Summary
implying term requiring knowledge and intent by holding that preferred stockholders could prove an implied covenant breach if the board of directors, in an attempt "to frustrate the [preferred stockholders’] right to a liquidation preference .... intentionally embarked upon a course of action tantamount to a liquidation and did so in bad faith."
Summary of this case from Archkey Intermediate Holdings Inc. v. MonaOpinion
No. 16362NC.
Submitted: May 25, 1999.
Decided: October 13, 1999.
Alan J. Stone and David J. Teklits of Morris, Nichols, Arsht Tunnell. OF COUNSEL: Kronish, Lieb, Weiner Hellman. Attorneys for Plaintiffs.
Charles F. Richards, Jr., Raymond J. DiCamillo and Megan Semple Greenberg of Richards, Layton Finger, Attorneys for Defendant.
MEMORANDUM OPINION
Does a Delaware corporation's Board create a de facto liquidation where it approves shutting down primary operations, embarks upon a sale of assets, grants its CEO a lavish severance allowance while continuing to employ him, and takes no action to block the CEO's purchase of 13 million shares of the corporation's common stock for $1,000?
Do these actions constitute a liquidation which triggers preferences. for the corporation's preferred shareholders under the Certificate of Designations and/or breach the Certificate's implied covenant of good faith and fair dealing?
I conclude, after hearing the evidence at trial and considering the post-trial submissions, that the corporation's board's course of action did not constitute a liquidation under Delaware law, that the actions did not trigger the liquidation preference contained in the Certificate of Designations, that the actions taken were reasonable, that they were designed to respond to potential insolvency in good faith and that any alleged wrongdoing by the Board or the corporation's officers did not specifically relate to bad faith refusal to declare formal or final approval of a liquidation of the corporation.
I enter judgment for the Defendant corporation.
I. FINDINGS OF FACT
A. Background
Plaintiffs Quadrangle Offshore (Cayman) LLC and Cerberus Partners, L.P. are investment funds. Kenetech is a holding company incorporated in 1986 in Delaware in which Plaintiffs invested. The Kenetech board authorized the issuance of 110,000 shares of PRIDES on March 31, 1994. PRIDES are a standardized preferred share marketed by Merrill Lynch Co. Kenetech PRIDES are similar to PRIDES issued during 1994-95 by Reynolds Metals Co., Kaiser Aluminum Corp., First USA, Inc., and Bally Entertainment Corp. among others. In May and June 1994, Kenetech sold 102,492 shares of PRIDES. Plaintiffs respectively bought 652,000 and 151,000 Depository Shares in Defendant Kenetech's preferred shares, the so-called Preferred Redeemable Increased Dividend Equity Securities ("PRIDES"). Each Depository Share represents a one-fiftieth interest in a PRIDES share.
Lawrence A. Heller testified on behalf of plaintiffs. He is managing member of L. Heller Advisors, an investment advising firm that provides investment advice to Quadrangle and the person who bought the PRIDES on behalf of Quadrangle.
Kenetech PRIDES pay on a quarterly basis a cumulative yearly dividend of $83.55 (or 8-1/4% of their stated value of $1012.50 paid quarterly). The shares are convertible at the option of the holder after three years and are mandatorily converted according to a prescribed formula into common shares four years after issuance. PRIDES are Kenetech's only class of preferred shares. In 1996 and 1997, Kenetech also had 36.8 million shares outstanding of common stock and approximately $99 million worth of 12-3/4% Senior Secured Notes (the "Senior Notes") due in 2002.
Historically, Kenetech's major business line was developing turbines and plants for wind-powered electricity generation. Kenetech started its operations as U.S. Windpower, Inc., later renamed Kenetech Windpower, Inc. ("KWI"). KWI designed and manufactured the turbines and plant equipment necessary to generate electric power through windmills. KWI also installed its products and financed purchasers who built windpower plants using KWI products.
Kenetech was formed as a holding company to hold KWI and other subsidiaries' stock. In the eighties, Kenetech (and its predecessor entities) diversified into related power generation businesses. In the mid-eighties, Kenetech bought a construction company, CNF, which chiefly provided construction services for other Kenetech subsidiaries. CNF began developing independent thermal power projects initiated by the Kenetech Energy Systems subsidiary ("KES"). In the early nineties, KES's largest project was a 50/50 joint venture with the Enron Corporation to build a cogeneration facility near Penuelas, Puerto Rico — a project known as "EcoElectrica."
EcoElectrica started off as a typical KES project. Kenetech envisioned that KES would collaborate with Enron in building and operating the electrical power generation complex. The site would include a liquefied natural gas import terminal, a gas-fired cogeneration facility of approximately 540 megawatts, a desalination plant, and ancillary facilities. Kenetech and Enron signed a 22-year Power Purchase and Operating Agreement on March 10, 1995, obligating themselves to obtain financing and regulatory permission to build a facility capable of generating and delivering electricity to the Puerto Rico Electric Power Authority ("PREPA"). Once the plant was up and running, Kenetech intended to sell its half interest. In 1994, the time that this dispute began, this project was still in its early planning stages, but EcoElectrica nevertheless constituted Kenetech's largest asset after its windpower subsidiary, KWI.
Kenetech also operated an energy conservation business through its Kenetech Energy Management subsidiary ("KEM") and a waste wood collection and processing business through its Kenetech Resource Recovery subsidiary ("KRR"). Despite this diversification, Kenetech remained fundamentally a wind power business.
