A Note of Caution: Adopting a Rights Plan Against a Controlling Stockholder
Stockholder rights plans are widely regarded as one of the most effective defensive measures available to a board of directors of a Delaware corporation. Indeed, rights plans may operate not only to prevent transactions at the corporate level, but also to prevent upstream transactions involving a controlling stockholder. It is precisely that latter operation that has been the subject of recent debate – i.e., to what extent may a board of directors adopt a rights plan to prevent the corporation's controlling stockholder from alienating its shares or, if the controlling stockholder is an entity, selling itself to a third party. The Court of Chancery was presented with that issue in Hollinger International, Inc. v. Black, and ultimately determined that, under the unique facts of that case, the adoption of a rights plan against a controlling stockholder “was a proper exercise of statutory authority that was consistent with the [independent directors'] fiduciary duty to protect the corporation.”
On April 19, 2005, the Delaware Supreme Court affirmed the Court of Chancery's decision with no additional substantive analysis. Nevertheless, the Delaware Supreme Court cautioned in a footnote that its decision to uphold the adoption of the rights plan should be understood as limited to the “specific, rather extreme, circumstances” presented in Hollinger. Accordingly, corporate practitioners should be mindful that Delaware courts likely will find the adoption of a rights plan against a controlling stockholder to be reasonable only in limited circumstances.
The Court of Chancery Decision
Hollinger, Inc. (the “Parent”) owned 30.3% of the equity and 72.8% of the voting control of Hollinger International, Inc. (“International”). The Parent, in turn, was 70% owned by Ravelston, Co., which was effectively controlled by Lord Conrad Black (“Black”).
In May 2003, one of International’s largest stockholders wrote to the board demanding an investigation into certain non-competition payments made to Black and other International executives in connection with asset sales in 2000. The International board established a special committee to investigate the non-competition payments and soon discovered that the payments may have been made without approval of the International board or any of its independent directors, notwithstanding disclosures indicating that such approval had been obtained.
Under scrutiny for his receipt of those payments, Black entered into an agreement with International (the “Restructuring Proposal”). Pursuant to the Restructuring Proposal, Black agreed: (i) to return the non-competition payments; (ii) to cooperate with the SEC in investigations regarding the payments; and (iii) to remain on the International board as Chairman and to devote his time and effort to the pursuit of a “Strategic Process” whereby International would be open to acquisition, sale of assets, or any other transaction designed to benefit the interests of all of its stockholders ratably. As part of the Restructuring Proposal, Black also agreed not to cause the Parent to enter into any transactions that would negatively affect the Strategic Process.
Almost immediately after entering into the Restructuring Proposal, Black began negotiating with David and Frederick Barclay (the “Barclays”) for a sale of all of the outstanding stock of the Parent. The Barclays were interested in purchasing one of International’s assets, the Daily Telegraph, and initially approached Black to pursue such a transaction. Black had rebuffed their earlier expressions of interest, but once the Restructuring Proposal was in place, he invited negotiations. In the course of those negotiations, Black provided the Barclays with confidential information about International that was only available to Black because of his involvement in the Strategic Process.
Upon learning of Black’s activities, the International board undertook steps to implement a rights plan to prevent a sale of control of International. The rights plan would be triggered by, among other things, the sale of the Parent to a third party. Before the rights plan could be put in place, Black caused the Parent to execute written consents to amend International’s bylaws and, among other things, essentially strip the International board of authority to implement a rights plan. The board, believing those bylaw amendments to be invalid, proceeded with implementation of the rights plan. Thereafter, Black announced the transaction with the Barclays that would give the Barclays a controlling interest in International.
International brought suit against Black, seeking: (i) a determination that the bylaw amendments were illegal and inequitable; (ii) a determination that the rights plan was valid; and (iii) a preliminary injunction preventing Black from entering into a transaction with entities owned by the Barclays. In a post-trial opinion, Vice Chancellor Strine held that the bylaw amendments were proper under the General Corporation Law of the State of Delaware (the “General Corporation Law”), but were nonetheless invalid because they were made in bad faith and for an inequitable purpose. The Court also found that the rights plan was properly adopted and that International was entitled to a preliminary injunction preventing Black from entering into the contemplated transaction with the Barclays.
In considering whether the rights plan adopted by the International board was proper, the Court of Chancery analyzed both the statutory validity of the rights plan and its reasonableness under Unocal. Finding the rights plan to be valid, the Court stated that “the mere fact that a rights plan inhibits the ability of an intermediate holding company to sell itself does not make that rights plan statutorily impossible, or even inequitable in all circumstances.”
