This article presents a brief overview of various defensive measures that have been the subject of litigation in the Delaware courts in recent years, highlighting certain key issues on which practitioners should be focused when reviewing a corporation’s defensive profile.
Because a rights plan has anti-takeover implications, the Delaware courts will review its adoption and use under the enhanced scrutiny standard of review first articulated in Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946, 954–55 (Del. 1985). In general, that standard involves an inquiry into whether the board had reasonable grounds for believing that a danger to corporate policy and effectiveness existed, and whether the board’s response was reasonable in relation to the threat posed. Applying Unocal, the Delaware courts have generally upheld rights plans that are designed to prevent hostile or abusive takeover threats, so long as they do not preclude stockholders from waging an effective proxy contest.
Rights plans were traditionally drafted such that a person or entity would become an acquiring person (and therefore trigger the rights plan) when the person or entity, together with its “affiliates” and “associates,” acquired “beneficial ownership” of more than a specified percentage of the outstanding common stock – usually in the range of 15 percent to 20 percent. Lower thresholds in anti-takeover rights plans, such as those set below 10 percent, may give rise to equitable challenges, depending on the specific facts and circumstances, principally due to the concern that a drastically low threshold could have a preclusive effect on a proxy contest.
A 10 percent triggering threshold in Sotheby’s rights plan was challenged in Third Point LLC v. Ruprecht, 2014 WL 1922029 (Del. Ch. May 2, 2014). The 10 percent threshold, in this case, was not unqualified in that the rights plan had a dual trigger: 20 percent for “passive stockholders” (13G filers) and 10 percent for activist investors (13D filers). The board had adopted the rights plan in response to an increase in hedge fund activity in its stock. The board then denied a request by Third Point, an activist investor, for a waiver that would allow it to purchase up to 20 percent of Sotheby’s stock. The plaintiffs claimed that the board breached its fiduciary duties by adopting the rights plan and by denying the request for a waiver. They argued that the board was acting solely to obtain an unfair advantage in the then-pending proxy contest, and not to protect against a cognizable threat to the corporation. The defendants responded that Third Point did in fact represent a threat to Sotheby’s and that the rights plan was a proportionate response to that threat. They further claimed that the dual trigger structure was reasonable, given that the threats to the corporation were stemming principally from hedge funds.
The court declined plaintiffs’ motion to enjoin the upcoming stockholders meeting, finding that they had not adequately demonstrated a reasonable probability of success on the merits of their claim. Applying Unocal, the court found that Sotheby’s board, consisting of a majority of independent members, acted reasonably in identifying a legally cognizable threat (namely, that Third Point, either on its own or with others, could obtain control without paying a control premium) and that the board’s response to the threat was reasonable. Although declining the plaintiffs’ motion, the court did note that the issue of whether the board properly declined Third Point’s request for a waiver presented “a much closer question.”
Inclusion of Derivatives
In determining whether a person, together with its affiliates and associates, acquired “beneficial ownership” of more than a specified percentage of the outstanding stock to trigger the issuance of rights under a rights plan, anti-takeover rights plans were traditionally drafted with the term “beneficial ownership” being defined in a manner generally consistent with the analogous concepts in Rule 13d-3 adopted pursuant to the Securities Exchange Act of 1934, as amended, and Section 203 of the General Corporation Law of the State of Delaware (the General Corporation Law). With the increasing use of derivative instruments by activist investors, rights plans began to evolve accordingly. As a result, many rights plans now include derivative positions within the definition of beneficial ownership. These provisions are designed to deter rapid accumulations of stock through complex financial instruments.
Although the Delaware courts have not yet squarely addressed these provisions, there is support for their validity. In In re Atmel Corp. Shareholders Litigation, C.A. No. 4161-CC (Del. Ch. May 19, 2009) (Transcript), the Court of Chancery denied an injunction through which the plaintiff sought to invalidate an amendment to Atmel’s rights plan that, among other things, expanded the definition of “beneficial ownership” to include certain derivative positions. Stockholder plaintiffs brought suit challenging the amendments, claiming that provisions dealing with derivatives should be invalidated on the grounds that they were so vague that no stockholder or potential stockholder could determine how they were intended to operate – and therefore could not determine when the rights plan would be triggered. The stockholder plaintiffs claimed that, as a result, the adoption of the amendments constituted an ultra vires act and that the board’s adoption of the amendments constituted a per se breach of its fiduciary duties.
In a bench ruling, the court denied the plaintiffs’ request for a preliminary injunction. The court found that speculation about hypothetical scenarios, where the application of the definition of “beneficial ownership” may be uncertain, could not form the basis for the extraordinary remedy of an injunction. The court indicated, however, that plaintiffs’ claim was ripe, and indicated a willingness to consider the issue on a more complete basis at trial. The Atmel action was settled, however, with the board agreeing to make clarifications to the definition of “derivatives contract” in any future rights plan. Although the validity of derivative and synthetic provisions in rights plans has not definitively been approved by the Delaware courts, the Atmel settlement suggests that, in certain circumstances, a properly drafted provision may survive a challenge.
