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On May 2, 2014, Vice Chancellor Donald Parsons of the Delaware Court of Chancery issued a significant decision in the litigation brought by Daniel Loeb's hedge fund, Third Point LLC, challenging Sotheby's stockholder rights plan ("poison pill"), which effectively permits "passive" stockholders to acquire up to 20 percent of Sotheby's stock, while capping activist investors such as Third Point at a 10 percent ownership position.1 Third Point had sought an injunction delaying Sotheby's May 6 annual meeting until a full trial could be conducted on the validity of the company's poison pill. The Court of Chancery denied Third Point's motion in a decision that could have significant long-term consequences for companies and "activist" stockholders seeking to obtain seats on a company's board or otherwise effect corporate change.
Notwithstanding Sotheby's victory in court, earlier today—the day before Sotheby's annual meeting—the parties reached an agreement to settle their disputes. The agreement gave Third Point much of what it had sought in the proxy contest and related litigation, including adding the three nominees proposed by Third Point to the Sotheby's board, as well as agreeing to the termination of the company's poison pill concurrent with the 2014 annual meeting. In addition, Third Point agreed to cap its equity ownership at 15 percent.
Beginning in the spring and summer of 2013, activist hedge funds including Trian Fund Management, L.P., Marcato Capital Management LLC (Marcato), and plaintiff Third Point made SEC filings announcing their purchases of equity interests in Sotheby's. Sotheby's board, following consultation with its legal, financial and other advisors, reviewed how stockholder activists influence companies as well as the potential impact of such actions upon the company. During this same period Sotheby's management held meetings with representatives from Marcato and Third Point.
In October 2013, Third Point amended its 13D, announcing that it had acquired a 9.4 percent stake in Sotheby's with an intent to effect corporate change. The filing included a letter from its CEO, Daniel Loeb, that attacked Sotheby's on several grounds, recommended that its CEO be replaced and stated that Loeb had already begun having discussions with potential candidates for the Sotheby's CEO position. At Sotheby's board meeting held October 3-4, the directors adopted a poison pill with three salient features: (1) it capped 13D filers at a 10 percent stake, but capped others (e.g., passive 13G filers) at a 20 percent stake; (2) it contained a "qualifying offer" exception, providing that the pill would not be triggered in response to an offer to purchase "any-and-all" shares of the company that would give the Sotheby's stockholders at least 100 days to consider the cash out offer; and (3) it included a "proscription of concerted action."2
Following adoption of the pill, Third Point bought additional shares to inch closer to the 10 percent threshold, announced that it would nominate a short slate of three new directors on the 12-member, non-staggered board at the May 6 annual meeting, negotiated with Sotheby's over the possibility of Loeb or another representative being added to the board to avoid a proxy fight, and continued to clamor for changes in the business and management.
In March 2014, Third Point requested that Sotheby's grant it a waiver from the pill's 10 percent trigger to allow it to purchase up to a 20 percent equity stake ahead of the meeting, i.e., to be treated the same as 13G filers under the pill. The Sotheby's board considered the request and decided not to grant the waiver, determining that nothing had changed that would warrant a change in the pill. Third Point filed a complaint in the Delaware Court of Chancery soon after learning of the board's decision denying Third Point the waiver from the pill's 10 percent trigger, arguing that the decisions to adopt and maintain the pill constituted breaches of Sotheby's directors' fiduciary duties. Third Point sought and obtained expedited discovery.
Among other things, the plaintiffs argued that the Sotheby's board was improperly using the pill—and had included a trigger that treated passive and activist stockholders differently—simply to help the incumbents win the proxy context, rather than in response to any legitimate perceived threat. As evidence of this motivation, the plaintiffs pointed to certain directors' willingness to consider (1) implementing Third Point recommendations, (2) adding Loeb as a new director outside of the proxy context, (3) making large dividends and stock repurchases that might preempt Third Point's platform when campaigning for votes from the other stockholders and (4) pulling the pill if it would result in large institutional investors and proxy advisory firms supporting the incumbent slate.3 In turn, the Sotheby's directors argued that the adoption and maintenance of the pill were appropriate responses to the threats that (1) a creeping takeover could be effected by a "wolf pack" of activist stockholders, (2) a stockholder could obtain "negative" control without paying a premium, and (3) Loeb's alleged disruptive behavior would harm the company's employee and customer relationships.
