Shareholder Rights Plans: Self-Limiting Features and Redemptions; What’S up with Stapled Financing? by Joris M

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Shareholder Rights Plans: Self-Limiting Features and Redemptions; What’s up with Stapled Financing? By Joris M. Hogan

A Comment on Restricted Stock Sold by a Non-Affiliate By Robert A. Barron

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Composite Shareholder Rights Plans: Self-Limiting Features And Redemptions; What’s Up With Stapled Financing? By Joris M. Hogan* After briefly summarizing the history and operation of shareholder rights plans, this article will discuss the vigorous attack by institutional shareholders against these plans in recent years as well as the resulting effects which include the adoption of various self-limiting features and , in some cases, outright redemption. The recent Unisuper decision by the Delaware Chancery Court may add impetus to this growing trend. Part two briefly describes stapled financing and its benefits to sellers and buyers in transactions where financeability may be an issue. Following a dis- cussion of certain precautions that sellers and their financial advisors often take to mitigate conflict of interest concerns, the article concludes that Vice Chancellor Strine’s expressed discomfort with stapled financing in the recent Toys “R” Us decision is unlikely to turn the tide against the use of this financing technique.

Shareholder Rights Plans: History And Basic Operation As takeovers increased in the 1970s, the topic of responses to hostile bids became more of a concern for corporate boards and the lawyers who advised them.1 In the face of such bids, companies had a small arsenal of defenses, including the anti-takeover statutes that had been adopted in thirty-seven states. Then, in 1982, the Supreme Court held that the Will- iams Act,2 one of the few federal statutes that address corporate decision- making, preempted any state statute that upset the balance struck by the Act.3 That decision left only the minimal protections of the Williams Act such as the requirement that unsolicited tender offers remain open for at least twenty business days.4

* Joris M. Hogan is a partner in the Corporate Group of the international law ﬁrm, Torys LLP, specializing in mergers and acquisitions, securities law and corporate governance matters. The author gratefully acknowledges the contributions of Timothy B. Martin and Carmen Korehbandi in the preparation of this article. 221 222 SECURITIES REGULATION LAW JOURNAL

In the fall of 1982, Martin Lipton published his memorandum entitled, “Warrant Dividend Plan,” earning credit as the inventor of the device that restored directors’ ability to determine their company’s destiny when confronted with an unsolicited takeover bid. The warrant he proposed came to be used in many forms, but each was designed to allow the board additional time to respond to an unsolicited bid. The labels given the warrant were just as various as its forms. While it is referred to technically as a “shareholder rights plan” or “preferred share purchase rights plan,” the colloquial name stuck after it appeared in The Wall Street Journal in the summer of 1983: the “poison pill”.5 As the use of poison pills increased, the stage was set for a confronta- tion between the corporate raiders and the proponents of these new devic- es. With state legislatures effectively sidelined by the Supreme Court’s Edgar v. MITE decision and federal judges similarly hamstrung,6 state courts were left to create a framework for takeover fights. The Delaware Supreme Court led this effort with four cases it decided in 1985: Smith v. Van Gorkom,7 Revlon, Inc. v. MacAndrews & Forbes Holdings,8 Unocal Corp. v Mesa Petroleum,9 and Moran v. Household International, Inc.10 Each case added to the framework, though Moran is regarded as a water- shed moment for the poison pill defense.11 The Delaware Supreme Court upheld the right of a board to adopt a poison pill without first getting shareholder approval and also upheld the board’s right to reject a takeover bid, subject to a new intermediate level of judicial scrutiny.12 Prior to the decision in Moran, there were thirty-five poison pills in effect; in the year after the decision, approximately 300 companies adopted a pill.13 Shareholder rights plans, though not structurally identical, generally operate in a similar fashion. After adoption of the poison pill by the board of directors, the rights are distributed to shareholders and “attach” to the company’s shares of stock. The rights are triggered automatically upon a specified event, which is typically the purchase of 10-20% of the company’s common stock without the approval of the board. After the rights are triggered, each shareholder, except for the purchaser who triggered the pill, has the right to purchase additional shares or receive other assets at a steep discount, which thereby dilutes the unwanted suitor’s shareholding to an unacceptable degree. This discriminatory discount can take the form of allowing the other shareholders to purchase more shares of the target (a “flip-in” provision) or, in the case of a merger or purchase by another acquiror, allowing the other shareholders to purchase a dispropor- tionate interest in the acquiror (a “flip-over” provision). In either case, the [VOL. 34:3 2006] SHAREHOLDER RIGHTS PLANS 223

