Pontiac GERS v. Ballantine: Chancery Court Declines to Dismiss Claims Against Board and Lenders Based on Loan Agreement Proxy Put

Practical Law Legal Update 4-587-7446 (Approx. 8 pages)

Pontiac GERS v. Ballantine: Chancery Court Declines to Dismiss Claims Against Board and Lenders Based on Loan Agreement Proxy Put

by Practical Law Corporate & Securities

Background

The case arises from Healthways, Inc.'s entry into a credit agreement containing certain change-of-control provisions, agreed to against the backdrop of a threatened proxy contest and ongoing stockholder pressure. In 2010, Healthways entered into an agreement with a poison put provision triggered by a change of control of the board of directors, commonly known as a "proxy put." Under the terms of the provision, the lenders can, by majority vote, accelerate repayment of the debt if, during a period of 24 consecutive months, a majority of the members of the board who were directors at the beginning of that period are no longer directors at the end of that period (other than if the new directors were approved by the directors who are stepping down). The purpose of the provision, as explained by counsel for the lender administrative agent SunTrust Bank, is to protect lenders from wholesale changes in the composition of the board over a two-year period and to allow the lenders to reevaluate the new situation at that time.

Healthways subsequently became the target of a possible proxy contest, resulting in the stockholders passing a non-binding proposal in May 2012, over the board's opposition, to declassify the then-staggered board. The board did eventually agree to declassify, but not before it took other, potentially entrenching action. Eight days after the stockholder vote, the board entered into a new amended and restated credit agreement containing a "dead hand" proxy put, in which the election of a majority of new directors within the 24-month period would trigger the provision even if the resigning directors were to approve the appointment of the new directors. The 2012 agreement has been subsequently amended three more times, with the proxy put always staying in the agreement.

In January 2014, amid continuing stockholder pressure and the threat of a new proxy contest, the board agreed to appoint certain activist nominees. These new directors are considered non-continuing directors for purposes of the proxy put and therefore bring the provision a step closer to trigger.

In March 2014, the plaintiff stockholder served the company with a demand under Section 220 of the DGCL, seeking documents and records relating to the dead hand proxy put. According to the complaint, the company did not produce any documents that would evidence either any negotiation over the put or any benefits to the company that might justify it.

The plaintiff subsequently filed suit. In addition to seeking a declaratory judgment that the proxy put is unenforceable, the plaintiff asserted claims against two sets of defendants: the individual directors of Healthways and SunTrust. Against the directors, the plaintiff claimed that they breached a fiduciary duty to the stockholders of Healthways by agreeing to the proxy put under the circumstances in which they did. The plaintiff also claimed that SunTrust aided and abetted that breach by agreeing to the proxy put.

In response, the two sets of defendants filed a motion to dismiss the claims. The defendant directors argued that the case is not ripe, because the proxy put will not come into play unless and until there is another contested election for the board, and that even were there to be more turnover on the board, the banks might still decide to waive the put. In the defendant directors' view, the plaintiff's argument must assume that the very act of agreeing to a proxy put is a per se breach of fiduciary duty. This, the directors stressed, would take Delaware law far beyond the decisions of Amylin and SandRidge, which only found the boards' actions problematic because of their threats to the stockholders of the consequences of triggering the put, which were made during active proxy contests. (For Amylin, see San Antonio Fire & Police Pension Fund v. Amylin Pharm. Inc., 983 A.2d 304 (Del. Ch. 2009), aff'd, 981 A.2d 1173 (Del. 2009) and Legal Update, DE Chancery Court Interprets Poison Put Provisions in an Indenture. For SandRidge, see Kallick v. SandRidge Energy, Inc., 68 A.3d 242 (Del. Ch. 2013) and Legal Update, Kallick v. SandRidge Energy: Delaware Court of Chancery Finds Board Likely Breached Fiduciary Duty by Failing to Approve Dissident Nominees.)

