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E-MailMarcel Kahan is George T. Lowy Professor of Law at NYU School of Law and Edward B. Rock is Professor of Law at NYU School of Law. This post is based on a recent paper by Professor Kahan and Professor Rock. 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 Law and Economics of Blockholder Disclosure by Lucian Bebchuk and Robert J. Jackson Jr. (discussed on the Forum here), and Pre-Disclosure Accumulations by Activist Investors: Evidence and Policy by Lucian Bebchuk, Alon Brav, Robert J. Jackson Jr., and Wei Jiang.
Hedge funds have become active in corporate governance. They push for changes in strategy, including making very specific proposals, and sometimes seek (and secure) board representation. They do this by buying shares, conducting public campaigns, lobbying managers and other shareholders, and sometimes running a proxy contest. In response, boards of directors have adopted a variety of “defensive measures” including deploying the “poison pill” shareholder rights plan against activists.
We provide a comprehensive policy and doctrinal analysis of the use of poison pills again activists in corporate governance contests. Although pills have been in common use as anti-takeover devices since the 1980s, it is only now—in the context of anti-activist pills—that many design features of pills start to matter. The reason lies in the different sources of gains derived by the raiders of yore and today’s activists. In takeovers, the bidder’s primary gains are expected to come from acquiring the company and improving it. As a result, bidders neither need to nor, it turns out, in fact buy substantial blocks of shares before they offer to buy a company. Hence, pill features such as the trigger threshold, the types of ownership interests that count towards the threshold, and the rules on aggregation of shares held by other investors turned out to be largely irrelevant. By contrast, many of today’s most prominent activists expect to profit from an increase in the stock price of the target generated by their activism and a corresponding increase in the value of their stakes. For activists, therefore, the ability to acquire a stake in the target—and the limitations on that ability created by a pill—is of great significance.
Under Delaware law, the validity of a pill hinges on whether the pill is a reasonable response to a cognizable threat. In the activist context, we identify two threats that may justify a pill: a threat that the activist is trying to obtain control (“creeping control”); and a threat to a fair election process caused by a contestant having an excessive voting stake. By contrast, we argue that the possibility that shareholders will support an activist in the mistaken belief that its proposals are in the best interest of the company or the possibility that the activist intends to focus on short-term profits are not cognizable threats from a doctrinal and policy perspective. The possibility that the activist may cause disruption by activism or obtain disproportionate influence, while possibly cognizable under existing doctrine, do not justify a pill as a reasonable response.
Importantly, the nature of the threat must justify the design features of the pill. Thus, for example, the threat of creeping control will generally not justify pills with a trigger threshold below 20%; and the threat posed to a fair election process requires a response that is evenhanded and does not favor one of the contestants. On our analysis, synthetic equity—which confers on an activist an economic interest but not voting rights—generally poses no cognizable threat and thus should not count towards the pill trigger because the cognizable threat posed by an activist derives from its power to vote its shares, and not from a pure economic stake. On the other hand, permitting an activist to accumulate an economic stake through synthetic equity is desirable as it enables the activist to benefit if the activism results in an increase in the value of the company and lends credibility to the claim that the activist is motivated to generate such an increase.
Similarly, it is generally not justified for pills to “grandfather” an existing shareholder friendly to management at a higher stake than an emerging activist. In the presence of existing large shareholders allied with management, it is unclear why permitting an activist to accumulate an equivalent stake would present a threat of creeping control; and permitting an activist to accumulate such a stake may enhance, rather than undermine, a fair election process. Different pill thresholds for active and passive shareholders, however, may be justified on the grounds that large stakes by passive shareholders do not pose threats to the fair election process or to control equivalent to large stakes by active shareholders.
One of the most difficult problems with respect to the terms of anti-activist pills is whether and how a company may consider “wolf-packs” (several hedge funds taking sizeable positions in a target and acting in what critics claim is a parallel manner, but without having any explicit or implicit agreements with each other). One approach is to aggregate the holdings of the entire pack to determine whether the pill threshold is exceeded. Thus, some pills aggregate the holdings of all shareholders who “act in concert” to change or influence the control of the target company if there is an “additional plus factor”, such as an exchange of information and attendance of the same meeting, that supports a determination that they intended to act in concert.
In our view, such wolf-pack provisions suffer from two fatal flaws. First, because triggering a pill would have severe adverse consequences, vague and potentially overbroad standards of aggregation are likely to have a chilling effect on an activist’s ability to communicate with other shareholders. Second, wolf-pack provisions would impede normal interactions among shareholders—such as meetings in which shareholders exchange and discuss their views about the company and management—that sound corporate governance depends upon and that decades of reform have sought to encourage.
On the other hand, it may be more legitimate for a company to take account the presence of a wolf pack in setting the pill threshold. Even if there is no formal or informal agreement between members of the wolf-pack at the time, all members of a wolf-pack may share a self-interested goal. If one accepts our view that preserving a fair election process may be a legitimate board goal, the detail of what this means will have to be worked out in the factual context of actual contests. While our thoughts on this issue are still preliminary, we can envision circumstances where there is a substantial likelihood that a member of a wolf pack will vote their shares not based on the “merits”—their assessment of the best interest of the company—but based on a self-interest that is aligned with the interest of the activist. In such circumstances, the goal of preserving a fair election process may be served by adjusting the pill threshold—and thereby limiting the voting stake of an activist—to take account of the presence of other shareholders whose votes are not up for grabs.
The complete paper is available for download here.
One Comment
The authors of “Anti-Activist Poison Pills” do us a service by focusing attention on the fundamental legal issues in adopting a poison pill: is it a reasonable and proportionate response to a threat to the corporation?
In applying these principles, however, the authors take a narrow view of what constitutes a threat, arguing, among other things, that the election of directors who will support an inadequate bid to acquire the corporation is not a threat against which a board can properly adopt a poison pill.
They take this position while acknowledging that the Delaware courts have found that a tender offer to acquire control at an inadequate price is such a threat. To support to their distinction between proxy contests and tender offers, they cite several cases that involved enhanced scrutiny of defensive measures under Unocal and struck down board actions that impermissibly interfered with shareholder voting rights. Those cases, however, were not focused on whether the board’s defenses were addressed to a threat, but on whether the actions taken by the board were preclusive or disportionate —- which are the very issues that a court would face if it concluded that there was a threat and went on to considered whether the board’s response to the threat was permissible.
This focus on reasonableness and proportionality seems to be the right way to deal anti-activist poison pills since the threat posed by an effort by activists to elect a board that will sell the corporation at a price the existing board considers inadequate is not fundamentally different from the threat posed by a tender offer at a price the board considers inadequate.
All the issues that the authors raise with such an anti-activist poison pill can also be considered in the context of an analysis of whether the pill precludes the activists from running a proxy context or unreasonably and disproportionately interferes with such an effort. However, at least one of their conclusions — that it is impermissible to count synthetic equity toward a poison pill trigger — would require rethinking if such a proxy contest were considered a threat against which it was permissible to apply a poison pill.