massive dilution of the acquiror’s position makes it prohibitively expen- sive to complete a hostile bid for control of the target. Efforts to circumvent a poison pill by replacing the board and redeeming the pill can be stifled by additional provisions that prevent or delay a board from redeeming the plan. These can take the form of a provision within the plan itself, such as a dead-hand,14 no-hand15 or slow hand16 provision, or by staggering the board so that more than one annual elec- tion cycle must be completed before an acquiror-friendly board can be constituted to redeem the pill. The pill therefore affords a board of directors some control over the takeover process through its ability to redeem the rights for a period before or within a specified period after they are triggered, and through the board’s power to grant an exemption from the pill to friendly buyers. This additional control usually gives the board of directors of the target company sufficient time to examine alternatives to an unsolicited bid.

Institutional Shareholders’ Frontal Attack On Poison Pills Nearly twenty-ﬁve years after its invention, the poison pill continues to evolve. Because of the power it gives to the board and the perceived danger of entrenchment when shareholder interests might be best served by accepting an unsolicited bid, companies have begun to insert self-limiting features into their shareholder rights plans. This movement to limit a board’s ability to “just say no” has been led by the large institutional shareholders and the corporate governance services they constitute.17 Service providers such as Institutional Shareholder Services (ISS), the Council of Institutional Investors, and the Investor Responsibility Research Center (IRRC)18 have each implemented policies to direct members on how to respond to boards that propose new or amended poison pills.19 ISS’ policy on shareholder rights plans is to evaluate management proposals on a case-by-case basis. However, ISS does have general guidelines regarding poison pills and recommends that such plans should have a “trigger” that is not lower than 20%, have a term not to exceed three years, contain no provisions that limit a future board’s ability to redeem the pill (such as a dead-hand provision), and have a “qualifying offer” exception (i.e., be a “chewable pill” that will fall away under certain circumstances). In recent years, institutional investors have been winning the battle against poison pills and their unilateral adoption by boards of directors.20 At the end of 2005, for example, 46% of the S&P 500 companies had a poison pill, a nearly eight-point drop from the number of companies that 224 SECURITIES REGULATION LAW JOURNAL

had one at the end of 2004.21 The number of companies with poison pills has been on the decline since 2002, when 60% of the S&P 500 had poison pill defenses.

Trends In Self-Limiting Features After a shareholder proposal regarding a poison pill is approved by a majority of the shareholders, a board of directors typically will choose to take no action, modify or redeem its poison pill, or, in some cases, make commitments regarding the future adoption of a poison pill. For those that choose to modify their poison pills, there are many options available. The board may, for example, attempt to accommodate the shareholders by: • putting the shareholder rights plan or future plans up for a binding shareholder vote; • adopting “chewable pill” provisions that carve out certain types of qualifying acquisition proposals or acquisition proposals that are approved by shareholders; • including a “permitted offer” exception; • including a three-year independent director evaluation (TIDE) provision; • shortening the term of the shareholder rights plan (a “sunset provision”); or • increasing the shareholder rights plan’s trigger threshold (usually to 15 or 20%); or • provide for more than one trigger level before the rights flip-in or flip-out.22 Frequently, however, institutional investors, who are the main proponents of shareholder proposals that oppose or seek to limit poison pills, are not satisfied with these “shareholder-friendly” self-limiting features. Institutional investors often continue to withhold votes in board elections until the poison pill is more effectively weakened or redeemed altogeth- er.23 As a result, a growing number of companies adopt poison pills that initially contain at least one of these self-limiting features.24 Other boards of directors, though a smaller group, are not moved by shareholder proposals regarding the adoption of self-limiting features, while still others continue to adopt traditional plans without shareholder approval or a sunset provision.25 [VOL. 34:3 2006] SHAREHOLDER RIGHTS PLANS 225

