In a recent decision by the Delaware Court of Chancery, the Court addressed a dispute between a group of affiliated investment funds (including their advisor, SV Investment Partners, LLC) (collectively, “SVIP”), and ThoughtWorks, Inc. (“ThoughtWorks” or the “Company”), a portfolio company of SVIP. The dispute centered on the language of a redemption right that had been negotiated by SVIP at the time of its initial investment in the Company. At the heart of the dispute was the meaning of “funds legally available,” as the term was used in the redemption provision of the certificate of incorporation, and its relation to the concept of surplus under the General Corporation Law of the State of Delaware (the “DGCL”) and common law precedent. In its opinion, the Court suggests that, even in the absence of a “funds legally available” limitation, directors of Delaware corporations should employ a solvency analysis in determining whether a stock redemption is permissible under Delaware law.
Background of the Company and the Investment
ThoughtWorks is an information technology services firm that develops custom business software applications and provides related consulting services. In 1999, after a period of significant growth, ThoughtWorks began to explore the possibility of an initial public offering (“IPO”) of its common stock. Prior to the IPO, the Company sought private funding from an institutional investor in an effort to enhance its credibility with the public markets. Upon learning of the ThoughtWorks opportunity, SVIP expressed interest and began to negotiate terms of an investment with the Company. Given the strong IPO market at the time, both parties anticipated an IPO within a few years of SVIP’s investment. Nevertheless, the parties also discussed redemption rights for SVIP’s shares in the event that an IPO did not materialize. Ultimately, the parties agreed on a redemption right for cash after five years, subject to, among other things, ThoughtWorks’ having “funds legally available” at the time of the redemption. The redemption provision contemplated a repurchase of 100% of SVIP’s shares upon exercise of its redemption rights. The provision also addressed a scenario wherein the Company would not have sufficient funds to redeem all of the shares of preferred stock. Under such circumstances, ThoughtWorks was obligated to use its available funds to redeem the shares on a pro-rata basis from each holder, and to do so on a continuous basis until its obligations had been completely fulfilled.
In April 2000, SVIP invested $26.6 million in ThoughtWorks in exchange for approximately 3.0 million shares of preferred stock.
The IPO Bubble Bursts and a Redemption is Explored
After peaking in 2000, the public equity markets declined precipitously in the following years, and IPO activity also fell considerably. It became clear that an IPO was no longer a viable liquidity option for SVIP, and the parties began discussions of how the Company might redeem the preferred stock instead. After an internal analysis and an attempt to raise additional outside capital from the debt markets, the Board of Directors of ThoughtWorks (the “Board”) concluded in 2003 that it likely could not pay the approximately $43 million (including accrued but unpaid dividends) that would be due SVIP to redeem its preferred stock in April 2005, and offered to redeem the stock at a discounted amount. SVIP rejected this offer and exercised its redemption rights effective July 2005.
In response, the Board underwent an extensive process to evaluate the Company’s finances to determine whether (i) it had surplus from which a redemption could be made, (ii) it had or could readily obtain cash for a redemption, and (iii) a redemption would endanger the Company’s ability to continue as a going concern. Based on this analysis, and in consideration of the highly cyclical and volatile nature of the Company’s cash flows, the Board determined that ThoughtWorks had $500,000 of funds legally available, and offered to redeem preferred stock in that amount. It underwent the same process in each of the next sixteen quarters, ultimately offering to redeem 214,484 shares of ThoughtWorks’ preferred stock for a total of nearly $4 million. Throughout this process, SVIP declined to submit its stock certificates for payment.
SVIP objected to the Board’s periodic approach to redemption of its preferred stock. In February 2007, it filed an action seeking a declaratory judgment as to the meaning of the phrase “funds legally available,” and a monetary judgment for the lesser of the full amount of ThoughtWorks’ redemption obligation or the full amount of “funds legally available.” SVIP alleged that the term “funds legally available” simply meant an amount equal to the Company’s “surplus,” a well-defined concept under Delaware law, and it presented an expert at trial who opined that ThoughtWorks’ surplus ranged between $68 and $137 million. Thus, SVIP’s argument ultimately rested on the equivalence of the terms surplus and “funds legally available.”
