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A Theory of Preferred Stock

Should preferred stock be treated under corporate law as an equity interest in the issuing corporation or under contract law as a senior security? Should a preferred certificate of designation be subsumed in the corporate charter and treated as an incomplete contract filled out by fiduciary duty, or should it be treated as a complete contract with the drafting burden on the party asserting the right, as would occur with a bond contract? Is preferred stock equity or debt? This Article shows that preferred stock is both corporate and contractual—neither all one nor all the other. It sits on a fault line between two great private law paradigms, corporate and contract law, and draws on both. The overlap brings two competing grundnorms to bear when interests of preferred and common stockholders come into conflict: on the one hand, managing to the common stock as residual interest holder maximizes value; on the other hand, holding parties to contractual risk allocations maximizes value. When questions arise concerning the relative rights of preferred and common stock, the norms hold out conflicting answers. Delaware courts have taken the lead in confronting these questions by seeking to synchronize the law of preferred stock with the rest of corporate law—a project that has led to both innovation and stress.

This Article examines recent cases about preferred stock to show two facets of Delaware law coming to bear as the synchronization process proceeds: first, reliance on independent directors for dispute resolution, and second, the common stock– value maximization norm. These trends cause the law to tilt toward corporate norms, thereby disrupting allocated risks in heavily negotiated transactions, particularly in the venture capital sector. The Article makes three recommendations that would promote the goal of restoring balance between the corporate and contract paradigms. First, the meaning and scope of preferred contract rights should be determined by courts, rather than by issuer boards of directors. Second, conflicts between preferred and common should not be decided by reference to a norm of common stock–value maximization. Instead, the goal should be the maximization of the value of the equity as a whole. Third, independent-director determinations of conflicts between preferred and common should not be accorded ordinary business judgment review. Instead, a door should be left open for good faith review tailored to the context. This review would require a showing of bad faith treatment of the preferred where the integrity of a deal has been undermined, with the burden of proof on the board.