Developments Since Unisuper Ltd. v. News Corporation Although companies that already have poison pills increasingly are adopting self-limiting features, other companies that do not currently have a poison pill defense may implement policies regarding their possi- ble future adoption. Several companies, for example, recently have adopted policies against adopting a poison pill without shareholder approval. However, due to an expressed concern about adopting policies that may limit the power of future boards to oppose coercive bids, those policies often contain a “fiduciary out” provision if the board should determine at a later date that the best interests of the shareholders require the board to adopt a pill without shareholder approval. As a result of Chancellor Chandler’s decision in Unisuper Ltd. v. News Corporation, directors of companies incorporated in Delaware may think twice before they “water down” their agreements requiring shareholder approval of poison pills.26 The court in Unisuper rejected News Corp.’s argument that its agreement with shareholders to refrain from adopting a poison pill required the inclusion of a “fiduciary out”. The Chancellor noted that the cases cited by News Corp. involved agreements which took power out of the hands of the shareholders. Here, the agreement between News Corp. and the shareholders put the power to decide whether to adopt a poison pill di- rectly into the shareholders’ hands. The fiduciary duty owed to shareholders, the Chancellor held, cannot be used as a means to “silence shareholders and prevent them from specifying what the corporate contract is to say.”27

What Is Stapled Financing? The terms stapled commitment and stapled financing are “generally used to refer to prepackaged financing terms offered by the seller’s financial advisor to potential buyers.”28 The financing package is “figuratively ‘stapled’ to the seller’s term sheet.”29 The buyer typically is not required to utilize the stapled financing package, but investment banks tend to offer aggressive terms that make it attractive to bidders in an auction.30 The stapled financing package often is created by the lending arm of an investment bank. When stapled financing is offered, the initial communica- tion from the seller to potential purchasers usually indicates that financing is available, the level of financing being offered, the minimum equity contribution required as part of a qualified bid, and the range of accept- able interest rates. 226 SECURITIES REGULATION LAW JOURNAL

If the financeability of a deal is an issue, then stapled financing can be quite useful. By establishing that a deal can be financed, the stapled financing package allows the seller to provide bidders with “sufficient comfort to spend time and money to participate in the auction process.”31 The use of stapled financing can also expedite the completion of the transaction by eliminating the need for the purchaser to secure third-party financing.32 Stapled financing can also be used to set a price floor that can aid the seller by limiting the ability of the winning bidder to renegotiate the purchase price based on a claimed deterioration in the terms of financing from third party sources. In addition to protecting the seller, stapled financing can also benefit the purchaser by allowing it to finance the deal on favorable terms since competing banks often will offer better terms in response to the stapled financing proposal. Despite the benefits that stapled financing can provide, there are a number of conflict of interest concerns that must be addressed by the seller and its financial advisor. Because the seller’s financial advisor will de- rive additional compensation from the transaction as a buy-side financing source, this may be viewed as providing an inappropriate incentive on the part of the seller’s financial advisor to recommend a transaction. It has been noted, however, that “[m]ost financial advisers with sell-side man- dates are compensated on a contingent basis anyway, so the financial advisor always has an incentive to recommend a transaction….”33 Since investment banks tend to make a great deal of money on financing fees, there are also concerns that the investment bank could attempt to tilt the auction in favor of a bidder who intends to utilize the stapled financing. Some bidders have also expressed concern that they have felt pressure to pursue the stapled financing package to ensure equal treatment in the auction. However, “[i]n most auctions, the question of who is the winning bidder is clear, and it is only in the rare situation that the advice of the seller’s financial adviser will be material to the decision of the seller.”34

Investment Bank Precautions In order to protect themselves from judicial scrutiny and avoid conflicts of interest when providing stapled financing, most investment banks have developed compliance guidelines. Some of the procedures include: • The use of separate teams of bankers to provide financial advisory services to the seller and to work on the financing arrangements for different bidders; [VOL. 34:3 2006] SHAREHOLDER RIGHTS PLANS 227

