In re Ebix: Corporate Defenses and Activist Engagement

Kai Haakon E. Liekefett is a partner and head of the Shareholder Activism Response Team at Vinson & Elkins LLP. This post is based on a Vinson & Elkins publication by Mr. Liekefett and Leonard Wood. This post is part of the Delaware law series; links to other posts in the series are available here. Related research from the Program on Corporate Governance includes The Long-Term Effects of Hedge Fund Activism by Lucian Bebchuk, Alon Brav, and Wei Jiang (discussed on the Forum here), and The Myth that Insulating Boards Serves Long-Term Value by Lucian Bebchuk (discussed on the Forum here).

The surge in shareholder activist campaigns directed at corporate America in recent years makes clear that few public companies are immune from shareholder activism. However, companies are not powerless in preparing for potential activist campaigns. Strengthening structural defenses in corporate bylaws before an activist appears is the best way to prepare for activism while minimizing the risk of shareholder litigation. [1] Courts are typically reluctant to second guess bylaw amendments adopted by a board on a “clear day,” where no activist is present, and review these actions under the deferential business judgment rule. By contrast, defensive bylaw amendments implemented in the middle of an activist engagement, or a “rainy day,” will likely be subject to greater judicial scrutiny out of a concern that a board may be changing the rules of the game after the game has begun. But in corporate law, as in the weather, grey area exists, commonly referred to as “cloudy days.” Open questions about the legal viability of implementing defensive measures will arise whenever engagement by an activist is looming or possible, but has not yet commenced or resumed in earnest. A recent Delaware decision now indicates that even a firm settlement agreement with an activist will not necessarily end the activist threat from the Court’s perspective.

A recent decision by the Delaware Court of Chancery highlights for public companies the risks of implementing structural defenses in the wake of a settlement agreement with an activist. In In re Ebix, Inc. Stockholder Litigation, Vice Chancellor Noble ruled, at the motion to dismiss phase, that certain bylaw amendments adopted only after the targeted company settled with the activist were nevertheless adopted as defensive measures and, accordingly, should be subject to heightened scrutiny under Unocal Corporation v. Mesa Petroleum Co. rather than under the business judgment rule. [2] Supporting his decision, the Vice Chancellor pointed to the timing of the drafting of the amendments (six days after notification of the activist’s intent to launch a proxy contest), the limited duration of the standstill covenant in the settlement agreement (signifying, in the Court’s opinion, a future threat to corporate control), and the facially defensive intent of the amendments. The Vice Chancellor paid particular attention to the special meeting bylaw, finding that it had “clear defensive value” by substantially encumbering, and in some scenarios eliminating, the ability of activists to convene a special meeting between annual elections for the purpose of electing new directors.

Background and Timeline of Events

In re Ebix, Inc. Stockholder Litigation arises from a threatened proxy contest against the board of directors of Ebix, Inc. [3] On November 11, 2014, activist investor Barington Capital Group, L.P. informed Ebix of its intent to launch a proxy contest to place four new directors on Ebix’s six-person board at the 2015 annual meeting. Two weeks later, Ebix and Barington entered into a settlement agreement. Under the agreement, Ebix appointed two activist designees to the company’s board. The settlement further provided that Barington would agree to a voting commitment and a standstill covenant prohibiting Barington from initiating a proxy contest through the annual election of 2015 and most of the year preceding the annual election of 2016. One month after executing the settlement agreement, on December 19, 2014, the Ebix board unilaterally adopted certain bylaw amendments. These bylaw amendments had been drafted six days after Barington delivered its nomination notice and prior to the settlement.

Plaintiff shareholders brought a class and derivative suit alleging, among other things, that the board breached its fiduciary duties by approving the bylaw amendments and further that the bylaw amendments contravened the Delaware General Corporation Law. The plaintiffs also alleged that the bylaw amendments constituted a defensive “entrenchment device” adopted in response to a threat to corporate control and thus requested judicial review of the amendments under the heightened scrutiny standard set forth in the line of landmark Delaware cases beginning with Unocal.

The bylaw amendments made four changes in particular to Ebix’s structural defenses that drew the attention of Vice Chancellor Noble. A “special meeting bylaw” encumbered, without entirely eliminating, the ability of shareholders to call special meetings. A “consent bylaw” required shareholders seeking action by written consent to request the board set a record date for shareholder-initiated consent solicitations. A “control of meeting bylaw” provided the chairman of the shareholder meeting with discretionary authority to control the conduct of shareholder meetings. Finally, “advance notice bylaws” enhanced the informational requirements needed from shareholders providing director nominations and other business to be considered at an annual meeting of shareholders.