In 1994, Kenetech considered windpower to be its most important growth opportunity. It represented about half of Kenetech's revenue, which totaled $236 and $338 million in 1993 and 1994 respectively. Entering into the nineties, Kenetech's management devoted an increasing amount of its efforts towards developing its windpower businesses. The company remained optimistic about the marketing prospects of its latest series of wind turbines, the KVS-33.
That optimism vanished in 1995. Amidst a nationwide stagnation in new electrical plant projects caused by pending deregulation of the electrical industry, Kenetech suffered unforeseen setbacks. First, KWI lost $1 billion in expected windplant projects with the California Public Utility Commission after the Federal Energy Regulatory Commission found that the commission's bidding process had been improper. Second, that year, Kenetech began receiving customer complaints about its new wind turbine, the KVS-33. Latent design defects in the new turbine manifested themselves in the field, creating huge product liability exposure for KWI.
To address these challenges, Kenetech hired a new CEO, Richard Saunders, to replace Gerald R. Alderson, who had been Kenetech's CEO since Kenetech's inception. Alderson retained his position as Chairman of the Board. Saunders brought expertise in heavy equipment manufacturing and in operating a financially distressed entity. Kenetech hired Saunders to address its design problems. Kenetech also hired Smith Barney to advise it on how to restructure its operations. At this juncture, Kenetech believed that it could solve the design defects in the KSV-33 and hoped to sell off its other non-core businesses to raise capital to fund that solution.
On January 6, 1996, the Kenetech board of directors met by telephone. They discussed Kenetech's financial problems and adopted a resolution ordering management to take all necessary steps to sell off KES and Kenetech's other nonwindpower operations, including CNF and EcoElectrica. In short, the board agreed to sell off everything else to save KWI. Later that month, the board also agreed to forego payment of a dividend on the PRIDES for the first time.
Further inquiry into the design flaws in the KVS-33 led Kenetech's management to conclude that the flaws could not be fixed. The turbines had cracks in the transmission. Fixing the problem would require dismantling the turbine and shipping the broken part to a factory for repair work. The Kenetech board decided that Saunders' manufacturing expertise was no longer of paramount importance and replaced him with Richard D. Lerdal, Kenetech's former General Counsel. Lerdal was familiar with the company and its problems and brought transactional experience that Kenetech needed to continue its asset sell-off. Angus Duthie was elected Chairman of the Board, replacing Alderson. With these changes, Kenetech's board of directors had four members: (1) Alderson, former Chairman and CEO; (2) CEO Lerdal; (3) Chairman Duthie, an employee of Price Ventures, a venture capital fund; and (4) Dr. Charles Christenson, a former Harvard Business School professor. The last two were outside directors never employed by Kenetech.
B. The "Liquidation" Scenario
In the first half of 1996, Kenetech sold a number of businesses. It disposed of KEM, KRR, Kenetech Investors, Inc., and a manufacturing facility in Texas. During the same period, the board recognized the intractable severity of KWI's problems and on May 8, 1996, approved KWI's filing for protection under Chapter 11. That filing, two weeks later, ended KWI's existence as a revenue producing Kenetech subsidiary. CNF, in particular, lost any chance of collecting on $16 million worth of receivables it had accrued in performing services for KWI. In fact, KWI's bankruptcy and Kenetech's abandonment of all new projects substantially diminished CNF's value as a going concern.
After KWI filed for bankruptcy, Lerdal circulated a memo for the upcoming October meeting in which he discussed his desire to focus on "end game" strategies for Kenetech. At the October meeting, the board evaluated a liquidation analysis prepared for the meeting. The analysis assumed sale of Kenetech's largest post-KWI asset, its 50% interest in EcoElectrica, for $126 to $146 million and concluded that no funds would be available for equity holders after paying off Kenetech's debt. Alderson testified that at the time he felt that this sale price was too low. The most important fact to come out of the October meeting was that Kenetech continued with its plan to sell all non-KWI assets, including EcoElectrica, even though KWI was now in bankruptcy. Although the minutes do not reflect this, the board, according to Alderson, agreed to offer EcoElectrica to an interested bidder, Central and Southwest International, for $152 million. The board never received a response.
Mark D. Lerdal, Memorandum to Board of Directors of KENETECH Corporation (Sept. 24, 1996) (PX22).
At the board's next meeting, they again went over a liquidation analysis prepared for the meeting.
KENETECH Corporation, Consolidated Liquidation Analysis for the KENETECH Corporation Board of Directors at KEN005195-6 (Oct. 24, 1996) (PX25).
At trial, Kenetech directors and officers, Alderson, Alvarez and Lerdal convincingly testified that to maximize the value of EcoElectrica, it would be necessary for Kenetech and Enron to obtain regulatory approval for the project from the PREPA and to obtain project financing. After these two hurdles were cleared, the risk in actually completing the project would be significantly reduced. This, they testified, would allow for sale of the project at a significantly higher price.
In Kenetech's 10-Q for the first quarter of 1997, the company stated that it faced dire financial straits and would try to raise funds by selling its EcoElectrica project, but that it might not be able to continue as a going concern. The 10-Q noted that Kenetech had to consider the option of filing for bankruptcy. At trial, Alderson and Lerdal tried to downplay the significance of this statement. They noted that Kenetech's note holders could have forced Kenetech into bankruptcy after the company defaulted on its June 15, 1996 interest payment (and subsequent payments) and that a purchaser of EcoElectrica might demand a "packaged bankruptcy" to cleanse title to the project as a condition of EcoElectrica's sale. While I am convinced that the 10-Q statement reveals a Kenetech on the verge of insolvency, the possibility that its note holders would force it into bankruptcy provided tangible economic incentive for Kenetech to liquidate assets.
