ELLIOTT ASSOCIATES, L.P. v. AVATEX CORP.

VEASEY, Chief Justice:

In this case of first impression, we hold that certain preferred stockholders have the right to a class vote in a merger where: (1) the certificate of incorporation expressly provides such a right in the event of any "amendment, alteration or repeal, whether by merger, consolidation or otherwise" of any of the provisions of the certificate of incorporation; (2) the certificate of incorporation that provides protections for the preferred stock is nullified and thereby repealed by the merger; and (3) the result of the transaction would materially and adversely affect the rights, preferences, privileges or voting power of those preferred stockholders. In so holding, we distinguish prior Delaware precedent narrowly because of the inclusion by the drafters of the phrase, "whether by merger, consolidation or otherwise."

Facts

Defendant Avatex Corporation ("Avatex") is a Delaware corporation that has outstanding both common and preferred stock. The latter includes two distinct series of outstanding preferred stock: "First Series Preferred" and "Series A Preferred."1 Plaintiffs in these consolidated cases are all preferred stockholders of defendant Avatex. The individual defendants are all members of the Avatex board of directors.

Avatex created and incorporated Xetava Corporation ("Xetava") as its wholly-owned subsidiary on April 13, 1998, and the following day announced its intention to merge with and into Xetava. Under the terms of the proposed merger, Xetava is to be the surviving corporation. Once the transaction is consummated, Xetava will immediately change its name to Avatex Corporation. The proposed merger would cause a conversion of the preferred stock of Avatex into common stock of Xetava.2 The merger will effectively eliminate Avatex' certificate of incorporation, which includes the certificate of designations creating the Avatex preferred stock and setting forth its rights and preferences.3 The terms of the merger do not call for a class vote of these preferred stockholders. Herein lies the heart of the legal issue presented in this case.

Plaintiffs filed suit in the Court of Chancery to enjoin the proposed merger, arguing, among other things, that the transaction required the consent of two-thirds of the holders of the First Series Preferred stock. Defendants responded with a motion for judgment on the pleadings, which the Court of Chancery granted, finding that the provisions governing the rights of the First Series Preferred stockholders do not require such consent.4

The plaintiffs allege that, because of Avatex' anemic financial state, "all the value of Avatex is [currently] in the preferred stock."5 By forcing the conversion of the preferred shares into common stock of the surviving corporation, however, the merger would place current preferred stockholders of Avatex on an even footing with its common stockholders. In fact, the Avatex preferred stockholders will receive in exchange for their preferred stock approximately 73% of Xetava common stock, and the common stockholders of Avatex will receive approximately 27% of the common stock of Xetava.

Under the terms of the Avatex certificate of incorporation, First Series stockholders have no right to vote except on:

The text of the terms governing the voting rights of the First Series Preferred Stock is set forth in the certificate of designations as follows:

These are the operative terms of Section 6 of the certificate of designations (with emphasis supplied) setting forth the rights and preferences of the First Series Preferred stock that became effective March 18, 1983 On September 14, 1983 a new certificate of designations became effective with respect to the Second Series Preferred stock. There is, however, no Second Series Preferred stock outstanding. Unlike the First Series certificate, Section 6 of the Second Series certificate expressly provides the Second Series Preferred stock with a right to vote on any consolidation or merger (with certain exceptions not relevant here) to which Avatex is a party:

We discuss this provision further in our analysis of the legal issue involved.

Issues That Are Not Before Us

Before proceeding further, we note preliminarily the allegations of the complaints that are not before us because they were not included in defendants' narrowly targeted motion for judgment on the pleadings. Those are the allegations claiming breach of fiduciary duty and entrenchment, as set forth in the Elliott Complaint,7 and breach of implied covenant of good faith and anticipatory breach of contract, as set forth in the Harbor Finance Complaint.8 Accordingly, we do not consider any claims or potential claims involving these issues or possible contentions of unfairness or inequitable conduct.9 We consider only the terms of the preferred stock, the statutory framework and the purely legal issue decided by the Court of Chancery.

