by Caitlin Millat*
Does a board of directors’ power to direct a corporation allow it to tie its own hands in the course of negotiating debt agreements? In this Contribution, Caitlin Millat (’18) analyzes the problem of dead-hand proxy puts under Delaware law, considering whether these provisions are ever allowed, and if they are, under what standard of scrutiny they should be reviewed. This contribution argues that dead-hand proxy put provisions should be evaluated under the business judgment rule, not the Unocal enhanced scrutiny standard.
The dead-hand feature of a proxy put has been one of corporate law’s most debated topics of late, as litigation concerning dead-hands has caused confusion among companies, lawyers, and judges alike.2 These features permit creditors immediately to accelerate debt once the majority of a board is comprised of non-continuing directors.3 However, the addition of features like a dead-hand – which provides that any new director elected through a proxy contest is a non-continuing director, regardless of board approval – has caused a flurry of litigation.4
In Healthways I, the most significant recent case law regarding dead-hand provisions, the Delaware Court of Chancery denied a motion to dismiss and held that banks could potentially be liable for aiding and abetting a creditor’s breach of loyalty due to the inclusion of a dead-hand.5 Healthways I opened the floodgates for plaintiffs’ lawyers to challenge dead-hand features, leaving companies and courts alike to make sense of whether dead-hands subject corporations to liability for a violation of the duties of care or loyalty.6 Delaware courts have also held that the Unocal intermediate standard of review should be applied to review of dead-hand puts.7
This article will argue that a dead-hand proxy put adopted by a board of directors before the threat of takeover should be evaluated under the business judgment rule, not the Unocal standard of enhanced scrutiny,8 and, as such, is generally legally valid when directors are disinterested. This article will also argue that there is and has been no per se rule against dead-hand features in the Delaware courts, and that case law purportedly striking these provisions is factually unique and inapplicable to dead-hands adopted before a takeover threat.
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Delaware courts have long held that the protection afforded by the business judgment rule is far-reaching and that, as long as directors remain disinterested and have taken appropriate care, their decisions are protected.9 When the business judgment rule is invoked, directors’ decisions will be upheld absent an “abuse of discretion.”10 If the business judgment rule is applied, the presumption is that “directors acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interest of the company.”11 When the business judgment rule applies, the board’s decisions “will not be disturbed if they can be attributed to any rational business purpose.”12 The business judgment rule is available even when organizations face a takeover threat, but organizations must first clear the hurdle prescribed in Unocal because of the “omnipresent specter that a board may be acting primarily in its own interests, rather than those of the corporation and its shareholders . . . .”13 Under Unocal, the business judgment rule may be applied in takeover situations only after directors have established “reasonable grounds for believing that a danger to corporate policy and effectiveness existed because of another person’s stock ownership.”14
In the context of dead-hand proxy puts, however, courts have debated how broadly the business judgment rule applies and whether the inclusion of a dead-hand feature constitutes a violation of fiduciary duties, even when the dead-hand was adopted before an existing takeover threat.15 But Delaware courts have not conclusively ruled on measures such as proxy puts with a dead-hand feature when adopted prior to a threat, and these provisions remain legally valid.16
The Delaware Court of Chancery has held that when measures such as dead-hand proxy puts are adopted in response to a takeover bid or in the shadow of a threat, the Unocal test is the appropriate standard of review.17 However, the Court of Chancery held in Doskocil Cos. v. Griggy that, because, in part, defendant directors neither asked for nor wanted the put provision at issue in the case, the Unocal standard was inapplicable, and business judgment should instead be used to evaluate defendant’s adoption of the provision.18 Indeed, in Unocal, the court articulated that the analysis comes into play only when a board is “address[ing] a pending takeover bid . . . .”19 Hence, as the Delaware Court of Chancery explained in Shamrock Holdings, Inc. v. Polaroid Corp., the Unocal analysis “starts from the premise that the board action at issue was defensive.”20