The defendant SunTrust, agreeing with the directors that the case was not ripe, added an argument that the element of knowing participation in a breach, which is required to make a claim for aiding and abetting, was missing. SunTrust emphasized that it had negotiated with Healthways at arm's length and had simply been trying to negotiate the best possible deal for itself, without attempting to induce a breach of fiduciary duty. SunTrust argued that it was unfair that bargaining for the benefit of its own stockholders, to whom its own board owes fiduciary duties, becomes recast as aiding and abetting a breach of its counterparty's fiduciary duties. SunTrust added in this regard that the proxy put is not just a tool for manipulating the borrower, but that it has a valid business purpose of allowing the lender to reassess the situation and regain comfort after the borrower has gone through significant change. SunTrust also emphasized that proxy puts are "market" and that a decision to invalidate them would have an effect reaching far beyond the particular credit agreement at issue.

Outcome

In a ruling from the bench, Vice Chancellor Laster rejected the motion to dismiss. Though emphasizing that the decision is "factually specific," Vice Chancellor Laster highlighted the problem of forcing the board to bargain "in the shadow of" the put, which is an issue that can be easily extrapolated to other situations.

Claims Are Ripe

The Court rejected the directors' argument that the plaintiff's claim is not ripe for judicial determination. In so doing, the Court explained that the problem with the proxy put is its deterrent effect. This effect is not something that may happen after future contingent events, but is currently happening. While the directors argued that the case will not become ripe until there has been a successful proxy contest and decision by the banks not to waive it, the Court explained that those are the steps necessary for the actual trigger of the put. The purpose of a deterrent, however, is to never actually be triggered, because the parties understand the consequences of the trigger. The Court therefore does not need to wait until a proxy contest for the issue to become ripe.

To support this understanding, the Court cited to several cases on takeover defenses, including Carmody v. Toll Brothers, 723 A.2d 1180 (Del. Ch. 1998). In Toll Brothers, the Court struck down a dead-hand poison pill because the pill would have a chilling effect on potential proxy contests and deter stockholders from deciding to launch one. Yet there was not a requirement that an actual proxy contest be underway for the Court to strike down the pill.

The Court further analogized the proxy put to deal-protection measures in public merger agreements, which are litigable even if there is no actual topping bid.

The Court emphasized that its decision of ripeness does not rely on a holding that the act of agreeing to a proxy put is per se a breach of fiduciary duties. The Court called the claim ripe because of the "factually specific manner" in which it was alleged that the board breached its fiduciary duties. In particular, the Court noted:

The backdrop of the proxy contest against which the dead hand proxy put was agreed to.
The company's change from historical practice in the 2012 agreement from an ordinary proxy put to a dead hand proxy put.
The stockholder vote to declassify, which indicated some dissatisfaction with the board at the time that the dead hand proxy put was agreed to.
That the board had just agreed to declassify and by agreeing to the two-year proxy put had essentially restored the effect of a staggered board.
That there is already a set of non-continuing directors on Healthways' board, which makes the shadow of the proxy put loom that much larger.
That the company had produced no exculpatory evidence in response to the Section 220 demand to explain why it needed to agree to the proxy put or whether it had specifically negotiated it at all.

Discussion in Allergan Litigation

The discussion of ripeness in Ballantine has already been cited in a more recent Court of Chancery decision, In re Allergan, Inc. S'holder Litig., Consol. C.A. No. 9609-CB, (Del. Ch. Nov. 7, 2014). In that decision, the Court denied the plaintiffs' motion for summary judgment on grounds that the claim of breach of fiduciary duty was not ripe. The plaintiff stockholders had sought a declaration from the Court that Allergan's by-laws permit the stockholders to remove the entire board of Allergan at a special meeting and simultaneously elect a new slate at the same meeting. The Court dismissed the motion because no stockholder is actually attempting to remove the entire board of Allergan. On the contrary, at Allergan's December 18th meeting, Valeant Pharmaceuticals and Pershing Square will be attempting to remove a majority, but not all, of the board (for a summary of another recent decision in the ongoing Valeant-Allergan battle, see Legal Update, Allergan v. Valeant: California District Court Questions Whether Co-bidder Vehicle Avoids Insider Trading Liability).

