“Proxy put” provisions, which have been widely used in credit agreements and indentures since the 1980s, have recently garnered the attention of shareholders and plaintiffs lawyers, calling into question their value and the motivations behind their use.

Proxy puts give lenders the ability to accelerate a company’s debt obligations if the majority of the company’s directors lose control of the board.  Shareholders claim that companies use that threat of accelerated debt repayment to coerce votes against directors nominated by dissident shareholders in a proxy context, turning a standard loan provision into an entrenchment mechanism used to ward off unwanted takeovers.  Companies respond that proxy puts are “market” and are required by their lenders, who argue they need to know their borrowers and protect themselves from sudden and unexpected changes in management philosophy and direction.

Proxy Put Provisions

The protections afforded to lenders and bondholders under most credit agreements and indentures typically include a “change in control” concept, which generally includes some form of proxy put provision.  In a common variation of the provision, an event of default is triggered if, over a specified time period (typically 12 to 24 months), a majority of the borrower’s directors cease to be individuals

• who were members of the board on the date the credit agreement or indenture was executed (“Original Directors”) or
• whose election or nomination to the board was approved by a majority of the Original Directors.

In another variation of the provision, called a “dead-hand proxy put,” an event of default occurs even if the board members nominated by a dissident shareholder in connection with a proxy contest are approved by the Original Directors.

Recent Cases

Courts have wrestled with proxy put provisions in a string of recent cases.

In San Antonio Fire & Police Pension Fund v.  Amylin Pharmaceuticals, Inc. (“Amylin”) (opinion can be found here), Amylin was embroiled in a proxy contest where two shareholders each nominated five directors to be elected to Amylin’s 12-person board of directors.  Amylin’s indenture had a proxy put provision that provided holders of the company’s senior notes with the right to sell their notes back to Amylin at par if the Original Directors did not constitute a majority of the board or the Original Directors did not approve the nomination of certain directors to the board.  When the proxy put provision came to light, one of the dissident shareholders requested that the board approve the nomination of the dissident nominees to avoid a default under the indenture.  When the board refused, the dissident shareholder sought a declaratory judgment from the Delaware Court of Chancery.

The court sided with the dissident shareholder and held that the board may approve the dissident shareholder’s nominees in order to prevent a default and, at the same time, oppose the election of such directors and run its own slate of nominees.  The court also analyzed whether the board breached its duty of care by adopting an indenture containing the proxy put provision. The court ruled that the board had not breached its duty of care, persuaded by the fact that the board had sought the advice of counsel, its investment bankers and Amylin’s management before adopting the indenture.

In Kallick v.SandRidge Energy, Inc. (“SandRidge”) (opinion found here), SandRidge was engaged in a proxy contest with one of its shareholders that was campaigning to declassify SandRidge’s board, remove the incumbent directors and elect a new slate of directors.  SandRidge’s board did not approve the dissident’s slate of directors and instead cautioned shareholders that the election of the dissident’s slate would constitute a change in control under SandRidge’s indenture and trigger the accelerated repayment of the company’s debt.  When SandRidge began soliciting shareholders and obtaining consent revocations from shareholders that had already voted, the dissident shareholder sought an injunction from the Delaware Court of Chancery.  In granting the injunction, the court subjected the board’s decision not to approve the dissident slate of nominees to a heightened standard of review and required the board to justify its actions as reasonable in relation to the threat posed.  The court was unpersuaded by the board’s argument that approving the dissident slate would circumvent the spirit of the proxy put, damage the company’s reputation and have an adverse effect on the company’s future efforts to refinance its debt.  The court cited testimony from the company’s financial advisor indicating that the lenders would not have placed as much emphasis on the proxy put as the SandRidge board argued it would.  The court also pointed to the fact that SandRidge failed to articulate the harm it would suffer if the nominees were elected to the board.   Accordingly, the court concluded that the SandRidge board had likely breached its fiduciary duties when it refused, without reasonable justification, to approve the dissident slate of nominees, and the court enjoined the board from soliciting votes and consent revocations until the board approved the shareholder’s slate of nominees.