Analysis

Delaware law permits corporations to create and issue stock that carries no voting power.10 Professor Buxbaum, in his seminal article on preferred stock nearly 45 years ago, noted, among many other cogent observations, that: (a) statutes often permit alteration of preferred stock rights and preferences by merger;11 (b) the merger may be with a "paper subsidiary created for that purpose with no independent business validity";12 (c) "corporate articles [often] require consent of two-thirds (or a majority) of the preferred shareholders as a class for the consummation of any merger....";13 and (d) courts have struggled with "controls in the name ... of `fairness' and generally abandoned them [, which] is as it should be [since the] issue is one of corporate power."14

The Avatex certificate of incorporation provides that Avatex preferred shares have no right to vote except on matters set forth therein or required by law.15 This denial of the right to vote is subject to an exception carved out for any "amendment, alteration or repeal" of the certificate "whether by merger, consolidation or otherwise" that "materially and adversely" affects the rights of the preferred stockholders. Such an event requires the consent of two-thirds of the First Series Preferred stockholders voting as a class.

This appeal, then, reduces to a narrow legal question: whether the "amendment, alteration or repeal" of the certificate of incorporation is caused "by merger, consolidation or otherwise" thereby requiring a two-thirds class vote of the First Series Preferred stockholders, it being assumed for purposes of this appeal that their rights would be "materially and adversely" affected. The Court of Chancery answered this question in the negative. Although we respect that Court's craftsmanlike analysis, we are constrained to disagree with its conclusion.

Relying primarily on Warner Communications Inc. v. Chris-Craft Industries Inc.,16 the Court of Chancery held that it was only the conversion of the stock as a result of the merger, and not the amendment, alteration or repeal of the certificate, that would adversely affect the preferred stockholders.17 It is important to keep in mind, however, that the terms of the preferred stock in Warner were significantly different from those present here, because in Warner the phrase "whether by merger, consolidation or otherwise" was not included. The issue here, therefore, is whether the presence of this additional phrase in the Avatex certificate is an outcome-determinative distinction from Warner.

In Warner, the question was whether the Series B preferred stock of Warner Communications, Inc. had the right to a class vote on a proposed merger of Warner with Time, Inc. (renamed Time Warner Inc.) and TW Sub, its wholly-owned subsidiary. As the first step in a two-step transaction, Time had acquired approximately 50% of Warner's common stock in a tender offer. The second step was the "back-end" merger in which TW Sub was merged into Warner, which survived as a wholly-owned subsidiary of Time. The Warner common stock not held by Time was converted into cash, securities and other property. In the merger, the Warner Series B preferred would be converted into Time Series BB preferred stock. The parties stipulated that the Warner Series B stockholders would thereby be adversely affected.18

The Chancellor held that the drafters of the Warner Series B certificate of designations did not intend for two-thirds of the Series B stockholders to have a veto over every merger in which their interest would be adversely affected because the right to vote was conferred expressly (as it must under Delaware law),19 and "only in narrowly defined circumstances ... not present here."20 The two provisions in the certificate of designations involved in Warner were as follows. Section 3.3 provided:

Section 3.4 provided:

We note again that nowhere in the Series B certificate of designations was found the phrase "by merger, consolidation or otherwise," which is the key phrase in the present case. Nevertheless, the heart of the Warner rationale, which we must address here, is that it was not the amendment, alteration or repeal of the Warner certificate that adversely affected the Warner Series B stock. The Chancellor held that it was only the conversion of the Warner Series B Preferred to Time Series BB Preferred that caused the adverse effect, and, moreover, that the conversion was permissible under 8 Del.C. § 251, which (unlike 8 Del.C. § 242) does not require a class vote on a merger.23 Further, the Chancellor held that no contractual protection of the Warner Series B stock provided for a class vote on a merger. The Chancellor summarized his rationale in Warner as follows:

In more detail, he continued:

Plaintiffs here argue that Warner is distinguishable for three reasons: (1) the fact that the words "whether by merger, consolidation or otherwise" were not present in the Warner Series B certificate; (2) in Warner, unlike here, the preferred stockholders did not remain as stockholders of the surviving corporation, whose certificate arguably was amended and on which the preferred stockholders in Warner were relying for a right to a class vote; and (3) in Warner, unlike here, the merger was not an attempt simply to change the rights of the preferred stock, but rather there was economic and business substance to that transaction beyond an effort to do indirectly what could not be done directly.

