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Common Misconceptions Regarding Preferred Stock Create Risk of Costly Mistakes

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Common Misconceptions Regarding Preferred Stock Create Risk of Costly Mistakes

By Gardner Davis, Partner, Foley & Lardner LLP and Danielle Whitley, Partner, Foley & Lardner LLP

Preferred stock is commonly used for venture capital and private equity investments.  It gives the investor the ability to convert to common stock if the deal succeeds, and also includes protection of the liquidation preference if things go poorly.  Preferred stock also often provides the holder with the right to designate a director on the corporation’s board, giving him visibility and input regarding the corporation’s activities and direction. However, common misconceptions about the security of preferred stock and the benefits from designating a director may lead to costly mistakes.

Gardner Davis

Gardner Davis

Many investors believe the mandatory redemption date for preferred stock is the equivalent of a loan maturity date. Many also believe the corporation is unconditionally obligated to repurchase the preferred shares. They are wrong on both counts. Preferred stock provides no guaranteed right of payment, and its redemption obligation is treated neither as debt nor as a current liability.

Under Delaware law, a wide range of statutes and legal doctrines restrict the corporation’s ability to use funds to redeem preferred shares, rendering them not “legally available.” Among these, Delaware common law has long restricted a corporation from redeeming its shares when it is insolvent or would be rendered insolvent by the redemption. Consequently, a corporation easily may have funds but still find they are not legally available.

Corporate directors have substantially more discretion than many assume regarding whether, when and how to raise additional funds to finance the redemption of preferred stock. The directors’ fiduciary duty is to maximize the enterprise value for the long-term benefit of the common stockholders.

In a recent Delaware case, Frederick Hsu Living Trust v. ODN Holding Corp[i]., No. 12108-VCL, 2017 WL 1437308 (Del. Ch. Apr. 24, 2017), the Chancery Court sided with the common stockholders, who claimed that the preferred stockholder and the board of directors violated their fiduciary duty to the common stockholders by taking extraordinary steps to raise funds to finance the mandatory redemption.

The ODN Holding complaint alleges that the preferred stockholder caused the corporation to alter its business plan by shifting its focus away from growth which benefitted common stockholders to raise cash that could be used for the redemption. The corporation sold three of its four lines of business in their entirety and divested the principal economic driver for the fourth line of business.

Vice Chancellor J. Travis Laster explained in ODN Holding that the existence of a mandatory redemption right, even one that is ripened, does not convert the holder of preferred stock into a creditor.

A redemption right does not give the holder the absolute, unfettered ability to force the corporation to redeem its shares under any circumstances. The case law establishes limitations on the ability of preferred stockholders to force redemption. The board of directors of a Delaware corporation must, within the limits of its legal discretion, treat common stockholder welfare as the only end, considering other interests only to the extent that doing so is rationally related to common stockholder welfare.

Danielle Whitley

Danielle Whitley

Vice Chancellor Laster found that “a board does not owe fiduciary duties to preferred stockholders when considering whether or not to take corporate action that might trigger or circumvent the preferred stockholders’ contractual rights.”

The ODN Holding complaint asserts that the board acted disloyally by selling businesses to raise cash to satisfy a future redemption obligation before there was any contractual obligation to redeem the stock. The plaintiffs contend that if the board had retained those businesses, they would have generated greater value for the benefit of the common stockholders.

According to Vice Chancellor Laster, the plaintiff correctly observes that if the corporation lacked legally available funds when the redemption provisions of the preferred stock came into play, then the corporation would not have been able or obligated to redeem the preferred stock.At that point, the board could have continued to manage the corporation for the benefit of the common stockholders without having to make a massive redemption payment.

All that the preferred stockholder possessed and could enforce was a contractual right to require the corporation to redeem the preferred stock to the extent the corporation had legally available funds.But the redemption provisions do not foreclose a claim by the common stockholders that the directors breached their fiduciary duties by generating legally available funds.

The terms of preferred stock frequently provide the stockholder the right to appoint directors to the board of the corporation.  Many investors wrongly assume the preferred-designated director will act to protect the preferred stockholder’s economic interests.