The Delaware courts have not yet squarely addressed so-called “wolf-pack” provisions in rights agreements. “Wolf pack” is a term used to describe a group of investors, each of which has a relatively small percentage of ownership of the target’s stock, who do not enter into formal agreements with respect to the target or its stock, but act largely in concert (e.g., through public announcements or other informal signals) toward a common goal. A “wolf-pack” provision in a rights agreement expands the definition of “beneficial ownership” such that the shares beneficially owned by one member of the wolf pack are beneficially owned by all other members. Although the Delaware courts have not addressed these provisions, the Court of Chancery noted, in a case in which a corporation had removed a wolf-pack provision from its rights agreement following a challenge, that the rights agreement’s trigger, in the revised form, was based on a “well-recognized standard” that the Delaware courts had previously upheld.
Structural Defensive Provisions
In Crown EMAK Partners, LLC v. Kurz, 992 A.2d 377, 401–02 (Del. 2010), the Delaware Supreme Court stated that directors are “elected” at annual meetings, and that in between annual meetings, the only mechanisms to change the composition of the board are the removal of directors, the filling of vacancies, and the filling of newly created directorships. Thus, provisions of the certificate of incorporation and bylaws regarding whether stockholders may call special meetings, whether they may act by written consent, whether they may remove directors with or without cause, and whether they may fill vacancies and newly created directorships take on heightened importance in any scenario in which an insurgent is seeking to change control of the board.
Stockholder-Called Special Meetings
Under Section 211(d) of the General Corporation Law, special meetings of stockholders may be called by the board of directors or by such person or persons as may be authorized by the certificate of incorporation or the bylaws. The certificate of incorporation or the bylaws of a corporation may give stockholders the power to call special meetings (or require an officer to call a special meeting upon the stockholders’ request), but the power to call special meetings is not an inherent right of stockholders under the General Corporation Law. To the extent the corporation includes in its certificate of incorporation or bylaws provisions granting stockholders the power to call special meetings, the corporation should be entitled to impose conditions, qualifications, and exceptions on the privilege so granted.
Where corporations have granted stockholders the power to call special meetings (whether as a result of stockholder proposals or otherwise), they often include several conditions on that right. At a bare minimum, the provisions fix the percentage of shares required to call a special meeting. These percentages tend to vary, with many public companies setting the threshold between 10 percent and 25 percent of the outstanding stock, but with a handful of others fixing the threshold as high as 80 percent. Other conditions and qualifications include restrictions on agenda items (e.g., no item of business may be transacted if it was presented to stockholders within the last 12 months), the stockholders who can be counted toward the requisite percentage (e.g., only those stockholders who have held a minimum percentage of stock for a specified holding period), and the time during which a special meeting may be required to be held (e.g., no special meeting may be held within 120 days after the last annual meeting or before the upcoming annual meeting). In addition, stockholder-called special meeting bylaws may require the stockholders seeking to call the special meeting to provide information regarding, among other things, the stockholder calling or requesting the special meeting as well as the proposal to be considered at the meeting (and, if vacancies or newly created directorships are to be filled at such meeting, information pertaining to such stockholder’s nominees). Although the Delaware courts have not squarely addressed the scope of conditions and qualifications in stockholder-called special meeting and bylaw provisions, the Delaware Court of Chancery, in a status conference regarding a challenge to a stockholder-called special meeting bylaw containing various conditions and qualifications, stated that the bylaw at issue raised “Unocal, Blasius, [and] Schnell issues” that required a more developed factual record to resolve.
Stockholder Action by Written Consent
Section 228(a) of the General Corporation Law generally provides that, unless restricted by the certificate of incorporation, stockholders may take action by written consent in lieu of a meeting. Thus, any provision restricting the stockholders’ ability to act by written consent must be set forth in the certificate of incorporation and not the bylaws. The Delaware Supreme Court has held that the bylaws may contain provisions relating to the “ministerial-type review” of the sufficiency of consents delivered to the corporation. Such bylaws, however, cannot be designed simply to defer stockholder action (e.g., by imposing an arbitrary delay). The bylaws must be narrowly tailored to allow for an efficient ministerial review of the validity of the consents; they must not impermissibly intrude on stockholders’ statutory rights. In this regard, it is worth noting that the Delaware Court of Chancery has upheld a “ministerial review” bylaw requiring a stockholder to request that the board of directors fix a record date for determining the stockholders entitled to act by written consent. The bylaw at issue required a stockholder seeking to solicit written consents to request that the board fix a record date, at which point the board was required to convene a meeting promptly (but in all events within 10 days of the request) to adopt a resolution fixing the record date. The court noted that the purpose of the bylaw provision was to create a procedure for determining which stockholders would be entitled to participate in the consent process, rather than to effect an arbitrary delay (and thereby give the corporation an extended opportunity to gather revocations).
