Third Point v. Ruprecht: Creeping Control and Negative Control Upheld as Defenses for Two-tier Poison Pill

Practical Law Legal Update 4-567-6928 (Approx. 12 pages)

Third Point v. Ruprecht: Creeping Control and Negative Control Upheld as Defenses for Two-tier Poison Pill

by Practical Law Corporate & Securities

Background

The case arose from the recent shareholder activism involving Sotheby's, the global high-end art auction house. At all relevant times, the board of Sotheby's consisted of 12 directors, ten of whom satisfied the definition of independence under the NYSE's listing rules. Defendant William F. Ruprecht is the Chairman and CEO of Sotheby's and the only employee serving as a director of the company. The board of Sotheby's is unstaggered, meaning every director comes up for reelection at every annual meeting.

In May 2013, Third Point disclosed that it had acquired 500,000 shares of Sotheby's stock. This move was soon followed by acquisitions of shares by other activist hedge funds, including Trian Fund Management and Marcato Capital Management. By July 2013, the board realized that it was to become the subject of an "imminent activist effort to shift [its] management agenda" and prepared to discuss this issue at its August meeting with its financial advisors at Goldman Sachs Group, Inc. and its legal counsel at Wachtell, Lipton, Rosen & Katz.

At that August meeting, the Board heard a presentation jointly prepared by Wachtell and Goldman Sachs describing the shareholder-activism market generally and activist issues specific to Sotheby's. The presentation described the typical tactics of shareholder activists as building a stake in the company either individually or by teaming up with other buyers to form a "wolf pack," threatening to agitate against the board's preferred strategy, and eventually taking action by threatening "withhold the vote" campaigns, demanding board seats and/or launching a short-slate proxy contest. Specifically as to Sotheby's, the presentation highlighted Third Point's penchant for writing "poison-pen" letters and its typical goals of stimulating an event such as a merger, tender offer, recapitalization, spin-off or liquidation. The presentation added that Third Point had in the past bid on a company in which it had invested.

Third Point's potential interest in making or spurring an acquisition was also revealed in Third Point CEO Daniel Loeb's notes for his August meeting with Ruprecht. Those notes suggested that Loeb intended to ask Ruprecht what he would do differently if Sotheby's was a private company. Soon after, the board learned that Third Point had multiplied its stake in the company, causing Ruprecht to comment that he will "not supervise the over-leveraging of this business which leads to wholesale termination of staff and suffocating debt." Later that month, Third Point disclosed an even larger stake of 5.7% in its initial Schedule 13D. In the filing, Third Point stated that it wished to hold discussions with the board that "may relate to potential changes of strategy and leadership."

In September 2013, Ruprecht voiced his view to the board's finance committee and to Goldman Sachs that a small, affordable share buyback would be an appropriate tactical step to take if it would prompt enough stockholders to vote for the incumbent board in an eventual proxy contest. Doing nothing, by contrast, would hand the leverage over to Third Point and cause disruption for the business that is hard to overcome when a company operates in a duopolistic market (as Sotheby's does with Christie's).

The next month, Third Point filed an amended Schedule 13D revealing a 9.4% stake. Daniel Loeb's letter accompanying the filing contained several accusations against the board. These accusations, in the words of the court, were made without "actual knowledge of their veracity." The letter also emphasized a need to replace Ruprecht as CEO and that Third Point had already identified and commenced discussions with potential candidates. In contemporaneous e-mails revealed in discovery, Loeb described his letter as both part of a "holy jihad" intended to "make sure all the Sotheby's infidels are made aware that there is only one true God," and part of a "Special Operation on Sotheby's" intended to "shock and awe" the company and "undermine the credibility" of Ruprecht.

The Rights Plan

At a special meeting held the day after the filing of the amended Schedule 13D, the board met to consider adopting a rights plan. The board heard from Wachtell that Third Point, Trian and Marcato had collective ownership of approximately 19% of the company's outstanding shares and that activists commonly use derivatives to accumulate larger positions without paying a control premium. The firm added that companies have adopted poison pills when facing activist situations, not just hostile takeovers, and that the pill is an effective device for preventing a creeping takeover.

