The Delaware Court of Chancery decision in Third Point highlights once again the breadth of the discretion of boards of directors when implementing defensive tactics subject to the Unocal standard. The decision is an illustration of the potential role of rights plans to fend off shareholder activists. Interestingly, it recognizes that negative control wielded by activists may present an objective threat to corporate policy and effectiveness that could justify the implementation of defensive measures.
From a Canadian perspective, the Third Point decision must be read in light of our particular legal landscape governing defensive tactics. Still, to the extent that National Policy 62‑202 Take-over Bids – Defensive Tactics does not purport to regulate defensive tactics outside the realms of takeover bids, it is worth reflecting on the teachings of Third Point in the context of shareholder activism from the point of view of corporate law and securities regulation.
In 2013, hedge fund activity increased significantly in Sotheby’s stock with three funds accumulating a position of about 15% of the shares at the end of summer. The situation was monitored closely by Sotheby’s board of directors. Presentations were made by the company’s legal and financial advisors to the board on the stockholder activism market generally and stockholder activism issues specific to Sotheby’s. Management also met separately with two of the funds in August to exchange opinions on Sotheby’s and its business.
On October 2nd, Third Point filed an amended Schedule 13D disclosing that it had increased its stake in the company to 9.4%. A letter was attached to the filing in which Daniel Loeb of Third Point criticized Sotheby’s management and board of directors. The letter recommended that Sotheby’s CEO, William Ruprecht, be replaced, and mentioned that Third Point already had identified potential CEO candidates.
The following day, the board held a special meeting with its legal and financial advisors to discuss the filing and letter, and review possible courses of action including the adoption of a shareholder rights plan. On October 4th, at its regularly scheduled meeting, Sotheby’s board adopted a rights plan with a one-year term.
The rights plan had an unusual two-tier structure. While the plan generally provided for a 10% threshold trigger, it also allowed an “acquiring person” who reported its ownership pursuant to Schedule 13G (used by passive institutional investors) to acquire up to a 20% interest in the company. The plan also contained a qualifying offer exception pursuant to which it would not apply to an any-and-all shares offer for the company that cashed out all Sotheby’s stockholders and gave them at least 100 days to consider the offer.
After failed negotiations with Sotheby’s board to avoid a proxy contest, Third Point increased its stake to 9.62% in March 2014. Third Point also requested a waiver from the rights plan’s 10% trigger to allow it to purchase up to a 20% stake. After consideration, Sotheby’s board denied the request to avoid a change in effective control of the company without any premium being paid to shareholders.
Chancery Court decision
Third Point challenged the board’s decision by filing a motion for preliminary injunction with the Delaware Court of Chancery. In a nutshell, Third Point argued that Sotheby’s directors violated their fiduciary duties by adopting the rights plan and refusing to provide it with a waiver from the rights plan’s terms so as to obtain an impermissible advantage in the ongoing proxy contest. Third Point’s request was denied by the Court.
To analyze the board’s decision to implement the two-tier rights plan and refuse to grant Third Point’s request for waiver of application, the Court applied the Unocal standard of review. The Unocal standard is a two-pronged test whereby the board has the burden of proof. The first prong is a reasonableness test. Specifically, the board must demonstrate that it “had reasonable grounds for believing that a danger to corporate policy and effectiveness existed”. The second prong is a proportionality test that requires the board to demonstrate that its defensive response was reasonable in relation to the threat posed. For the defensive response to be proportionate, it must not be draconian by being either preclusive or coercive. Further, the response must fall within a range of reasonable responses to the threat posed.
After examining the adoption of the rights plan in October 2013 in light of the Unocal standard, the Court held that the board conducted a good faith and reasonable investigation into the threat posed by Third Point. The investigation gave the board reasonable grounds to believe that Third Point presented an objectively reasonable and legally cognizable threat to Sotheby’s. Specifically, Third Point posed a threat of forming a control block with other hedge funds without paying a control premium.
The board’s decision to implement the rights plan also passed muster under the second prong of Unocal. Referring to the Blasius line of cases, the Court found that the primary purpose of the board was not of interfering with the shareholder franchise, i.e. of impeding the voting rights of Sotheby’s shareholders. The plan was neither preclusive nor coercive in that it did not “impose any consequences on stockholders for voting their shares as they wish[ed]”. Indeed, despite the adoption of the rights plan, the proxy contest remained eminently winnable by either side according to the Court. In addition, the Court held that the rights plan fell within the range of reasonableness. Interestingly, the Court recognized that the two-tier structure of the plan was a proportionate response to the threat posed by Third Point. For the Court, the plan was “a closer fit to addressing the company’s needs to prevent an activist or activists from gaining control than a garden variety rights plan”.
The Court likewise dismissed Third Point’s challenge of the board’s decision not to grant a waiver from the rights plan 10% threshold. The Court expressed skepticism toward the board’s ability to argue successfully that it still had a reasonable belief that Third Point posed a risk of creeping control in March 2014. However, it accepted that the threat of negative control constituted an objectively reasonable and legally cognizable threat. The Court acknowledged Sotheby’s concerns that if it reached the 20% threshold Third Point could exercise disproportionate control and influence over major corporate decisions, even if it did not have an explicit veto power.
Finally, the Court held that the refusal to grant the waiver fell within the range of reasonableness. The Court remarked that there may well be some level of ownership between 10% and 20% where the board could have allowed Third Point to increase its stake. It emphasized, however, that the test is one of reasonableness, not perfection. In this case, the 10% threshold was reasonable.
Third Point LLC v. William F. Ruprecht, et al., and Sotheby’s (Del. Ch.), May 2, 2014.