In an opinion issued on March 8, 2013, the Delaware Court of Chancery preliminarily enjoined the board of SandRidge Energy, Inc. from impeding a consent solicitation by one of the Company’s largest stockholders to replace the incumbent directors, finding that the directors likely would be breaching their duty of loyalty if they did not “approve” the insurgent slate in the face of a change of control put provision in the company’s public notes that would be triggered upon election of an unapproved dissident slate.
Analyzing the SandRidge board’s behavior under the Unocal standard, Chancellor Strine found that the board did not identify any reasonable basis for their failure to approve the dissident nominees, and thereby nullify the change of control put, and that the only apparent threat the board perceived was a threat to their incumbency, a threat that could not justify their actions. The Court concluded that the board appeared to be intentionally pressuring the Company’s stockholders to oppose the consent solicitation out of a desire for self-preservation, a likely breach of the directors’ duty of loyalty.
The Court’s opinion has the following implications for directors of Delaware corporations:
- Directors who have the contractual option to nullify change of control put provisions triggered by a turnover in the majority composition of the board should do so in the face of an insurgent slate unless the insurgents pose a “specific and substantial risk” to the corporation (e.g. lack ethical integrity, are known looters or threaten the corporation’s ability to meet its legal obligations to creditors), even if the incumbent directors believe they are better qualified than their rivals.
- The SandRidge opinion reinforces the fact that Delaware courts will scrutinize closely board action taken in the context of the shareholder franchise and the apparent entrenchment of insiders.
- In dicta, the Court, opining that change of control put provisions may be used for insider entrenchment, stated that “directors should police aspects of agreements like this,” making clear that management and advisors should bring change of control put provisions, especially ones triggered by changes in the composition of the board, to the specific attention of the board, and that directors should attempt to negotiate the terms of the puts out of indentures or at least ensure that the inclusion of such provisions in particular circumstances is warranted by benefits to the corporation.
Beginning in November 2012, TPG-Axon (“TPG”), a hedge fund holding approximately 7% of SandRidge Energy, Inc. (“SandRidge”), publicly demanded various governance reforms, accusing SandRidge of underperforming since its 2007 IPO due to strategic missteps at the board level and “appalling” corporate governance practices, including overcompensating (and turning a blind eye to alleged self-dealing by) the current CEO. The SandRidge board responded to these demands by adopting a poison pill and amending its bylaws to inhibit stockholder action by written consent.
In December, TPG commenced a formal consent solicitation to declassify SandRidge’s seven-member board and to remove and replace all of its incumbent directors, prompting the SandRidge board to initiate its own consent revocation solicitation to defeat TPG’s dissident slate. In its preliminary consent revocation statement, the SandRidge board warned stockholders that replacing all of the Company’s directors, as TPG intended, would trigger an optional redemption right at 101% of par in the Company’s outstanding $4.3 billion principal amount of public notes (the “Proxy Put”) that the Company might not have sufficient liquidity to finance, and that “[a] mandatory refinancing of this magnitude would present an extreme, risky and unnecessary financial burden.”1
As the SandRidge board itself acknowledged, it could negate the risk posed by the Proxy Put by approving TPG’s nominees because the Company’s public notes contained fairly typical language defining the incumbent board to include any new directors “approved” by the incumbent board, thereby averting a “change of control” that would trigger the Proxy Put.
Gerald Kallick, a SandRidge stockholder unaffiliated with TPG, initiated litigation on January 7, 2013, seeking a mandatory injunction ordering the SandRidge board to “approve” TPG’s nominees for the limited neutralizing purpose of defanging the Proxy Put. (Eventually, Kallick requested more limited relief: a negative injunction prohibiting the SandRidge board from soliciting or voting consent revocations until they either approved TPG’s slate or explained in full their reasons for not approving it.)
