Don't Pay Twice for Your Equity!

In certain cases, a company may seek to exchange its outstanding debt for equity while also extinguishing (or 'squeezing-out') the interests of some or all of its prior shareholders. The need to reduce or eliminate shareholders typically stems from perfectly valid business reasons, including a desire to avoid becoming a reporting company under federal securities laws, to limit ongoing obligations to many small shareholders or to change the equity sponsor. In addition, the parties may seek to effect the transaction 'out-of-court' due to a perception (or the reality) that bankruptcy proceedings would take longer or damage the business.

One commonly used non-bankruptcy mechanism to eliminate shareholders and to vest ownership with the holders of exchanged debt is a statutory cash-out merger. Other mechanisms, such as pre-exchange or post-exchange reverse splits, although on their face attractive, may be more trouble than they are worth. Such mechanisms will not avoid the basic obligation to pay 'fair value' for fractionalized shareholders, some of the increase in equity value resulting from debt cancellation. For these reasons, as well as the accepted protections found in statutory mergers, a merger's certainty might be preferred. Although the cash-out merger is relatively straightforward, its use creates unique issues that necessitate specialized structuring. One such potentially costly issue is the impact of statutory shareholder appraisal rights after the transaction. If mismanaged or overlooked at the structuring stage, these appraisal rights can result in an intrusive court process and in significant payments to prior shareholders. Notwithstanding the potential cash outlay, the issue of appraisal rights risks being overlooked for two reasons: First, it seemed obvious to all involved that the old equity has no value and is clearly 'under-water.' Second, the question was delegated to the company's counsel whose focus was on matters that directly affect existing officers, directors and shareholders (such as signing, closing and releases) and not on matters with post-closing consequences only to new ownership. Experience shows that, due to misaligned incentives, other issues may be 'glossed over' by the company's counsel. For example, Board approval for the merger may be treated as a purely 'technical' matter even though Delaware courts can be unforgiving and deny important Business Judgment Rule protection to directors who do not inform themselves and discuss alternatives in an actual meeting when approving the merger. As a seemingly basic but sometimes ignored rule of thumb: Have the meeting and document legal and financial advice and other material factors considered. Since former directors may be indemnified, the new owners should demand this simple act of compliance and risk management.