The Perils of Governance by Stockholder Agreements (2): A Note on Unplanned Consequences

Lucian Bebchuk is the James Barr Ames Professor of Law, Economics, and Finance, and Director of the Program on Corporate Governance, at Harvard Law School.

The Delaware Legislature is considering a proposal (“the proposal”) to amend Section 122 of the Delaware General Corporation Law (“DGCL”) to permit expansive use of stockholder agreements to opt out of the governance arrangements set by a company’s charter. (For a description of this proposal and the rationale offered in its accompanying Synopsis, see here) In an earlier post (available here), I discussed the perils of this proposal, explaining that (1) the proposal would enable opting out without the safeguards involved in the long-established procedures for opting out via the charter and bylaws, and (2) the proposal would have substantial effects in wide-ranging settings that seem not to have been considered by the proposal’s supporters, so the legislation should be paused until they are adequately considered. In light of reactions I received to my earlier post, I would like to discuss point (2) further. In particular, I highlight the significance of (2) by discussing how proposal could have transformative effects on hedge fund activism that the proposal’s supporters have not considered.

Whereas the Moelis decision, and some of the academic articles on stockholder agreements, have focused on stockholder agreements in public companies in their early years post-IPO, I stressed in my earlier post that the proposed amendment would have major effects on the vast number of companies that are further down the road from their IPO and that represent most of the economy’s market capitalization.

Such companies currently enter from time to time into stockholder agreements when they settle with hedge fund activists. In a study titled Dancing with Activists, which Brav, Jiang, Keusch, and I co-authored, we provide an empirical study of hundreds of such settlement agreements and document the types of provisions that they include. We find that the current practice of such agreements largely involves company commitments that avoid tying the board’s hands down the road. However, if the proposed legislation is adopted, this practice should be expected to change greatly.

In particular, our study finds that settlement agreements often involve the addition of directors agreed upon by both sides immediately or at the coming annual meeting, but they generally avoid granting the activist a right to board seats in future annual meetings over time. Adoption of the proposed legislation, however, would authorize settlement agreements that entitle the activist to board seats, or to a veto over inclusion of any candidate on the company’s slate, for many years to come.

Similarly, we also find that, while settlement agreements sometimes include a commitment to establish a board committee to study the possibility of a sale and they are in many cases followed by a sale down the road, settlement agreements generally avoid a commitment to sell the company or granting the activist power over the sale process. However, the proposed legislation would authorize settlement agreements that would commit the company to, say, accept any offer that provides at least a specified premium, or that would grant the activist power to veto the company’s use of a poison pill to block any offer that provides more than a specified premium. Of course, it might be argued that ex post a court might not require specific performance of this commitment if the board shows that shareholder interests would be served by not performing the contract. However, the considered agreement could specify that, if the agreement is not specifically performed, the activist would be able sell its stake to the company at the premium of the offer that the board elects not to accept.

Also, we find that while a small number of settlement agreements are accompanied by an immediate stepping down of the CEO, in many cases, possibly aided by the addition of new directors, the CEO is replaced within a year or two — but without any contractual commitment to replace the CEO. However, the proposed legislation would authorize settlement agreements that would commit the company to, say, replace the CEO within a specified period of time or, alternatively, that would provide the activist with the power to veto any new compensation contract with the current CEO.

In addition, we find that settlement agreements are often followed by an increase in the likelihood of a dividend increase or buyback within the next three years, but such agreements largely avoid including any contractual commitment to taking such steps down the road. However, the proposed legislation would authorize settlement agreements that would commit the company to, say, make certain future cash distributions and that would entitle the activist to its pro rata share of the specified distributions if for some reason a court allowed the board to avoid specific performance down the road.

It might be argued that settlement agreements of the type discussed above would take place only if incumbents agree to enter into them. But in many cases, underperforming incumbents might have little leverage and might agree to make large concessions in order to avoid being ousted quickly.

Supporters of the proposal have argued that it is intended to bring the law in line with practice. I questioned in my initial post whether this is a good basis for the legislative intervention. In the case of activism practice, however, the expansive legislative intervention would not bring the law in line with practice. To the contrary, the law here would provide private players with opportunities that would likely lead to a considerable change in practice.

Such a change in practice would likely be troubling for many institutional investors. Although companies entering settlement agreements with hedge fund activists have largely avoided providing activists with governance rights with respect to corporate actions down the road, some institutional investors have expressed concerns about such agreement being made without their having an opportunity to express their views. In 2016, for example, State Street Global Advisors expressed such concerns about settlements with activists. In their view, institutional investors are not at the bargaining table when a settlement agreement is made, and they often do not have an opportunity to opine on the concessions that the company makes in the settlement agreement.

For institutional investors with this concern, the change in practice that would be facilitated by the proposed legislation would substantially exacerbate their concern. When a settlement agreement adds a couple of activist directors or establishes a strategic opportunities committee, institutional investors at least have an opportunity to make their voice heard before such directors are reelected for another term or before the committee agrees to a sale. If the proposed legislation is adopted, institutional investors should be expected to face settlement agreements with significant and substantially irreversible consequences down the road, and they would have substantially reduced ability to undo whatever negative externalities they expect to be imposed on them.

Note that in this area, the legislation would not bring about certainty but rather increased litigation. With any of the types of agreements discussed above declared facially valid by the legislation, challenges might be brought against them on grounds that they violate directors’ fiduciary duties. Much litigation would be needed to bring clarity with respect to the fiduciary duty constraints on the large set of settlement agreements declared permissible by the proposed legislation.

To what extent would the effects of the expected transformation in activism practice be beneficial and to what extent would they be detrimental? I have avoided discussing this question because it is not the point of this post. The point is that these effects might have first-order importance and should be carefully weighed before adopting any legislation.

To conclude, this post supplements my earlier post in opposition to the proposed legislation by demonstrating that, in the specific setting of hedge fund activism, the proposed legislation would have a wide-ranging array of fundamental effects. And, as discussed in my earlier post, there are other settings in which mature companies, far from the time of their IPO, are going to be affected. Regrettably, it seems that the Synopsis accompanying the proposal and writings of the proposal’s supporters do not engage with or adequately consider such effects.

The rush to adopt the proposed legislation should be stopped. No such fundamental change in Delaware law should be made without an adequate study of the full range of potential effects, with input on the subject from institutional investors, scholars, and all others who have an interest in effective stockholder protections and good corporate governance in Delaware companies.

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