Chancery and Proxy Puts

Kallick v. Sandridge Energy, Inc., C.A. No. 8182-CS (Del. Ch. Mar. 8, 2013).

The highly regarded corporate law scholar Professor Larry Hamermesh has provided his insights on this decision in  highlights available on his blog at The Institute of Delaware Corporate & Business Law. The entire post follows:

Chancellor Strine’s March 8, 2013 opinion in Kallick v. SandRidge Energy is a welcome reaffirmation and clarification of director duties in relation to takeover deterrents built into otherwise customary commercial transactions—in this case, a put right (the “Proxy Put”) in the company’s credit agreements that would require the company to refinance debt in the event of a change in the majority of the board not approved by a majority of the pre-existing directors.

Responding to a dissident hedge fund’s consent solicitation to replace the board, the company (SandRidge) made the (in hindsight) grievous error of warning its stockholders that replacing the board could result in “mandatory refinancing of [a] magnitude [that] would present an extreme, risky and unnecessary financial burden” on the company. Talk about playing right into the dissident’s hands! You don’t have to be as smart as Chancellor Strine to figure out that this great a burden on the electoral franchise requires some explanation. Who agreed to it? Why? And why can’t the burden be avoided? The company later tried to ride a different horse, claiming that the Proxy Put was no problem after all, because refinancing would be easy and inexpensive – a better argument in light of Unocal, of course, but regrettably awkward in light of the company’s prior position .

Those first two questions—how and why did the Proxy Put get there in the first place?—didn’t get much of an answer in the record. The Chancellor usefully reminded transactional lawyers, however, that playing with matches like the Proxy Put requires some care: “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.” SandRidge’s lawyers involved in negotiating the credit agreements may have missed that message from the Court’s 2009 opinion in San Antonio Fire & Police Pension Fund v. Amylin Pharms., Inc., 983 A.2d 304, 315 (Del. Ch. 2009) (“The court would want, at a minimum, to see evidence that the board believed in good faith that, in accepting [a Proxy Put], it was obtaining in return extraordinarily valuable economic benefits for the corporation that would not otherwise be available to it.”).

In any event, what was done was done. The real question in the case was not how the Proxy Put got there, but what to do about it. The premise from which the Chancellor approached the question was that the board could “approve” the dissident candidates for purposes of the Proxy Put (and thereby avoid triggering it) without endorsing their candidacy. The question then became whether there was any reason not to grant such limited approval, and that’s where the defendants’ proof fell totally to the ground. The Court noted that there was nothing in the record to “indicate[] that any incumbent board member or incumbent board advisor has any reasonable basis to dispute the basic qualifications of the [dissident] slate.” And the board’s financial advisor conceded that approving the dissident slate for purposes of the proxy put wouldn’t breach any obligation to the creditors.

And most notably, the Court found that:

[T]he 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—not a change in board composition accompanying a merger or acquisition or another type of event having consequences for the company’s capital structure, but a mere change in the board majority.

It was this failure of proof that was defendants’ undoing, given the application of a legal standard of enhanced scrutiny that requires the defendants to demonstrate at least some justification for insisting on maintaining whatever deterrent effect the Proxy Put imposed on the stockholder vote. Summarizing the governing legal rules, the Chancellor explained:

By definition, a contract that imposes a penalty on the corporation, and therefore on potential acquirers, or in this case, simply stockholders seeking to elect a new board, has clear defensive value. Such contracts are dangerous because, as will be seen here, doubt can arise whether the change of control provision was in fact sought by the third party creditors or willingly inserted by the incumbent management as a latent takeover and proxy contest defense. Unocal is the proper standard of review to examine a board’s decision to agree to a contract with such provisions and to review a board’s exercise of discretion as to the change of control provisions under such a contract.

The Court’s approach to relief bought into a nuanced alternative thoughtfully put forward by plaintiff, who had originally asked for an order requiring the board to approve the dissidents’ candidacies for purposes of the Proxy Put. Recognizing that such affirmative, mandatory relief is an uncomfortable, extraordinary thing for a court to award, the plaintiff alternatively (but no less effectively) sought an order preventing the company from soliciting revocations of stockholder consents so long as the board was declining to approve the dissidents’ candidacies. And that’s exactly what the Court granted.

The opinion also features a citation to the scholarship of a corporate law scholar often cited in Delaware opinions: Prof. Stephen Bainbridge, who discusses the citation on his own blog. An insightful overview of this decision is available on The Harvard Law School Corporate Governance Blog.