In our view, only the first reason is valid in this appeal. The third reason cited is not before us because we do not examine the economic quality of the merger for purposes of this appeal.27 The second reason strikes us as a distinction without a difference.28 Here the First Series Preferred stock of Avatex is converted to common stock of the surviving corporation, Xetava, a newly formed corporation admittedly a wholly owned subsidiary of Avatex created for the sole purpose of effecting this merger and eliminating the rights of the Avatex First Series Preferred. In Warner, the Warner, Series B Preferred also received a new security — Time Series BB Preferred — a senior security29 issued by the surviving corporation, Time (renamed Time Warner). This was accomplished by using TW Sub, Time's wholly-owned subsidiary, as the merger partner of Warner. Since we do not reach the question of the economic quality of the transaction,30 it makes no difference for purposes of this analysis (as plaintiffs argue) that in Warner there were two distinct acts that operated independently — that the substitution of charters was between Warner and TW Sub and the exchange of shares was between Warner and Time. The operative events here are that the proposed downstream merger of Avatex into Xetava results in the conversion of Avatex stock to Xetava stock and the elimination "by merger" of the certificate protections granted to the Avatex First Series Preferred. Thus, it is both the stock conversion and the repeal of the Avatex certificate that causes the adverse effect to the First Series Preferred. In Warner, it was only the stock conversion that caused the adverse effect because the phrase, "whether by merger, consolidation or otherwise" was not present.

The relevant statutory provisions are found in Sections 251(b) and 251(e) of the Delaware General Corporation Law ("DGCL"), which provide, in pertinent part:

In short, Section 251 of the DGCL describes three ways that a merger or consolidation can affect the certificate of a constituent corporation:

In speaking of the "amendment, alteration or repeal" of the Avatex certificate by "merger, consolidation or otherwise," the drafters must have been referring to some or all of the events permitted by Section 251. Therefore, Section 251 provides the relevant backdrop for the interpretation of the First Series Preferred voting rights.

Avatex argued below, and the Court of Chancery appears to have agreed,35 that only a Section 251(b)(3) Amendment to the surviving corporation's charter amounts to an "amendment, alteration or repeal" within the meaning of the provisions defining the voting rights of the preferred stockholders. Accordingly, the argument runs, these provisions would apply only in the circumstance (not present here) where Avatex survives the merger and its certificate is amended thereby. Since the proposed merger with Xetava does not contemplate any such amendments to the disappearing Avatex certificate, the argument goes, the transaction can go forward without a First Series class vote.

The difficulty with this reading is that it fails to account for the word consolidation, which appears in the phrase "by merger, consolidation or otherwise." A consolidation cannot entail a Section 251(b)(3) Amendment because in a consolidation there is no "surviving corporation" whose pre-existing certificate is subject to amendment. The resulting corporation in a consolidation is a completely new entity with a new certificate of incorporation.36 All the certificates of the constitutent corporations simply become legal nullities in a consolidation. In short, Avatex' proposed reading of the relevant provisions would render the word consolidation mere surplusage, and is problematic for that reason.37

Although the transaction before us is not a consolidation, the drafters' use of the word consolidation is significant. They must have intended the First Series Preferred stockholders to have the right to vote on at least some mergers or other transactions whereby the Avatex certificate — and indeed, Avatex itself — would simply disappear. Consolidation, by definition, implicates the disappearance of all constituent corporations. Here, Avatex disappears, just as it would in a consolidation. Under the terms of the proposed merger, Xetava will be the surviving entity and, since Avatex will cease its independent existence, its certificate becomes a legal nullity, as defendants concede. In our view, this constitutes a repeal, if not an amendment or alteration. Thus, the proposed merger is potentially within the class of events that trigger First Series Preferred voting rights.