The law doesn’t recognize a special duty held by directors to any special class electing them. Although the director nominated by the preferred stockholder may have a natural affinity for the preferred stockholder’s economic interests, a director owes a fiduciary duty exclusively to the common stockholders, not to holders of preferred stock. Directors nominated by preferred stockholders are then put in the difficult situation of putting the common stockholders’ interests ahead of the preferred stockholder.The board has no fiduciary duty to maximize the preferred stockholder’s return or facilitate the preferred stockholder’s exit.

The preferred stockholder risks being drawn into stockholder litigation under the theory that the stockholder “aided and abetted” the breach of fiduciary duty by its designee directors. This litigation is more difficult to defend than garden-variety claims against corporate directors because the business judgment rule, a judicial presumption which protects directors from liability for good faith mistakes, does not apply in the conflict of interest context. Corporations also can’t indemnify directors against personal liability for breach of the duty of loyalty under Delaware law.

In short, investors must realize that the contractual protections granted to holders of preferred stock may be overridden by restrictions on the corporation’s ability to only redeem shares from legally available funds. The protections may also be overridden by directors’ fiduciary duties to common stockholders to manage the corporation’s legally available funds to prevent situations that are not in the best interests of those stockholders.

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Revitalising the token market

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Revitalising the token market 1

By Gavin Smith, CEO at Panxora

With interest rates near zero and fears that whipsawing stock markets are set for further plunges, many investors are turning to alternative markets in the search for returns. Money flowing into cryptocurrency hedge funds and trusts like Grayscale is at all-time highs and the large cap coins seem to be entering a bull phase, but that capital is not trickling down into new token projects. Why are blockchain token projects struggling to attract funding?

Seed investor scepticism

Setting aside the reputational issues with mainstream investors, even those educated in blockchain tech are not signing on the dotted line. This is certainly due in part to the hangover from the early token market.

During the heady days of 2016/17, investors could buy tokens during the token sale, and if the project was legitimate – even if the business case wasn’t particularly strong – prices would soar based on market enthusiasm. Early investors purchased at a discount and cashed out almost immediately for a handsome profit – and then repeated the process again. The token sale allowed founders to amass a war chest large enough to finance the entire token project – without having to give up a large chunk of company equity. Everyone got what they needed out of the deal.

Running a token sale is far more expensive today than it was during the boom. Getting the attention of the token buying public in a market where advertorial has replaced editorial is expensive. This coupled with a regulatory framework that requires the advice of accountants, solicitors and information gathering of KYC details for investors all comes with an escalating price tag.

To accommodate the change in cost structure, tokens now need to acquire funding in two rounds. Frequently there is a first round where capital is raised from a few, large investors. This cash is then used to finance setup and marketing the main token sale. The token sale, in turn, provides the capital needed to run the entire business project.

Bridging the gap between token projects’ needs and early stage investors

To successfully get a token through the capital raising process, founders must acknowledge the risk assumed by those very early investors and reward them appropriately. And given that tokens may stagnate or fall in price post token sale means that a deep discount in token price is not necessarily attractive enough to get investors to commit.

Many tokens have turned to offering equity in the business in the effort to raise that first tranche of capital. If you look at the number of successfully concluded token sales, the downward trend has continued since Q2 2018, so offering equity is not sufficiently stimulating the market.

Two sides of the coin

So, what is the answer? It’s a complex question but one thing is certain. Any solution must be rooted in a deep understanding of what both parties need to successfully conclude the deal.

Gavin Smith

Gavin Smith

On the one hand, token founders’ needs are clear: they need enough capital to get the token ready for and through a successful liquidity event that will provide sufficient funds to build the project. The challenge lies in striking the right balance between accruing that capital and making sure not to offer so much project equity that give up either the control or the incentive founders need to drive the project forward.

On the other hand, while the needs of the seed capital investors are more complex, there are two areas of key concern: transparency and profit incentives.