In considering whether the International Board had satisfied its duties under Unocal, the Court found both a threat and a proportionate response to that threat. The Court determined that International faced a threat from harm that the Barclays transaction posed to the ability of International to complete the contractually bargained for strategic process. Although a parent typically owes no contractual or fiduciary obligation to permit a subsidiary to explore alternative transactions, the Court found that this situation was “importantly distinct from the usual situation when a controlling stockholder closes down a subsidiary’s exploration of alternatives.” Unlike the typical situation, International secured a binding commitment from its controlling stockholder to lead a Strategic Process to seek a transaction at the International level that would provide an “equal and ratable” benefit to all of International’s stockholders. Accordingly, the Court determined that the independent directors made a reasonable determination that the transaction with the Barclays “thwarted the Strategic Process, denie[d] International the bargained-for benefits of the Restructuring Proposal, and [was] a serious threat to International….”
In addition, the Court found that the rights plan was a proportionate response to that threat because “there are circumstances when a subsidiary has a legitimate right to contest a parent’s sale of its control position” and that such circumstances were present in the case. In reaching that conclusion, the Court stated that, “in the ordinary case,” a plaintiff would have a decisive argument that a rights plan was not a proportionate response to the threat of a parent selling itself. Indeed, the Court found that “the replacement of a subsidiary’s controlling corporate stockholder with another through a transaction at the parent level should pose no cognizable threat to the subsidiary.” Rather, the Court indicated that a parent “has a legitimate right to sell itself absent breaking some recognized duty to the subsidiary” and there is “utility to respecting this freedom.”
The Court noted, however, that the law has recognized situations in which a subsidiary will have a legitimate right to contest a parent’s control of its control position. The Court pointed out that former Chancellor Allen was “open to the possibility that … extraordinary scenarios might justify subsidiary resistance to a controlling stockholder that wrongly endangers the corporation’s best interests, even by taking action to dilute the controlling stockholder’s control position.” Such an extraordinary scenario “might be justified when a ‘controlling shareholder … was in the process or threatening to violate his fiduciary duties to the corporation.”
The Court argued that, if dilution was warranted in certain circumstances, it was certainly the case that circumstances could exist where the adoption of a rights plan against a controlling stockholder would be a proportionate response to a cognizable threat. Applying this reasoning to the facts before it, the Court determined that the rights plan was a proportionate response to the threat. In particular, the Court noted that the “most direct way that International can protect itself and pursue the Strategic Process Black promised to support is by using the Rights Plan.” The Court found it persuasive that the International Board would still need to respect the Parent's rights, even with the rights plan in place, and would need to pursue a strategic transaction that was amendable to the Parent, because of the Parent's ability to veto any strategic transaction. The Court also was persuaded by the fact that the rights plan would necessarily be limited in its duration because the justification for the rights plan was the Strategic Process. The Court noted that “[o]nce the board has completed the Strategic Process and developed its preferred option, the further use of the Rights Plan would be suspect, absent further misconduct justifying its continued use.”
The Delaware Supreme Court Decision
With no further substantive analysis, the Delaware Supreme Court affirmed the Court of Chancery's decision. The Delaware Supreme Court cautioned in a footnote, however, that its affirmance was limited to the specific facts set forth in Hollinger. In particular, the Court noted as follows:
[O]ur upholding the adoption of the Rights Plan should be understood as limited to the specific, rather extreme, circumstances of this case. It should not be viewed as creating any broad exception to the transaction paradigm in which rights plans are normally designed to operate: settings involving a change of control transaction at the level of the corporate entity whose board of directors adopts the rights plan.
Given this cautionary note in Hollinger, it is clear that a rights plan adopted specifically to thwart a change of control transaction at the controlling stockholder level, and not necessarily relating to a change of control at the level of the corporate entity, will be carefully scrutinized by a Delaware court. Although the Court stated that “rather extreme” circumstances were at issue in Hollinger, it is unclear what other set of facts would also be viewed as sufficiently extreme to support the adoption of a rights plan against a controlling stockholder.
The reasoning of the Court of Chancery’s decision might provide some insight into the types of circumstances that are sufficiently extreme. In particular, the Court seemingly recognized that a rights plan might be appropriate where a controlling stockholder was in the process of violating, or threatening to violate, its contractual obligations to a corporation in connection with a strategic process. It is possible that a rights plan also may be appropriate where a breach of a contractual obligation is not at issue.