Several Delaware cases give criteria for what makes an action a defensive measure under Unocal. One key criterion is the timing of a challenged board decision. If the decision to implement a measure was planned or discussed before a Schedule 13D was filed, this can weigh against seeing the measure as defensive under Unocal.21 Schedule 13Ds must be submitted to the U.S. Securities and Exchange Commission (“SEC”) within 10 days when a person or entity acquires beneficial ownership of more than 5 percent of a voting class of a corporation’s publicly traded equity securities.22 Although the filing of a Schedule 13D can signal that the target corporation may shift into “defensive mode,” the Court of Chancery has held that this does not mean all corporate decisions post-filing must be evaluated as defensive actions.23 Additionally, the Court of Chancery has primarily analyzed the decision to adopt the measure – not just the potential effects of that measure – to determine whether the action was purely defensive or for a legitimate business purpose.24
The most recent and significant case law coming out of Delaware, Healthways I, squarely dealt with the issue of timing in regards to whether dead-hand features should be struck.25 In Healthways I, the court declined to dismiss plaintiff’s allegations that the board of directors breached its fiduciary duties when it included a dead-hand provision in its credit agreement.26 In his ruling, Vice Chancellor Laster determined that the dead-hand proxy put’s existence – even if it were never triggered – created a “Sword of Damocles” effect on shareholders.27 Vice Chancellor Laster further called the dead-hand a “highly suspect” device that could leave the board powerless to stop the triggering of a proxy put.28 Because of this, shareholders could be strong-armed: run a proxy contest and risk triggering the dead-hand feature, or accept the existing board of directors as-is.
Importantly, Healthways I turned on intensely case-specific facts, most notably the timing of the dead-hand. The dead-hand at issue was adopted mere days after stockholders voted to destagger the board, which itself threatened the existing board members’ chances to remain in office.29 Vice Chancellor Laster emphasized this point when he clarified his Healthways I decision in a second bench ruling in 2015. Calling the ruling “frequently misunderstood,” he stated that it “can’t be stressed enough” that his holding only applied to provisions “adopted in the shadow of a proxy contest,” – not “any change-in-control provision.”30 Under this analysis, a dead-hand feature built into a proxy put years before a takeover threat should not trigger Unocal review because it would lack the defensive timing commonly associated with takeover attempts, and would likely be in place before the filing of a Schedule 13D. Therefore, such a dead-hand would not appear as a deliberate attempt to entrench the board.
Under the business judgment rule, the applicable standard in factual scenarios without evidence of self-dealing,31 dead-hand features are presumptively valid because there may be a legitimate business purpose for the provision: they protect creditors’ interests in knowing their borrowers and build confidence in the stability of the loan. Dead-hand proxy puts of this kind are not unilaterally adopted by the board of directors; they are often negotiated with third-party lenders to incentivize better deals on loans.32 The Court of Chancery’s jurisprudence on this issue is limited, but it held in Healthways I that the commonly held “know-your-borrower” rationale is part of a “fundamental belief that lenders like to know who their borrowers are.”33
Indeed, research conducted on dead-hand proxy put provisions demonstrates legitimate business reasons for using dead-hands in debt agreements. One study found that a dead-hand can “reduce the cost of debt by approximately 50 basis points.”34 The study also indicates that bondholders benefit and that shareholders are not significantly harmed by such a provision.35
In spite of this, the Court of Chancery has found that features like dead-hands may not always survive a business judgment inquiry if the board has not fully informed itself of their existence.36 In San Antonio Fire & Police Pension Fund v. Amylin Pharmaceuticals, Inc., Chancery said that the board should take all precautions to become aware of, and meaningfully become informed about, a dead-hand put.37 Indeed, the court cautioned in Amylin that a “court would want, at a minimum, to see evidence that the board believed in good faith that, in accepting [a proxy put], it was obtaining in return extraordinarily valuable economic benefits for the corporation that would not otherwise be available to it.”38 Additionally, the court held in Kallick v. Sandridge Inc. that companies should “bargain hard to exclude that toll on the stockholder franchise and only accede to the Proxy Put after hard negotiation and only for clear economic advantage.”39
