Preferred Stock Positions in Distressed Companies: The Secured Debt Alternative

Con Chapman, Burns & Levinson LLP

In a recent Buzz of the Week, So You Think You Own Preferred Stock (9/9/2003), the editor-in-chief described how to escape, Houdini-like, from situations in which a minority of a company's preferred stockholders prevent it from raising desperately needed capital by objecting to a conversion of preferred to common stock.

In the best of all possible capital structures, the company's charter provides for conversion of preferred shares to common upon a majority vote of the preferred shareholders voting as a class, and not separately by series, thus disarming the dissident minority.

There will, however, be situations where the charter does not so provide, or where the company cannot obtain the necessary votes of preferred stockholders in order to satisfy the class voting requirement. The hold-out's siren song-"Let's roll the dice and see how we do in a liquidation!"-may find receptive ears among investors who have tired of the company's tune.

Even where the right to compel conversion to common is clear, there is no guaranty that the objecting minority won't commence litigation against directors and their fellow shareholders alleging breach of fiduciary duties, taking advantage of the company's weakened state to force a settlement that benefits the hold-outs to the detriment of the company and other investors. As Henry Kissinger is once supposed to have said, the party who wins a negotiated dispute is the first person to become unreasonable.

So what exactly do the hamstrung company and its remaining investors do? As anyone who has ever dealt with an uncooperative child knows, one solution to the hold-my-breath-till-I-turn-blue style of negotiation is to call in a stricter disciplinarian--"Wait till your father (or in my case, their mother) gets home!"

The counterpart of this type of bad cop in the realm of corporate capital for a privately-held company is one you might not have thought of-secured debt.

Every legal tyro knows that in Anglo-Saxon jurisprudence the claims of creditors-who have no stake in a company's glamorous upside-take precedence over the interests of equity holders. This principle represents the flip side of a stockholder's limited liability; an investor's exposure is limited to his or her capital, but the bills of the butcher, the baker and the guy who delivers the copy paper must be paid before any stockholders' capital is returned.

This rule is codified in state and federal statutes and expressed somewhat more eloquently by the judges who slapped the wrists of promoters who took capital out ahead of vendors when general corporation laws first began to appear in the 19th century.

A secured creditor similarly occupies a preferred position vis a vis a company's general creditors. Secured creditors hold an interest in a company's property-receivables, inventory, fixed assets-that they may liquidate without ever setting foot inside a courtroom. Unsecured creditors, by contrast, must sue and win (an expensive and troublesome business) and then hire a sheriff to literally walk up to a company's receptionist and demand payment before acquiring a lien.

How does all of this fit into the muddied situation described above, where a minority of equity holders threaten the investment of those who are willing to give the company a little more time and money?

For those companies that have secured debt outstanding, willing investors can purchase the debt, possibly at a discount if lenders are concerned about the company's future prospects without additional equity capital. Where the company has no secured debt outstanding or wishes to leave its senior debt in place, willing investors can--subject to necessary authorization by the company's directors and in some cases its shareholders--put their fresh capital into the company as secured debt. Most bridge financings in harmonious situations follow this model. (Where the objecting preferred stockholders have the right to approve the issuance of debt voting separately as a series, the company will of course be legally prohibited from borrowing without their consent.)

A third method, which is generally not undertaken voluntarily, occurs when a secured lender demands that one or more investors-generally those with a personal financial statement with some heft to it--guaranty the company's debt, and they in turn pay off the loan and step into the shoes of the lender by subrogation.

Once the willing investors become the holders of secured debt, the tables have been turned on their obstinate fellow shareholder. Like heavyweight boxers stepping down in weight class, the stockholders who ponied up in a time of crisis find their punches now pack additional wallop. If the hold-outs continue to starve the company for capital, the secured creditors may force a liquidation in which they acquire the assets of the company while the objecting series of preferred stockholders get nothing.

We generally think of liquidations as involving an auctioneer who brings a hammer down while a weeping family stands by, but the law governing secured debt in all 50 states-the Uniform Commercial Code ("UCC")--provides for a more discreet proceeding. A secured creditor may propose simply to take back a company's collateral in satisfaction of its debt, thereby becoming the owner of its assets.

This procedure, which has a long history in American law and is sometimes referred to as "strict foreclosure," has recently been enhanced by amendments to the UCC so that junior lien claims can be wiped out through its use. The equity interests of the dissenting stockholders are not modified as a legal matter, but the value of their shares is reduced to zero since the company now has no assets.