For example, the recent litigation involving Printcafe Software, Inc. (“Printcafe”) and its most formidable stockholder, Creo, Inc. (“Creo”), might provide an example of extreme circumstances supporting the adoption a rights plan against a controlling stockholder. In that case, a committee of the Printcafe board adopted a rights plan against Creo, an entity that owned approximately 45% of Printcafe’s shares at the time of the Court’s decision, after learning that Creo intended to purchase a sufficient block of shares to become a majority stockholder of Printcafe, and thereafter offer to purchase all of the outstanding shares of Printcafe for $1.30 per share. The committee decided to adopt the rights plan because, immediately after Creo’s offer became public, a third party offered to purchase all of the outstanding shares of capital stock of Printcafe for $2.60 per share. After negotiating and agreeing to a deal with the third party, the committee believed it imperative that Creo be prevented from consummating its acquisition of voting control and thus obtaining the right to block the more lucrative third party offer.
After the committee’s adoption of the rights plan, Creo commenced an action in the Court of Chancery seeking a temporary restraining order, among other things, to enjoin Printcafe from enforcing the rights plan. As legal support for this requested relief, Creo alleged that the Printcafe board had violated its fiduciary responsibilities, that it had adopted an unprecedented rights plan that was invalid as a matter of law, and that it had tortuously interfered with Creo’s contractual right and obligation to purchase the critical block of Printcafe shares which would give it absolute control of Printcafe. After expedited briefing and argument, the Court declined to grant injunctive relief on the grounds that Creo had failed to demonstrate that it would suffer imminent irreparable harm if it were unable to complete its sale contract to acquire control of Printcafe and that the balancing of the equities tipped strongly in favor of allowing the highly fluid bidding process to proceed without judicial intervention. Although the Court’s decision did not address the merits, the Court’s willingness to refuse to grant the temporary restraining order may signal recognition that the circumstances facing Printcafe were sufficiently extreme to justify the adoption of a rights plan against a formidable stockholder.
The Delaware Supreme Court has indicated that rights plans adopted against a controlling stockholder will be closely scrutinized and upheld only in limited circumstances. For that reason, a board of directors (or committee of the board) should proceed with caution when considering whether to adopt rights plans against controlling stockholders.
1 Mark A. Morton is a partner and Michael K. Reilly is an associate in the Wilmington, Delaware law firm of Potter Anderson & Corroon LLP. The views expressed are solely those of the authors and do not necessarily represent the views of the firm or its clients.
2 844 A.2d 1022 (Del. Ch. 2004).
3 Id. at 1090.
4 Black v. Hollinger Intern., Inc., C.A. No. 183-N (Del. April 19, 2005).
5 Id., slip op. at 16 n.16.
6 Hollinger, 844 A.2d at 1084.
7 Id. at 1085.
9 Id. at 1086.
10 Id. at 1087.
11 Id. at 1087.
14 The Court stated that the “classic example is if the controlling stockholder is going to sell to a known looter.” Id.
16 Id. (quoting Mendel v. Carroll, 651 A.2d 297, 306 (Del. Ch. 1994)).
17 Id. at 1088.
18 Hollinger, slip op. at 16.
19 Hollinger, slip op. at 16 n.16.
20 Creo Inc. v. Printcafe Software, Inc., C.A. No. 20164, Chandler, C. (Del. Ch. Feb. 21, 2003) (Bench Ruling).
21 The threat of the loss of negotiating leverage under Delaware’s business combination statute, 8 Del. C. § 203 (“Section 203”), through the guise of a technical reading of that statute, and in an effort to thwart a corporation from pursuing other strategic alternatives, may also constitute extreme circumstances justifying the adoption of a rights plan against a controlling stockholder. In particular, one could conceive of a situation in which a controlling stockholder, who is also a director and officer of the corporation, asserts that it could transfer shares to a third party without that third party becoming an “interested stockholder” (as defined in Section 203) because of the parenthetical set forth in the exception in Section 203(a)(2). Similar to the situation in Hollinger, a breach (actual or threatened) of a director’s fiduciary obligations might be at issue, and therefore a rights plan might be justified. A less extreme solution may also be available, e.g., removing the controlling stockholder as an officer and thus foreclosing any argument that an exception under Section 203(a)(2) could be utilized.