Most recently, in Pontiac General Employees Retirement System v. Ballantine (opinion found here) the Delaware Court of Chancery refused to dismiss a shareholder’s suit against Healthways, Inc. (“Healthways”) and its board seeking to declare that the dead-hand proxy put in the company’s credit agreement was unenforceable.

In 2010, Healthways entered into a credit agreement that contained a conventional proxy put provision permitting the lender to accelerate the company’s debt if (1) the majority of the Original Directors were no longer members of Healthways’ board or (2) the new directors were not approved by the Original Directors.  Subsequently, a shareholder threatened a proxy contest, which ultimately led to the declassification of the company’s board.  Within days after the declassification proposal passed, Healthways entered into an amended and restated credit agreement containing a dead-hand proxy put.  The dead-hand proxy put would trigger the lender’s right to accelerate the company’s debt following a change in control on the Company’s board even if the Original Directors approved the appointment of the new directors.

In the face of renewed shareholder pressure a few years later, Healthways agreed to appoint certain new directors to the board, bringing the company one step closer to triggering the dead-hand proxy put.  After making an unanswered demand for documents and records related to the proxy put, the dissident shareholder filed suit against the board and the company seeking a declaratory judgment that the dead-hand proxy put was unenforceable. The suit also named the lender as a defendant for aiding and abetting the company’s entrenchment efforts.

In denying the company’s motion to dismiss, the court concluded that the board may have breached its fiduciary duties based on the facts alleged in the complaint, but the court refused to go so far as to hold that the company’s agreement to a dead-hand proxy put was a breach of its fiduciary duties per se.  The court cited several compelling factors in its analysis, including (1) the company’s decision to accept a dead-hand proxy put in its new credit agreement just days after the board declassification proposal was approved by shareholders and on the heels of a threatened proxy contest and (2) the company’s failure to produce documents or records related to the negotiation or benefits of the dead-hand proxy put in response to the shareholder’s demand.

The court also rejected the lender’s argument that it was entitled to a dismissal because it negotiated the credit agreement at arms-length.  The court held that while a lender may negotiate for the best economic terms it can get (e.g., a higher interest rate), a lender may not insist on incorporating terms that take advantage of a conflict of interest between the board and its shareholders or that put the board at odds with its shareholders.  The court also rejected the lender’s argument that the lender needed to know its borrower, stating that lenders should expect more changes with public companies who hold annual director elections.  Instead, the court suggested a lender should seek to protect itself by negotiating for more favorable financial covenants with its public company borrowers.  Finally, the court acknowledged that such proxy put provisions may be “market,” but noted that “at the time of a riot, riot is market” and reiterated that, following the Amylin and Kallick decisions, lenders should have known that courts would closely scrutinize any proxy put provision.

Practical Implications

These recent court decisions provide us with the following guidance:

• Proxy put provisions, especially dead hand proxy put provisions, present a litigation risk.  In recent months, shareholders have attacked a number of companies (and lenders) for the proxy put provisions in their credit agreements.  Although Ballantine confirmed that adopting a proxy put provision is not a per se breach of a board’s fiduciary duties, courts are likely to scrutinize the process by which a board approves a credit agreement or indenture containing such a provision, particularly when the board is operating under the threat of a looming proxy contest.  Because these suits typically name the directors as defendants, they will probably be covered by a company’s D&O policy; however, suits will divert management attention and may include costs beyond those covered by a D&O policy.
• Companies negotiating credit agreements should record and document the process, especially with respect to the negotiation of a proxy put provision.  If a company chooses to agree to a proxy put provision following the Amylin, Kallick and Ballantine decisions, its board of directors should ensure the following procedural safeguards are well-documented:
  • the lender made it clear that the proxy put was valuable and that the loan would not have been made without a proxy put;
  • the company bargained to reject the provision and the provision was accepted only after the company received an economic benefit; and
  • the company’s independent directors were informed of the proxy put provision to protect against the company’s acceptance of a put when there was no real need to do so or merely as an entrenchment mechanism.
• In evaluating the propriety of a proxy put provision, courts will likely consider other factors. Such other factors may include whether the company’s credit agreements have generally contained such protections in the past or whether the provision was added in response to, or in anticipation of, an existing or looming proxy contest.