By Beth Berg, Kai Liekefett and Derek Zaba of Sidley Austin LLP
“Things haven’t been this interesting in a generation.”1 While most of Corporate America is struggling with the COVID-19 pandemic, some don’t see a humanitarian and economic crisis of epic proportions — they see an opportunity.
In addition to putting almost unprecedented stress on our healthcare system, the COVID-19 crisis presents the most severe challenge of Corporate America since World War II. It has caused one of the worst crashes in the stock markets since the Great Depression, and management teams and boards are desperately working to protect the lives of employees, customers and business associates and save their businesses from demise.
As explained in our previous Sidley Update (Will the Coronavirus Become a “Poison Pill” for Proxy Contests This Season?), one of the few silver linings is that most activists are abandoning their campaigns for the 2020 proxy season. Many activist funds are struggling to survive after suffering millions or billions of losses and facing imminent redemptions as a result of the virus-driven market rout.
In the midst of this mayhem, however, some see the most exciting opportunity in a generation. Take, for example, Carl Icahn: In the past two weeks alone, he nearly quadrupled his stake in Occidental Petroleum and rapidly acquired almost 15 percent in Delek US Holdings. From his perspective, the market crash has created a target-rich environment of undervalued companies with distracted leadership teams. Reportedly, several other well-capitalized activist funds are similarly poised to exploit current market conditions. The same applies to resilient companies with strong balance sheets that finally, after the dramatic end of an 11-year bull market, see an opportunity to acquire competitors and other complementary businesses on the cheap. As a consequence, we expect to see a rise in unsolicited approaches and hostile takeover bids in the near future.
We typically advise public companies to refrain from adopting a shareholder rights plan or “poison pill,” which creates a cap on maximum share ownership (typically 10 percent or 15 percent), unless and until an insurgent (or group) approaches or crosses a 10 percent ownership threshold, a public unsolicited takeover bid is made or a company has substantial net operating losses (NOLs) to protect. After all, ISS, Glass Lewis and many institutional investors generally oppose, and ISS and Glass Lewis may recommend votes against directors who have adopted, poison pills without such a justification. Consequently, most public companies instead keep a poison pill “on the shelf” (i.e., fully drafted and ready for adoption, with the board having been properly briefed).
In the current environment, boards of public companies should, at a minimum, make sure they have an up-to-date poison pill on the shelf and consider whether to adopt one. At least in Delaware, the standard of review of the board’s decision to adopt depends on the company’s particular circumstances at the time of adoption. In Delaware, if a poison pill is adopted on a “clear day” (i.e., where the company is not facing a hostile takeover bid or other specific threat), the business judgment rule applies (Moran)2, whereas adoption of a poison pill as a defensive measure in response to a specific threat is subject to enhanced scrutiny (Unocal)3. Notably, even if a poison pill is adopted on a clear day, the decision whether to redeem the poison pill in the face of a hostile bid remains subject to enhanced scrutiny.
In these extraordinary times, a board may, in the exercise of its reasonable business judgment, conclude that it is in the best interests of the company and its shareholders to adopt a poison pill even in the absence of a specific threat. High trading volumes make it easier for activists and hostile bidders to scoop up large stakes within a few days. The current high level of market volatility and use of derivatives by activists make it extremely difficult for stock watch services to detect rapid stock accumulations. Management teams are distracted by the severe challenges of the crisis and may not have the bandwidth to pay attention to these threats. As a consequence, companies may wake up to a Schedule 13D of a new insurgent reporting ownership of 15 percent, 20 percent or even more of the shares. These share ownership levels approach what Delaware courts have referred to as “de facto” or “negative” control — meaning that as practical matter, most boards and management teams cannot ignore the wishes of a shareholder with a stake of that size (e.g., the Sotheby’s case).4 In other contexts, Delaware courts have suggested that directors may be liable for breach of fiduciary duty if they do not prevent a change of control without the payment of a control premium (e.g., the Landry’s case).5 It is no accident that at least nine companies have adopted poison pills since the beginning of March 2020, either as a preventive measure (e.g., Williams Cos and Global Eagle Entertainment) or in response to a specific threat (e.g., Occidental Petroleum and Delek US).6
However, that does not mean that every public company should adopt a poison pill in these times. Whether a public company should adopt a poison pill depends on the circumstances, and boards that adopt a poison pill should be prepared for the corporate governance consequences. There is no assurance that institutional investors or proxy advisory firms will change their general opposition to poison pills even in these unprecedented circumstances. Also, adopting a poison pill could draw poisonpill-related shareholder proposals. In determining whether to adopt a poison pill, a board should also consider factors including the following:
· Industry: While most of Corporate America has experienced stock price declines, some industries have been hit harder and are therefore most vulnerable (e.g., energy, retail, restaurant, entertainment and travel). Moreover, smaller players in industries that have been consolidating are more vulnerable.