Kenetech Corporation, Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 at 9 (quarter ending March 29, 1997) (available via www.sec.gov) (PX5OA).
In the last half of 1996, Kenetech moved forward with its sale of assets. It sold:
• a subsidiary that owned 25% of a steam heating facility in Connecticut;
• the development rights to a windplant in Spain;
• an equity stake in another Spanish windplant (along with a promissory note from the plant's owner); and
• its equity stake in a California cogeneration plant.
Tellingly, Kenetech's 1996 third quarter 10-Q dropped any mention of future operations. By 1997, Kenetech had sold off most of its major assets, with the exception of its largest, EcoElectrica, and fired most of its workers. Kenetech also dropped pursuit of all new business ventures. Even as it went about selling its assets, Kenetech defaulted on its semiannual Senior Note interest payments for both 1996 and 1997. The first default in June 1996 caused a group of Kenetech's Senior Note holders to form an informal note holder committee to protect their interests and to seek repayment of the notes. Kenetech, faced with forced bankruptcy as an alternative, agreed to pay for an investment bank and law firm to advise the committee. The formation of this committee resulted in relentless pressure on Kenetech's board to sell EcoElectrica in order to satisfy the Senior Note holders.
Kenetech's witnesses convincingly testified about the difficulties involved in selling EcoElectrica. The board had concluded (and the note holders committee apparently agreed) that Kenetech needed to obtain a financing commitment before selling its 50% interest. To get that commitment, Kenetech had to deal with a series of regulatory issues with the Environmental Protection Agency and PREPA in order to obtain some 40 permits. Once Kenetech and Enron obtained regulatory approval, they convinced Credit Lyons to finance EcoElectrica in late 1997. But after all this, Kenetech had to comply with extremely cumbersome requirements contained in its agreement with the joint venturer, Enron, on how to shop Kenetech's 50% interest. These cumbersome requirements further slowed down the sale. During the entire 1996 to 1998 period, Kenetech ran into numerous conflicts with Enron and PREPA. Kenetech put on convincing evidence at trial to show that the delay in selling EcoElectrica was not a bad faith attempt to avoid the PRIDES' liquidation preference, but the unavoidable consequence of having to deal with bureaucrats and a difficult joint venturer.
Finally, in July 1998, Edison Mission offered Kenetech (a) $237 million; (b) assumption of a $33.5 million obligation; and (c) a 7-1/2% interest in the revenue stream generated by tolling fees assessed by the natural gas import terminal against non-cogeneration plant users. On December 23, 1998, five months after Edison Mission submitted its bid, Kenetech and Edison Mission signed a sales agreement for Kenetech's 50% interest in EcoElectrica. Edison Mission assumed an equity funding commitment to KES and paid cash worth $247 million in the aggregate. Part of the cash was paid directly to the Senior Note holders, whose debt was retired. The final sales agreement gave Kenetech a lump sum for its entire interest with no continuing stake in tolling revenue.
The offer was contingent upon certain regulatory clearances from PREPA which were requested on August 21, 1998 and obtained months later from PREPA in exchange for $29 million.
C. Inflammatory Ancillary Dealings
1. The Putative "Severance" Agreements
Two other events transpired in 1997 that color this dispute.
First, Kenetech's board agreed to pre-fund Lerdal's severance allowance. The idea was to provide him with creditor-proof compensation if his employment was terminated by Kenetech's bankruptcy. With bankruptcy an imminent threat, the board was concerned that Kenetech's top people might go elsewhere when they were most needed or might be pressured by the note holders committee into sewing their interests. Kenetech decided to set up an escrow fund holding $600,000. Lerdal could obtain these funds by delivering a letter to the escrow agent stating that Lerdal's employment with Kenetech had been terminated.
Michael Alvarez, Kenetech's CEO also received a pre-funded severance allowance but eschewed the chutzpah required to cash in on it. Therefore, I focus on Lerdal.
Second, during Arthur Andersen's 1996 audit of Kenetech, according to Lerdal, Arthur Andersen informed Kenetech and Lerdal that the IRS might consider Lerdal in constructive receipt of his severance compensation and tax him on the income. Lerdal discussed the problem with the Kenetech Compensation Committee, directors Duthie and Christenson. He suggested that Kenetech pay his tax liability. According to Lerdal, he then left the room. When he returned, Duthie and Christenson informed him that Kenetech would pay the tax on his $600,000 severance compensation. Furthermore, Kenetech did not actually escrow funds, but issued a letter of credit with Lerdal as the beneficiary. Lerdal drew on the letter in March 1997 although he continued his employment with Kenetech until at least this 1999 trial. Considering Kenetech's payment of his tax liability, Lerdal in fact received approximately $1.16 million in pre-funded severance compensation that year.
A fairly minor portion of that amount reflected social security, medicare and other taxes normally incurred by the employer. More importantly, Lerdal dramatically increased the size of his severance allowance when Kenetech picked up his federal and state income taxes.
2. The "Sweetheart" Stock Deal
Meanwhile, in October of 1997, a former Kenetech director associated with Kenetech's largest shareholder, the Hillman Co., approached Lerdal. The former director, Mark Laskow, informed Lerdal that Hillman wanted to liquidate its Kenetech holdings, which consisted of 13 million shares of common stock. Lerdal offered to help look for a buyer and expressed interest in Laskow's suggestion that Lerdal buy the shares if no other buyer was found. The Hillman Co. also approached Duthie. At one point, Duthie contacted Lerdal about the idea of all four Kenetech directors buying Hillman's shares. Lerdal resisted on the grounds that director Alderson and Hillman Co.'s representatives were on bad terms. Lerdal described how Laskow contacted him a second time about actually buying the shares as follows:
"Then sometime the second or third week of December — I don't know the exact date. I got a call from Mark Laskow, who said, `We haven't been able to dump these things.'