Transparency can mean many things, but almost always includes providing more informative cost and profit projections, as well as answers to a whole range of questions, not least the following:

  • What happens to investor capital if the token sale event fails? Token founders must be transparent from the outset. The token market is highly speculative and early investors run the risk of losing their money should the project fail. Therefore, investors require a well-established fund governance process in place throughout the fundraising so they can make informed decisions on whether the project is worthwhile.
  • How are the assets for the entire project managed? Investors need to know that their money is in good hands and that proper treasury management techniques are being used to manage cryptocurrency volatility risk. Ideally, an independent custodian will be used to hold the funds and limit founders’ ability to draw down the capital – releasing funds to an agreed-upon schedule of milestones.
  • How are the rights of investors protected, for instance in the case of a trade sale? Investors need to know what happens if the company they are investing in is sold. What impact could this have on the value of their stake? Would a separate governance framework need to be established? These are critical questions and investors aren’t likely to settle for any ambiguity in the answers.

Profit incentives are important when it comes to encouraging early participation in a project. Investors need convincing that the proposition will keep risks to a minimum and focus on providing a strong probability of a return. This means that founders need to be able to defend the case for the increase in the value of their token.

But this isn’t the only incentive that matters. Investors can also be incentivised by preferential offerings such as early access to projects and services that might help their own business.

Let’s not forget that investors don’t support just any project. What really matters is that there is something special and unique about the business being underwritten by the token. Preferably something that could be shared upfront and directly benefit the investor – proof that the investment is really worth it.

And that’s what it all comes down to. Ultimately, while token projects are having a hard time finding funds at the moment, if they can prove their worth and provide full transparency and clear profit incentives to ease investors’ concerns, the money is out there. And deals can be done.

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Achieving steady returns in challenging times for later life planning

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Achieving steady returns in challenging times for later life planning 2

By Matt Dickens, Senior Business Development Director at Ingenious

The macro-economic conditions of the last five years have presented a relentless challenge for money managers seeking to produce consistent returns. It seems an all too distant memory that UK markets were caught in a happy period of low volatility and positive growth since the recovery from the financial crisis started in 2009. Enter 2016 and we have since found ourselves in an era of exceptional uncertainty. An acrimonious Brexit referendum and the following ambiguity, pressure on sterling, repeated challenges to the UK Government, a trade war between two of the world’s super-powers and now a global pandemic. All this as the world is going through a digital revolution.

Under these exceptional conditions, many investment strategies have understandably struggled to sustain the growth that investors had previously enjoyed without taking on elevated levels of risk and experiencing greater volatility and its associated negative impact. However, Ingenious Estate Planning has been operating alternative investment strategies for several years, which have produced a steady return with low volatility over this time as they possess little correlation to the main listed markets.

Real Estate

The affordable end of the UK’s residential real estate market has proven to be extremely robust during the recent uncertainty. The market benefits from some core fundamentals that have assisted it withstanding a lot of the pressures experienced by other sectors. Firstly, a large and sustained supply deficit. In 2018 the UK built 80,000 fewer houses than the actual requirement of 300,0001. This strong, inherent demand poses a clear investment opportunity to investors who can fund construction projects in the safe knowledge that there is an established demand on completion.

Secondly, this supply deficit has been recognised by Governments for several years and there has been a raft of policies enacted, all supportive of building more houses. For instance, the Help to Buy scheme has enabled many, often first-time buyers onto the property ladder. This scheme means there is a well-established and subsidised group of buyers ready to buy whenever developers complete construction. Thirdly, and more recently, the Government has acted quickly to identify the property sector as one that is key to the UK’s recovery from Covid-19. Through relaxing planning laws and offering stamp duty holidays, both the construction and sales market are being given valuable incentives that support an ongoing return for real estate investors.

Secured lending model

Despite these positive forces however, there remain some risks with investing in the property market, so a conservative investment strategy is key to protecting investors. Rather than take a 100% equity, or ownership, position in a house-builder, developer or single property, a portfolio-based, secured lending model, has a number of clear risk-mitigating benefits. For instance, by lending to a portfolio of developers, carefully selected on a project-by-project basis, and by earning a fixed rate of interest, rather than taking equity risk, there is inherently lower volatility in returns given the protection of a senior debt position on each development. Contracts set out clear loan terms meaning that regular interest is paid on the investment and upon final sale the repayment is made in full, all with the benefit of banking-style security protections. By contrast, equity investments and associated valuations can fluctuate over time as the asset price changes and so it is far more vulnerable to market conditions and sentiment, and ultimately any drop in value is suffered by the investor. In the lending model, any loss is initially felt by the borrower.