The Court of Chancery's Decision
Vice Chancellor Parsons evaluated the implementation and the adoption of the pill under the Unocal standard,4 essentially requiring the board to articulate a legally cognizable threat5 and to demonstrate that the defensive response was reasonable in relation to the threat posed.6 The court separately applied this Unocal analysis both to the initial adoption of the pill and the decision to deny Third Point a waiver.7
The court determined that the Sotheby's board's decision to adopt the pill was justified by a perceived, and objectively reasonable, threat that Third Point, in tandem with the other activist Sotheby's stockholders, could acquire "creeping control" of the company without paying a control premium or negotiating with the board. Specifically, the court held that the presence of multiple hedge funds buying up Sotheby's stock simultaneously, and the input the board had received that such funds may "form a group or 'wolfpack,' for the purpose of jointly acquiring large blocks of a target company's stock," supported the board's "assertion that its good faith investigation led it to determine that Third Point posed a legally cognizable threat."8 Additionally, the court held, in further application of the Unocal test, that the pill was not coercive or preclusive, as it did not inhibit the way that any stockholder could cast his or her vote, and, by all accounts, the outcome of the proxy fight was a "coin flip."9 After pointing out that the plaintiffs had not directly attacked the validity of a 10 percent trigger under Delaware law, the court noted that such a level may appropriately respond to the concern that several hedge funds, acting with "conscious parallelism,"10 could make open market purchases to arrive at a control position without paying a premium, and concluded that "Delaware law mandates a reasonable response, not a perfectly tailored solution."11
Notwithstanding the plaintiffs' evidence that they claim showed the directors' focus on the outcome of the proxy fight, and potential willingness to pull the pill if it would help the incumbents' chances at the meeting, the court determined that these board composition motivations were incidental to the directors' response to the "creeping control" threat described above.
The court stated that the decision not to waive the 10 percent threshold for Third Point presented a "much closer question" under Unocal.12 Specifically, the Vice Chancellor described this question as "uncomfortably close" and stated that he was "not unsympathetic to Plaintiffs' position," in light of the evidence indicating that the board may have been motivated by winning the proxy contest and remaining in office, and the fact that poison pills are "potent defensive measures [that] can, and do, affect the shareholder franchise."13 Nonetheless, the court ultimately found that the decision not to waive the 10 percent threshold was also justified. It found there to be a perceived, and objectively reasonable, threat of "effective, rather than explicit negative control" that would result from Third Point having such a large stake in the company, along with the board seats that it would be more likely to win in the proxy contest, against the backdrop of the Sotheby's board's allegations of aggressive prior actions on the part of the Third Point CEO. Even though the board pointed to no supermajority voting rights or other provisions that could give Third Point an actual veto right with a greater-than-10-percent stake or three board seats, the court held that the evidence indicated that the Sotheby's board had a good faith belief that Third Point would have "disproportionate control and influence over major corporate decisions" at a 20 percent stake, "even if they do not have an explicit veto power."14 The court further determined, on the preliminary record, that "there appears to be an objectively reasonable basis" for the belief that Third Point could exercise influence sufficient to control certain corporate actions, in light of the fact that Sotheby's had no other stockholders near that level, and in light of the allegations of Third Point management's "aggressive" behavior in relation to Sotheby's.15
To obtain a preliminary injunction of the annual meeting pending a trial on the merits of the pill, the plaintiffs were required to demonstrate "(1) a reasonable probability of success on the merits, (2) that absent injunctive relief, they will suffer irreparable harm; and (3) that the balance of the parties' harms weighs in favor of injunctive relief."16 Because the court held that the Sotheby's board's decisions with regard to the pill were likely to satisfy the Unocal standard, the plaintiffs could not demonstrate that they had a reasonable probability of success on the merits. Therefore, the court denied the motion for preliminary injunction. Though it is perhaps cold comfort to the plaintiffs, the court stated that Third Point17 had presented stronger arguments than the Sotheby's board on the irreparable harm and balance of the equities prongs of the Unocal test.18
It is important to remember that the procedural posture was a motion for preliminary injunction and that the ultimate outcome of the case could have been different if Third Point had continued to trial, as a trial can be significantly influenced by a number of factors not present at the preliminary injunction phase. That said, the court's decision is still likely to be perceived as at least some support for rights plans with 10 percent triggers and for two-tiered rights plans that permit passive investors to take a higher stake, albeit with the Court stating that it is "generally sympathetic to the policy concerns" raised by the institutional investor stockholders regarding a two-tiered pill. 19
The decision will also be a useful reference point for companies seeking to address "activist" stockholders, as well as for stockholders themselves. Here, the court confronted a novel issue under Delaware law: the use of a poison pill—which has been upheld by Delaware courts many times, but most typically in the context of warding off a takeover—in response to stockholder activism. The decision potentially gives support to companies seeking to adopt measures in response to this modern issue. At the same time, it is important to bear in mind the specific facts of the decision. The court cited several factors in determining the Sotheby's board likely did not act with the primary purpose of entrenchment: the board was "dominated by" outside, independent directors; the board's turnover rate (of about 7 years) was faster than the average S&P 500 and S&P 1500 rates (each of which is a little more than 10 years); and the court noted that the pill contained a "qualified offer" exception. At the same time, the court also focused on the specific language of the funds' Schedule 13Ds and the funds' behavior to determine the "threat" they posed. Without these factors supporting the board's decision, one can imagine a very different outcome—particularly with respect to the decision not to waive the pill to treat the activist the same as a passive stockholder would be treated. Simply put, this decision is very fact-specific and boards should be sensitive to the particular facts and circumstances they face, as well as the process they use in reaching a decision, including the appropriate use of legal and financial advisors, when adopting or maintaining pills in the proxy contest context.