But no Delaware court has ever held that boards must become aware in order to avoid liability; the Amylin holding may also be read as a warning about dead-hands that stops just short of striking them. The law under Amylin merely requires that directors act in good faith in using dead-hands and take reasonable steps to inform themselves about the put.40 Indeed, it’s well-established that a director need not read every word of “every contract or legal document he or she approves.”41
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Though it has come close, Delaware courts have chosen on several occasions not to strike dead-hand proxy puts, and dead-hands are, as the law stands now, a legally valid option for corporations – with some conditions.42 Indeed, directors of corporations that include dead-hand features in agreements should proceed cautiously after the clear warning from Delaware courts that they are on “notice” that these such provisions are “highly suspect” and could potentially lead to breach of duty claims.43 Additionally, after Healthways I, the timing of the dead-hand is crucial; corporations that adopt a dead-hand proxy put in the shadow of a takeover situation could be subject to a Unocal inquiry if courts find the move to be defensive in nature.44
In spite of this, it must be acknowledged that dead-hands are risky and can put the shareholder franchise in jeopardy.45 Delaware courts have expressed contempt toward provisions like dead-hands, calling them “catastrophic”46 to shareholders and citing the “troubling reality that corporations and their counsel routinely negotiate contract terms that may, in some circumstance, impinge on the free exercise of the stockholder franchise.”47 Though there is a longstanding tradition of protecting directors’ decisions with the business judgment rule, there exists also the bedrock principle of shareholder protection that is baked into the foundation of corporations law.48 As it weighs this balance, Delaware courts may continue to tighten restrictions on dead-hand proxy puts. Until that point, however, these provisions remain legally valid extensions of a board’s business judgment, provided that directors take heed of a dead-hand’s terms.
* Caitlin Millat is a 3L at New York University School of Law. This piece is a commentary on the 2017 Problem at the Ruby R. Vale Interschool Corporate Moot Court Competition held in Wilmington, Delaware. The issue in the problem dealt with a corporation that had written a dead-hand proxy put into its charter several years before a takeover threat emerged and the subsequent shareholder litigation that commenced. The views expressed in this article do not necessarily represent the views of the author on this point. Rather, this article is a distillation of one side of an argument assigned to the team the author represented at the Vale Interschool Corporate Moot Court Competition.
2. See, e.g., Pickering Bomba et al., “Dead Hand Proxy Puts” – What you Need to Know, Fried Frank M&A Briefing 1 (2015), http://www.friedfrank.com/siteFiles/Publications/FINAL%20-%206-5-2015%20-%20Dead_Hand_Proxy_Puts_What_You_Need_to_Know.pdf (“There has been much recent concern and confusion over the inclusion of ‘dead hand proxy puts’ . . . in debt agreements.”).
3. T. Brad Davey & Christopher N. Kelly, Dead Hand Proxy Puts Face Continued Scrutiny, Bloomberg BNA Corp. L. & Accountability Rep. 1 (June 5, 2015), http://www.potteranderson.com/media/publication/670_TBD%20CNK%20Dead%20Hand%20Proxy%20Puts%20Face%20Continued%20Scrutiny%20Bloomberg%20BNA%206%205%2015.pdf.
4. See, e.g., San Antonio Fire & Police Pension Fund v. Amylin Pharms., Inc., 983 A.2d 1173 (Del. 2009); see generally Pontiac Gen. Emps. Ret. Sys. v. Ballantine (Healthways I), C.A. No. 9789-VCL (Del. Ch. Oct. 14, 2014) (transcript ruling) (holding that plaintiff’s complaint asserting a claim for aiding and abetting against SunTrust for being a “party to an agreement containing an entrenching provision that creates a conflict of interest on the part of the fiduciaries on the other side of the negotiation.”).
5. See Healthways I (Tr. 80) (“I believe that, as pled, this complaint satisfies the motion to dismiss.”).
6. T. Brad Davey & Christopher N. Kelly, supra note 3, at 1 (“Dead hand proxy puts have emerged as the target du jour for entrepreneurial plaintiffs counsel litigating corporate governance claims.”).
7. See, e.g., Kallick v. Sandridge Energy, Inc., 68 A.3d 242, 247-48 (Del. Ch. 2013) (applying the Unocal standard of review to conclude Sandridge Energy violated its duties when failing to approve a dissident slate). Under Unocal, when a board is addressing a pending takeover bid, a heightened level of scrutiny applies because of the “omnipresent specter” of a board attempt at entrenchment. Unocal Corp v. Mesa Petroleum Co., 493 A.2d 946, 954 (Del. 1985). This requires boards to show that their actions were “reasonable in relation to the threat posed” and not coercive. Id. at 955.
