Corporate Governance

MCG Capital v. Maginn: Preferred Stockholders and the Right to Bring Derivative Suits

By Daniel Snare

In MCG Capital Corporation v. Maginn, Civil Action No. 4521-CC, 2010 Del. Ch. LEXIS 87 (Del. Ch. May 5, 2010), the Delaware Chancery Court addressed whether preferred stockholders have standing to bring derivative actions on behalf of the corporation in the same way that common stockholders do.   In a lengthy opinion, the court held that preferred stock holders do, in fact, have equal standing to sue, absent express limitation in the corporation's charter or other documents.  The decision expands the potential pool of derivative plaintiffs.     

The Defendant, Jenzabar, Inc. ('Jenzabar'), is a Boston software company.  The Plaintiff, MCG Capital Corporation ('MCG'), is a publically traded investment company that invested in Jenzabar.  MCG loaned Jenzabar $30 million, becoming the majority holder of its outstanding warrants and sole holder of its senior preferred shares.  At the time, MCG did not own a single share of Jenzabar's common stock. 

In return, MCG obtained special consent rights codified in Jenzabar's amended charter and a Preferred Stock and Warrant Purchase Agreement ('PSWPA') negotiated by the parties.  These consent rights (1) prohibited Jenzabar from entering into certain transactions with 'affiliates' without MCG approval; (2) conditioned Jenzabar's repurchase of MCG's preferred stock position on repayment of the $30 million dollar loan; and (3) allowed MCG to appoint one director to the five-member Board of Directors.

Three key events caused Jenzabar to file a twelve-count complaint alleging, among other things, breach of contract and breach of fiduciary duties. 

First, Jenzabar's compensation committee, without MCG approval, approved retroactive bonuses and salary increases for Jenzabar Chairman and CEO Robert Maginn and his wife, Jenzabar COO Ling Chai.  Both Maginn and Chai appointed themselves to the Jenzabar Board of Directors, and were considered ‘affiliates' under the PSWPA, purportedly violating MCG's consent rights. 

Second, the Jenzabar Board, again without MCG approval, re-approved a bonus for Maginn which was previously approved in 2002 prior to MCG's investment; that bonus was never paid. 

Finally, Jenzabar decided to exercise its contractual repurchase rights of its senior preferred stock held by MCG, which, according to MCG, was designed to force the investor to choose between selling its warrants at an unfavorable price or lose is valuable consent rights.  MCG maintained the repurchase was intended to eliminate its right to object to the salary increases and bonuses to be paid to Maginn and Chai.  

Defendants sought to dismiss the direct claims under Rule 12(b)(6) and the derivative claim for failing to make demand.  Before resolving the issues, the Chancery Court noted that the right of preferred shareholders to bring derivative suits amounted to an issue of first impression (preferred shareholders had maintained derivative actions but the legal issue had not been raised and addressed).  MCG owned preferred stock and common stock warrants.  As the court noted, however:  "Delaware law is clear that holders of common stock warrants do not have standing to bring a derivative suit."

MCG argued that the distinction in standing between holders of preferred and common stock was irrelevant because both enjoyed the same rights and remedies unless modified by contract.  In addition, Delaware statutes allowed corporations to limit stockholder standing by class of stock owned, but first required that such limitations on a class of stock be expressed in either the corporation's charter or the preferred stock designations themselves.

Janzabar, on the other hand, argued that to grant preferred stock holders standing to bring derivative actions as a matter of law should be strictly limited.  Jenzabar argued that such actions should be allowed only where (1) preferred shares participate proportionally with common stockholders in dividends and liquidation payments; or (2) only when preferred stockholders, like creditors, take the place of common shareholders in the event of insolvency, thus becoming residual beneficiaries of a change stock value.   

The court adopted MCG's view, and held that,  '…all stock is created equal.  By this I mean that all classes of stock enjoy the same rights and privileges unless an affirmative expression alters those rights…' MCG v. Maginn at *6.  

The court further reasoned that Section 327 of the Delaware Corporate Code governing derivative shareholder lawsuits requires only that a plaintiff be a 'shareholder' at the time of the questionable transaction, making no distinction between common or preferred stock classes.  Importantly, the court reiterated the Delaware Supreme Court's holding in Matulich v. Aegis Comm. Group, Inc., that any rights or limitations on preferred stock which are different from common stock must be expressly provided for, and no special right or limitation will ever be implied. 

Having resolved this issue in favor of Jenzabar, the court proceeded to grant in part, and deny in part, Jenzabar's Motion to Dismiss eleven of the twelve counts in the Complaint.  

Practically, however, this case represents the Chancery Court's first explicit holding that preferred stockholders have a right to bring derivative lawsuits on behalf of the corporation.  However, the court emphasized that this standing to sue is not absolute, and can be limited by the issuer in its charter, the preferred stock designations, or by contract.  Thus, Delaware corporations will now presumably look very closely at the possibility of imposing limitations on their preferred stock in order to limit exposure to derivative suit liability from holders of their preferred stock.  

The primary materials for this case may be found on the DU Corporate Governance website.  

Full post as published by The Race to the Bottom on October 01, 2010 (boomark / email).