As a result, the board unanimously approved the adoption of a two-tier rights plan. Under the plan's definition of an "Acquiring Person," those who report their ownership using a Schedule 13G (available to those who qualify as passive investors) would be permitted to acquire up to a 20% interest in Sotheby's. By contrast, 13D filers would be limited to a 10% stake before triggering the pill. The plan would also contain an exception for qualifying offers, meaning that those proposing to acquire any and all shares of the company would not trigger the pill.

Meanwhile, Ruprecht continued to favor a share buyback, stating that he assessed the risks of a full proxy contest with Loeb as "very severe," with the consequences of a buyback being "much less severe." In late January 2014, the board approved a special dividend of $300 million and a $150 million share buyback.

Interactions with Loeb

The record indicated that during this late-2013 to early-2014 timeframe, Loeb conducted himself as if he already had significant sway over the company's decision-making. Loeb had apparently represented himself to employees as the person who "was going to be the one appointing management soon." He also had contacted a real-estate developer that Sotheby's had been working with and stated that he was "in charge" of Sotheby's and would be making these decisions. He also had followed through on his threats from his October letter and contacted prominent members of the art community to gauge their interest in the Sotheby's CEO position.

In February 2014, Sotheby's and Third Point began negotiations to avoid a proxy contest. Third Point proposed that:

The board redeem or at least modify the rights plan to allow 15% ownership.
The roles of CEO and Chairman be separated.
Loeb and one other designee of his choosing join the board.
The board implement 360-degree director reviews and a mandatory director retirement age.

Far from an explicit threat to buy the company, one Sotheby's director "strongly favored" Third Point's position on the separation, review and retirement issues, noting that "we can fault Loeb for his ego, his rough edges, his 'ready, fire, aim' approach, but on the substance he is far from wrong and he is with us already on the core issue of" the share buyback. However, on the matter of board representation, Sotheby's responded with a conditional offer of one board seat, which Loeb rejected.

Announcement of Proxy Contest and Request for a Waiver

On February 27, 2014, Third Point amended its Schedule 13D, revealing a 9.53% stake of Sotheby's stock and notifying that it intended to run a slate of three directors to be voted on at the company's next annual meeting.

On March 13, 2014, Third Point again amended its Schedule 13D, revealing a 9.62% stake. In a letter accompanying the filing, Third Point requested a waiver of the 10% trigger to allow it to purchase up to 20%. In considering the request, the board heard from its advisors that the contest would be a "dead heat." According to the meeting minutes, the board concluded that the rationale for adopting the rights plan the previous October still applied with respect to a waiver: that Third Point and Marcato's rapid accumulation of shares constituted a threat to the company's corporate policy and effectiveness by attempting to achieve a change of control without paying a premium. In addition, the board determined that a build-up of a large stake could give the activists "negative control" by which they would have a controlling influence over the company's strategic direction without having paid a premium for that influence. The board therefore denied the request for a waiver.

Third Point's Colorable Claim

On March 25, 2014, Third Point filed a complaint contending that the board of Sotheby's had breached its fiduciary duties by adopting a discriminatory rights plan and refusing to waive the 10% trigger at Third Point's request. At a hearing on March 31, the court granted Third Point's motion to expedite, stating that Third Point had a colorable claim that the rights plan, by virtue of its two-tier structure and the fact that Third Point had stated that its plan was only to run a short-slate proxy contest, was unreasonable under Unocal and its progeny.

To obtain a preliminary injunction, a plaintiff must demonstrate:

A reasonable probability of success on the merits.
That absent injunctive relief, it will suffer irreparable harm.
That the balance of the parties' harms weighs in favor of injunctive relief.

The plaintiffs argued that under any standard of review, they had a reasonable probability of succeeding on the merits of their claim that the board of Sotheby's breached its fiduciary duties by adopting and enforcing the rights plan. According to the plaintiffs:

Under Blasius, the board had adopted and enforced the rights plan for the primary purpose of inhibiting Third Point's ability to wage a successful proxy contest, and without any compelling justification for doing so.
Under Unocal, regardless of the board's intentions, its actions were disproportionate to the minimal (or non-existent) threat posed and unreasonable by favoring the incumbent directors.