The Court’s Opinion on the Motion to Dismiss

Vice Chancellor Noble held that heightened scrutiny under Unocal would apply in its evaluation of the validity of bylaw amendments adopted by Ebix. The Unocal standard applies “whenever the record reflects that a board of directors took defensive measures in response to a perceived threat to corporate policy and effectiveness which touches on issues of control.” [4] The Vice Chancellor found that the bylaw amendments served a defensive purpose, emphasizing that (1) the bylaw amendments, while adopted after the settlement, were initially prepared just six days after Barington delivered its nomination notice, (2) the standstill provision in the settlement agreement had a limited duration that extended through only one future annual election, leaving open a future threat to corporate control by Barington, and (3) at least one of the bylaw amendments had “clear defensive value” by substantially encumbering, and in some scenarios eliminating, the ability of activists to convene a special meeting between annual elections for the purpose of electing new directors.

In the most novel aspect of the decision, the Vice Chancellor rejected arguments that the standstill provision in the settlement agreement had taken the company back to a “clear day” and removed the threat to corporate control. Instead, the Vice Chancellor found that the bylaw amendments were, “in the aggregate, a forward-looking prophylactic designed with Barrington [sic] in mind, but holstered until the period of Barrington’s guaranteed complacency expired.” [5] The Vice Chancellor thus found no basis for reducing the level of scrutiny of the bylaw amendments from heightened scrutiny under Unocal to the business judgment rule.

If the case continues to trial, Ebix will bear the burden of proving under Unocal that it had reasonable grounds for believing that a danger to corporate policy and effectiveness existed and that the bylaw amendments were reasonable in relation to the threat posed. Heightened scrutiny sets a high bar for success, although not an insurmountable one.

Implications for Public Companies

1. It is better to strengthen structural defenses before an activist appears

The adoption of defensive bylaws in the context of an activist engagement carries more legal risk. As the Court ruled in Ebix, defensive bylaws adopted in the context of an activist campaign are susceptible to review under heightened scrutiny, even if adopted in the context of a settlement agreement. The plaintiffs in Ebix survived the forgiving pleading standard at the motion to dismiss stage, which requires the Court to draw all reasonable inferences in favor of the plaintiffs. The Court readily accepted as true, for preliminary hearing purposes, the plaintiffs’ allegations that the bylaw amendments were defensive measures, made in response to a threat to corporate control, and unreasonable under Unocal principles.

Holding that heightened scrutiny applies to the adoption of the defensive amendments is far from holding that bylaw amendments are invalid under heightened scrutiny. Whether a full trial on the merits will convene remains to be seen. In the meantime, risking litigation with uncertain ends is rarely a first choice for companies working through an activist campaign. Strengthening structural defenses before an activist appears is the best way to prepare for activism while minimizing risks of litigation.

These comments are to speak only of the litigation concerns. Early action, if undertaken prudently and with limits, also serves the important function of protecting a company’s standing among the leading proxy advisory services. [6]

2. The Delaware courts may evaluate all circumstances when scrutinizing the validity of bylaw amendments under Unocal

Vice Chancellor Noble rejected the company’s defense that each of the bylaw amendments, taken individually as a discrete measure, had either been previously approved or viewed as not problematic in previous Delaware decisions. The Vice Chancellor singled out the special meeting bylaw as particularly defensive among the others, but he expressed a strong preference for reviewing the bylaw amendments in the aggregate as one, single defensive measure. The Vice Chancellor was also inclined to evaluate the defensiveness of the amendments in light of the circumstances in which they were adopted. He emphasized that the amendments were drafted only six days after Barington’s nomination of dissident director candidates and noted that the company failed to show this timing as having been coincidental. The company may have fared better in the Vice Chancellor’s eyes had the record reflected that the board had considered the bylaw amendments for beneficial purposes beyond the intent of blunting Barington’s shareholder rights. Among other lessons from the holding, companies considering the adoption of defensive bylaws should bear in mind how the record will reflect the board’s deliberations.

