Contractual blockers have become a common tool in offerings of preferred stock and warrants to cap an investor’s beneficial ownership at 4.9% or 9.9% — which can effectively prevent the investor from becoming subject to Section 13(d) or Section 16. That is, unless the blocker is considered “illusory.” Here’s a recent development on contractual blockers that Alan shared earlier this month on Section16.net:

It has become settled law that a blocker in a derivative security can be effective to cap the holder’s beneficial ownership at an amount not exceeding the cap so long as the blocker is contractually binding. The SEC filed an amicus brief in 2001 supporting that position provided that the blocker is not “illusory.” The SEC’s brief listed four factors it considers relevant to whether a blocker is illusory. In a recent decision dismissing a complaint filed by Bed Bath & Beyond against an investment fund and its manager, a judge in the SDNY applied those factors in finding that blockers included in derivative securities acquired by the fund were not illusory.

The fund invested in BB&B on February 7, 2023, by purchasing three derivative securities: convertible preferred stock, warrants to purchase more preferred stock, and common stock warrants. The preferred stock and the common stock warrants contained blockers limiting the fund’s ownership to no more than 9.9% of the outstanding common stock. The strike prices of the derivatives allowed the fund to buy common stock at discounted prices, which the fund began doing immediately through serial conversions, each for a number of shares that kept the fund below the cap, followed by a sale of the acquired shares before submission of the next conversion request. Within two weeks the number of outstanding shares doubled, and within three months BB&B filed for bankruptcy.

BB&B challenged the validity of the blockers and sought $310 million in short-swing profits. The defendants argued that the blockers were contractually binding and therefor effective to limit ownership. The court agreed the blockers were binding but also agreed with the SEC (and BB&B) that a blocker also must not be illusory. The court then addressed the SEC’s factors.

Whether the blocker is easily waivable by the parties. BB&B argued that the parties could have agreed at any time to amend the derivatives to eliminate the blockers. The court said that argument was “nonsensical” and would render every contract illusory. In any case, the documents expressly prohibited amendment of the blocker provisions.

Whether the blocker lacks an enforcement mechanism. The plaintiff argued that BB&B had no way to determine whether the fund’s ownership exceeded the cap and that, in any case, BB&B lacked the will to enforce the blockers because BB&B would have been “thrilled” to receive the additional cash. The court said an enforcement mechanism existed because the fund was required to represent in each conversion or exercise request that the issuance would not cause the fund to exceed the cap. Whether BB&B had any interest in enforcing the caps was not relevant. BB&B also argued that it could not have enforced the blockers because a side letter prohibited it from requesting any information from the fund beyond the conversion and exercise requests. The court said a blocker can be valid even if enforcement rests with the derivative’s holder. The terms of the blockers also served as an enforcement mechanism, in that the blockers provided that any issuance in excess of the cap would be null, void and cancelled ab initio, and that any excess shares would be cancelled and not eligible to vote at meetings of stockholders.

Whether the blocker has not been adhered to in practice. The fund submitted 90 exercise and conversion requests, including 15 during the first two days after acquiring the derivatives. Following each exercise, the fund immediately sold the acquired shares and submitted another exercise request. BB&B argued that the fund remained the beneficial owner of sold shares until the sales settled, meaning the cap was regularly exceeded. The court concluded that shares the fund sold could be excluded from the fund’s beneficial ownership calculation because shares are deemed sold when the seller is irrevocably committed to the transaction, which occurs on the trade date, not the settlement date.

Whether the blocker can be avoided by transferring the securities to an affiliate. The plaintiff didn’t argue that the blocker could be avoiding by transferring the securities to an affiliate, so the court didn’t address this factor.

The court’s decision serves as a useful guide in drafting blocker provisions. Also useful is the court’s statement (in footnote 8) that the SEC’s list of factors that tend to support a conclusion that a blocker is valid does not suggest that the absence of those factors undermines the validity of a blocker.

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– Meredith Ervine