In an 8-K filed on February 8, 2013, the SandRidge board made, in the Court’s words, an “about-face,”2 claiming noteholders would be unlikely to exercise the Proxy Put because the notes were trading (and had been trading for several months) above the redemption price. Furthermore, even if noteholders were to exercise the Proxy Put, Morgan Stanley, SandRidge’s financial advisor, had offered to refinance the debt, thus providing the “backup financing necessary” to ameliorate the financial risks attributable to the Proxy Put.3 The Court viewed this “about-face” as mere posturing to evade Kallick’s preliminary injunction motion, either because there no longer was a need to expedite the proceedings or because there was no irreparable harm warranting injunctive relief. In any event, the SandRidge board continued to withhold approval of TPG’s slate, citing concern over their supposed lack of relevant experience and fear that credit would become more difficult to obtain if SandRidge obtained a reputation for “circumventing” change of control provisions.
On March 13, the parties settled the litigation. Among other things, the size of the board initially will be increased from seven to eleven directors, with the newly created positions filled by TPG’s “approved” nominees. After June 30, 2013, the board will be reduced to nine directors and either (a) the current Chairman & CEO will resign from the board or (b) TPG will have the right to appoint a fifth director, which would result in TPG’s nominees constituting a majority of the nine-person board. In exchange, TPG agreed to terminate its consent solicitation.
THE COURT’S DECISION
A. Affirmative Duty to “Approve” Dissident Slates Absent a “Specific and Substantial Risk” for Note Put Purposes
Without applying the onerous Blasius standard of review, which the Court characterized as more of an “emphatic and enduring [articulation of] the serious scrutiny that Delaware law gives to director action that threatens to undermine the integrity of the electoral process” than as “a useful standard of review to decide actual cases,”4 the Court relied on San Antonio Fire & Police Pension Fund v. Amylin Pharmaceuticals, Inc.5 to reaffirm that the duty of loyalty requires directors to exercise contractually conferred discretion in the best interests of the corporation and its stockholders, limited only by honoring its company’s obligations under the implied covenant of good faith and fair dealing. Furthermore, “[b]ecause a board that acts in good faith must seek to protect the stockholders’ ability to make an uncoerced choice of directors,”6 Chancellor Strine held, as an affirmative obligation in the context of continuing director change of control put provisions that provide companies with the discretion to nullify the put by “approving” dissident slates, that if
“an incumbent board cannot identify that there is a specific and substantial risk to the corporation or its creditors posed by the rival slate, and approval of that slate would therefore not be a breach of the contractual duty of good faith owed to the noteholders with the rights to the Proxy Put, the incumbent board must approve the new directors as a matter of its obligations to the company and its stockholders, even if it believes itself to be better qualified and have better plans for the corporation that the rival slate.”7
The Court concluded that the SandRidge directors failed to demonstrate any reasonable justification for their refusal to approve the TPG slate in the context of the Proxy Put.