I said, `Well, I would be interested in buying them.'
He said, `Okay.'
And I said, `What do you want me to pay?'
He said, `A thousand bucks, $5,000. It's sort of irrelevant.'
I said, `I'll pay a thousand.'
And that is how the negotiation went" (emphasis supplied).
Lerdal claimed that he considered whether Kenetech might want to purchase the shares, but never offered them to the corporation because he knew that the Senior Notes prohibited any repurchase of common stock and because the PRIDES prohibited any payment to junior stock when the preferred's dividend had not been paid.
D. Kenetech's Final Throes
While Lerdal cashed in his letter of credit and bought out Hillman's interest in Kenetech, the company continued to look for a buyer for EcoElectrica. Finally, in December 1998, Kenetech and Edison Mission signed a sales agreement. Although Kenetech's few remaining employees had busied themselves with the sale of this asset, the company was already describing itself in the past tense. In its Form 10-K Report for 1997, dated March 30, 1998, Kenetech describes itself as follows: "Kenetech Corporation . . . is a holding company which participated through its subsidiaries in the electric utility market in two principal ways. Historically, the Company developed, constructed, financed, sold, and operated and managed independent power projects."
Kenetech recently sold its last asset, the Chateaugay partnership, for $2.4 million. As of December 31, 1998, Kenetech has sizeable cash holdings ($67 million) and no ongoing business operations. Lerdal testified that at some point in the near future, the board will resolve whether to liquidate, become an investment company, move into consulting, or enter some other business.
II. PARTIES' CONTENTIONS
Quadrangle asserts in its complaint that Kenetech effectively approved a liquidation of the company at its October 24, 1996 board meeting or sometime between that date and May 14, 1998, the date of the PRIDES mandatory conversion. They point to the following language in the PRIDES' Certificate, which provides a liquidation preference for the PRIDES holders in the event of a liquidation:
In the event of any voluntary or involuntary liquidation, dissolution, or winding up of the Corporation and subject to the rights of holders of any other series of Preferred Stock, the holders of outstanding shares of PRIDES are entitled to receive the sum of $1012.50 per share [the "Liquidation Preference"], plus an amount equal to any accrued and unpaid Preferred Dividends thereon . . .
Certificate § 9.
Quadrangle raises Kenetech's decision to sell its assets, fire most of its workers, prepay Lerdal's severance allowance, and — after the mandatory conversion — pay off the Senior Notes as evidence that the board approved a de facto liquidation. It argues that these actions triggered this Liquidation Preference and seeks a court order forcing Kenetech to pay each PRIDES holder $1012.50 per share (or a prorata amount if the company lacks the proceeds to pay the entire preference).
Kenetech argues that no liquidation preference is due. First, it notes that the board never formally declared a § 275 liquidation, which requires a shareholder vote. Second, it argues that the acts supposedly constituting a "constructive liquidation" could be interpreted as the acts of a corporation trying to pay off its debt and possibly move into new business lines. Because the significance of those acts is ambiguous, Kenetech believes that Quadrangle has not met its burden of proof. Third, Kenetech disputes whether Delaware law recognizes a "constructive liquidation." Fourth, Kenetech notes that a liquidation requires sale of all assets, declaration of a liquidation dividend, and abandonment of the corporate form. It notes that neither the sale of EcoElectrica nor declaration of a liquidation dividend occurred before the PRIDES were mandatorily converted into common shares on May 14, 1998. Furthermore, Kenetech continues (albeit in a diminished capacity) to operate. Fifth, Kenetech notes that a sale of all or substantially all of its assets is expressly defined under the certificate to not constitute a liquidation:
a sale, lease or exchange of all or substantially all of the assets of the Corporation shall not be deemed to be a voluntary or involuntary liquidation, dissolution or winding up of the Corporation.
Id.
This language, Kenetech argues, protects the most significant of its actions from the remedy sought here. Finally, Kenetech argues that the PRIDES' mandatory conversion extinguished the PRIDES holders' liquidation preference rights on May 14, 1998, making this action illusory. The mandatory conversion provides:
Unless previously either redeemed or converted at the option of the holder in accordance with the provisions of Section 3(c), on May 14, 1998 (the "Mandatory Conversion Date"), each outstanding share of PRIDES shall mandatorily convert ("Mandatory Conversion") into (i) shares of authorized Common Stock at the PRIDES Common Equivalent Rate (as defined herein) in effect on the Mandatory Conversion Date and (ii) the right to receive cash in an amount equal to all accrued and unpaid Preferred Dividends on such share of PRIDES (other than previously declared dividends payable to holder of record as of a prior date) from and after the Mandatory Conversion Date, whether or not declared, out of funds legally available for the payment of Preferred Dividends. . . .
Certificate § 3.
