basis and a majority of the voting power of the Company's preferred stock, voting together as a class. As a result of the previous Series C financing, the Company's certificate of incorporation provided, among other things, that:

  1. So long as any shares of Series A or B preferred stock remained outstanding the Company could not, without the consent of at least a majority of the then outstanding shares of Series A and B preferred stock voting together as a single class, authorize or issue, or obligate itself to issue, any other equity security senior to or on a parity with the Series A or B preferred stock with regard to dividend, redemption or voting rights or liquidation preferences.
  2. The Company could not materially adversely change the rights, preferences and privileges of the Series A or B preferred stock without the consent of a majority of the respective holders of shares of each series.
  3. The protective provisions described in paragraphs 1 and 2 above could be waived by a majority vote of a class consisting of the holders of Series A , B and C preferred stock (which CIBC controlled by itself and the court therefore referred to as CIBC's "Series C Trump"), provided, CIBC could not exercise the Series C Trump with regard to any amendment or modification that diminished or altered the liquidation preference or other financial or "economic rights" of the junior preferred stockholders.
  4. The Company must provide the holders of the junior preferred stock with a class vote before the Company sold all or substantially all of its assets or consolidated or merged into any other corporation (significantly, other than a wholly-owned subsidiary of the Company) or increased the number of the Company's directors.

In early 2002, the Company advised its investors that additional capital was necessary to sustain its operations. The only volunteer for the proposed Series D preferred stock financing, however, was CIBC. Being the only potential investor and, in essence, the Company's only hope at staying alive, CIBC extracted its pound of flesh. CIBC proposed to provide $50 million of financing through the issuance of Series D preferred stock that would have the effect of granting CIBC an additional 23% of the Company on a fully-diluted basis and reducing the collective equity interests of the holders of Series A and B preferred stock from 29% to 7%.

Because of the above-described provisions in the Company's certificate of incorporation, in order to avoid the votes of the junior preferred stockholders which could have vetoed the transaction, this transaction was structured first as a merger of a wholly-owned subsidiary, Juniper Merger Corp., with and into the Company with the Company as the surviving entity. As part of the merger process, each share of existing Series A and B preferred stock would convert into one share of new Series A or B preferred stock plus a small fraction of a share of common stock in the Company, plus a small amount of cash and a warrant to purchase a small fraction of a share of common stock of the Company. The court noted that while the differences between the new and old Series A and B preferred stock would be significant, the resulting modifications to the Company's certificate of incorporation would not alter the class and series vote requirements described above.

Due to the exclusion of mergers with wholly-owned subsidiaries of the Company from mergers requiring junior preferred approval, the junior preferred stock did not have a right to veto the merger. Also, as a result of the Series C Trump, CIBC had enough votes to approve the merger by itself in a class vote. The junior preferred therefore argued that they had a right to vote on the merger and that the Series C Trump could not be used because the merger adversely effected their economic rights. The court easily dismissed these arguments citing "a long line of Delaware cases," culminating with the decision of the Delaware Supreme Court in Elliott Associates L.P. v. Avatex Corporation, et al., (1998), holding that protective provisions which purport "to provide a class of preferred stock with a class vote before those shares' rights, preferences and privileges may be altered or modified" are not effective if the adverse consequences derive from a merger and the protective provisions "do not expressly afford protection against a merger."

The court noted that the drafters of the Company's certificate of incorporation had expressly provided protection against mergers under other circumstances (as described above), but not with regard to changes in the rights, preferences and privileges of the junior preferred stock. In addition, the court noted that the Company's charter was adopted after the Delaware Supreme Court's decision in Avatex in which the Court established a "safe harbor" for just this issue:

"The path for future drafters to follow in articulating class vote provisions is clear. Where a certificate . . . grants only the right to vote on an amendment, alteration or repeal, the preferred have no class vote in a merger. When a certificate . . . adds the terms "whether by merger, consolidation or otherwise" and a merger results in an amendment, alteration or repeal that causes an adverse effect on the preferred, there would be a class vote."

The court noted that as the sophisticated and knowledgeable drafters of the documents in question clearly were aware of Avatex and yet did not incorporate the safe harbor so clearly established in Avatex in their documents, that the drafters did not intend for the junior preferred shares to have a vote on mergers of the type they sought in this case.

Benchmark also argued that the junior preferred were entitled to a class vote on the authorization and issuance of the Series D preferred stock because it is the Series D preferred stock which negatively affected the economic rights of the junior preferred shares. The court, however, disagreed saying that the negative effects instead flowed from the merger in which the Series D preferred stock was authorized and for which the court had already determined that the junior preferred did not have the right to a class vote. As such, the issuance of the Series D preferred stock would be subject to the type of class vote for which CIBC could exercise its Series C Trump since the issuance of the shares itself did not adversely impact the economic rights of the junior preferred stock (the court did, however, recognize that the junior preferred shares would be "burdened" by the issuance of the senior preferred shares).

In the end, Benchmark not only did not have a novel legal theory upon which to base its claim, but the court also ruled that in "a balancing of the equities or relative hardships" the equities also weighed "heavily" in favor of the Company. The court held that Benchmark's loss of a right to vote or dilution did not come anywhere close to the harm that would be caused by stopping the transaction, namely, forcing the Company into liquidation.