8. See generally Unocal, 493 A.2d 946.
9. See, e.g., Sinclair Oil Corp. v. Levien, 280 A.2d 717, 720 (1971) (under the business judgment rule, “a court will not interfere with the judgment of a board of directors unless there is a showing of gross and palpable overreaching.”).
10. Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984) (“Absent an abuse of discretion, that [business] judgment will be respected by the courts.”).
12. Sinclair Oil, 280 A.2d at 720.
13. Unocal, 493 A.2d at 954.
14. Id. at 955.
15. See, e.g., Pontiac Gen. Emps. Ret. Sys. v. Ballantine (Healthways II), C.A. No. 9789-VCL (Del. Ch. May 8, 2015) (transcript ruling) (Tr. 35) (in which Vice Chancellor Laster explained that the legality of a dead-hand was contextual based on the narrow facts of the case and that the key to the decision was that it had been adopted “in the shadow of a proxy contest”); Kallick v. Sandridge Energy, Inc., 68 A.3d 242, 258 (Del. Ch. 2013) (applying intermediate scrutiny under Unocal to conclude that the board breached its fiduciary duties to its stockholders, holding that “Unocal is the proper standard of review to examine a board’s decision to agree to a contract with [dead-hand] provisions and to review a board’s exercise of discretion as to the change of control provisions under such a contract.”); Fire and Police Fund San Antonio v. Stanzione, C.A. No. 10078-VCG (Del. Ch. Feb. 25, 2015) (transcript ruling) (Tr. 7-8) (“as our case law describing the use of similar proxy puts as problematic becomes more developed, the value of removing such a device decreases. The situation begins to be less like chaining up a vicious bulldog and more like chaining up a toothless bulldog.”).
16. See, e.g., Pontiac Gen. Emps. Ret. Sys. v. Ballantine (Healthways I), C.A. No. 9789-VCL (Del. Ch. Oct. 14, 2014) (transcript ruling) (Tr. 76) (“No one is suggesting [this is a per se analysis]. Nor does the denial of the motion to dismiss depend on any theory that entering into an agreement that contains a proxy put is a per se breach of fiduciary duty.”).
17. See, e.g., Kallick, 68 A.3d at 258 (holding that for clauses with defensive value such as proxy puts adopted in the shadow of a takeover, “Unocal is the proper standard of review to examine a board’s decision to agree to a contract with such provisions.”).
18. Doskocil Cos. v. Griggy, No. CIV.A. 10,095, 1988 WL 85491, at *6 (Del. Ch. Aug. 18, 1988) (holding that a plan that was reactivated several months prior to a potential threat and had been under consideration for over a year could be explained by the “condition of the market” and therefore, even if defendant directors were operating in a “defensive mode,” it would not “necessarily follow that other corporate decisions were also made in response to a perceived takeover threat.”).
19. Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946, 954 (Del. 1985).
20. Shamrock Holdings, Inc. v. Polaroid Corp., 559 A.2d 257, 271 (Del. Ch. 1989) (holding that adopting employee stock ownership plan several months after a takeover threat was posed was entirely fair because the plan had been in development prior to the threat).
21. See Doskocil, 1988 WL 85491 at *5 (“The adoption of a Rights Plan within a few weeks after the Schedule 13Ds were filed . . . strongly suggest that the defendant directors were operating in a defensive mode.”).
22. 17 C.F.R. § 240.13d-1(a).
23. See Doskocil, 1988 WL 85491 at *6 (“However, even assuming that the Rights Plan was adopted as a defensive measure, it does not necessarily follow that other corporate decisions were also made in response to a perceived takeover threat.”).
24. See, e.g., Henley Grp., Inc. v. Santa Fe S. Pac. Corp., No. CIV.A. 9569, 1988 WL 23945, at *13 (Del. Ch. Mar. 11, 1988) (deciding whether Unocal applied to the decision to adopt a particular debenture by analyzing when planning began on the debenture, how the debenture fit into other, existing plans, and, among other reasons, if the restructuring could have been accomplished without the debenture).