The plaintiffs argued that they would suffer irreparable harm if their motion to enjoin the annual meeting were denied, because they would not be able to exercise their voting rights over as many shares as possible. They added that the balance of equities favored their position, because the harm to Sotheby's of a brief postponement of the annual meeting would be outweighed by the harm of holding the meeting as scheduled, only to have to hold another one if eventually the court decided that the rights plan was invalid after all.

The defendant directors responded that they had identified several legally cognizable threats that justified the plan's adoption and enforcement. They also contended that the harm that Third Point claimed it would suffer was only speculative, both because it could win the proxy contest without acquiring any more shares and because there was no guarantee that it would acquire shares up to the 20% threshold even if the trigger were waived. The defendants also argued that the balance of equities weighed in their favor because postponing the meeting would prolong the disruption and distraction that the proxy contest causes.

Of note, during the hearing on the motion to expedite, the court sounded somewhat favorable to the board's argument that there is value to the stockholders in holding a meeting at a predictable time year after year. However, this argument was not treated in the court's decision on the motion for a preliminary injunction.

Outcome

The court ruled that the plaintiffs did not have a reasonable probability of success on the merits of its substantive claims. The court added that had it ruled otherwise, it would have found that the plaintiffs were likely to suffer irreparable harm and that the balance of equities favored postponing the meeting. However, the latter two issues were of no practical consequence.

Standard of Review Is Unocal, not Blasius

The court began its analysis by establishing that the proper standard of review of the board's actions was reasonableness under Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946, 949 (Del. 1985). The plaintiffs had argued that the more exacting standard under Blasius, which requires a compelling justification for actions that the board takes with the primary purpose of interfering with the stockholders' voting rights, was appropriate under the circumstances (Blasius Indus., Inc. v. Atlas Corp., 564 A.2d 651, 659 (Del. Ch. 1988)). By that theory, because the adoption and enforcement of the pill would have the effect of inhibiting Third Point's voting rights (by capping its ownership of voting shares), the board had to demonstrate a compelling justification for its actions.

However, though the court here was sympathetic to the plaintiffs' argument in theory, it held that Delaware precedent had established that poison pills are reviewed under Unocal. In support of this finding, the court cited to Moran v. Household International, Inc., which was the first case to establish that rights plans are analyzed under the Unocal standard (500 A.2d 1346, 1347 (Del. 1985)). The court also referenced other cases in which pills have been reviewed under Unocal, even when the case did not involve a hostile takeover, such as in Versata Enterprises, Inc. v. Selectica, Inc., 5 A.3d 586 (Del. 2010). The court also quoted the Delaware Supreme Court's decision in Liquid Audio, in which the Supreme Court stated although Unocal and Blasius are not mutually exclusive, the Blasius standard is "rarely applied, either independently or within the Unocal standard of review" (MM Cos. v. Liquid Audio, Inc., 813 A.2d 1118, 1130 (Del. 2003)).

By contrast, the plaintiffs had not cited to any case in which a poison pill was reviewed under Blasius, likely because:

It is rare that a board's primary purpose of implementing a pill is to interfere with the stockholder franchise.
Though there may be some incidental interference, Blasius is not implemented as long as a proxy contest remains viable (as in the decision regarding the Barnes & Noble poison pill, Yucaipa Am. Alliance Fund II, L.P. v. Riggio, 1 A.3d 310, 335 (Del. Ch. (2010), aff'd, 15 A.3d 218 (Del. 2011)).
The Unocal standard has always been adequate to deal with any incidental interference without invoking Blasius.

The Unocal Standard

As the court explained, the Unocal standard consists of two prongs:

A reasonableness test, satisfied when the board demonstrates a reasonable grounds for believing that a danger to corporate policy and effectiveness existed.
A proportionality test, satisfied when the board demonstrates that its response was reasonable in relation to the threat posed.

Each of these prongs essentially requires its own two-part showing. The first prong depends on a finding of a legally cognizable threat. This, as explained in Air Products, is "essentially a process-based review" (Air Prods. & Chems., Inc. v. Airgas, Inc., 16 A.3d 48, 92 (Del. Ch. 2011)). It is satisfied when the board demonstrates "good faith and reasonable investigation" (Paramount Commc'ns, Inc. v. Time, Inc., 571 A.2d 1140, 1152 (Del. 1990)). However, the board must also demonstrate an objectively reasonable threat, over and above its showing of a good process.

