Venture-backed companies doing investor-led “down round” financings are often concerned about the risk of litigation associated with these transactions. Down-round financings are frequently led by investors with board representation, and can lead to claims of self-dealing and breach of fiduciary duty.

The transactions often involve “pay-to-play” provisions in which stockholders who do not participate in the financing are converted into common stock, or suffer some other adverse consequence. Counsel is frequently consulted to offer structuring suggestions to help insulate these financings from attack by disgruntled stockholders. Now, for the first time, in WatchMark Corp. v. ARGO Global Capital LLC, a Delaware court has addressed the issues raised by a standard “pay to play” financing.

Practical Guidance

The WatchMark case offers important practical guidance to venture capitalists and emerging companies seeking to implement financings with “pay-to-play” provisions. Based on the WatchMark case, these are the lessons for companies intending to use pay-to-play provisions as part of a financing strategy:

• Offering existing stockholders the right to participate in the financing will provide significant protection against legal challenges.
• “Pay-to-play” provisions should ideally be structured to penalize non-participating stockholders only pro-rata in proportion to the extent of their non-participation.
• Exposure for breach of fiduciary duties in a down-round is reduced if the potential plaintiffs are preferred stockholders.
• It is very important that the record show that the board carefully considered the transaction involving the down-round financing, and determined after a careful review that the financing was in the best interest of the company’s stockholders.

Analysis of WatchMark Corp. v. ARGO Global Capital, LLC

Delaware Chancery Court case WatchMark Corp. v. ARGO Global Capital, LLC (Nov. 4, 2004), involved WatchMark, a venture-backed company that needed to raise cash for an acquisition that was essential to the company’s future. To raise the necessary funds, WatchMark proposed to issue a new Series F Preferred Stock, and the company’s investors were invited to participate in the negotiation of a term sheet. After the key terms had been agreed upon, WatchMark invited its significant investors to participate in the round. In response, several funds managed by ARGO Global Capital ("ARGO") indicated that they would not participate.

The financing involved a pay-to-play feature in which any non-participating investor would have its preferred stock converted to common stock. Under the “protective provisions” of WatchMark's certificate of incorporation, the amendment to the company’s certificate of incorporation necessary to implement the financing required the approval of 80% of each series of preferred stock. Because ARGO owned enough shares to block this amendment, WatchMark planned instead to amend its certificate of incorporation through a merger to eliminate the 80% vote requirement. Once the 80% vote requirement was eliminated, the financing could go ahead.

To address ARGO's opposition, WatchMark sought a declaratory judgment from the Delaware courts that its plans were lawful — and the Delaware Chancery Court held in favor of WatchMark.

First, the Court found that the protective provisions of the existing preferred stock did not apply to mergers, and that the elimination of the 80% voting threshold through the merger was lawful. Next, the court addressed claims that the investor board members had breached their fiduciary duties to WatchMark’s stockholders. Importantly, the Court noted that fiduciary duties to preferred stockholders are more limited than the fiduciary duties owed to common stockholders. In deciding that no fiduciary duties were breached, the Court placed great weight on the opportunity given to all preferred holders to participate in the offering:

“All preferred stockholders have an equal opportunity to participate [in the financing]. Only if a preferred stockholder chooses, of its own volition, not to participate in the new Series F issuance will its shares be converted into common. Any disparate treatment between the preferred stockholders is therefore a self-imposed consequence and not the result of any self-dealing.”

The Court made similar observations with respect to the merger, noting that the change in voting rights affected all preferred stockholders equally. In finding that the transaction was "not the result of any self-dealing," the Court stated that ARGO needed to show that the other investors "through the acts of their director-representatives, obtain[ed] a benefit from the merger and Series F financing to the exclusion or detriment of ARGO." In reaching its result, the Court specifically noted that the pay-to-play provision converted preferred shares to common stock "only to the pro rata extent of [the investor’s] non-participation."

For additional information, please contact Michael Sullivan (415.399.3017, msullivan@howardrice.com) or your usual Howard Rice attorney to discuss this issue.

Related Groups:

• Corporate & Securities
• Financial Institutions & Services
• Mergers & Acquisitions
• Securities Litigation

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