• the implementation of informational barriers designed to prevent the unauthorized disclosure of information from the financial advisory team to the financing teams, and vice versa; • generally requiring that all bidders be informed that stapled financing is being made available and that the terms of the stapled financing will be provided upon request to all bidders, or at least all financial buyers; • permitting potential purchasers to freely choose their preferred sources of financing; • refusing to offer stapled financing when representing a special committee evaluating a management buyout; and • requiring sellers desiring a fairness opinion to obtain a fairness opinion from unconflicted financial advisors.35 Another factor for investment banks to consider is The National Asso- ciation of Securities Dealers (NASD) proposed rule 2290 governing fairness opinions, which may affect the feasibility of providing stapled financing.36 If the rule is adopted in its current proposed form, the exist- ence of a stapled financing package may be considered a material relationship that would require certain disclosures in fairness opinions which would be included in proxy statements. The adoption of this rule would, therefore, likely have a chilling effect on the use of this financing technique in many deals.

Seller Precautions An important concern for sellers is the “increasing scrutiny of the inde- pendence of the directors and their advisers in considering and approving M&A transactions that raise the spectre of a management conflict of interest … ,”37 though there are a number of steps that sellers can take to mitigate conflict of interest concerns created by stapled financing. The seller could, for example, retain “one bank to act as an adviser and another to act as the provider of the stapled commitment…,”38 though the high costs associated with retaining a second advisor must also be considered.39 The seller could also seek a fairness opinion from a second financial advisor, though the effectiveness of this tactic has been questioned.40 Financeability will often be an issue that stapled financing can allevi- ate “when the financing markets are weak (as in 2000-2001), or if the business being sold is in a troubled industry.”41 However, “[c]ounsel 228 SECURITIES REGULATION LAW JOURNAL

should question whether it is even necessary to establish that a bid is fi- nanceable”42 in situations where the risks associated with stapled financing clearly outweigh its benefits. In every instance where stapled financing is offered, the board of directors must take extra precautions to ensure that they are performing an “informed and independent evaluation of the proposed deal”43 without having been compromised by the investment bank’s dual role. A detailed record of the board’s consideration of the benefits and risks associated with stapled financing for a particular transaction will bolster the board’s decision in the event of judicial scrutiny.

In Re Toys “R” Us Shareholder Litigation There is little case law on the appropriateness of using stapled financing in Delaware, and there is no case law specifically addressing the issue in other U.S. jurisdictions. However, the recent Toys “R” Us decision in Dela- ware discusses the apparent conflict of offering stapled financing in certain transactions where the sell-side financial advisor also offers financing to potential buyers. Vice Chancellor Strine, in dicta, stated his discomfort with the actions of the board of directors of Toys “R” Us as well as with the actions of its financial advisor, which acted as both the buy and sell-side financial advisor in the auction of the company’s assets.44 Although the board of directors of Toys “R” Us initially rejected its financial advisor’s request to provide buy-side financing, the board later acquiesced to a further request from the advisor after a deal had been struck. Although the court ultimately found no evidence that the financial advisor’s actions improperly influenced the board’s decision-making process, the court did question the practice of having the same bank provide financial services on both sides of a deal.45 In the court’s view, a seller that consents to its financial advisor offering a stapled financing package “tends to raise eyebrows by creating the appearance of impropriety...”46

Will Stapled Financing Survive? Many commentators expected that Chancellor Strine’s dicta in the Toys “R” Us case would chill the use of stapled financing. However, “[s]tapled financing commitments continue to play a big part of M&A auctions.”47 Consistent with the continued use of stapled financing, Vice Chancellor Strine, while speaking at a recent M&A conference, played down concerns that his ruling was meant to discourage the use of stapled financing, and indicated that he could envision situations where stapled financing would be useful.48 [VOL. 34:3 2006] SHAREHOLDER RIGHTS PLANS 229

