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Public Companies at Risk

January 29, 2009

The recent plunge in the stock price of many public companies has left them with market capitalizations well below historical levels and has exposed many to an enhanced risk of a hostile takeover attempt. The risk is particularly acute for small and medium-sized companies, as many large cap companies continue to hold considerable cash balances and untapped lines of credit available for acquisition funding. Boards confronted with a fully financed, all cash offer at a substantial premium to current market value will have to take that offer seriously and carefully consider their legal duties and obligations in light of it.

The issue confronting boards is complicated by the difficulty in determining what a fair and adequate price is for an enterprise operating in a recession environment with limited access to the debt or equity capital markets. Some stockholders will believe the company should be valued with reference to historical market values while others will be more willing to accept a premium to current market values, even if below historical levels. Under Delaware case law, however, an offer at a premium to the current market price is not the sole measure of the adequacy of the offer. 

Moreover, many public companies have either terminated anti-takeover devices or permitted them to expire, often in response to pressure from shareholder rights advocates and shareholder advisory services such as RiskMetrics and Glass Lewis. 

Boards that are unprepared to deal with a hostile takeover attempt expose the enterprise to the risk of being unable to execute its corporate strategy, expose the stockholders to risk of an inadequate sales price and expose its directors to criticism for failure to meet their duty of care.

Delaware Standards

Delaware courts give wide latitude to boards to protect legitimate corporate and stockholder interests and to respond to actual threats to those interests under the business judgment rule. To avail itself of the protection of the business judgment rule, a board must demonstrate that it was disinterested and acted after due consideration of the risks and alternatives confronting a corporation or its stockholders. Boards that can meet those standards are entitled to a presumption that their decisions, even if later proved to be ill advised, were made in good faith and will be respected by Delaware courts, insulating the members of the board from liability to stockholders.

In taking defensive action, boards are required to consider two questions under Delaware law under the so-called "Unocal Test": 

  • Is there a threat that justifies the board's taking defensive actions?
  • Are the actions taken reasonable in relation to the threat? 

The burden is on the board to demonstrate that the actions taken are not done for the purposes of entrenchment. Once that burden is carried, a properly functioning board becomes entitled to the protection of the business judgment rule.

Applying Delaware Law to the Risk

Any public company with a deeply depressed stock price in an environment in which potential hostile bidders exist is entitled to protect itself against the threat of a takeover at an inadequate price or at a time when a long term strategy initiative has not had the opportunity to be fully implemented and return value to the stockholders. Even before a specific threat is identified, most public companies operating in such an environment will meet the first part of the Unocal test.

Public companies have a multitude of alternatives available to protect themselves from a hostile takeover, including:

  • shareholder rights or "poison pill" plans;
  • staggered boards;
  • supermajority voting requirements;
  • defensive mergers, and
  • recapitalizations.

Some of these alternatives, such as supermajority voting requirements and defensive mergers, require stockholder approval while others, such as shareholder rights plans, may be implemented by the board alone. What will best suit a company seeking to protect its stockholders from coercive takeover tactics will depend on the particular facts and circumstances of that company's situation.

Structuring Protective Devices

There are two important things to remember in structuring protective devices. First, while it is permissible under Delaware law for the board to adopt measures designed to prevent a company from being acquired at an inadequate price, it is not permissible to adopt measures designed to prevent a company from being acquired at any price. Any device or plan that deprives stockholders of the opportunity to realize a premium in a change of control transaction when no other short or long term alternative can reasonably be expected to result in a higher price will not be respected by Delaware courts.

Similarly, Delaware courts will examine very closely any protective measure that has the effect of making it more difficult to remove or replace the board or management. Accordingly, adopting staggered board provisions, eliminating the ability to call special meetings and similar measures will be rigorously scrutinized to determine whether they are reasonable responses to a perceived threat or simply a way to entrench management.

Advice to Directors

Delaware cases provide considerable guidance to directors as they consider adopting anti-takeover protections.

First, boards should regularly assess the degree to which their company is exposed to the risk of a hostile takeover attempt and monitor the situation closely as circumstances evolve. Sudden unexplained spikes in trading volume or what appear to be casual contacts from competitors may indicate an imminent threat.

Defensive actions that are taken thoughtfully and in response to a generalized risk environment rather than hurriedly and in response to a specific threat are more likely to be sustained. Companies at risk should undertake contingency planning to defend against a coercive takeover attempt, which may include the identification and retention of professionals, a public relations strategy and similar steps. Actions that are taken to defend a well thought out corporate strategy intended to provide stockholders with long term value are  likely to be respected by Delaware courts. 

The lesson for corporate directors is to examine the risk environment in which their corporation operates and to consider proactively a series of strategic responses, of which one or more protective devices may be an integral part.

Delaware courts also tend to confirm defensive actions taken as the result of an organized and deliberate board process that supports the conclusion that the directors have satisfied their duty of care. The attributes of this process include:

  • The independent directors, acting either collectively or by committee, should consider and approve the defensive measures a corporation should take, thus removing any potential taint to the process by the involvement of management seeking to entrench themselves.
  • These independent directors also should consider the engagement of independent advisors who can advise them without any suggestion of self interest and solicit and understand the professional perspectives that these advisors can offer. 
  • The independent directors should act in an informed manner and be able to demonstrate adequate time spent considering alternatives.
  • Any structural defense adopted by the board should be proportional to the threat identified.  As mentioned above, a defensive measure adopted by the board that acts as an absolute bar to a change of control will not be enforced by a Delaware court. 

Boards must focus their attention on provisions that protect shareholders against a legitimate risk but continue to provide stockholders with opportunity to realize a change of control premium when a change of control is in their best interest.