The Court of Chancery took a dim view of this argument. Surplus is defined in Section 154 of the DGCL as the excess of net assets (i.e., the amount by which total assets exceed total liabilities) over the amount determined to be capital. The “capital” of a corporation is calculated pursuant to Sections 154 and 244 of the DGCL. If a corporation has only par value stock, its capital typically is equal to the aggregate par value of its issued shares, unless the board of directors has determined that the capital shall be a greater amount. Section 160 of the DGCL prohibits Delaware corporations from purchasing or redeeming its own shares of stock “when the capital of the corporation is impaired or when such purchase or redemption would cause any impairment of the capital stock of the corporation.”3 A stock repurchase or redemption impairs capital if the funds used therefore exceed the amount of the corporation’s surplus.4 To redeem shares in excess of the corporation’s surplus would impair the corporation’s capital and render the corporation “balance-sheet insolvent” under Delaware law.
Vice Chancellor Laster observed that although a corporation cannot be balance-sheet insolvent and meet the requirements of Section 160 of the DGCL, a corporation could have surplus, as such concept is defined by the DGCL, yet be insolvent within the meaning of Delaware law. Under such circumstances, the common law prohibition on redemptions by corporations that are insolvent or would be rendered insolvent by a stock redemption restricts the corporation’s ability to redeem shares of its own stock. A corporation is insolvent under Delaware law when its liabilities exceed its assets or when it is unable to pay its debts as they come due. In its analysis, the Court of Chancery noted that Delaware law has long recognized that “in addition to the strictures of Section 160 … a ‘corporation cannot purchase its own shares of stock when the purchase diminishes the ability of the company to pay its debts, or lessens the security of its creditors.’”5 Thus, if a corporation redeemed shares and was thereby rendered insolvent, the redemption would not be in conformance with Delaware law, notwithstanding that the corporation may have legal surplus. This implies a distinction between simply demonstrating surplus (which takes into account total assets) and having “funds legally available” to redeem shares of a corporation’s stock.
SVIP premised its claims on the equivalence of surplus and “funds legally available.” Because the two concepts differ, and because the mere existence of surplus is insufficient to establish conclusively a corporation’s obligation to redeem shares irrespective of whether the corporation has “funds legally available,” the Court rejected SVIP’s claims. In reaching its decision, the Court noted that, where the phrase “funds legally available” is employed, a corporation may only use or expend funds that are available (in the sense of being on hand or readily accessible through sales or borrowing) and capable of being deployed legally without violating Section 160 or other statutory or common law restrictions. The Court’s opinion is clear that even if the redemption provision in ThoughtWorks’ certificate of incorporation did not specifically refer to “funds legally available,” a comparable limitation would nevertheless be implied by law in the sense that a corporation may not be able to redeem shares, even if it has surplus, if such redemption would result in insolvency. Because SVIP could not show that ThoughtWorks had sufficient “funds legally available” to redeem all of the outstanding shares of preferred stock, the Court of Chancery entered judgment in favor of the Company.
Analysis of the Court’s Decision
Delaware law requires that stock redemptions be made only from a corporation’s surplus. However, from a financial point of view, this case distinguishes surplus from “funds legally available” in two ways. First, surplus considers a company’s total assets (including working capital, fixed assets, and intangible assets), while “funds legally available” only contemplates a corporation’s cash and cash equivalents (or its ability to raise such cash). Second, while surplus only considers a corporation’s balance sheet solvency, “funds legally available” considers the second test of solvency, a corporation’s ability to pay its debts as they come due.
