Why it matters

In a noteworthy decision, the Delaware Court of Chancery ruled that a lender could be held liable for aiding and abetting a breach of fiduciary duty by directors of a public company borrower by including in a syndicated credit facility a dead hand proxy put. A shareholder of Healthways, Inc., challenged an amendment to the company’s credit agreement with SunTrust Bank that featured a dead hand proxy put. Although the lender and the firm filed motions to dismiss, the court said such provisions are “highly suspect” and can give rise to lender liability for their entrenching effect, denying the motion. The decision highlights the associated risks of such provisions based on recent attacks of the plaintiffs’ bar. After the court’s ruling, the parties reached a settlement agreement that required Healthways and SunTrust to eliminate the dead hand proxy put from the credit agreement.

Detailed discussion

Shareholder Pontiac General Employees Retirement Fund brought a derivative action against the directors of Healthways, Inc., and SunTrust Bank in Delaware Chancery Court, alleging that the directors of Healthways breached their fiduciary duties by approving a credit agreement that included a dead hand proxy put and that SunTrust aided and abetted the breach.

The dispute arose after the borrower was faced with shareholder dissatisfaction and a potential proxy contest. While the proxy contest loomed, the borrower’s directors approved a fifth amendment to the company’s credit agreement.

Prior versions of the agreement contained a proxy put: a covenant intended to protect the lender in the event of a change of control that allowed the lender to accelerate the debt if a majority of the borrower’s board became composed of “non-continuing” directors.

The new amendment added in 2012 incorporated a dead hand feature that made any director elected as a result of an actual or threatened proxy contest a non-continuing director for purposes of the change of control covenant. Unlike the previous proxy put under which the board could approve new or dissident directors as continuing directors and thereby avoid triggering the covenant, the dead hand feature precluded new directors from qualifying as continuing directors and thus ensured that the election of a majority of new directors would breach the covenant.

SunTrust filed a motion to dismiss the suit, arguing that the dead hand feature was a customary or “market” term for credit agreements, that lenders like to know their borrowers, and that the dead hand feature protected the lender in the event of a wholesale change in the borrower’s board. The mere inclusion of a dead hand proxy put should not give rise to aiding and abetting liability, the lender told the court, and it should be allowed to protect its own commercial interests.

But in a ruling from the bench, Delaware Chancery Court Judge J. Travis Laster disagreed.

Because dead hand proxy puts impose a cost for and deter board changes, they can have an “entrenching” effect on the existing board and limit shareholder choice in directors, the court said. As a result, previous Delaware decisions—such as San Antonio Fire & Police Pension Fund v. Amylin Pharmaceuticals, C.A. No. 4446 VCL (Del. Ch. May 12, 2009) and Kallick v. SandRidge Energy, C.A. No. 446 VCL (Del. Ch. March 8, 2013)—have recognized that dead hand proxy puts raise conflict issues for directors.

The prior case law established that dead hand proxy puts serve a director’s personal interest in protecting his or her board incumbency but can disenfranchise shareholders and may give rise to breach of fiduciary duty claims for directors approving them, the court explained. The “ample precedent” put lenders on notice that proxy put provisions are “highly suspect.”

The judge questioned whether the lender’s change of control concerns could be better addressed through other financial covenants going to the creditworthiness of the borrower—debt ratio constraints or investment restraints, for example.

The dead hand feature was not the subject of negotiation and the borrower failed to obtain anything in return for its inclusion, the court said, and the lender knew or should have known that dead hand proxy puts are disfavored terms under recent cases in light of their eviscerating effect on shareholder franchise. Finally, notwithstanding the known public policy issues with such provisions, the lender participated in the inclusion of a provision that created a conflict for its counterparty.

Ultimately, the court was satisfied that the plaintiff had stated an aiding and abetting claim based on allegations that the borrower did not need the additional credit and the directors sought the amendment and its dead hand feature specifically because it would tend to protect their removal in the looming proxy contest.

The judge was careful to note that dead hand proxy puts are not illegal per se but can give rise to lender liability where included for their entrenching effect rather than to protect a commercial interest of the lender. The ruling reconfirms that courts view dead hand proxy puts as suspect and that lenders should be aware of the litigation risks they pose.

In May, Judge Laster granted final approval of a settlement between the parties in which Healthways and SunTrust agreed to eliminate the dead hand proxy put from the credit agreement.

To read the hearing transcript in Pontiac General Employees Retirement Fund v. Healthways, Inc., click here.