The second of a six-part series examining six specific and evolving rights plan provisions.

As discussed in greater detail in some of our prior articles,[1] a shareholder rights plan is a defensive measure used by a public company to deter (though not necessarily prevent) a stockholder from exceeding a specified ownership percentage without prior approval from the company’s board.

We have prepared a series of articles on some of the interesting and evolving features of rights plans and the various considerations that go along with them. This article is the second in the series and focuses on a clause in most rights plans that grandfathers existing stockholders whose ownership stakes are at or above the specified threshold at the time the plan is adopted.

Grandfathering Existing Stockholders

Rights plans commonly include a “grandfather clause” that exempts stockholders who, at the time of the rights plan’s adoption, have ownership stakes equal to or greater than the rights plan’s specified threshold. This allows these stockholders to maintain their stakes without immediately triggering the rights plan.

Not every company needs a grandfather clause—i.e., if they have no stockholders above the rights plan’s specified threshold. However, it has become customary to include a grandfather clause as a precaution, even where there is no known stockholder at or above the specified threshold, to avoid triggering the rights plan upon adoption if a stockholder has a greater interest than known to the board, particularly given the broad scope of “beneficial ownership” covered by rights plans, which goes beyond that covered by federal securities rules and reported by investors in their public filings.

A typical grandfather clause is drafted as follows: “No Person who Beneficially Owns, as of the time of the first public announcement of the declaration of the Rights dividend, 15% or more of the Common Shares then outstanding shall become an ‘Acquiring Person.’” This clause would also provide that grandfathered stockholders would no longer be exempt if they drop below the specified threshold, meaning that if they again went above the relevant threshold, they would trigger the rights plan.

Below are some considerations that should be taken into account when including a grandfather clause:

• Should grandfathered stockholders be permitted to acquire additional shares up to a cap (e.g., an additional 1% of the shares outstanding)? Or, should they be prohibited from acquiring any additional shares?
• If there is a known stockholder with a large ownership stake, should a specific provision be drafted dedicated to the stockholder instead of relying on the general grandfather clause?
• If a large stockholder is being grandfathered (particularly an insider), to what extent should the company take that into account when setting the general triggering threshold?
• How should founding stockholders and their families be handled?

For example, when considering a family that owns a significant number of shares, some rights plans provide that individual family members are not deemed to beneficially own shares held by his or her family members.[2] Depending on the circumstances, this language may result in each family member having an ownership stake below the specified threshold and may allow each of them to acquire additional shares up to that threshold.

Other rights plans will aggregate the entire family ownership and place a higher cap on their aggregate ownership, whether it be their aggregate ownership at the time of the rights plan’s adoption or a higher threshold. Given the coverage of most rights plans of “arrangements and understandings,” as well as more formal agreements, care should be taken not to set too narrow a grandfather clause that is triggered right away.

• If, at the time of a rights plan’s adoption, a grandfathered stockholder is party to an agreement or arrangement (e.g., a derivative contract) pursuant to which the stockholder is deemed the beneficial owner of common shares, should the stockholder be able to extend or exercise on such arrangement when it expires? Or, should any extension be considered an acquisition of additional common shares that would cause the rights plan to be triggered? To what extent can or should the company try to prevent such further acquisitions of shares based on existing arrangements?
• Be wary of a to-be‑grandfathered stockholder rapidly accumulating a significant number of additional shares right before the rights plan is adopted. The company could accidently grandfather in a stockholder at a much higher ownership percentage than originally expected.

For example, in 2014, American Apparel adopted a rights plan the day after its former CEO disclosed a 27% ownership stake.[3] However, before the plan was adopted, the former CEO had increased his stake to 43% by acquiring a significant block of shares from a hedge fund, and that large stake was grandfathered.

To help avoid situations like this one, companies should employ a good stock watch program to keep abreast of any unusual accumulations of its stock and hedge fund trading. It should also pay attention to rumors in the market.

Ultimately, the specifics of a grandfather clause will depend on facts and circumstances and should reflect, among other things, the company’s stockholder base, the identity and motives of any grandfathered stockholders, and the company’s relationship with any grandfathered stockholders.

[1] For more background, see our client alerts, “Protecting Against Opportunistic Acquisitions and Activism – Considering a Stockholder Rights Plan” and “Poison Pill Deep Dive Series: The Inadvertent Triggering Exception.”

[2] Under standard beneficial ownership language, each family member is deemed to beneficially own the shares of his or her family members.

[3] See Shan Li, American Apparel, ousted founder trade power plays, Los Angeles Times (June 30, 2014), available at: https://www.latimes.com/business/la-fi-american-apparel-20140701-story.html.

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