The potential repercussions should a company redeem stock, and thereafter enter bankruptcy or go out of business altogether, may be harsh. The company and its directors may expect legal action from the remaining stockholders who did not benefit from the redemption, but were left holding an insolvent company after the fact. In addition, the company may be subject to fraudulent conveyance laws, which are designed to prevent secured creditors, stockholders, and others from benefitting financially at the expense of unsecured creditors. Fraudulent conveyance is addressed in Section 548 of the Federal Bankruptcy Code and falls into two categories: intentional fraud and constructive fraud. Section 548(a)(2) of the Federal Bankruptcy Code defines “constructive” fraud as occurring when a debtor has received less than reasonably equivalent value for the transfer made and either: (i) was insolvent on the date such transfer was made or becomes insolvent as a result of such transfer; (ii) retained “unreasonably small assets” or “capital” after the transfer; or (iii) made the transfer with the intent to incur, or reasonably should have believed that it would incur, debts beyond its ability to pay. If a fraudulent conveyance is found to have occurred, a company’s directors could face personal liability and selling stockholders could be forced to return the transaction proceeds, among other penalties.
In light of this decision, company fiduciaries should consider obtaining a solvency opinion (or certain elements thereof) before approving a stock redemption. A solvency opinion is distinct from a traditional “capital adequacy” opinion, which in the past was often the only financial opinion a board would seek in these circumstances. However, a capital adequacy opinion considers only whether, on a pro forma basis (i.e., taking into account the effects of the transaction), a company is balance sheet solvent, and is intended to address the surplus requirement of Section 160 of the DGCL. It is primarily conducted by means of a “balance sheet” test, wherein the fair value of a company’s assets is compared to its liabilities to determine if the net amount is at least equal to the company’s capital.
A solvency opinion, on the other hand, considers not only a company’s balance-sheet solvency, but also its ability to pay its debts as they come due (the “cash flow” test) and the adequacy of its capital to fund ongoing operations (the “reasonable capital” test). The cash flow test considers the company’s projected cash flows and utilizes sensitivity analyses on these projections to determine the “safety margin” available to the company. The reasonable capital test goes beyond a traditional capital adequacy opinion and considers whether a company’s “equity cushion” is too small to provide some level of downside protection if the company’s results don’t meet its projections. If its capital is inadequate, it may be unable to fund its continuing operations in such a downside scenario. A financial advisor may suggest that one or both of these analyses be included in a financial opinion in instances where a company may have significant asset value but little current cash flow – for example, a start-up business with promising technology but minimal revenue or profits, or a homebuilder with an inventory of completed and in-process homes but depressed current sales. In both of these cases, a company may have surplus under a strict reading of Delaware law, but not have “funds legally available” to distribute to stockholders.
Although one cannot (based on the limited public record) determine whether ThoughtWorks could redeem a greater number of shares, the Company’s failed attempts to raise a sufficient amount of capital to redeem the shares in full are consistent with the type of analysis that a financial advisor would conduct to inform itself of a company’s liquidity. In addition, many commercial lending agreements expressly prohibit a redemption of stock in a manner consistent with the outcome of this case. Lenders may explicitly require a company to maintain liquidity greater than simple surplus in order to buy back shares of its stock or pay a dividend to stockholders.
When undertaking a redemption transaction, a board of directors would be wise to consider all factors affecting the solvency of a corporation, and not just its surplus as defined under the DGCL. This should include its current cash available to fund the redemption, its ability to raise additional cash through the capital markets, and its ability to continue as a going concern following the redemption (i.e., its ability to fund the capital needs of its ongoing operations, such as working capital and fixed asset additions, and its ability to pay its debts as they come due). A financial advisor can assist a board of directors in determining if a redemption will render a company insolvent, based upon all of the factors enunciated by the Court of Chancery in this decision. With the proper information in hand, and with assistance from a financial advisor that is experienced in evaluating a corporation’s solvency from a number of different perspectives, a board can still meet its fiduciary duties under Delaware law and make a properly informed decision as to the legality, and appropriateness, of such a transaction.
Also contributing to this article:
Roxanne L. Houton
Potter Anderson & Corroon LLP