If the rule isn’t that everything goes with enough votes, what is?
Entrepreneurs and experienced investors understand that stock dilution is a fundamental aspect of investing in companies. This is especially true when companies anticipate needing additional capital before their potential profitability. But investors don’t always trust management to act fairly and wisely when selling additional shares or restructuring shareholder rights.
This is the first part of a series of blogs focusing on corporate capital changes in equity financings. In this first part, I assess the law applicable to charter amendments in Texas and Delaware. As many readers will know, Delaware is the primary US jurisdiction for corporate domiciliation and has a highly developed body of corporate decision-making law. Texas does not enjoy the same depth or breadth of case law. As a result, courts in Texas, like those in other states, frequently look to Delaware precedent when making decisions relating to Texas corporate law. However, the statute and case law of Texas and Delaware differ in important respects.
Amendments to the Charter [i]
Equity financings often require charter amendments to change the share capital. This can be due to various reasons. A team of founders may have issued the entire authorized capital of the company. 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 requiring the insertion of certain “preferred” rights in the corporate charter. These rights may include agreed ratios for the conversion of their preferred stock into common stock upon an IPO or other event, with conversion ratios protected by adjustments for certain dilutive stock issuances.
Because unreasonably restricting capital structure changes can cripple companies that desperately need capital and change, these provisions are subject to change. But what laws govern the modification of corporate charters? If it’s essentially contracts as upheld by the Delaware courts, who can change the contract if everyone doesn’t agree?
Delaware Corporate Status
Section 242 of the Delaware General Corporate Law (DGCL) permits corporations to change the shareholding structure set forth in their articles of association (to “recapitalize”) upon approval by a simple majority. In relevant part, Section § 242(a) of the Delaware General Corporate Law (DGCL) permits changes:
“Increase or decrease its authorized share capital or reclassify it, by changing the number, par value, designations, privileges 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, with or without an increase or decrease in the number of shares, or by subdividing or combining the shares into circulation of any class or series of a class of shares in a greater or lesser number of shares outstanding[.]”
In addition, Delaware law provides that actions affecting a class or series must be approved by a majority of the class or series concerned. DGCL § 242(b)(2).
Texas corporate statutes
Texas law qualifies charter amendments as fundamental transactions that require the approval of two-thirds of shareholders eligible to vote, except in limited circumstances. Texas Bus. org. code § 21.364(1); see Texas Buses. org. Code § 21.053. If a charter defines separate classes or series of shares, approval of an amendment that would affect the capital of the charter or the rights of any class or series requires the approval of each separate class or series. Texas Bus. org. Code § 21.364(d). Unlike Delaware, for class approval of an amendment (and any other fundamental transaction), Texas requires approval of at least two-thirds voting shares of the class or series. Texas Bus. org. Code § 21.364(c).
No Breach of Contract Claim for a Duly Approved Charter Amendment
Courts in Delaware have held that under statutory authority, corporations are contractually permitted to restructure their capital by amending their articles of association. See Hartford AI Co. vs. WS Dickey CM Co., 24 A.2d 315 (Del. 1942). Similarly, Section 21.051 of the Texas Business Organizations Code states that “[a] shareholder of a company does not have an acquired property right resulting from the certificate of incorporation, including a provision […] concerning the management, control, capital structure, right to dividends, purpose or duration of the company.
But that raises a question. East any modification of the validly approved charter affecting the lawful share capital simply because it is authorized by law?
What can I do if a Corporate Action affects or dilute my voting rights or economic ownership?
Imagine a company in need of capital whose charter offers significant anti-dilution protections to preferred investors. To reward investors willing to provide capital and create pressure on others, a company amends its charter to allow a “pay-to-play” system. Under such a system, any investor who refuses or is denied the right to participate in future equity financing would see their percentage of ownership in the company diluted, including voting rights and economic rights. If a fair price or better is paid for the stock, existing shareholders will see the value of their stock stay the same or increase. If less than fair value is paid, the value of the stock will be depreciated.
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 going to take it” as they’re pushed down the courthouse steps?
I found the answer somewhat surprising: it depends. Maybe after years in this business I shouldn’t have (haha).
Corporate actions double test
In the words of the Delaware courts, the companies’ actions are “double-checked.” Seefor example., Carsanaro vs. Bloodhound Techs., Inc.., 65 A.3d 618, 641 (Del. Ch. 2013). In 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”. The review of compliance with the principles of fairness is tantamount to a scrutiny of the actions of the directors in the event of a breach of fiduciary duty.
While contract law does not provide a method to challenge charter amendments that are approved in accordance with legal requirements, breach of fiduciary duty lawsuits can sometimes provide recourse when actions are taken that dilute equity. . Whether a remedy will be provided depends on a silent factor and, primarily, on two stated factors: (1) whether the board of directors is independent of the shareholders participating in the transaction; and (2) whether the transaction is fair.
The silent factor? The fact finder. Fairness and independence are fair and independent in the eyes of the beholder. In the absence of an arbitration clause, in Delaware it is a judge specializing in company law. In Texas, this means a jury unless the parties waive their right to a jury trial or have contractually agreed to a bench trial.
The next article in this series will discuss, under Delaware and Texas law, the extent of fiduciary duties owed to common and preferred shareholders by corporate directors and certain shareholders. Subsequent posts will address potential shareholder claims for breach of fiduciary duty, the review standards applied to assessing shareholder claims in different contexts, and steps that can be taken to mitigate the risk of shareholder claims.
[i] Corporate charters are referred to in Texas statutes as certificates of formation. In Delaware, they are called Certificates of Incorporation.