In order to effect this procedure the investors who hold the secured debt must give notice to the company, other creditors with interests in the collateral and guarantors of the company's debt. Note that the company's preferred stockholders are not included in this list, although it will obviously be desirable for the investors putting in new money to let their balking colleagues know what is happening if the ultimate goal is to persuade them to participate by compulsion. "When a man knows he is to be hanged in a fortnight," Dr. Johnson noted, "it concentrates the mind wonderfully." When investors learn their preferred stock will become worthless in twenty days, their willingness to contribute new capital or consent to a conversion to common increases dramatically.

If no objection is made within the twenty day period, the assets become the property of the secured debt holder. If an objection is received in a timely fashion, the secured debt holder must dispose of the assets by another means-public or private sale--but an objecting party cannot use the objection procedure to (for example) force the investors who hold the secured debt to buy out its interest as preferred stockholder. Like a chess piece, the investor who becomes a secured lender can only be pushed in a particular fashion.

There are of course legal risks involved in using this procedure. If the company is already insolvent, money contributed as secured debt by insiders may be treated as equity when a court takes a retrospective look at the situation. Since the investors writing the checks for the secured debt were willing to accept equity in the first place, this is not normally a problem. If the willing investors can't persuade the unwilling to come along and instead end up running the new company with the assets of the old, unpaid creditors of the old company may seek payment from the new. The willing investors can ordinarily deal with this issue by paying those vendors who are essential to the continuation of the business, ignoring those who are not and settling with vendors who actually sue.

As for the claim that stockholders of a failing company who put in new money as debt owe a fiduciary duty as stockholders to the investors who failed to ante up, it is often made in testy negotiations, seldom pursued to the point of legal action, and not supported by case law.

There are business risks as well, most notably the possibility that customers of the business will be confused by the transition from old company to new-if it comes to that--or concerned if discord among shareholders becomes public. These types of problems can be solved by the same type of business response that won the customer in the first place--namely, good products and good service.

A few examples will help limn the real-world boundaries of the tactic discussed here, which for want of a better term might best be described as a secured debt implosion of a troubled company's balance sheet.

Company 1, a business located on a tech beltway you might have driven on to get to work this morning, is owned by two different types of investors-institutional investors holding preferred stock, and company founders holding common shares who struggle daily to keep the company alive. Company 1 needs another infusion of equity, but the institutional investors refuse to extend themselves any further. A Friday payroll looms and, in order to keep engineers and others from walking out the doors without checks in their hands, probably never to return, the company's CEO gives a guaranty and a pledge of marketable securities to the bank that would otherwise have cut off its line of credit.

The crisis passes and the CEO decides to re-focus the business on one product and to abandon another. He again solicits institutional investors to contribute, but they again say no. He ends up raising money from new investors, who share his vision of the marketplace. The new money is advanced as debt to Company 1 by a new entity, Company 2, which lends the money on a secured basis, taking a second position behind the bank.

Things fall apart, as the poet said, and the new investors in Company 2 decide to pull the plug on Company 1. They notify the bank and Company 1's preferred shareholders of their intent to take back Company 1's assets in satisfaction of the debt. The bank may decide to take action itself, most likely by collecting receivables, but it may simply do nothing, since its lien priority will be unaffected by the process; under the revised UCC, strict foreclosure wipes out only subordinate liens, not those that are prior in time and right (UCC 22(a)(3)). Company 2 turns its attention to the new product and is a more agile competitor without the burden of the old, unprofitable product line.

For a sense of how this sort of internal arm-wrestling among preferred and common stockholders can go wrong, however, consider another situation. Oldco is a low-tech company whose debt to Bank 1 is in default, and whose preferred stockholders are unwilling to put up more money or permit a dilutive round. The founders decide to purchase the assets through a "friendly" foreclosure. They propose that Bank 1 hold a foreclosure sale at which a new company they form ("Newco") will use financing from Bank 2 to purchase the assets of Oldco. The auction is held and the assets are transferred to Newco, which continues in business using the same phone and fax numbers as Oldco.

Preferred stockholders sue, and the court finds that the founders and Newco are liable to the preferreds for the value of Oldco in excess of its debt to Bank 1 at the time of the foreclosure. If this situation is repeated in a state with a so-called "mini-FTC act" that proscribes unfair and deceptive practices among businesses, damages may be doubled or trebled and the jilted investors' may be able to recover their legal fees as well.

Thus, if properly handled, secured debt can act as a solvent to loosen the gears of a company whose capital structure is rusted stuck. Like other solvents, however, secured debt can be highly flammable as well.

About the Author

Con Chapman is a lawyer with Burns & Levinson LLP in Boston who frequently represents investors in distressed companies. He can be reached at