Whether or not stapled financing ultimately will survive after Toys “R” Us is an open question. According to some observers, since the Toys “R” Us decision, “conservatism on the part of boards of directors is setting the bar at a level that is not permitting sell-side advisers to provide buy-side financing, at least in the absence of a second investment bank on the sell- side that is fully involved in any auction process.”49 It has also been noted, however, that “[i]n the current market, with private equity sponsor M&A activity high and the number of banks willing to be able to lend large amounts in leveraged acquisition financings more limited, the pos- sibility of a commercial bank providing buy-side financing while also providing sell-side advice is quite high, even without stapled financing. “50 Although boards may be justifiably concerned by Judge Strine’s com- ments in Toys “R” Us, it does not presently appear that the decision will result in any significant changes in stapled financing practice.

Conclusion Although poison pills have been targeted for extinction by institutional shareholders since the early days after they appeared on the M & A scene, some companies continue to adopt traditional shareholder rights plans without seeking shareholder approval. The current trend, however, is for boards to adopt poison pills with self-limiting features and to ask for shareholder approval. Some boards are going the extra mile and elect- ing to permit their plans to expire or redeeming their pills outright. Sta- pled financing has been used by sell-side parties in M & A transactions as encouragement to potential bidders and to set a floor on pricing. Finan- cial advisors on sell-side M & A engagements are motivated to offer stapled “buy-side” financing by attractive fees, notwithstanding the apparent conflict in acting for both sides. After shining a light on the apparent conflict of interest associated with certain stapled financing transactions, the Toys “R” Us decision has not, at least so far, shut the door on this financing technique.

NOTES 1. See Martin Lipton, Takeover Bids in the Target’s Boardroom, 35 Bus. Law. 101, 101 & n.1 (1999). 2. See 15 U.S.C.A. §§ 78m(d)-(e) and 78n(d)-(f) (2000). 3. Edgar v. MITE Corp., 457 U.S. 624, 633-34 (1982). 4. Regulation 14E requires that a tender offer remain open for at least 20 business days and pro- vides additional protection to a target shareholders against other unlawful tender offer practices. 17 CFR 240.14e-1(a). 230 SECURITIES REGULATION LAW JOURNAL

5. Frank Allen and Steve Swartz, Lenox Rebuffs Brown-Forman, Adopts Defense, Wall St. J., June 16, 1983 at 2. 6. See Santa Fe Industries v. Green, 430 U.S. 462, 479 (1977) (stating that the federal judiciary is “reluctant to federalize the substantial portion of the law of corporations that deals with transactions in securities”). 7. Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985) (directors need not evaluate a takeover bid solely in light of the value assigned by the stock market). 8. Revlon, Inc. v. MacAndrews & Forbes Holdings, 506 A.2d 173 (Del. 1986) (directors are not required to maximize short-term value unless and until they decide to sell the company). 9. Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946 (Del. 1985) (accepting the utility of takeover defense mechanisms, but subjecting their adoption to review under an enhanced business judgment rule). 10. Moran v. Household International, Inc., 500 A.2d 1346, (Del. 1985). 11. See Len Costa, The Perfect Pill; A Small Innovation That Transformed Corporate Take- overs, Legal Affairs (Mar.-Apr. 2005), available at, http://www.legalaffairs.org/issues/March- April-2005/toa_costa_marapr05.msp. 12. See Moran, 500 A.2d at 1356 (noting that after Unocal, the business judgment rule, when applied to the adoption of takeover defenses, includes an “enhanced reasonableness” review). 13. See Costa, supra note 11. 14. Council of Institutional Investors, Glossary of Terms, available at, http://www.cii.org/ library/learning/poison_pills.htm (defining “dead-hand pills” as ones that can only be redeemed by the board members that adopted the plan, or their designees). 15. Id. (defining a “no-hand pill” as a non-redeemable plan). 16. Id. (defining a “slow-hand pill” as a plan that cannot be redeemed for a certain time after director elections). 17. See Soren Lindstron, Shareholder Activism Against Poison Pills: An Effective Antidote?, 9 Wall St. Law. 17 (2005). 18. IRCC agreed in mid-2005 to ISS’ acquisition of its commercial advisory services. IRCC will continue as the IRCC Institute for Corporate Responsibility, an independent, non-profit entity. Press Release, IRRC Returns to its Research Roots with New Independent Institute for Corporate Responsibility, Sells its Commercial Business to ISS to Respond to Evolving Client Needs (July 13, 2005) at http://www.irrc.com/company/07132005_ISS.html. 19. See, e.g., ISS Policy on Ratification of Shareholder Rights Plans, ISS 2006 Policy Updates, at, http://www.issproxy.com/policy/2006us/antitakeover.jsp. 20. See Thaddeus C. Kopinski, Shareholders Continue Efforts to Limit Poison Pills, ISS Gover- nance Weekly (Apr. 22, 2005), available at, http://www.issproxy.com/governance/publications/ 2005archived/066.jsp (“The trend is for companies to redeem their existing poison pill provisions and pledge not to institute new ones without shareholder approval.”). 21. Marc Saltzburg, Investors File Fewer Pill Proposals, ISS Governance Weekly (May 16, 2006), available at, http://www.issproxy.com/governance/publications/2006archived/103.jsp. 22. Alex Frutos, ShareholderRights Plans: Alternative Response to Shareholder Opposition, 16 Insights II (2002). 23. See Lindstron, supra note 17, at 19. 24. Thaddeus C. Kopinski, Anti-Entrenchment Efforts Bring Changes in U.S., ISS Governance Weekly (June 17, 2005), available at, http://www.issproxy.com/governance/publications/ 2005archived/109.jsp. [VOL. 34:3 2006] SHAREHOLDER RIGHTS PLANS 231