The first question is: What will happen as a result of the merger to the "rights, preferences, privileges or voting power" of the Avatex First Series Preferred stock as set forth in the existing Avatex certificate? They disappear when the preferred stockholders of Avatex become common stockholders of Xetava under its certificate that does not contain those protections. We assume, as did the trial court,38 that their elimination would affect the First Series Preferred stockholders adversely.

The second question is: What act or event will cause this adverse effect if the merger is consummated? The trial court held that, "[a]s in Warner," the adverse effect on the plaintiffs "will not flow from any `amendment, alteration or repeal' of the First Series Certificate (however accomplished) but from the conversion into common stock of the First Series Preferred in the Proposed Merger."39 The Court so held notwithstanding that it had noted the distinguishing language of the certificate here — not present in Warner — "whether by merger, consolidation or otherwise." But the Court dismissed this distinction by concluding that this "language only modifies the phrase `amendment, alteration and repeal' and does not independently create a right to a class vote in the case of every merger."40 But that is not the issue here where there is no contention that the First Series Preferred have a right to a class vote on every merger.41

The First Series Preferred holders claim to have the right to a class vote only if (a) a transaction effects the "amendment, alteration or repeal" of the rights provided in the certificate, and (b) "any right, preference, privilege or voting power of the First Series Preferred" would thereby be materially and adversely affected. For example, plaintiffs make clear that the First Series Preferred would not have a class vote on mergers where they receive the same security in a new entity or are cashed out. The attributes of the First Series Preferred would be intact but for the merger or might be continued if the certificate of the corporation surviving the merger — Xetava — provided for separate classes of stock, guaranteeing to these holders those same attributes. In our view, the Court of Chancery misapplied Warner's holding that "the amendment contemplated [as a "housekeeping" measure post-merger] is necessitated by the merger [and the] amendment, like the conversion, flows from the merger and is not a necessary condition of it."42 This was the case in Warner, but is not here. The error of the trial court here was in its conclusion that the observation in Warner quoted above "is at least equally apposite here, where Avatex is to be merged with and into Xetava and will simply cease to maintain a separate corporate existence as a matter of law, without the necessity of any amendment, alteration or repeal" of the certificate.43

In our view, the merger does cause the adverse effect because the merger is the corporate act that renders the Avatex certificate that protects the preferred stockholders a "legal nullity," in defendants' words. That elimination certainly fits within the ambit of one or more of the three terms in the certificate: amendment or alteration or repeal. The word repeal is especially fitting in this context because it contemplates a nullification, which is what defendants concede happens to the Avatex certificate.44

Articulation of the rights of preferred stockholders is fundamentally the function of corporate drafters. Construction of the terms of preferred stock is the function of courts. This Court's function is essentially one of contract interpretation against the background of Delaware precedent. These precedential parameters are simply stated: Any rights, preferences and limitations of preferred stock that distinguish that stock from common stock must be expressly and clearly stated, as provided by statute.45 Therefore, these rights, preferences and limitations will not be presumed or implied.46 The other doctrine states that when there is a hopeless ambiguity attributable to the corporate drafter that could mislead a reasonable investor such ambiguity must be construed in favor of the reasonable expectation of the investor and against the drafter.47 This latter doctrine is not applicable here because there is no ambiguity.

In our view, the rights of the First Series Preferred are expressly and clearly stated in the Avatex certificate. The drafters of this instrument could not reasonably have intended any consequence other than granting to the First Series Preferred stock the right to consent by a two-thirds class vote to any merger that would result in the elimination of the protections in the Avatex certificate if the rights of the holders of that stock would thereby be adversely affected. The First Series Preferred stock rights granted by the corporate drafters here are the functional equivalent of a provision that would expressly require such consent if a merger were to eliminate any provision of the Avatex certificate resulting in materially adverse consequences to the holders of that security.