III. RULINGS
This action raises the difficult issue of the board's duty towards preferred shareholders within the context of managing a corporation bordering on insolvency. The facts show that Kenetech's board was caught between the conflicting demands of its Senior Note holders and its duty towards its equity holders. As a general principle, a board owes fiduciary duties towards its shareholders, not its debt holders. The rights of debt holders are restricted to those provided in the instrument creating the debtor/creditor relationship.However, in this case, Kenetech defaulted on its interest payments on the Senior Notes. This triggered the right of the note holders to place Kenetech in bankruptcy. As demonstrated in the liquidation analysis prepared for the board's October 24, 1996 board meeting, the effect of bankruptcy at that point would be to nullify the value of Kenetech's common. Thus, it was in the best interests of Kenetech's common shareholders to placate the Senior Note holders. Kenetech convinced the note holders' committee to refrain from filing an involuntary bankruptcy petition and sought to maximize the sale price of EcoElectrica in order to satisfy the notes and (possibly) retain some value for the common shareholders. Those actions were reasonable in light of Kenetech's situation and comported with the board's fiduciary duties towards its common shareholders.
The focus then turns to what duties the board owed the PRIDES holders in the midst of Kenetech's crisis and whether those duties were met. It is oft noted that a preferred shareholder's rights are those specified in the certificate of designation, but existing precedent also supports the proposition that in so far as their interests are harmonious, preferred shareholders share with common shareholders the right to demand loyalty and care from the fiduciaries entrusted with managing the corporation. A preliminary question then is whether this matter is resolved as a matter of fiduciary or contract law.
E.g. Judah v. Delaware Trust Co., Del. Supr., 378 A.2d 624, 628 (1977) ("Generally, the provisions of the certificate of incorporation govern the rights of preferred shareholders, the certificate of incorporation being interpreted in accordance with the law of contracts, with only those rights which are embodied in the certificate granted to preferred shareholders."). As with all contracts, however, the rights and obligations expressed in the certificate are protected by an implied covenant of good faith and fair dealing. Glinert v. Wickes Cos., Inc., Del. Ch., C.A. No. 10407, mem. op. at 22, 16 Del. J. Corp. L. 764, 781, Allen, C. (Mar. 27, 1990) (holding "even holders of preferred stock, insofar as the rights of preference against the common stock are concerned are not owed a duty of loyalty, even if they may be owed a contractual duty of good faith.").
Gale v. Bershad, Del. Ch., C.A. No. 15714, mem. op. at 14, Jacobs, V.C. (Mar. 4, 1998) (noting that fiduciary duties attach to a preferred shareholder's right created not as a preference, but shared with the common); Jedwab v. MGM Grand Hotels, Inc., Del. Ch., 509 A.2d 584, 594 (1986) (stating that preferences were governed by contract law and rights shared with the common were subject to standards of fiduciary law).
The PRIDES shareholders' right to a liquidation preference places them in an economically antagonistic relationship with the common. Therefore, to the extent that the PRIDES shareholders enjoy liquidation rights preferential to those of the Kenetech common shareholders, those rights must be spelled out in the Certificate. "Nothing is to be presumed in favor of preferences attached to stock, but rather they must be expressed in clear language."
Rothschild Int'l Corp. v. Liggett Corp Inc., Del. Ch., 463 A.2d 642, 646 (1983) [hereinafter Rothschild Trial ].
As mentioned earlier, the Certificate expressly provides for payment of a special preferential dividend to the holders of PRIDES in the event of a liquidation, dissolution or winding up of Kenetech:
In the event of any voluntary or involuntary liquidation, dissolution, or winding up of the Corporation and subject to the rights of holders of any other series of Preferred Stock, the holders of outstanding shares of PRIDES are entitled to receive the sum of $1012.50 per share [the "Liquidation Preference"], plus an amount equal to any accrued and unpaid Preferred Dividends thereon, out of the assets of the Corporation available for distribution to stockholders, before any distribution of assets is made to holders of Junior Stock.
Certificate § 9.
Thus, the outcome of this dispute comes down to whether the acts taken by Kenetech between 1996 and 1998 fall within the meaning of "liquidation" as that term is used in the Certificate. The first step in resolving that question is to define the term. Chancellor Brown faced a similar claim by a preferred shareholder that the company's merger constituted a "constructive liquidation" that triggered the preferred share's liquidation preference. The Chancellor rejected that allegation. He noted that even though the preferred shares were extinguished by the transaction, the "corporation did not sell off all of its assets, pay its obligations, distribute the remaining proceeds to its shareholders and cease to exist as a corporate entity." The Supreme Court affirmed the Chancellor, holding "[o]ur view of the record confirms the correctness of the Chancellor's finding that there was no "liquidation" of Liggett within the well-defined meaning of that term." I adopt Chancellor Brown's elements of liquidation: (1) sale of assets; (2) paying off of creditors; (3) distribution of remaining proceeds to shareholders; and (4) abandonment of corporate form.
The parties focus exclusively on the term "liquidation" and I perceive no reason why the outcome would be any different if they litigated over the meaning of "dissolution" or "winding up."
Del. Ch., 463 A.2d 642 (1983).
Id . at 646.
Rothschild Int'l Corp. v. Liggett Group Inc., Del. Supr., 474 A.2d 133, 136 (1984) (holding the "term `liquidation,' as applied to a corporation, means the `winding up of the affairs of the corporation by getting in its assets, settling with creditors and debtors and apportioning the amount of profit and loss."') [hereinafter Rothschild Appeal ]. The Rothschild Appeal cites Fletcher's treatise on corporations for the definition of liquidation, but it does so by affirming Brown's use of the term. As a matter of interpretation, this raises the question of whether the Fletcher citation is intended to replace the Chancellor's definition of liquidation or is merely additional support for the Supreme Court's conclusion that the Chancellor correctly defined the term. I conclude that it is the latter because the Fletcher definition does not expressly include abandonment of corporate form as an element of liquidation, but the Supreme Court points to this element, which was raised by the Chancellor, as one of the reasons that his understanding of the term liquidation was correct. The Supreme Court states, "the fact is that Liggett has retained its corporate identity." Rothschild Appeal, 474 A.2d at 136. See also Rosan v. Chicago Milwaukee Corp., Del. Ch., C.A. No. 10526, mem. op. at 9, Chandler, V.C. (Feb. 6, 1990) (holding "two of the central characteristics of a liquidation are the winding up of the corporation's affairs and the abandonment of its corporate identity.").