25. Andrew R. Brownstein & Igor Kirman, Can A Board Say No When Shareholders Say Yes? Responding to Majority Vote Resolutions, 60 BUS. LAW 23, 70 (2004). 26. Unisuper Ltd., No. 1699-N, 2005 WL 3529319, at 8. 27. Unispuer Ltd. v. News Corp., No. 1699-N, 2005 WL 352919, *1 (Del. Ch. 2005). 28. Kevin Miller, In Defense of Stapled Finance, The M & A Lawyer, Jan. 2006, at 5. 29. Franci J. Blassberg and Joshua J.G. Berick, A Private Equity Primer—An Evolving U.S. Market?, The M & A Lawyer, July/Aug. 2005, at 10. 30. Thomas W. Van Dyke, The M&A Process: A Practical Guide for the Business Lawyer, A.L.I. –A.B.A. 789, 803 (2005). 31. Ronald Cami, Fear of Commitment, The Deal, May 8, 2006, at 21. 32. Julia Werdigier and Christine Harper, ‘Stapled’ Loans Create Potential Conflicts for Merger Advisers, Oct. 23, 2005, http://www.bloomberg.com/apps/news?pid=71000001&refer=home&sid=aNS.Y5u9qCb8. 33. Richard Hall, Stapled finance packages under scrutiny, Int’l Fin. L. Rev., 2006, http:// www.iflr.com/?Page=17&ISS=21679&SID=624568. 34. Miller, supra note 28. 35. Id. (footnotes omitted). 36. Stephen I. Glover and William J. Robers, The NASD’s Proposed Rule Governing Fairness Opinion Practice, The M & A Lawyer, Sept. 2005, at 22. 37. Hall, supra note 33. 38. Cami, supra note 31. 39. Hall, supra note 33. 40. David Marcus, Banker banter breaks out at Tulane, Corporate Control Alert, May 2006, at 15. 41. Cami, supra note 31. 42. Id. 43. James C. Morphy, What All Business Lawyers & Litigators Must Know About Delaware Law Developments 2006, 1543 P.L.I. 479, 482 (May 2006). 44. In re Toys “R” Us, Inc. Shareholder Litigation, 877 A.2d 975, 1005-1006 (Del. Ch. 2005). 45. Id at 1006. 46. Id. 47. Id. 48. Marcus, supra note 40, at 13. 49. Hall, supra note 31. 50. Id.