An investor acquired 18% of a company and publicly stated he was considering purchasing more shares. The company’s board responded by adopting a poison pill that is triggered if any shareholder acquires more than 20% of the outstanding stock. The company’s poison pill is unusual in that it does not apply to its founder and chairman, who owns approximately 30% of the company, although the pill does limit him from increasing his stake.
The plaintiff investor filed suit in Delaware against the company’s directors, claiming that they breached their fiduciary duties by adopting the poison pill. The plaintiff argued, among other things, that the pill’s 20% trigger should be increased to at least 30%, thereby putting him on equal footing with the company’s founder in a proxy contest.
Following a four-day trial, the Delaware Chancery Court issued a highly anticipated decision that upholds the poison pill. See Yucaipa Am. Alliance Fund II, L.P. v. Riggio, 2010 WL 3170806 (Del. Ch. Aug. 12, 2010). The court concluded that the poison pill protected against the threat that the plaintiff would obtain control of the company through a “creeping acquisition” without giving the shareholders a control premium, but also allowed the plaintiff to exercise his franchise rights by mounting a proxy contest to acquire control of the company. In reaching this conclusion, the court held that the Delaware Supreme Court’s holding in Unocal v. Mesa Petroleum Co. provided the appropriate standard of review by which to scrutinize the company’s poison pill, not the stricter “compelling justification” or “entire fairness” standards. Under the Unocal standard, a board’s decision to adopt a defensive mechanism is protected by the business judgment rule if: (a) the board had “reasonable grounds for believing that a danger to corporate policy and effectiveness existed”; and (b) the “defensive response was reasonable in relation to the threat posed.”
The plaintiff argued that the company’s poison pill was not a reasonable response because it grandfathered in the founder’s 30% stake and, consequently, gave the founder an unfair advantage in a proxy contest. The court acknowledged that the reasonableness of the poison pill was “complicated by the pre-existing presence of the [founder’s] substantial bloc,” but said “that reality does not undermine the reasonableness of the board’s concern that without a limit on open market purchases by [the plaintiff] and others at a level below the level of the [founder’s] range, a control bloc could emerge that did not pay a control premium.” Equally important, the court found that the poison pill did not unreasonably inhibit the plaintiff’s ability to mount an effective proxy contest because he held almost 20% of the shares, another friendly shareholder held almost 20%, and the remaining shareholders would likely be swayed in large part by recommendations from the independent proxy advisory firms that make recommendations concerning proxy contests. The court therefore dismissed the plaintiff’s lawsuit.
The decision makes clear that boards of directors should carefully document their deliberations when adopting defensive measures such as a poison pill because, if challenged, it is the board that has the burden of proving that it satisfied the Unocal standard. The court recounted in considerable detail the steps the company’s board took when considering whether to adopt the poison pill, and the court relied extensively on notes taken by the company’s general counsel. The decision also makes clear for the first time that, under Delaware law, a board of directors may adopt a poison pill that gives special treatment to one or more existing shareholders by exempting them from the pill’s trigger threshold. The Delaware Chancery Court carefully explained why, in its view, the plaintiff still had a fair chance to mount and win a proxy contest, notwithstanding the existence of the poison pill. The court may have felt differently if, for example, the company’s board had adopted a poison pill with a lower trigger (e.g., 10% or 15%) or had not limited the founder’s ability to increase his 30% stake.