Finally, the case is again a reminder of the increasing use of electronic discovery in expedited litigation. For example, the briefs and opinion cited lengthy quotations from emails written by executives from both sides that included disparaging language about the other parties. The parties not only used these emails in their contentions about the other side's motivations, but the correspondence, which have now become publicly reported on, also contained sensitive statements about Sotheby's business and may, as a practical matter, factor into the results of the proxy contest. It is hard to imagine in today's world that executives of public companies or activists have not been repeatedly advised by counsel of the risks associated with email (and other electronic transmissions), yet the reality is that even when litigation is likely—and litigation is always likely in any proxy contest or public company change of control transaction—it is very difficult to develop an effective communication policy to limit the damage in a future litigation. Nonetheless, it must be again emphasized that contemporaneous documents can be the most persuasive evidence in any litigation, and companies and their advisors must continually focus on these communications prior to commencement of the litigation (as well as completion of the transaction).
1 Third Point LLC v. Ruprecht, C.A. No. 9469-VCP (May 2, 2014).
2 The court presumably used this phrase to refer to pill language combining the holdings of parties sharing an "agreement, arrangement or understanding" for purposes of counting a stockholder's "beneficial ownership" and determining whether the pill has been triggered.
3 Institutional stockholders, purporting to represent the class of non-hedge-fund Sotheby's stockholders and represented by traditional plaintiffs' attorneys, also joined the litigation as plaintiffs, arguing that the discriminatory nature of a two-tiered pill would chill beneficial activist participation in the corporate franchise.
4 The plaintiffs had presented some arguments that the more exacting Blasius standard should apply, requiring a "compelling justification" for board actions taken "for the primary purpose of interfering with the effectiveness of a stockholder vote." Op. at 35 (quoting Yucaipa Am. Alliance Fund II, L.P. v. Riggio, 1 A.3d 310, 330 (Del. Ch. 2010); Blasius Indus., Inc. v. Atlas Corp., 564 A.2d 651, 659 (Del. Ch. 1988)). But after considering an application of the facts to a Blasius analysis within the Unocal framework (and describing such approach as unlikely to apply in the poison pill context), the court determined that the plaintiffs had not shown a likelihood that the Sotheby's board had acted with the primary purpose of disenfranchisement, and therefore that the "compelling justification" standard was not applicable.
5 This first prong is referred to as the "reasonableness" test and is process-oriented.
6 This second prong is referred to as the "proportionality" test and requires the court to consider whether a board's actions were "draconian, by being either preclusive or coercive," and whether they fell within a range of reasonableness. Op. at 38. Notably, Third Point conceded that the rights plan was not preclusive, as it believed that, in spite of the pill, its proxy fight was still winnable. Id. at 45 n.30.
7 See Op. at 39 ("[E]ach independently must pass muster under Unocal.").
8 Op. at 40.
9 Op. at 55.
10 Op. at 47.
11 Op. at 47 n.35.
12 Op. at 50.
13 Op. at 52 n.39.
14 Op. at 51.
15 The court presented "executive recruitment" as an example of corporate action not requiring actual control or an explicit veto that Third Point could affect significantly if the pill was waived to allow it to control a 20 percent stake. Op. at 51-52. This emphasis appears to be colored by the fact that Sotheby's identified client relationships, financial discipline, and the ability to attract and retain experts and specialists as the "three key factors" driving its business. Id. at 5.
16 Op. at 34 (citing In re Netsmart Techs., Inc. S'holders Litig., 924 A.2d 171, 191 (Del. Ch. 2007)).
17 Notably, the court distinguished plaintiff Third Point from the institutional investor stockholder plaintiffs in this regard. Op. at 53. The court determined that arguments against the discriminatory nature of the pill did not present imminent threats because there were no 13G filers who had more than a 10 percent stake anyway.
18 Specifically, the court found that "Third Point's reduced odds of winning the proxy contest due to the Rights Plan likely would have qualified as a threat of irreparable harm, if Third Point had established a likelihood of success on the merits," even though, in order for the failure to grant a waiver to have had an effect, Third Point would have had to lose by a small enough margin that increasing its holdings by 10 percent could swing the election—meaning that they would have otherwise actually needed to buy stock (including the votes, which was questioned by Sotheby's since the record date for stockholders entitled to vote at the annual meeting had already been set) from enough supporters of the incumbents to have made a difference. Op. at 54; 56. Creating the confusion of undoing the election or telling Third Point to wait until next year would not have been sufficient remedies, according to the court. Moreover, the balance of the harms also would have been "slightly" in Third Point's favor, justifying a prompt expedited trial if it had shown a likelihood of success on the merits, as, in that case, Sotheby's would not have been significantly harmed by delaying an annual meeting that would have been under a cloud because of questions over its validity.
19 Op. at 62.
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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.
© Wilson Sonsini Goodrich & Rosati
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