San Antonio Decision Instructive for Boards on Impinging Shareholder Franchise and the Duty of Care

The recent decision by the Delaware Chancery Court in San Antonio Fire and Pension Fund v. Amylin Pharmaceuticals, Inc. provides a valuable lesson to both Boards of Directors and the lawyers who advise them on the duty of care required when approving terms in agreements that might interfere with the voting rights of shareholders. The case arose in the context of the increased shareholder activism that was discussed in Goodwin Procter’s January 21, 2009 Public Company Advisory. In this case, it was the attempt by dissident shareholders, Carl Icahn and Eastbourne Capital, to put a majority of new directors on the Board of Amylin Pharmaceuticals. That proxy contest was recently resolved with the ouster of the company’s chairman and lead director and the election of two of the dissident nominees.

Initially, however, Icahn and Eastbourne had each nominated five directors, which would have given them the possibility of capturing 10 of the 12 Amylin Board seats. That result would have triggered an indenture covenant requiring the company to offer to redeem notes following a change of control, effectively triggering a noteholders’ put of more than $900 million of debt at par. As Amylin did not have adequate cash to meet this obligation and the debt was trading at a significant discount, the consequences could have been dire for the company. Noting that a “provision in an indenture with such eviscerating effect on the shareholder franchise would raise grave concerns,” Vice Chancellor Lamb proceeded to rule on the case. By the time the opinion was issued on May 12, 2009, however, the provision at issue had been waived by the noteholders, and the dissident shareholders had reduced their slates to a total of five nominees.

The principal legal issue addressed in the opinion was whether a Board could avoid triggering the change-of-control provision by approving a dissident “slate of nominees without endorsing them.” The Vice Chancellor ruled that the Board could do so even though it opposed the dissident slate and applied the definition of “to approve” from Black’s Law Dictionary “to give formal sanction to; to confirm authoritatively.” To apply the alternative interpretation that “to approve” means to “endorse or recommend” would severely limit a Board’s scope of action when considering a dissident slate. Further, he wrote that the provision, if so interpreted, would effectively prevent shareholders from exercising their franchise to replace a majority of the Board and “might be unenforceable as against public policy.”

The Duty of Care

The court’s construction of the indenture and its suggestion that a change-of-control provision in a debt instrument might be held void have received a lot of attention. On a more practical level, the most interesting point was the court’s rejection of the claim that the Board had breached its fiduciary duty of care by adopting and approving the indenture without being aware of the change-of-control provision. In this case, the pricing committee of the Board (to whom the approval of the indenture had been delegated by the whole Board) was let off the hook because of the failure of its outside counsel to inform the directors about the provision. When the directors asked if there was anything “unusual or not customary” about the indenture, the company’s “highly-qualified counsel” (as described by the court, though there was no evidence presented that this counsel had particular expertise on indentures) informed the directors that there was not. It was on this basis that the directors approved the issuance of the notes. The court applied a gross negligence standard to the Board’s conduct and found that it was “not the sort of conduct generally . . . defined as a substantial deviation from the standard of care.”

Lessons to Be Learned

Directors may take some comfort from the gross negligence standard applied in the ruling and the court’s statement that “no one suggests that the directors’ duty of care required them to review, discuss and comprehend every word of the 98-page Indenture.” At the same time, directors, especially in this time of increased shareholder activism, should understand the potentially serious consequences of being accused of not having dug deep enough into the business terms of complex agreements, even where those terms are in fact “market standard” (as the change-of-control put in high yield indentures in fact is). This case should caution directors to inform themselves of and understand the implications of key substantive provisions of material agreements, even though the provisions may appear highly technical or be of the type that is customarily, or even uniformly, included in such agreements.

That this case involved a debt instrument was something the court found “particularly troubling” for two stated reasons. First, the court opined that few events can be more catastrophic for a company than the triggering of an event of default in a debt instrument. The court was also concerned that an event of default like the “poison pill” change-of-control provision at issue involved negotiating rights that belong to shareholders with debtholders, whose interests may be directly adverse. To quote from the opinion:

Outside counsel advising a board in such circumstances should be especially mindful of the board’s continuing duties to the stockholders to protect their interests. Specifically, terms which may affect the stockholders’ range of discretion in exercising [their voting] franchise should, even if considered customary, be highlighted to the board. In this way, the board will be able to exercise its fully informed business judgment.

This is very expansive language that can apply far beyond the negotiation of debt instruments. The court points out that companies, relying on their outside corporate counsel, routinely negotiate other types of contracts that, in some instances, may impinge on the free exercise of the shareholder franchise. In the exercise of their duty of care, directors should make sure they engage counsel  with experience in those types of contracts and will be able to correctly identify provisions that are customary and standard, as well as to understand the importance of bringing to the directors’ attention provisions that could materially impact the interests of the company and its shareholders. In many instances it would be advisable to have the corporate record reflect that the Board or relevant committee was advised by counsel of the material terms and conditions of the agreement, though unnecessary precision could be as troublesome as lack of a record if the specific provision at issue is not flagged. Given the strong language in this case and the court’s zeal in protecting the rights of shareholders, the Delaware courts may not be so forgiving in the future of directors who enter into agreements without weighing carefully (or even being made aware of) terms that impact materially the rights or interests of shareholders.