Yikes! I thought they were dead but they’re back! A recent paper from Proxy Mosaic sheds light on another defense for entrenched zombie directors. I’m busy on other projects but recent developments reviving this device are certainly worthy of shareholder attention, so I’m just pasting clips from their paper below to give readers a general sense of direction. Hopefully, this will encourage several to read the full paper and participate further in discussions. Thanks to the experts at Proxy Mosaic.
First, the executive summary:
Proxy puts, also known as “poison puts,” are anti-takeover defenses embedded within a variety of contractual agreements. In a bond indenture, a change in control of a majority of the board would trigger an acceleration of debt. But what is disguised as alleged protection for creditors has been used as a clever way for corporate boards to inappropriately entrench themselves. Bondholders do not typically ask for these provisions; instead, they are included at the request of management or as boilerplate.
Proxy puts have been referred to as “unregulable” defenses, which reflects the difficulty in monitoring them because they are contractual rather than subject to shareholder vote, and because they may be cloaked in an ordinary and otherwise legitimate business transaction.1
Two recent court cases, San Antonio Fire & Police Pension Fund v. Amylin and Kallick v. SandRidge, have limited the enforceability of proxy puts. The Delaware Court of Chancery has held that, in order for boards to justify the inclusion of a proxy put, there should be a clear economic benefit to the issuer that goes beyond simple managerial entrenchment.
Despite having their utility limited by Amylin and SandRidge, poison puts have appeared recently in the struggles for control over American Apparel and Cliffs Natural Resources. In the future, we advise that shareholders need to be wary of when boards invoke proxy puts during contested elections, as it generally sends a strong message that the board is trying to usurp shareholder enfranchisement.
Now from the full paper (footnote references removed):
The arrival of the first poison pill in 1984 supplemented the defensive power of the classified board of directors and made corporations considerably more resistant to hostile acquirers. But whereas poison pills have garnered the majority of the attention, there is a considerably more subversive (and arguably more effective) tactic that companies have used to entrench directors. Proxy puts, a specific subcategory of poison puts, exist as embedded defenses, which are often inappropriate.
Unlike poison pills, poison puts are largely outside the reach of shareholders, but have a similar ability to deter hostile deals by threatening the possibility of financial catastrophe in the event of large-scale shareholder dissent. A typical poison put provision within a debt instrument states that, upon the occurrence of a triggering event, creditors “have the right to sell the bonds back to the issuing company at [or slightly above] par.” In the case of a revolving credit agreement, the triggering event would enable a lender to accelerate a company’s outstanding debt. By accelerating debt repayment, poison puts clearly can have a chilling effect on shareholder dissent, given the accompanying risk of setting in motion a liquidity crisis. Proxy puts are one specific type of poison put, and are triggered by a change in control following a proxy contest, while poison puts can have any number of triggering events. Importantly, bondholders and loan officers are not the ones driving poison puts. Instead, poison puts are more often than not an inappropriate ploy for boards and management to entrench themselves…
Broadly speaking, poison puts can be drafted in three ways. A single-trigger proxy put, also known as a “Hostile Control Change Covenant,” is triggered “exclusively by takeover-related events that occur without the approval of management.” A ratings-decline covenant is triggered only by a bond rating decline that may result if a proxy contest is imminent, rather than the actual change in control. Finally, dual-trigger covenants are triggered by both a change in majority control of the board by non-approved directors as well as a bond rating decline. Of the three, a single-trigger Hostile Control Change Covenant is the most common, which reflects the purpose of proxy puts as almost exclusively a management entrenchment device; if the purpose of proxy puts was really to protect bondholders, one suspects that bond ratings would feature more prominently…
Ultimately, despite being dealt a seemingly mortal blow in a series of judicial decisions, proxy puts appear to be zombies of the corporate governance world: With their enforceability cast into considerable doubt after Amylin and SandRidge, their potency as a way of ensuring managerial entrenchment is questionable. Still, the fact that they have played an important role in two of the major corporate governance events of the past year suggests that they are not yet obsolete. And with the recent proliferation of shareholder activism, we expect that proxy puts will remain an important arsenal in an issuer’s proxy contest toolkit.
As Chancellor Strine noted, counsel for issuers should think carefully before agreeing to a proxy put provision in contracts. For some contracts, proxy puts would make sense. For example, a third party licensing software might have a legitimate concern that, if an incumbent board is replaced by a dissident slate, their intellectual property might be at risk. In this case, a proxy put provision terminating the IP license upon the election of the dissident slate would serve an obvious non-entrenching purpose and thus satisfy the business judgment rule. However, if a company were to embed proxy put covenants in a debt instrument after a takeover bid has been made, the negative entrenching effects would outweigh any benefits in terms of cost of capital. The board would have a much more difficult time justifying this proxy put provision in the event of shareholder challenge. Proxy puts should not be viewed by either party to a transaction or their counsel as boilerplate, but should be carefully considered and only included if they have some significant benefit beyond entrenching management.
For shareholders, we caution them to pay close attention to the issue. Although they may no longer be enforceable in every instance, proxy puts still represent an attempt by an incumbent board to usurp shareholder enfranchisement. If an incumbent board plays the proxy put “card,” this should send a strong (negative) message to shareholders that the board thinks it knows best. Proxy puts should raise serious red flags for shareholders as to whether a board is acting in their best interests.
Proxy Mosaic is a proxy research and corporate governance firm. “We believe that corporate governance is a valuable risk management tool that has the ability to affect real economic return. Our unique, targeted approach focuses on key issues that are data driven and highly correlated with shareholder value.”
The Ballantine decision illustrates the careful scrutiny that the Court of Chancery continues to place on proxy puts. Although the decision does not explicitly discuss the standard of review as it did in SandRidge, the Court clearly approached the proxy puts as entrenchment devices that warrant, at a minimum, Unocal review for reasonableness in relation to the threat posed (for a discussion of the Unocal test, see Practice Note, Fiduciary Duties of the Board of Directors: Defensive Measures). Of particular interest here is the fact that the Court applied this level of review even though there was, in fact, no actual threat. Nevertheless, the Court viewed the proxy put as a “Sword of Damocles,” in its words, that hangs over the stockholders and must therefore be scrutinized for reasonableness.
Viewed in this light, it is not hard to extend the import of Ballantine to situations that do not exactly match the facts here. Although the Court emphasized the factually specific nature of the case and highlighted several facts that add up to something like a semi-proxy contest, the underlying theory for the decision should apply even when there is no threat of a proxy contest at all. While the Court can be expected to shy away from blanket pronouncements that declare all proxy puts per se breaches of fiduciary duties, lenders and borrowers are best advised to avoid them and use financial covenants to get comfortable with the borrower’s credit-worthiness.