Vacancies and Newly Created Directorships
Section 223 of the General Corporation Law sets forth the basic framework for determining which parties may fill vacancies and newly created directorships on the board. In general, Section 223 provides that the board may fill vacancies and newly created directorships, although the Delaware courts have found that, where stockholders have not been effectively divested of the power, they may also fill vacancies and newly created directorships. Although Section 223 does not provide the incumbent directors the exclusive power to fill vacancies, the Delaware courts have validated charter provisions vesting directors with the exclusive power in the board to fill board vacancies and newly created directorships. Thus, where the certificate of incorporation grants directors the exclusive power to fill vacancies, and where fewer than all of the directors are removed at a special meeting or by written consent, the stockholders could be prevented from effecting a change of control, since the remaining directors could (subject to equitable considerations) reappoint the displaced directors or fill the vacancies with individuals who are less likely to be hostile to incumbent management.
Even where the directors have the exclusive power to fill vacancies, the stockholders may (assuming they have the power to call special meetings and to propose the removal of directors as an item of business) seek to remove one or more directors at the special meeting pursuant to Section 141(k). If the remaining directors making the appointment constitute less than a majority of the whole board as of immediately prior to the removal, the stockholders may petition the Court of Chancery under Section 223(c) of the General Corporation Law to order an election – and may thereby gain control of the board. While there is scant case law construing Section 223(c), the Court of Chancery in Canmore Consultants Ltd. v. L.O.M. Medical International, Inc., 2013 WL 5274380 (Del. Ch. Sept. 19, 2013), addressed such a petition. In that case, the court, noting that Section 223(c) is permissive and that the court may exercise its discretion to order an election, found that it was at liberty to weigh the equities of the petition. In that particular case, the court found that the equities did not weigh in favor of holding a meeting, noting that the corporation had recently conducted a court-ordered meeting of stockholders for the election of directors and that the corporation did not have sufficient funds to call and hold a new meeting.
Section 141(d) of the General Corporation Law permits a Delaware corporation to provide for a classified board, either in its certificate of incorporation or in its original bylaws, or in a bylaw adopted by stockholders. Where an effective classified board provision is in place, an acquiror generally may elect only one third of the directors in each year and must therefore wait at least two election cycles before electing a majority of the directors. An effective classified board provision, therefore, operates as a significant deterrent to a hostile change of control. To be effective, however, a classified board provision must bear certain elements that prevent its anti-takeover features from being circumvented. First, the provision must be included in the certificate of incorporation, rather than the bylaws. Under Delaware law, stockholders have the power to amend the bylaws without prior board action, whereas any amendment to the certificate of incorporation must be initiated by the board. Classified board provisions in bylaws, therefore, may be eliminated by stockholder action. Second, the certificate of incorporation must (a) either (i) fix the precise number of a directors (or a fairly tight range), or (ii) provide that the total number of directors shall be fixed exclusively by the board, and (b) provide that vacancies and newly created directorships shall be filled exclusively by the remaining directors. If stockholders, either through the existing bylaws or through their power to amend the bylaws, have the ability to expand the size of the board and fill the newly created directorships, they may be able to gain a majority of the board in a single election. Third, the certificate of incorporation must not provide that directors may be removed with or without cause. The default under Section 141(d) of the General Corporation Law is that directors serving on a classified board may be removed for cause only, unless the certificate of incorporation provides otherwise. Where the certificate of incorporation provides that stockholders may remove directors for cause, if stockholders have the ability to act in between annual meetings (either by having the power to call special meetings or to take action by written consent) and have the ability to fill vacancies, they could effect a change in control at the board level in a single instance, despite the board’s classification.
When coupled with a rights plan, an effective classified board provision serves as a formidable anti-takeover measure. Nevertheless, the Delaware courts have concluded that the combination of a classified board and a stockholder rights plan does not constitute a preclusive defensive measure under Unocal. In Versata Enterprises, Inc. v. Selectica, Inc., 5 A.3d 586 (Del. 2010), a hostile acquiror argued that in order for the target’s defensive measures not to be preclusive: (1) a successful proxy contest must be realistically attainable, and (2) the successful proxy contest must result in gaining control of the board at the next election. The Delaware Supreme Court disagreed, rejecting plaintiff’s proposed “realistically attainable” standard, and holding specifically that the combination of a classified board and rights plan did not in fact preclude (so much as delay) a successful proxy contest.
This article describes in general terms only a few of the many defensive measures that corporations may adopt – and generally summarizes only certain of the key issues practitioners and corporations should consider when adopting and implementing such measures. In considering the adoption or use of any defensive measure, corporations and practitioners should give careful thought to the many legal and equitable issues that may arise under particular factual circumstances.