Here, the Certificate modifies the term "liquidation" as it is used in Delaware case law: "a sale, lease or exchange of all or substantially all of the assets of the Corporation shall not be deemed to be a voluntary or involuntary liquidation." Chancellor Brown noted that the company in Rothschild had preferred shares with a virtually identical provision. He wrote that this provision was designed to reinforce the concept of independent significance: "that a merger, a sale of assets or certain other transactions would not constitute a "liquidation" for the purpose of the liquidation rights given to the $5.25 Convertible Preferred." Here as well, the sale of all Kenetech's assets cannot be deemed a constructive liquidation even though sale of assets is one of the elements of a liquidation. The Certificate's language does not, however, preclude a claim for a "constructive liquidation" that included asset sales. It merely requires more. The circumstances of this case suggest a modification of the Chancellor's definition of liquidation to add element three:
Rothschild Trial, 463 A.2d at 645.
(1) sale of assets (or subsidiaries);
(2) paying off of creditors;
(3) otherwise winding up business affairs;
See Rosan, supra note 21, at 9 (holding that one central characteristic of liquidation is winding up of corporation's affairs).
(4) distribution of remaining proceeds to shareholders; and
(5) abandonment of corporate form.
In enumerating these five elements, I do not conclude that Quadrangle must establish each element. Instead, applying these five factors, Quadrangle must establish by a preponderance of the evidence that Kenetech's board had committed unambiguously to a liquidation of the corporation and not some other lawful course of action permitted under the Certificate.
After exploring the basic meaning of "liquidation" within this particular Certificate, it is necessary to consider the modifiers prefacing the term and the implication of other language within the Certificate which might further change its meaning. The Certificate's liquidation preference is triggered by a "voluntary or involuntary liquidation." What does the prefatory language "voluntary and involuntary" mean? That language is designed to capture two types of events: (a) a court-ordered liquidation of Kenetech caused by a third party such as a creditor and (b) a voluntary liquidation approved by the Kenetech board.
First, for an involuntary liquidation to occur, the third-party group with the right to force Kenetech into liquidation (by petitioning for bankruptcy) in these circumstances was the Senior Note holders (represented in part by the note holders committee). The Certificate makes the PRIDES holders' liquidation preference dependent upon the right of the Kenetech debt holders to force a liquidation. Where, as here, the debt holders forgo an immediate liquidation because they deem that an orderly sale of assets will produce the best return for themselves, the preferred shareholders must suffer in silence. If Kenetech defaults, the debt holders may force a liquidation if they deem it in their own best interests to do so, but they are under no obligation to do so. If they do not, the PRIDES holders are without recourse. The meaning of "involuntary" is that the PRIDES liquidation preference is contingent upon the debt holders or another third party's decision to force a liquidation.
The second type of event triggering the PRIDES liquidation preference is a "voluntary" liquidation. Normally, one would expect a "voluntary" liquidation to be a liquidation formally approved by the board and voted upon by the shareholders under 8 Del. C. § 275. It is unnecessary to conclude whether the board's resolution or the shareholders' vote of approval would be the act triggering the PRIDES liquidation preference. Neither took place. Here, however, the board approved steps that are similar (if not identical) to a liquidation, but without any formal resolution. Consequently, I must decide whether discretionary acts that fall within the scope of acts typically occurring during a liquidation — but are otherwise permitted — constitute a constructive "voluntary liquidation" in the absence of a formal decision to liquidate the company.
The Certificate carves out an exception for certain activities — mergers and a sale of all the assets — that fall within the scope of liquidating acts. A merger or sale of assets might result in the corporation's liquidation of its assets, but the corporation could remain in business. Thus, this carve out protects the board's freedom to engage in a merger or sale of assets without a challenge from the preferred. It reinforces the sense that the word "voluntary" means the idea that the liquidation is an act approved by the exercise of the board's (and shareholders') free will. Thus, against this express grant of discretionary authority to the board, I must define the circumstances under which I might find that Kenetech "constructively" liquidated directly as a result of the board's intentional acts.
BLACK'S LAW DICTIONARY defines "voluntary" to mean: "Done by design or intention, purpose, intended. . . . Produced in or by an act of choice. . . . Resulting from choosing." BLACK'S at 1746-47 (4th ed. 1968).
In light of the discretionary authority protected by the carve out and this Court's traditional reluctance to create preferential rights not found in the Certificate, I conclude that the only way that Kenetech could be found to be in constructive liquidation would be if the board acted in bad faith. In other words, to prevail, Quadrangle must show that Kenetech's board approved a course of action that unambiguously and inexorably would lead to liquidation and must further show that the board attempted to liquidate Kenetech with the intention of dishonoring the PRIDES' liquidation preference.
If Quadrangle convincingly demonstrated that Kenetech engaged in a bad faith liquidation of the corporation, that act would also violate the common shareholders' right to approve the liquidation under 8 Del. C. § 275.