The drafters were navigating around several alternatives. First, all parties agree that pure amendment protection available to the First Series Preferred stockholders as granted by Section 242(b)(2) of the DGCL and Section 4 of the certificate does not — absent the very phrase at issue here — apply to this merger. Although Warner was decided after the Avatex certificate of designations became effective, Warner clearly supports this view and it continues to be valid precedent for that proposition.48 Second, all parties agree that if Avatex would have been the survivor, and its certificate were amended in the merger as contemplated by 8 Del.C. § 251(c)(3), the First Series Preferred would have the right to consent by two-thirds class vote. Third, all parties agree that the right to consent to any merger that was granted (subject to certain exceptions not relevant here) to the Second Series Preferred stock (of which none is outstanding) was not intended to be granted to the First Series holders whose rights are more narrowly circumscribed. In their case: (a) the merger must be the cause of an "amendment alteration or repeal" of the certificate (not all mergers do this); and (b) their rights must be adversely affected (which does not inevitably occur in a merger).

If Section 6 of the certificate does not guarantee a class vote to the First Series Preferred in this merger, what could it conceivably be interpreted to mean? Defendants argue that the certificate can be construed to apply only in the second instance noted above — namely, in the case where Avatex is the survivor and its certificate is amended, altered or repealed, as contemplated by Section 251(b)(3). But, as plaintiffs point out, this cannot be the only outcome the drafters intended because the certificate grants the First Series Preferred this protection in a consolidation where Section 251(b)(3) does not apply.49 Because the word consolidation is included, it cannot reasonably be argued that the protections of Section 6 of the certificate applicable to the First Series Preferred are confined to a Section 251(b)(3) amendment. Therefore, the term consolidation cannot be ignored or wished away as surplusage, as defendants argue. It is well established that a court interpreting any contractual provision, including preferred stock provisions, must give effect to all terms of the instrument, must read the instrument as a whole, and, if possible, reconcile all the provisions of the instrument.50

Conclusion

The Court of Chancery held, and defendants contend on appeal, that Warner compels a different result from that which we reach because Warner held that there it was only the stock conversion, not the amendment that adversely affected the preferred. But the short answer here is that the language of the First Series Preferred stock is materially different from the language in Warner because here we have the phrase, "whether by merger, consolidation or otherwise." This provision entirely changes the analysis and compels the result we hold today. Here, the repeal of the certificate and the stock conversion cause the adverse effect.

It is important to place what we decide today in proper perspective. The outcome here continues a coherent and rational approach to corporate finance.51 The contrary result, in our view, would create an anomaly and could risk the erosion of uniformity in the corporation law. The Court of Chancery was mindful of this concern in referring to our general observations in Kaiser that the courts should avoid creating enduring uncertainties as to the meaning of boilerplate provisions in financial instruments.52 To be sure, there are some boilerplate aspects to the preferred stock provisions in the Avatex certificate and those found in other cases. But one is struck by the disuniformity of some crucial provisions, such as the differences that exist when one compares the provisions in Warner and Sullivan with those presented here. That lack of uniformity is no doubt a function of (a) the adaptations by different drafters of some standard provisions; (b) negotiations by preferred stock investors seeking certain protections; (c) poor drafting; or (d) some combination of the above. The difference between the provisions in the Warner certificate and the Avatex provisions are outcome-determinative because we find there is no reasonable interpretation of the Avatex certificate that would deny the First Series Preferred a class vote on an "amendment, alteration or repeal ... by merger, consolidation or otherwise" of the protective provisions of the Avatex certificate.

The path for future drafters to follow in articulating class vote provisions is clear. When a certificate (like the Warner certificate or the Series A provisions here) grants only the right to vote on an amendment, alteration or repeal, the preferred have no class vote in a merger. When a certificate (like the First Series Preferred certificate here) adds the terms "whether by merger, consolidation or otherwise" and a merger results in an amendment, alteration or repeal that causes an adverse effect on the preferred, there would be a class vote. When a certificate grants the preferred a class vote in any merger or in any merger where the preferred stockholders receive a junior security, such provisions are broader than those involved in the First Series Preferred certificate. We agree with plaintiffs' argument that these results are uniform, predictable and consistent with existing law relating to the unique attributes of preferred stock.

The judgment of the Court of Chancery is reversed and the matter is remanded for further proceedings consistent with this Opinion.