June 22, 2014

KEEPING CURRENT: Sotheby’s Poison Pill Battle Reshapes World of Shareholder Activism

Gardner Davis

The recent battle between auction house Sotheby’s and its largest shareholder, Daniel Loeb’s Third Point LLC, will have lasting implications for the corporate governance landscape and provide a playbook for how activist investors conduct future campaigns for influence and how companies respond. 

In Third Point LLC v. Ruprecht, et al., CA 9469-VCP (Del. Ch. May 2, 2014), the Delaware Chancery Court held the Sotheby’s board acted reasonably by adopting and then maintaining a stockholder rights plan, or so-called “poison pill,” with a relatively new, two-tiered triggering threshold. 

The rights plan, adopted by the Sotheby’s board in response to rapid stock accumulations by several activist hedge funds, is triggered at a 10 percent stock ownership threshold, except that passive stockholders, who file a Schedule 13G with the SEC rather than a Schedule 13D, may acquire up to 20 percent stock ownership. Traditionally, most rights plans have had a single threshold of stock ownership, generally 15 to 20 percent, regardless of whether the stockholder was an active or passive investor. The traditional, higher thresholds have not proved effective in preventing changes of control when activist hedge funds form a group or “wolf pack” for the purpose of jointly acquiring large blocks of a target company’s stock. 

Vice Chancellor Parsons held in the context of a request for a preliminary injunction that the Sotheby’s board of directors, comprised primarily of independent and disinterested directors, did not breach its fiduciary duty by adopting the two-tiered rights plan. The court found that the Sotheby’s board had reasonable grounds for believing that the simultaneous rapid stock accumulation by several activist hedge funds constituted a danger to corporate policy and effectiveness. Based on the advice of its outside legal and financial advisors, the board believed that the activist hedge funds, acting in conscious parallelism, were attempting to gain effective control of the company without paying a premium. The court held that the board’s adoption of the plan, and subsequent decision not to grant the acquiror a waiver of the 10 percent limit, were a reasonable and proportionate response to a legitimate control threat. 

Vice Chancellor Parsons further found that the adoption of the pill was not primarily motivated to defeat the Third Point’s proxy contest to elect its short slate of directors to the board. In fact, the court held that the hedge funds’ proxy contest was “eminently winnable by either side.” 

The Vice Chancellor acknowledged the “discriminatory” nature of the two-tier structure, in that it permits passive investors to buy 20 percent of the company shares, while activist stockholders cannot purchase more than 10 percent. However, he found that the bifurcated pill is arguably a “closer fit” to addressing the company’s needs to prevent an activist or activists from gaining control than the traditional rights plan that would restrict the ownership levels of every stockholder, even those with no interest in obtaining control or asserting influence. Therefore, the board’s initial adoption of the rights plan was a reasonable and proportionate response to a legitimate threat of a change of control posed by Third Point. 

A separate and distinct issue in the lawsuit was whether several months after adopting a rights plan the Sotheby’s board should have granted Third Point a waiver so that it could buy up to a 20 percent interest in the company. Vice Chancellor Parsons admitted that he was skeptical that the board could establish it had an objectively reasonable belief that Third Point continued to pose a “creeping control” risk to the company at that time. 

However, Vice Chancellor Parsons concluded that Sotheby’s made a sufficient showing of at least one objectively reasonable and legally cognizable threat: negative control. Vice Chancellor Parsons found that Sotheby’s may have had legitimate real-world concerns that enabling individuals or entities, such as Third Point, to obtain 20 percent as opposed to 10 percent ownership interest in the company could effectively allow those persons to exercise disproportionate control and influence over major corporate decisions, even if they do not have explicit veto power. 

Vice Chancellor Parsons recognized that the notion of effective, rather than explicit, negative control raises significant concerns about where to draw the line to ensure that effective negative control does not become a license for corporations to deploy defensive measures unreasonably. However, the evidence in the case indicated that at the time the board was considering granting a waiver of the pill, Loeb was behaving publically in a manner that suggested he intended to be running Sotheby’s and calling all the shots. Vice Chancellor Parsons cited Loeb’s “aggressive and domineering manner” as a reasonable basis for concern that Third Point would in fact be able to control certain important corporate actions, such as executive recruitment, despite a lack of actual control or explicit veto power.

Shortly after Sotheby’s victory in court, but in the face of an uncertain proxy contest where Third Point was attempting to elect a slate of three directors, the parties reached a settlement. Sotheby’s terminated the pill, expanded its board to add Third Point’s three nominees, and reimbursed Third Point’s out-of-pocket expenses of the lawsuit and proxy fight. Third Point agreed to limit its stock ownership to 15 percent, to refrain from conducting another proxy contest, to refrain from pursuing various extraordinary transactions, and to avoid publically making disparaging statements about the company or its officers and directors. 

Perhaps the biggest tactical lesson from the Sotheby’s battle is the importance for both company management and the activist investors to be on their best behavior – avoid making ad hominem attacks on the adversary, focus on the legitimate business issues, and appear to be reasonable and fair in all matters related to the contest. In the event of litigation, the activist shareholder will try to demonstrate the board acted with animus or an entrenchment motive in adopting defensive measures. Likewise, the company will try to establish the activist investor presents a threat to corporate policy and is trying to seize effective control without paying a premium. 

In the final analysis, the outcome of the Sotheby’s case may have come down to the company’s ability to successfully portray Loeb in a very unfavorable light. It was clear that Vice Chancellor Parsons did not think highly of Loeb publishing poison pen letters attacking management without knowledge as to the veracity of some of his allegations. Loeb’s seemingly insignificant comments that he was going to be making the important decisions at Sotheby’s appear to have been the basis for the Vice Chancellor’s acceptance of Sotheby’s rather tenuous argument that “effective negative control” was a sufficient threat to justify not waiving the pill and permitting Third Point to acquire up to 20 percent of the stock. 

The Sotheby’s case also shows the importance of the board remaining focused on preventing a change of control without payment of a premium, rather than keeping the activist investors out of the boardroom. Delaware law clearly prohibits adoption of the poison pill for the primary purpose of winning a proxy fight or entrenching management. In this case, Sotheby’s position in the litigation benefited from having previously offered to put one or two activist investor representatives on the board pursuant to a negotiated deal. 

Finally the Sotheby’s battle shows the desirability of negotiating a deal to provide the activist investor with board representation in exchange for a standstill and other protections for the minority shareholder interests. The institutional investors and the influential shareholder advisory services may be inclined to support activist investors in a proxy fight. The new, two-tier pill gives the board more leverage to negotiate a reasonable deal and avoid the potential business disruption and collateral damage that can result for a proxy fight. 

In light of the Sotheby’s decision, many more companies will adopt the new variety, two-tier pill when facing the threat of activist investor activity in the stock.

Gardner Davis

Gardner Davis is a partner in the Transactional & Securities practice of Foley & Lardner LLP. He regularly counsels companies and their boards of directors in M&A transactions and corporate governance matters.