January 21, 2009

Takeover Defenses and Shareholder Activism

In light of the unprecedented economic decline of 2008, Boards of Directors of public companies have found themselves in uncharted territory. Companies are facing intense economic pressures on their business, stock prices are at historic lows and the shareholders of many companies, facing liquidity challenges of their own, are pressuring directors to focus on short-term returns. At the same time, hostile M&A has reached record levels. While general M&A activity was down 37% through September 30, 2008, hostile M&A activity increased from $97 billion in 2007 to $211 billion during this period. Additionally, shareholder activism is at an all-time high. During 2008, dissident shareholders conducted 56 proxy contests (as opposed to 46 in 2007 and 31 in 2006). Moreover, dissident shareholders were successful in obtaining at least one Board seat in over 70% of contested situations in 2008. These statistics reflect only public contests. Many other contests are resolved quietly, with corporations acceding to at least some of the demands of activist shareholders in an effort to avoid the potential distractions and costs associated with a proxy contest.

In this environment, Boards of Directors should review their takeover defenses to determine their exposure to tactics often employed by dissident shareholders and potential acquirers which are not in the best interest of all shareholders. In particular, in light of recent court decisions, Boards should consider amending their bylaws to ensure that activist shareholders disclose all of their holdings, including those in derivative form. Boards of Directors also may wish to consider adopting shareholder rights plans (also known as “poison pills”). The purpose of a shareholder rights plan is to protect shareholders of a company from coercive takeovers or other actions that a Board believes are not in the best interests of all shareholders. By adopting a shareholder rights plan, a company establishes a level of stock ownership (typically 15%) which a shareholder cannot exceed without incurring significant dilution to its holdings. Thus, a shareholder rights plan deters coercive takeover tactics by making them unreasonably expensive to the bidder and thus encourages prospective acquirers to negotiate with the Board of a company rather than to attempt a hostile takeover.

Shareholder Rights Plan

In many cases, a shareholder rights plan is an essential component of a Board’s strategy to remain independent and to pursue its long-term business plan. A shareholder rights plan is the only defensive mechanism designed to protect a company against an accumulation of the company’s stock by a shareholder who the Board deems not to be acting in the best interests of all shareholders. By contrast, the Delaware “business combination statute” and analogous statutes in other jurisdictions prohibit a shareholder who exceeds a specific threshold of ownership from engaging in a broad range of transactions with the company for a period of three years thereafter. These statutes, however, do not prevent or limit accumulations of share ownership in and of itself. With a shareholder rights plan in place, a Board, when presented with an unsolicited acquisition proposal or demands by an activist, is afforded the necessary time to evaluate all alternatives to enhance shareholder value without being pressured by coercive takeover tactics. In 2008 the number of shareholder rights plans adopted by companies increased for the first time since 2004-2005 and for only the third time since 1998. Concerned that their companies are trading at depressed valuations, and in many instances at substantially below their cash balances or liquidation values, Boards are again viewing a shareholder rights plan as one of the few effective defenses they have at their disposal to respond to takeover tactics by dissident shareholders and hostile acquirers.

Responses to Shareholder Activism

In light of current market conditions, Boards of Directors should be prepared for aggressive approaches by activist shareholders and hedge funds. In this regard, a company should be aware of the deadlines under the federal securities laws and its organizational documents for shareholders to submit proposals and director nominations. A company should closely monitor the trading volume of its stock and changes to its shareholder base. Boards are likely to receive increased pressure from activist shareholders to take actions that increase short-term shareholder value but may impair a company’s ability to execute its long-term business strategy. For example, such shareholders may demand actions which directly result in short-term gains such as large or special dividends, stock repurchases or tender offers, divestitures of certain assets or business lines and cancellation of capital expenditures. When confronted with these requests, Boards of Directors should remember that Delaware courts have consistently upheld the rights of Boards to take actions that are in the best long-term interests of their shareholders. A Board not only has the right but a fiduciary duty to resist pressures for short-term actions that it determines are not in the long-term best interests of the company. In considering requests made by activist shareholders, it is important that a Board has recently considered and adopted a business plan that reflects the long-term strategic objectives of the company’s management and Board. This plan should be evaluated and updated annually and should reflect discussion between the company’s management and Board (and outside consultants and advisors to the extent appropriate). In considering a shareholder’s request, the Board then examines how the proposed actions fit within the long-term plan and whether the actions would impair the company’s ability to achieve its objectives and enhance long-term shareholder value.

As a final note, shareholder activists frequently demand that a company “immediately” adopt their suggested courses of action. In this regard Boards of Directors should remember the importance of fulfilling their duty of care in reaching decisions. Directors have a duty to act in an informed and deliberate manner in reaching decisions. This analysis can be divided into two components: (i) the Board must have received sufficient information to make an informed decision with respect to a matter, and assuming that it has, (ii) the Board must have sufficient time to consider the information, ask appropriate questions and reach a decision with respect to the matter. In reaching a decision, a Board should consider whether it should receive advice from outside advisors (e.g., attorneys, investment bankers, compensation consultants) on areas within their expertise. For example, if an activist shareholder wants a company to be liquidated, a Board may want to consider hiring an investment banking firm to conduct a liquidation analysis as well as a “stand alone” valuation analysis assuming the business remains intact and is operated under the ongoing business plan. As the above discussion illustrates, to satisfy its fiduciary duties to all of its shareholders, a Board of Directors generally will find it difficult to take immediate action. A Board will need sufficient time to gather appropriate information and act in a deliberate manner in considering a course of action proposed by shareholders to satisfy the Board’s duty of care.

Communications with Activist Shareholders

Companies also are facing pressure for their Board and management to meet directly with activist shareholders. With increasing frequency, management and Boards of public companies are communicating directly with shareholders about the company, its business and various corporate governance matters. In each situation a company will need to consider the advantages and disadvantages of such communications. In general, activist stockholders should be treated like every other significant holder. In situations where a meeting is scheduled, a company needs to coordinate the meeting carefully and communicate a clear and consistent message. It is important that a company identify one spokesperson who will speak for the company and be responsible for all shareholder communications. In certain situations it may be advisable for the lead outside director or another independent director to participate in meetings with shareholders. At such a meeting, to comply with its obligations under Regulation FD, a company should take steps to ensure to either have a shareholder sign a confidentiality agreement or not disclose material non-public information in such a meeting. Finally, it should be remembered that in any proxy contest the ultimate jury is a company’s institutional shareholders. Once a Board has carefully considered issues raised by an activist and reached conclusions, it should develop a communications strategy so its conclusions are clearly and quickly conveyed to investors.