Of interest to Maryland REITs, underwriters and investors, the Maryland Business and Technology Case Management program recently published the May 18, 2015 opinion of Judge Michel Pierson of the Circuit Court for Baltimore City in Poling v. CapLease, Inc., which held that a cash-out merger does not constitute a “redemption” of preferred stock and, therefore, is not prohibited by a common five-year redemption restriction contained in articles supplementary for preferred stock.

Background

In April 2012 and January 2013, CapLease, Inc., a Maryland corporation qualified as a real estate investment trust (“CapLease”), amended its charter by filing Articles Supplementary which permitted it to issue 8.375% Series B Cumulative Redeemable Preferred Stock and 7.25% Series C Cumulative Redeemable Preferred Stock ( collectively, the “Preferred Stock”), respectively. The Preferred Stock was subject to certain redemption rights in favor of CapLease, but the articles supplementary for each series prohibited CapLease from redeeming the stock prior to the fifth anniversary of its issuance (except in the case of a defined “Change of Control” or to preserve the corporation’s REIT status). As a result of their relatively high yield, both the Series B Preferred Stock and Series C Preferred Stock traded above their liquidation preference.

On May 28, 2013, CapLease and VEREIT, Inc., a Maryland corporation then known as American Realty Capital Properties, Inc. (“ARCP”), announced that they had entered into a merger agreement, pursuant to which ARCP would acquire all of the outstanding capital stock of CapLease. ¹ Pursuant to the terms of the merger agreement, the Series B Preferred Stock and the Series C Preferred stock would be cashed-out in the merger for their liquidation preference of twenty-five dollars per share plus all accumulated and unpaid dividend dividends. The merger ultimately closed on November 5, 2013.

On October 6, 2013, CapLease preferred stockholder John Poling (“Plaintiff”) filed a putative class action in the Circuit Court for Baltimore City against CapLease, members of its board of directors, ARCP and various related parties. Plaintiff alleged that the merger agreement breached the terms of the Articles Supplementary by proposing to redeem shares of Preferred Stock in the merger and prior to the five-year anniversary. Plaintiff further alleged that the merger did not constitute a “Change of Control” under the articles supplementary for either series and, therefore, neither series of preferred stock could be redeemed in the merger. Alternatively, Plaintiff alleged that the merger “converted” both series of preferred stock into the right to receive cash in a manner that was prohibited by the same Articles Supplementary. Finally, Plaintiff alleged that, as a result of the foregoing, the CapLease board’s declaration that the merger was advisable constituted a breach of the fiduciary duty that it owed to the REIT’s preferred stockholders. The complaint then brought related claims for declaratory relief against ARCP and the various affiliate entities for aiding and abetting the purported breach by the CapLease board.

In response, the defendants moved to dismiss the complaint for failure to state a claim arguing that the referenced restrictions only apply to “redemption” of the Preferred Stock, not the cashing-out of the Preferred Stock in a merger, and that the restrictions on conversion only prevented the holder from converting the Preferred Stock except in the manner provided.

Holding of the Circuit Court

In granting the motion to dismiss, the Court succinctly explained that “the basic flaw in [P]laintiff’s theory is that the transaction at issue did not constitute a redemption, because CapLease did not acquire the stock.” Under Maryland law, a redemption is a transaction in which a corporation or Title 8 real estate investment trust uses its own funds to purchase its own stock. In a merger, and specifically in the merger at issue, this did not occur. Instead, the preferred stock was converted into the right to receive cash from a third party.

Although not expressly stated in the opinion, by relying on Rauch v. RCA Corporation, 861 F.2d 29 (2d Cir. 1988) (applying Delaware corporate law) and In re Heston Corporation, 870 P.2d 17 (Kan. 1994), the Court effectively adopted the long-recognized Delaware doctrine of independent legal significance:

Any attempt to equate the current transaction with a redemption, notwithstanding the form of the transaction, runs afoul of the basic rule that the preferred shareholders’ rights are to be found in the charter, the contract between the company and them. The provisions of the Articles cited by [P]laintiff relate to a redemption, which is a term with a defined meaning as discussed previously. The court is not at liberty to disregard these provisions and recast the transaction so as to bring it within restrictions of the charter that do not explicitly forbid mergers. As the court stated in Hesston, supra, given the fact that a stock purchaser is charged with the knowledge of the possible defeasance of its stock interests upon a merger, “the absence of a Certificate provision for a cash-out merger does not create an ambiguity in the Certificate requiring its redemption provision to be interpreted in the [shareholders’] favor.” 870 P.2d at 42-43.

Poling, supra., at 12-13. Stated otherwise, while a certain action may be proscribed in the charter of a Maryland REIT, an alternative action is not prohibited merely because the end result would be the same for the stockholder. Thus, while CapLease was prohibited from redeeming the preferred stock for its liquidation preference prior to the fifth anniversary of its issuance, CapLease was not prohibited from entering into a merger agreement that caused the preferred stock to be cashed-out for its liquidation preference in the resulting merger.

The Court then went on to reject two alternative arguments raised by plaintiff. First, the Court held that the language in the Articles Supplementary prohibiting conversion of the preferred stock only prohibited conversion by the stockholder and not conversion of the stock into the right to receive cash in a merger. Second, the Court held that Plaintiff’s belated arguments related to voting rights, namely, the right to vote on any merger or amendment to the charter that would materially affect the rights of the holders of the preferred stock, were underdeveloped and, absent clarity and legal authority, simply did not find support in the text of the charter.

The Court also dismissed the related breach of duty, declaratory judgment and aiding and abetting claims. Plaintiff has appealed the result to the Court of Special Appeals, and that appeal remains pending.

¹ Miles & Stockbridge P.C., primarily through Topper Webb and Scott Wilson, served as Maryland counsel to ARCP in the transaction. Miles & Stockbridge P.C. did not represent ARCP in the Poling litigation.

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