25. See generally Pontiac Gen. Emps. Ret. Sys. v. Ballantine (Healthways I), C.A. No. 9789-VCL (Del. Ch. Oct. 14, 2014) (transcript ruling).
26. See id. at 80-81.
27 Id. at 80.
29 Id. at 45 (“on May 31st, 2012, Healthways’ shareholders, over the boar’s objection, voted to destagger the board. Nine days later, Healthways adopts the dead hand provision.”)
30. Pontiac Gen. Emps. Ret. Sys. v. Ballantine (Healthways II), C.A. No. 9789-VCL (Del. Ch. May 8, 2015) (Tr. 36); see also id. at 35 (the ruling on the previous motion to dismiss was a “contextual ruling based on the facts of the case”; the court also refused to grant the motion to dismiss was because the dead-hand was adopted “in the shadow of a proxy contest.”).
31. See, e.g., Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984) (business judgment rule protects “disinterested directors whose conduct otherwise meets the tests of business judgment[,]” i.e. the “directors can neither appear on both sides of a transaction nor expect to derive any personal financial benefit from it in the sense of self-dealing, as opposed to a benefit which devolves upon the corporation or all stockholders generally.”).
32. See T. Brad Davey & Christopher N. Kelly, supra note 3, at 2.
33. Healthways I (Tr. 28).
34. Sean J. Griffith & Natalia Reisel, Dead Hand Proxy Puts, Hedge Fund Activism, and the Cost of Capital 6 (manuscript of Dec. 17, 2016), available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2799491; see also id. at 23 (“Although the precise amount of savings varies with each specification, we consistently find that Dead Hand Proxy Puts provide a benefit to corporations by reducing the cost of debt.”).
35. Id. at 23 (“we find evidence that bondholders benefit from the inclusion of the provision in loan agreements, and we find no evidence that shareholders are harmed by the provision.”).
36. See, e.g., San Antonio Fire & Police Pension Fund v. Amylin Pharms., Inc., 983 A.2d 304, 318 (Del. 2009) (acknowledging that directors need not read every word of an indenture, but specifically acknowledging provisions like dead-hand features to hold that, “specifically, terms which may affect the stockholders’ range of discretion in exercising the franchise should, even if considered customary, be highlighted to the board. In this way, the board will be able to exercise its fully informed business judgment.”).
38. Id. at 315.
39. Kallick v. Sandridge Energy, Inc., 68 A.3d 242, 247-48 (Del. Ch. 2013) (explaining that the record on whether lenders had “pressed hard” to include such a change of control provision containing a proxy put was “nonexistent”).
40. See, e.g., Amylin, 983 A.2d at 318 (holding that a board which retained counsel and consulted with investment bankers as well as inquired if there were any “unusual or not customary” provisions in the terms of the indenture was not grossly negligent when adopting a continuing directors provision akin to a dead-hand).
41. Smith v. Van Gorkom, 488 A.2d 858, 883 n.25 (Del. 1985).
42. See, e.g., Pontiac Gen. Emps. Ret. Sys. v. Ballantine (Healthways II), C.A. No. 9789-VCL, Del. Ch. May 8, 2015) (Tr. 36) (provisions adopted in the shadow of a takeover threat are more likely to be subject to Unocal review and breach of duty or aiding and abetting claims); Kallick, 68 A.3d at 248 (holding that boards should attempt to negotiate out of including provisions like a dead-hand put); Amylin, 983 A.2d at 315 (the inclusion of a proxy put should result in “extraordinarily valuable economic benefits for the corporation that would not otherwise be available to it.”).
43. Healthways I (Tr. 80) (there has been “ample precedent from this Court putting lenders on notice that these provisions were highly suspect and could potentially lead to a breach of duty on the part of the fiduciaries who were the counter-parties to a negotiation over the credit agreement.”).
44. See generally id.
45. See Amylin, 983 A.2d at 315 (citing the “eviscerating effect on the stockholder franchise” that a dead-hand provision could have).
46. Id. at 319.
48. See, e.g., Hambleton Bros. Lumber Co. v. Balkin Enterprises, Inc., 397 F.3d 1217, 1227 (9th Cir. 2005) (“Shareholder protection through the corporate form is ingrained in our economic and legal systems.” (internal quotation marks omitted)).