The Delaware Chancery Court’s opinion in San Antonio Fire & Police Pension Fund v. Amylin Pharmaceuticals, Inc. et al. (“Amylin”) interpreted a so-called “poison put” provision in a bond indenture in the context of a proxy fight. This decision has significant ramifications regarding the interpretation of these provisions and offers important guidance to boards and companies in approving and applying these provisions. This decision has immediate relevance in the current economic environment, where many companies are struggling with (or will soon be facing) financing or refinancing needs or are (or will be) vulnerable to takeover attempts or overtures from activist shareholders. Directors should be aware of the issues the Amylin case presents and heed the helpful guidance offered by the court.
A so-called “poison put” is a “change-of-control” provision that allows lenders or bondholders to declare a default under the debt agreement and accelerate (or “put”) the debt back to the company at its principal value. The poison put emerged following the famed RJR Nabisco and other leveraged buyouts of the 1980s that left stunned, risk-averse bondholders holding “junk bonds” overnight without any recourse. These provisions came back in force most recently following the wave of large leveraged buyouts (LBO) in 2006 and 2007, which again stung many unprotected bondholders. Following this LBO resurgence, the Credit Roundtable, an association of fixed income investors, issued a white paper in December 2007 (updated in July 2008) recommending that bond indentures include “change of control” covenants (i.e., poison puts). The purpose of such a change-of-control covenant is to provide the bondholders with an opportunity to rethink their original investment decisions if the company is acquired by new owners.
Though the definition of a change of control initially contemplated equity control changing hands (particularly to buyout funds that tended to significantly increase a target company’s leverage), the definition of change of control has since expanded to include an event where a company’s board of directors no longer includes the majority of directors present at the time the debt was issued or were approved by those incumbent directors. This provision is commonly referred to as a Continuing Directors provision. Bondholders are risk assessors and therefore corporate governance, control, and capital structure are each material to the pricing and valuation of bond issues. Bondholders would suggest this protection is also necessary because boards do not owe any fiduciary duty to bondholders (outside of insolvency at least), and bondholders’ only protections are the covenants they are able to negotiate and the company’s duty of good faith and fair dealing. It is not surprising, therefore, that bondholders need to be comfortable with a company’s existing board and management.
Though clearly not intended or approved by issuers as “takeover defenses” like the better known “poison pill,” the poison put has recently gained attention (or notoriety) from stockholder activists and hostile suitors in connection with proxy fights and takeover attempts – being cast as a tool for board and management “entrenchment.” This is in response to issuers publicly appealing to stockholders and the dissidents to withdraw or reduce their nominees to avoid triggering such a provision. This could obviously have disastrous consequences for an issuer, especially given the limited access to refinancing in the current economic environment or when the debt is impaired. Not surprisingly, these dissidents or hostile suitors have demanded that issuers “approve” their nominees or seek a waiver from the lenders to avoid triggering this default – actions which would likely be viewed as irresponsible if triggered by the dissidents or hostile suitors.
Delaware Chancery Court Vice Chancellor Stephen P. Lamb interpreted a Continuing Directors provision in this context in Amylin. In the Amylin case, Amylin was facing competing dissident slates, each of who had requested that the company approve the dissidents’ slates for purposes of the Continuing Directors provisions in the Amylin debt agreements in order for the stockholders to be able to fully exercise their franchise without triggering the poison put. Ultimately, in partial settlement of related litigation by the dissidents, Amylin approved each of the dissident slates solely for purposes of negating a default under the Continuing Directors provision but continued to oppose their election publicly and in their proxy materials. Not surprisingly, the bondholders were not receptive to such “approvals” given that the point of such provisions – from the bondholders’ perspective – was to allow them the unilateral ability to waive such provision in connection with a potential change in control (including, or maybe especially, in the form of a proxy contest). Bondholders clearly want an opportunity to assess the long-term platform of the dissidents and the independence and qualifications of their nominees to confirm their willingness to maintain their investment. Accordingly, the indenture trustee litigated the proper definitional interpretation of the Continuing Directors provision.
Relying on a strict textual interpretation of the Continuing Directors provision, the court ruled that the Continuing Directors provision as drafted did not prevent the Amylin board from “approving” the nomination of the dissident slate while nevertheless opposing their actual election. In particular, the provision did not expressly prohibit board “approval” after the commencement of a proxy fight, and the court was concerned that an interpretation that it effectively did prohibit such approval could severely limit the stockholder franchise (by coercing stockholders into only voting for directors supported by the existing directors).
Though not formally ruled on, the court suggested the right or “power” to approve dissident directors in this context (i.e., while opposing them in the actual election) was subject to the implied covenant of good faith and fair dealing under the indenture – which required that the board must make this approval in the good faith belief that the “election of one or more of the dissident nominees would not be materially adverse to the interests of the corporation or its stockholders.”