The plaintiffs, citing to Ballantine, argued that their claim is ripe for adjudication because the confusion is impeding the stockholders' understanding of, and discouraging their ability to exercise, their rights to call a special meeting. The Court, reviewing the same takeover and proxy put decisions as Vice Chancellor Laster did in Ballantine, distinguished the situations. In Ballantine and similar cases, the provision in question had caused a deterrent effect that could already be said to have begun, even if unseen. In Allergan, however, there cannot be said to be any deterrent effect on the stockholders' franchise rights because Valeant and Pershing Square are in fact pursuing a proxy contest. They are simply using a different strategy than the one the plaintiffs would have chosen.

Aiding and Abetting Claim against Lender Survives

The Court in Ballantine also rejected SunTrust's motion to dismiss the claim of aiding and abetting. In doing so, the Court acknowledged that negotiating at arm's length usually does negate a claim of aiding and abetting. However, this only means that a party can negotiate for the best economic terms it can get. What a party cannot do, on the other hand, is propose, insist on and incorporate terms that take advantage of a conflict of interest that its fiduciary counterpart faces. Here as well, the Court analogized M&A negotiations, in which a party can negotiate for the best possible economic terms, but cannot offer entrenchment benefits without negating the arm's length posture. In the lending context, the lender can ask, for example, for a high interest rate or coverage ratio, because the borrower's directors have the same incentives as the stockholders when responding to those requests. The lender cannot, however, ask for a term that puts the board of the borrower at odds with its stockholders. This is the effect of a proxy put, because it incentivizes the directors to accept that provision for the sake of entrenching themselves, and at the same time disincentivizes the stockholders to run a nominee slate in opposition to the board. When a lender knowingly negotiates for such a term, it knowingly participates in the breach.

The Court was also not swayed that the proxy put has a legitimate business purpose absent facts showing that the borrower was in particular distress. The "know-your-borrower" argument that SunTrust argued is more appropriate to private companies or public companies with controlling stockholders. The Court felt that the argument does not translate to public companies, which have ever-changing float, annual elections and CEO turnover that averages three to five years. The Court added that the need to reassess the borrower's credit after a change of control can be achieved through financial protections like debt-coverage covenants and other provisions that actually address the creditworthiness of the borrower, rather than proxy puts.

The Court acknowledged that market practice is a factor to be taken into account, but that it does not end the discussion. In the Court's words, "at the time of a riot, rioting is market." The Court approved of plaintiff's counsel's point that staple financing was also once market before the decisions in Del Monte and Rural/Metro changed it. The Court also agreed with the plaintiff that lenders were put on notice after Amylin and SandRidge that proxy puts are "highly suspect" and could potentially lead to a breach of duty, and that this undermined arguments of market practice and uncertainty over the law.

Practical Implications

The Ballantine decision illustrates the careful scrutiny that the Court of Chancery continues to place on proxy puts. Although the decision does not explicitly discuss the standard of review as it did in SandRidge, the Court clearly approached the proxy puts as entrenchment devices that warrant, at a minimum, Unocal review for reasonableness in relation to the threat posed (for a discussion of the Unocal test, see Practice Note, Fiduciary Duties of the Board of Directors: Defensive Measures). Of particular interest here is the fact that the Court applied this level of review even though there was, in fact, no actual threat. Nevertheless, the Court viewed the proxy put as a "Sword of Damocles," in its words, that hangs over the stockholders and must therefore be scrutinized for reasonableness.

Viewed in this light, it is not hard to extend the import of Ballantine to situations that do not exactly match the facts here. Although the Court emphasized the factually specific nature of the case and highlighted several facts that add up to something like a semi-proxy contest, the underlying theory for the decision should apply even when there is no threat of a proxy contest at all. While the Court can be expected to shy away from blanket pronouncements that declare all proxy puts per se breaches of fiduciary duties, lenders and borrowers are best advised to avoid them and use financial covenants to get comfortable with the borrower's credit-worthiness.

Pontiac GERS v. Ballantine: Chancery Court Declines to Dismiss Claims Against Board and Lenders Based on Loan Agreement Proxy Put | Practical Law