The PRIDES Certificate, as with all contracts, contains an implied covenant of good faith and fair dealing. "In rare circumstances, an implied covenant of good faith and fair dealing plays a narrow but necessary role, prohibiting opportunistic conduct that defeats the purpose of the agreement and runs counter to the justified expectations of the other party." It protects a party from arbitrary or unreasonable conduct that would deny it the fruits of the bargain without violating an express term of the contract. Here, the covenant would protect a PRIDES holder from a de facto liquidation designed to frustrate the holder's right to a liquidation preference. To substantiate a breach of this implied covenant, however, the PRIDES holder must prove that Kenetech's board intentionally embarked upon a course of action tantamount to a liquidation and did so in bad faith.
Wilgus v. Salt Pond Inv. Co., Del. Ch., 498 A.2d 151, 159 (1985).
Hudson v. Wesley College, Del. Ch., C.A. No. 1211-K, Mem. Op. at p. 32, Steele, V.C. (Dec. 23, 1998), . aff'd, Del. Supr., No. 29, 1999, (June 30, 1999) (Order).
Wilgus, 498 A.2d at 151 (holding that implied covenant "requires a party in a contractual relationship to refrain from arbitrary or unreasonable conduct which has the effect of preventing the other party from receiving the fruits of the contract.").
Within a claim for breach of the implied covenant, this element of intent or bad faith has been defined by the Supreme Court as follows:
[The] term "bad faith" is not simply bad judgement or negligence, but rather it implies the conscious doing of a wrong because of dishonest purpose or moral obliquity; it is different from the negative idea of negligence in that it contemplates a state of mind affirmatively operating with furtive design or ill will.Desert Equities, Inc. v. Morgan Stanley Leveraged Equity Fund, L.P., Del. Supr., 624 A.2d 1199, 1209 n. 16 (1993) (citing BLACK'S LAW DICTIONARY 72 (5th ed. 1983)).
Before moving to that analysis, it is worth noting that the PRIDES' mandatory conversion date, May 14, 1998, limits the temporal viability of Quadrangle's claim. As of that date, the rights of PRIDES holders were extinguished. Even if Kenetech eventually does decide upon a plan of liquidation, that decision will necessarily take place after the mandatory conversion. Consequently, Quadrangle must show that Kenetech's board breached the liquidation preference's implied covenant before that date. It may, however, do so by showing that the board unambiguously committed to Kenetech's liquidation by May 14, 1998, but intentionally delayed the liquidation until after that date for the purpose of avoiding the liquidation preference.
For the following reasons, I conclude that Quadrangle failed to prove by a preponderance of the evidence that Kenetech delayed the sale of EcoElectrica in bad faith. Without convincing evidence that Kenetech's board delayed a decision to liquidate in bad faith in order to frustrate the liquidation preference, the PRIDES holders cannot escape the mandatory conversion of their shares into common stock.
A. Sale of assets (or subsidiaries)
One of the most difficult aspects of this case is the liquidation exception for sale of all or substantially all of Kenetech's assets. The sale of assets is such a fundamental or integral part of a liquidation that it is almost impossible to give meaning to the term liquidation without considering this element. Accordingly, I find that the asset sale exception was not designed to remove evidence of asset sales from an examination of Kenetech's overall conduct, but to exclude an asset sale alone from being considered a liquidation without evidence of other conduct falling within the meaning of that term. Therefore, I will accord Quadrangle's evidence of asset sales cumulative significance in determining whether the Board intended to liquidate Kenetech before May 14, 1998.
Kenetech sold the majority of its assets (except EcoElectrica) before the mandatory conversion. This evidence lends cumulative support to the allegation that Kenetech was in constructive liquidation before the mandatory conversion. Moreover, it is clear that the board committed Kenetech to the sale of all assets at the October 24, 1996 meeting. That decision too must be given cumulative, but not independently dispositive significance.
On the other hand, Kenetech convinced me that the delays in selling EcoElectrica, not actually disposed of until December 1998, were the result of bureaucratic inefficiencies, governmental hurdles and difficulties with Enron. These problems gave the Kenetech board's delay in liquidating legitimacy until after December 1998. The mere fact that there was delay in selling EcoElectrica cannot itself be evidence that the Board intentionally delayed liquidating Kenetech in bad faith.
B. Paying off creditors
Kenetech paid off its largest outstanding creditors, the holders of Senior Notes, after the sale of EcoElectrica. This event took place after the mandatory conversion date and cannot support Quadrangle's claim.
C. Otherwise winding up business affairs
Lerdal, and the other Kenetech witnesses candidly admitted that Kenetech laid off most of its workers and cancelled its new business ventures in the period between 1996 and 1998. It prepaid its CEO and CFO's severance allowances. This evidence strongly suggests that Kenetech intended to shut down operations. It can also be fairly construed, however, to be a sign that Kenetech intended to discontinue its operations after paying off the Senior Notes.
D. Distribution of remaining proceeds to shareholders Abandonment of corporate form .
Quadrangle offered no credible evidence that Kenetech ever decided to make a final distribution or abandon its corporate form before the mandatory conversion. It showed that the board considered these options at the October 24, 1996 (and its next) board meeting. But, the board never committed to these options. The crucial difference between selling assets to satisfy creditors (while remaining in business) and liquidating is found in the last two elements of liquidation, distribution and abandonment. With no evidence of these two elements, Quadrangle's evidence about asset sales and paying off the Senior Notes leaves the issue susceptible to two inconsistent but equally plausible conclusions. That is to say, it can be viewed as consistent with paying off the Senior Notes and moving on to other ventures as with a liquidation. Accordingly, Quadrangle has failed to convince me that Kenetech unequivocally committed to a liquidation before the mandatory conversion date.