Noting that the SandRidge board had conceded that all of TPG’s nominees possessed integrity and general business acumen and that five of the seven nominees had industry-specific experience, but only quibbled with the extent of the dissident nominees’ experience in specific geographic and business areas, the Court stated that these supposed concerns “do not come close to a reasoned conclusion” that TPG’s slate posed a sufficient risk to justify pressuring stockholders to vote against TPG’s slate by refusing to neutralize the Proxy Put.8
Moreover, the Court gave short shrift to speculation that lenders might view SandRidge as having circumvented the Proxy Put and thus refuse to lend in the future because it said that fear was “fundamentally inconsistent” with SandRidge’s position that refinancing the $4.3 billion debt posed no irreparable harm in the current, “frothy” credit markets, and with the reality that Morgan Stanley was willing to refinance the outstanding debt.9 In any event, the Court noted that “the incumbent board and its financial advisors have failed to provide any reliable market evidence that lenders place a tangible value on a Proxy Put trigger.”10
In sum, the Court found the “incumbent board’s behavior [to be] redolent more of the pursuit of an incremental advantage in a close contest, where a small margin may determine the outcome, than of any good faith concern for the company, its creditors, or its stockholders.”11 Such “self-interested, tactical reasons for withholding approval” of the dissident slate, the Court stated, likely indicated the absence of good faith and reasonableness required by a board’s fiduciary duties.12 Due to the procedural setting of a preliminary injunction motion, the Court granted only negative (and expressly not mandatory) injunctive relief,13 enjoining the SandRidge board from (i) soliciting any further consent revocations; (ii) giving effect to any consent revocations received; and (iii) impeding TPG’s consent solicitation process in any way, unless and until the board approves the TPG slate for the limited purposes of the Proxy Put.14
B. Dicta Regarding Need for Review and Approval of Agreements with Change of Control Put Provisions
The Court expressed concern over the apparently scant attention that the SandRidge board had paid to the Proxy Put when initially approving the indentures under which the notes with the Proxy Put were issued. Referring to what academics have termed “embedded defense substitution,”15 Chancellor Strine noted that continuing director provisions are “dangerous” because it is difficult to determine if the contract term “was in fact sought by the third party creditors or willingly inserted by the incumbent management as a latent takeover and proxy contest defense.”16 Because of this danger, the Court expounded on the role of directors, particularly independent directors, in approving contracts with terms that could reflect mere embedded defense substitution:
“Given the obvious entrenching purposes of a Proxy Put provision, one would hope that any public company would bargain hard to exclude that toll on the stockholder franchise and only accede to the Proxy Put after hard negotiation and only for clear economic advantage. In ‘frothy’ credit financing markets, there is reason (such as [Morgan Stanley’s offer to refinance the notes]) to suspect that the costs of such resistance would be insubstantial to non-existent. Most important, however, because of management’s special interest in retaining office, the independent directors of the board should police aspects of agreements like this, to ensure that the company itself is not offering up these terms lightly precisely because of their entrenching utility, or accepting their proposal when there is no real need to do so.”17
Because the plaintiff in this case did not challenge the SandRidge board’s original decision to agree to the Proxy Put, the Court’s comments in this regard are limited to dicta. Furthermore, the Court acknowledged that treating all contracts that have change of control provisions may have “simplistic analytical appeal,” but such an approach would ignore the fact that the contractual context remains relevant in assessing whether a change of control put provision reflects a bona fide, bargained-for exchange within the purview of directors’ business judgment.18
Given the prevalence of change of control provisions with a continuing director requirement, the Court’s comments provide important guidance to directors. In the context of Proxy Puts or any other “provisions that affect the stockholder franchise,” directors may be duty-bound to consider the provisions in some depth—and perhaps even to attempt to negotiate them out of the final contract—before approving them.19
The SandRidge Court’s opinion has the following implications for directors of Delaware companies:
- Directors may be duty-bound to ensure that change of control put provisions are insisted upon by counterparties and are necessary to obtain credit or other benefits to the corporation (as compared to what would be available without the change of control put) before approving contracts containing them, and management and advisors should bring such provisions specifically to the attention of directors.
- Directors should continue to expect the Delaware courts to apply significant scrutiny to actions that have the potential to affect corporate elections. As the Delaware Supreme Court emphasized in Schnell v. Chris-Craft Industries, Inc., cited several times in Chancellor Strine’s opinion, “inequitable action does not become permissible simply because it is legally possible.”20
- Under the Court of Chancery’s decisions in both Amylin and now in SandRidge, directors are under an affirmative duty to exercise their discretion to “approve” dissident slates and neutralize change of control provisions containing a continuing director requirement, a protection that arguably benefits lenders, unless the directors can identify a “specific and substantial risk to the corporation or its creditors posed by the rival slate.”21
- Increased borrower and issuer attention to change of control puts relating to board of director changes in credit facilities, indentures and other debt instruments is likely to result from SandRidge. While lenders likely will continue to seek protection against hostile management changes, the change of control provisions may see some modification to address the potential issues with Proxy Puts raised by the Court of Chancery.