Benefits for estate planning

Ingenious Estate Planning Private Real Estate utilises this secured lending investment strategy. The Business Relief- qualifying service is commonly used by clients planning for later life. As savers and investors reach retirement and decumulation, they present wealth managers with a unique set of investment problems. Without careful planning, the start of this phase for many could signal the end of any capital growth and herald their savings being eroded to pay for life’s needs. Any investment offering both high volatility and potential drawdowns may therefore become unpalatable. And while many would wish to gift savings to their children to mitigate the risks to their beneficiaries of paying a hefty inheritance tax bill upon their death, the thought of losing both control and access to these savings when they may still need them, means many feel uncomfortable in taking that step.

However, this does not need to be a fate accepted by savvy investors and planners who can utilise a proven trading strategy that continues to both carefully and predictably grow their investment while also providing potentially full relief from inheritance tax.

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Getting ahead in 2020: Why building an emergency fund is the way forward

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Getting ahead in 2020: Why building an emergency fund is the way forward 3

By Shahid Munir, co-founder of MintedTM, an investment platform which allows individuals to buy and sell gold bullion.

2020 has forced a lot of changes, especially where personal finances are concerned; attitudes towards investment have shifted and financial security has taken priority. Knowing that high-risk investments won’t guarantee profit, individual investors are considering longer-term alternatives and opportunities to save. So, at a time when stock markets are volatile, where should individuals be investing their money for the best returns?

While no one could have predicted the coronavirus crisis or the widespread economic devastation that has come with it, tension has been growing across global marketplaces for some time. Back in 2018, there were talks of a financial crisis and, even before the pandemic, unsecured debt hit a new peak of £14,540 on average per household. Now, with the UK entering into the deepest recession on record, unemployment climbing, and government support dwindling, the true value of quick-access ‘emergency’ funds has come to the fore.

Whether it’s a failed MOT, a broken boiler, or redundancy, in the event of a financial emergency, individuals are less likely to have the time or inclination to research the options available; many may resort to quick-fixes such as a high-interest payday loans to get themselves out of a difficult situation. According to research from Which?, 30 percent of people earning up to £28,000 a year were unable to save during lockdown. However, as recovery gets under way, it’s clear putting money aside to cover any large, unforeseen expenses can help to preserve existing finances and keep stress to a minimum.

Shahid Munir

Shahid Munir

Despite there being plenty of investment options available, very few lend themselves to building an emergency fund. With government premium bonds currently yielding virtually nothing and interest rates on cash ISAs sitting far below inflation, what was once considered safe is not only under-performing but is costing investors money in the long run. To reduce risk, investors should be diversifying their portfolios and investing in cryptocurrency or physical assets such as gold. For example, gold Exchange Traded Funds (ETFs) are popular with some individuals because they provide an easy way of gaining exposure to any increases in the precious metal’s value, while still allowing easy access to the funds if they are needed

With new types of technology platforms offering easy-to-use mobile savings apps, individuals can look further than traditional ISAs and bonds and begin to start investing in precious metals, something that may not have seemed possible in the past. Being based on an average rate of return and outperforming inflation, gold isn’t just a safe haven risk-off asset, it’s a key step towards establishing a watertight emergency fund.

While many people are looking for innovative ways to maximise saving potential, it doesn’t have to be complicated. Often, taking a step back and considering both personal and financial objectives can work wonders. This may involve analysing personal expenditure, taking stock of any outgoings and gauging their appetite for risk. It is wise to work towards building an emergency fund that covers three to six months’ worth of bills and expenses or to save around 10 percent of an annual salary.

Treating an emergency fund like any other fixed cost on pay day and separating it from day-to-day bank accounts and transactions will make it easier to commit to investing. For example, taking advantage of any platform-specific features, such as setting up a minimum standing order, can take the pressure off investing a lump sum. Often, it’s easier to reach an end goal by saving smaller, regular amounts, and topping them up where possible – autosaving apps are a perfect example of how these costs can add up over time.

Kickstarting an emergency savings fund is one of the first steps investors can take towards financial health, future planning and getting out of any debt cycles. While gut instinct may tempt people to keep money in the bank, investment in physical assets, such as gold, offers individuals the opportunity to benefit from greater returns and peace of mind, providing that all-important safety net for whatever the future may hold.

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