E. Bad Faith
The evidence shows that Kenetech began selling all its assets before KWI filed for bankruptcy. Kenetech intended to rescue the windmill business. When it became clear that saving KWI was impossible, Kenetech approved the subsidiary's bankruptcy in May 1996. Soon thereafter, in June, Kenetech defaulted for the first time on an interest payment for the Senior Notes. This placed the board under enormous pressure after the note holders demanded formation of a committee to safeguard their investment in the financially troubled company.
At Kenetech's next board meeting, the board decided to move forward with the sale of Kenetech's remaining assets, including EcoElectrica and to otherwise shut down Kenetech's current operations. These actions were all in accord with a liquidation, but they are equally in accord with the board's avowed plan to satisfy the note holders and then revisit the company's future.
Neither side focused on the relevance of 8 Del. C. § 271 to Kenetech's systematic sale of all its assets.
That next reassessment could not take place until Kenetech sold EcoElectrica. Kenetech sold the project after the mandatory conversion date and then paid off the Senior Notes. Quadrangle failed to produce convincing evidence that this delay resulted from Kenetech's intentional attempt to frustrate the PRIDES holders' right to a liquidation preference. I see no credible evidence that otherwise demonstrated a bad faith delay in deciding to sell EcoElectrica.
As of the time of the mandatory conversion, the evidence shows that Kenetech was shutting down operations and selling assets. To elevate these acts to a de facto liquidation would be to ignore the fact that the board sought to retain the flexibility to enter into new lines of business after paying off the Senior Notes. I cannot ignore the board's right to put off the decision of whether to liquidate or not until the last possible moment — unless the delay was taken in bad faith.
I realize that Quadrangle put on evidence of two events that arguably constituted breaches of fiduciary duty: (1) Lerdal's $1000 purchase of 13 million Kenetech common shares and (2) prepayment of Lerdal's severance allowance. A fiduciary who usurps an economic opportunity properly belonging to the corporation violates his or her duty of loyalty to the shareholders. By not offering the 13 million shares to the corporation, Lerdal arguably denied it the opportunity to buy back its own shares at a huge discount. Even the restrictions in the Senior Notes and PRIDES cannot explain Lerdal's unilateral action.
The evidence as to Alvarez' pre-funded severance allowance fails to constitute bad faith for the same reasons that apply to Lerdal's.
Guth v. Loft, 5 A.2d 503, 508, Del. Supr., (1939) (setting forth corporate opportunity doctrine).
While this conduct may be a breach of fiduciary duty, it is not an act of bad faith which would sustain a breach of the Certificate's implied covenant. Although Lerdal's ownership of 30% of Kenetech's outstanding common shares provides an economic incentive for him to prevent the PRIDES holders from receiving a liquidation preference, the Hillman offer took place after Kenetech convinced the Senior Note holders to afford Kenetech enough time to sell EcoElectrica. Lerdal's self-dealing does not necessarily implicate the entire four person Kenetech board in a self-interested transaction orchestrated to dilute the PRIDES holders' equity in the common after conversion.
The transaction was potentially unfair to common shareholders as well because it denied them the value enhancement that one would expect from a share repurchase by Kenetech at such a low price. Where the wrong harmed all shareholders, it cannot be a basis for relief to the preferred alone. It is not specifically directed against the PRIDES; therefore, it cannot be the basis of relief that favors the preferred shareholders over the common.
See Rosan, supra note 21, at 12 (dismissing "constructive liquidation" claim where "[t]he intent of the directors appears to be inferred from the fact that they are holders of common and not preferred stock. Such as inferential allegation of intent is conclusory and inadequate in nature.").
Unarguably, the prepayment of Lerdal's severance allowance took place under suspicious circumstances. It is unclear how the Kenetech compensation committee arrived at its decision to pay Lerdal's income tax. This compensation, if it was improper, gave rise to a claim for breach of fiduciary duty shared by common and preferred shareholders alike. It is not a fact supporting intent to frustrate the PRIDES holders' right to a liquidation preference — the intent necessary for a successful claim for breach of the Certificate's implied covenant of good faith and fair dealing.
IV. CONCLUSION
This is a case where the board's strategic possibilities were restricted by the need to raise funds for the Senior Note holders. By engaging in raising capital and cost cutting activities that involved selling assets, laying off workers, and canceling new projects, Kenetech performed tasks that fall within activities commonly associated with a liquidation. But, those tasks were otherwise within the bounds of the board's authority and can be plausibly explained as an attempt to pay off the note holders and avoid the consequences of an involuntary liquidation.
The PRIDES liquidation preference was contingent upon either a third party such as the Senior Note holders forcing Kenetech into liquidation or upon the Kenetech board approving a voluntary liquidation with shareholder approval. Neither happened. To allow Quadrangle to prevail on its claim would be to allow the PRIDES holders to usurp the decision making process contractually delegated to either third parties (such as the note holders) or the board (with shareholder approval). That would create a new right for the preferred not present in the Certificate. Plaintiffs' claim, therefore, had to be analyzed as one for breach of an implied covenant of good faith and fair dealing. Because Quadrangle's evidence of a defacto or constructive liquidation was equally consistent with a reasonable plan to pay off Senior Note holders and preserve equity in the corporation and because Quadrangle failed to produce convincing evidence of bad faith on the board's part, I cannot conclude that Kenetech breached the Certificate's implied covenant of good faith and fair dealing.
Accordingly, I grant judgment in favor of defendant Kenetech.
IT IS SO ORDERED.
_________________ Vice Chancellor