· Market Capitalization: Mega- and large-cap companies are less at risk than small- and midcap companies because few insurgents have the financial wherewithal and risk appetite to spend billions of dollars on a single position.
· Trading Volume: High trading volumes make a company more vulnerable to a surprise attack. Thinly traded companies are less at risk.
· Relative Value: If a company’s trading multiple (or other indicia of value) is lower than those of its peers, it may be perceived as a particular bargain and may, therefore, be more at risk, as are companies whose stock prices have declined significantly more than competitors’.
· Shareholder Base: If a company already has an existing controlling shareholder, it is more or less immune from an activist campaign or hostile takeover. In addition, significant insider ownership reduces the risk of a hostile approach. By contrast, having significant free float makes a company more vulnerable to a surprise attack.
· Existence of a Potential Hostile Bidder or Known Activist: If a company has already been approached by a potential hostile bidder, or a known activist already owns stock, there is a greater risk of attack, particularly if the insurgent’s cash position remains strong.
· Debt Change of Control Triggers: Most public companies have credit facilities and/or bonds with provisions that trigger a default or put right in the event of a change of control. The trigger thresholds generally vary from as low as 25 percent to as high as more than 50 percent. The lower the threshold, the higher the risk for a company to have to refinance its debt as a result of a rapid stock accumulation.
· NOLs: Companies with significant NOLs should consider the adoption of a poison pill because the related tax benefits will be impaired in the event of an ownership change pursuant to Section 382 of the Internal Revenue Code. That definition is extremely broad and includes an ownership increase by 5 percent of shareholders by more than 50 percentage points within a rolling three-year period. A poison pill with a 4.9 percent trigger threshold can protect a company against such an ownership change and has been upheld by the Delaware courts.7
If a board decides to adopt a poison pill, it should tailor its terms to the company’s circumstances and be mindful of the standard of judicial review that is likely to apply to the decision to adopt. If a poison pill is adopted in the absence of a cognizable threat of a potential hostile bidder, known activist or NOLs to protect, consider a limited duration of six to 12 months. In any event, it is critical to communicate clearly to all constituencies the rationale for adoption.
1 Reported quote from a well-known activist
2 Moran v. Household Int’l, Inc., 500 A.2d 1346 (Del. 1985).
3 Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946 (Del. 1985).
4 Third Point LLC v. Ruprecht, C.A. No. 9469-VCP (Del. Ch. May 2, 2014).
5 Louisiana Municipal Police Employees’ Retirement Sys v. Fertitta, C.A. No. 4338-VCL (Del. Ch. July 28, 2009).
6 See “Corporate America’s Medicine Against Coronavirus,” Deal Point Data, March 20, 2020.
7 Selectica, Inc. v. Versata Enters., Inc., C.A. No. 4241-VCN (Del. Ch. Feb. 26, 2010).
Kai Liekefett, Partner +1 212 839 8744, email@example.com
Derek Zaba, Partner +1 650 565 7131, firstname.lastname@example.org
Beth Berg, Partner +1 312 853 9763, email@example.com
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