3. A settlement agreement does not necessarily create a “clear day” for adopting defensive bylaw amendments

The most novel aspect of Ebix is its holding that a settlement agreement did not sufficiently diminish the threat to corporate control so as to remove the defendants’ defensive measures from the ambit of analysis under Unocal principles. Here, the standstill covenant prevented the activists from waging a proxy campaign through one annual meeting and most of the subsequent year, but not through the following annual meeting. The downside for companies is that this decision may prevent them from reforming their structural defenses during a period of hard-won peace. The upside is that the ruling may illuminate a pathway for passing defensive bylaws validly in the wake of a settlement agreement. One such path would be to make clear in the record that bylaw amendments were adopted to protect the company not from the former activists but from future, as-yet-unknown, threats to the interests of the company and its shareholders.

4. In an activism context, the Delaware courts are more likely to reject certain bylaw amendments than others

To borrow a phrase from the Vice Chancellor, bylaw amendments range in their respective “defensive value.” The Delaware courts are far from having provided clear guidance as to the ranking of bylaws from most to least shareholder friendly. Ebix indicates, however, that the Court’s thinking aligns with the common sentiments of corporate attorneys, investors, and proxy advisory firms on the notion that some bylaws are more defensive than others. Preventing shareholders from calling shareholder meetings is arguably more restrictive of shareholder rights than an advance notice bylaw that increases the informational requirements for nominating dissident directors. As Vice Chancellor Noble observed, “although most of the Bylaw Amendments achieved little more than making shareholder action more cumbersome, one reform has clear defensive value: the Special Meeting Bylaw’s series of clauses that allow the Board, at the very least, to delay shareholder-initiated special meetings … and, at most, prevent elections from occurring at special meetings indefinitely.” [7] When adopting bylaw amendments, companies should consult with experienced counsel to understand better which amendments pose more and less risk from a litigation standpoint, as well as from the standpoint of investor relations.

5. Ambiguity surrounding the question of when an activist campaign began can provide a tactical advantage to companies on the defensive

It is often unclear when an activist campaign has begun. Put in Unocal terms, it may be difficult to pinpoint when a threat to corporate control and policy has commenced. Full-blown activist campaigns are often preceded by weeks, months, or even years of private engagement between the company and an activist outside of the public view and without an explicit threat of a proxy contest.

A company holding discussions with an activist during this the period between “clear” and “rainy” days likely has options for amending bylaws before a certain and specific threat of a proxy contest is made. Taking advantage of this opportunity prudently requires precautions, give-and-take to appease the proxy advisory firms, and a thoughtful investor relations strategy around any adoption of bylaw amendments.

6. Activists are not the only plaintiffs

For investor relations purposes, companies in an activist context are justifiably reluctant to sue their shareholders, including activists, even when the law is on the company’s side. For similar reasons, activists may be reluctant to sue companies. A suit against a company may have a basis in law, but may also be received poorly by the same investors to whom the activist will be appealing for support in the election. Yet, these factors do not mean that litigation is unlikely in an activist contest.

Activists are increasingly finding that their litigation aims can be pursued and achieved by third-party plaintiffs who file derivative and class action suits that support the effort of the activist. When these suits are filed, the activist can look forward to all of the upside while assuming no risks of the downsides of litigation. With this potential in mind, it is all the more important for a company considering strengthening its structural defenses to make sure that its strategy is pursued carefully, with counsel, in a risk-sensitive manner.

7. Responding to shareholder activism is not business as usual

Responding to shareholder activism is not “business as usual” from a corporate law standpoint, although companies frequently assume as much at their peril. Conducting an effective response to a shareholder activism campaign requires careful timing, expertise in the distinctive landscape of state and federal law that comes into play, and consideration of how investor relations and proxy solicitation strategies can influence the outcome of a proxy contest.

Endnotes:

[1] See Stephen M. Gill, Kai Haakon E. Liekefett & Leonard Wood, Structural Defenses to Shareholder Activism, 47 REV. OF SECS. AND COMMODITIES REG. 151 (2014).
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[2] 3 493 A.2d 946 (Del. 1984).
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[3] C.A. No. 8526-VCN, 2016 WL 208402 (Del. Ch. Jan. 15, 2016).
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[4] Ebix, 2016 WL 208402, at *17 (citing Gantler v. Stephens, 965 A.2d 695, 705 (Del. 2009)).
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[5] Id. at *19.
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[6] For further discussion of the role of proxy advisory services in shareholder activism and when considering defensive options, see footnote 1.
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[7] Ebix, 2016 WL 208402, at *19.
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