Finally, the court also ruled that the Amylin board did not breach its duty of due care (citing a “gross negligence” standard) in failing to learn of and specifically consider and approve the poison put provision – in particular noting the highly-qualified outside legal and financial advisors and the fact that directors did not have an obligation to know every term of the indenture. However, given the magnitude of the effect of a default under a debt agreement, the court expressed the fact that boards should request that their advisors inform them of the default provisions, even if “customary,” including those which could impair the shareholder franchise so that the board will be able to exercise its fully informed business judgment.
The court also informally suggested that boards that actually and intentionally limit the stockholder franchise in this context (i.e., by agreeing that the board cannot approve dissident nominees after commencement of a proxy fight) could face a tough burden in demonstrating the “extraordinarily valuable economic benefits for the corporation that would not otherwise be available to it” in order to satisfy the board’s fiduciary duties.
Given that lenders will likely continue to insist on including these provisions in a typical debt agreement or indenture, directors may feel they are between a rock and hard place. Directors can take comfort from the court’s application and discussion of the applicable gross negligence and duty of care standards in Amylin, but need to be aware of the issues this case presents and heed the helpful warnings offered by the court as follows:
Advanced preparation needed: Companies should review their existing debt (and other material) agreements now to identify the change in control provisions and their potential impact in a proxy contest or hostile takeover – particularly companies who may be currently vulnerable to stockholder activism or takeover attempts. Such provisions can also restrict the ability of a board or stockholders to pursue a friendly takeover offer. The contractual, fiduciary and strategic issues that companies and boards may face are potentially daunting, so advanced and careful planning and preparation will help facilitate a successful result.
Be fully informed: Poison puts are no longer a dirty little secret, and the Amylin case made clear that boards have a continuing duty to protect their stockholders’ interests notwithstanding a need to incur indebtedness and the fact that such provisions are customary and typically required by the debt holders. To ensure compliance with their fiduciary duties, directors should be informed of and attentive to all change of control provisions in new debt and other material agreements going forward – particularly those which may impair the stockholder franchise. Boards should not be passive in these approvals and should ask questions of their advisors to their satisfaction. Future courts may not be as forgiving after the warnings set forth in Amylin. Bondholders are unlikely to drop these provisions for new issues and will likely seek ways to close the loophole identified in the Amylin case.
Boards need to fully understand the impact (financial, business and otherwise) of the company’s refusal to accept the poison put. Each situation will be different and a company’s financing options may be particularly limited in this economic environment or if otherwise in distress, but care should be taken to negotiate these provisions carefully (particularly Continuing Director provisions) and to ensure the Company is receiving commensurate economic and other benefits by accepting these provisions – even if advised that they are “customary.”
A poison put is not a poison pill: Boards should be well advised prior to using the poison put as an affirmative takeover defense (i.e., by a decision not to “approve” a dissident slate under) or giving the appearance of doing so (i.e., by publicly using this provision as leverage against the dissident), as this may draw undesired public criticism and litigation – which could undermine the company’s other efforts to purport to represent the best interests of the stockholders in connection with the proxy fight or takeover response. While not addressed by the Amylin court, boards should also be mindful that using a poison put as a takeover defense may trigger heightened scrutiny of the board’s actions beyond the “gross negligence” and business judgment rule standard – similar to a court’s analysis of the adoption and use of the better known “poison pill.” Although the implied duty of good faith and fair dealing to the lenders may provide a board some flexibility to not approve a dissident slate, the intent, circumstances and manner in which the approval is denied would nonetheless be scrutinized. Similar scrutiny may apply to a board that agrees to such a provision for a new issue when “in play” or otherwise engaged in a proxy or takeover battle.
No carte blanche: Boards do not have the unfettered right to grant an “approval” to circumvent a Continuing Directors provision as a result of the implied covenant of good faith and fair dealing applicable to commercial agreements. In particular, boards are required to make a “good faith” decision that the election of one or more of the dissident nominees would not be materially adverse, or pose danger, to the interests of the corporation or its stockholders. Companies should take care that their public opposition to the dissident nominees does not go beyond “election puffery” to avoid potentially undermining the credibility of a board’s “good faith” decision to approve the nomination by the dissidents. Perhaps more importantly, the failure to meet this standard could also indicate a duty of loyalty breach – for which directors may be personally monetarily liable (and without D&O coverage).
Expect scrutiny in hindsight: Courts will likely apply greater hindsight scrutiny in future cases and may expect to see “evidence” of fully informed and good faith decision-making. Boards should take care to get expert legal and, as appropriate, financial advice and should exercise their business judgment in good faith and on a fully informed basis. Boards and their advisors should create a good “record” of the decision making process.
Be well advised: Directors and officers are entitled to reasonably rely on expert advisors selected with due care. The need to observe proper process and decision-making will likely necessitate the early involvement of experienced outside legal and, in some cases, financial advisors.
Ryan D. Thomas is a partner in the Corporate and Securities Practice Area at Bass, Berry & Sims PLC, and counsels boards and companies on corporate governance, shareholder activism, mergers and acquisitions, and securities matters. Thomas K. Wedeles is an associate in the Corporate and Securities Practice Area at Bass, Berry & Sims PLC.