Fiduciary Duties During a Time of Volatility

Ethan Klingsberg is a partner and Vinita Sithapathy is an associate at Freshfields Bruckhaus Deringer LLP. This post is based on their Freshfields memorandum, and 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 Case Against Board Veto in Corporate Takeovers by Lucian Bebchuk.

Relevant to the times in which we find ourselves, the Delaware Court of Chancery, in a newly released transcript ruling in K-Bar Holdings LLC v. Tile Shop Holdings, Inc., found a colorable claim that the board of a publicly traded company had breached its fiduciary duties by allegedly sitting on its hands while a stockholder group (which included three members of the board of directors) took advantage of the corporation’s depressed trading price to increase its ownership from 29 percent to 42 percent.

The Court ordered the stockholder group to cease purchases of stock and stated that, after an evidentiary hearing, the Court would consider ordering divestiture and/or neutering of the recently acquired voting power.

The suit, brought by an unaffiliated stockholder, claimed that the board had breached its affirmative duty to prevent the stockholder group from accumulating control without the payment of a premium to all stockholders. The case points to a flip-side to the considerations that we highlight when corporate clients are considering anti-takeover protections on “clear days.”

We regularly brief boards on the Unocal proportionality standards that would apply if a stockholder were to challenge actions by the directors, such as the adoption of a poison pill rights plan, to impede accumulations of control by a hypothetical hostile actor.

Even more so than the Unocal standard (which is relatively easy for a well-advised board to satisfy in the case of the adoption of a standard rights plan where the company has a single class of stock and no pre-existing controlling stockholder), we focus boards on the details of the latest guidelines from ISS, Glass Lewis and major institutional investors on which set of anti-takeover protections would, if adopted by the board, trigger “withhold” recommendations against incumbent directors.

But boards need to keep in mind the flip-side of these considerations:  At some point, a failure to affirmatively act to impede accumulations of control can, by itself, constitute a breach of duty and diminish stockholder value.

Moreover, directors, who are understandably focused on their levels of stockholder support at annual meetings, should take note that the opponents of board-imposed restrictions on stockholder rights, including ISS and many of the major actively and passively managed institutional stockholders, will be open to moving beyond their bold-faced guidelines and considering the situation at hand if the corporation engages with them proactively and directly to explain why a rights plan and other restrictions are necessary to act in the best interest of stockholders under the specific facts and circumstances where control is at stake.

The Tile Shop case itself had particularly gruesome allegations. The board of directors had allegedly announced approval of steps to de-list and de-register the corporation, which in turn sent the stock price tumbling and created an opportunity for a group of insider stockholders to make open-market purchases of meaningful additional voting power.

The stockholder-plaintiff argued that the board should have adopted a poison pill or obtained standstill undertakings to prevent the insider group from taking its position up to 42 percent with the potential (and the alleged intent) to go even higher.

Tile Shop serves as a reminder that “control” of a corporation is a sacrosanct asset of the stockholders that the board needs to oversee with care. Moreover, as the Court observed in Third Point LLC v. Sotheby’s in 2014, even the risk that a stockholder would accumulate “negative control” through holding a mere 20 percent of the voting power may be meaningful enough to justify the imposition of a 10 percent ownership cap via a rights plan.

The flip side of Sotheby’s is that boards have an affirmative duty to be careful to prevent a stockholder from reaching a level that poses a risk of the stockholder’s obtaining even “negative control” without payment of a premium.

This perspective becomes especially relevant when a corporation’s prospects become uncertain and strategic plans lose their foundations, as had allegedly happened at the corporation in Tile Shop. Although the corporation may be struggling to find its way, the risk of opportunistic accumulations remains and is arguably greater.

For example, Bill Ackman, after announcing a bearish view of the hotel and restaurant industries due to COVID-19, has confirmed that his Pershing Square fund has been acquiring shares in Hilton Worldwide Holdings Inc. and Restaurant Brands International Inc. Carl Icahn, after criticizing the prospects of Occidental Petroleum Corp., has increased his voting power from 2.5 percent to 9.9 percent through open market purchases.

This perspective on the importance of taking affirmative steps to safeguard control is further relevant as struggling corporations consider “friendly” equity infusions through PIPEs (in the case of public companies) and new financing rounds (in the case of private companies).

Directors need to be watchful of the rights granted to and accumulated by these investors and should push for restrictions (e.g. through standstills, rights plans, and/or neutering of voting rights) to avoid a sale of control where the board cannot be reasonably confident that the sale of control is the best reasonably available alternative for maximizing value for all the stockholders.

Assuring that entrance into these “friendly” equity infusions occurs within the right fiduciary duty framework becomes even more challenging when the investors are already insiders (e.g. with pre-existing board representation) and therefore, in addition to the challenge of maximizing stockholder value, the board must take steps to preserve procedural integrity.

During “clear days,” we focused boards on the costs of and bases for challenges to any implementation of anti-takeover defenses. Now, when macro developments are rendering companies vulnerable to efforts to grab control either on the open markets or through transactions directly with issuers, it is time for us to complement that perspective by focusing boards on both:

  • how a failure to implement protections against accumulations or sales of control may constitute a breach of duty; and
  • how to convey to governance-oriented investors this perspective, which, after all, is focused on the preservation of stockholder value.

For the full transcript of the ruling in K-Bar Holdings LLC v. Tile Shop Holdings, Inc., please click here.

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