As for the proportionality prong, the court must consider the Unitrin factors of both:

Whether the board has proven that its response was not "draconian, by being either preclusive or coercive."
Even if it was not draconian, whether the response fell "within a range of reasonable responses to the threat."

(Unitrin, Inc. v. Am. Gen. Corp., 651 A.2d 1361, 1367 (Del. 1995).)

Because the plaintiffs had challenged both the adoption of the pill and the refusal to waive the 10% trigger, the court here analyzed both actions under both prongs of the Unocal standard.

Adoption of the Rights Plan

The court had little trouble finding that, under Delaware precedent, the Sotheby's board's adoption of the rights plan satisfied the entire Unocal test.

Reasonableness Prong Met through Threat of Creeping Control

The board of Sotheby's was almost entirely comprised of independent directors, few of whom received any material pecuniary benefits for serving on the board. The record also established that the board frequently consulted with its financial and legal advisors and relied on their advice. The good-process factor was therefore easily met.

As for the legally cognizable threat, the court ruled that it needed to focus on only one: creeping control. The board had been informed that investors commonly formed "wolf packs" to quickly and jointly acquire large blocks of the target company's stock. The possibility that they could acquire control without paying a premium was legally cognizable and objectively reasonable.

Rights Plan also Justified under Blasius

The court here also addressed the adoption of the rights plan under Blasius, in spite of its previous discussion, invoking the ruling in Inter-Tel that the purpose of Unocal is to "smoke out" impermissible pre-textual justifications for defensive actions (Mercier v. Inter-Tel (Del.), Inc., 929 A.2d 786, 807 (Del. Ch. 2007)). The court held that the record did not support a conclusion that the board adopted the rights plan for the primary purpose of interfering with the franchise of any stockholder. The court stated that:

The effect on any voting rights was incidental to the primary purpose of preventing a creeping takeover.
There was nothing to indicate that the directors were attempting to entrench themselves, seeing as how:
- the board was not staggered;
- the board customarily turned over at an above-average rate;
- the board was dominated by outside directors who did not receive material financial benefits for serving on the board; and
- the plan contained a qualifying-offer exception.
The several e-mails revealed in discovery that contained derogatory statements about Loeb did not prove that the board's decisions were motivated by personal animosity toward him. The directors were entitled to dislike Loeb as long as they acted reasonably.
Under Inter-Tel, an action by the board cannot be presumed to have been taken for the primary purpose of disenfranchising the stockholders if it was neither preclusive nor coercive (929 A.2d at 818).

To the last point, the court noted that the rights plan was not coercive, because it would not impose any consequences on any stockholder for voting as it wished. It also was not preclusive, because the proxy contest was winnable by either side.

Two-tier Plan Satisfies Proportionality Prong

In addressing the proportionality test through the Unitrin gloss, the court first noted that its analysis of preclusiveness and coerciveness under Blasius applied equally here to establish that the board's response was not draconian. As for the range of reasonableness, the court again cited to Air Products for the proposition that the "reasonableness of a board's response is evaluated in the context of the specific threat identified," meaning that the "specific nature of the threat sets the parameters for the range of permissible defensive tactics" (16 A. 3d at 122).

Here the plaintiffs argued that the response of a two-tier pill was disproportionate to the threat of creeping control because it discriminated between passive and activist investors. The court rejected this argument, holding that on the contrary, a two-tier approach was a better response to the threat than a "garden variety" plan that imposes one standard on every stockholder. If a 10% threshold is reasonable and proportionate, there is no reason why allowing passive stockholders to reach 20% should become unreasonable or disproportionate.

Enforcement against Third Point

The court next addressed the board's refusal to waive the 10% trigger in March 2014 and found this to be a closer call.

Reasonableness Prong Met through Threat of Negative Control

The court stated that the showing by the board of good faith and reasonable investigation remained true in March 2014 as it was in October 2013. The good-process factor was therefore met. The harder question was whether there was an objectively reasonable and legally cognizable threat to the company when Third Point made its waiver request.

The concern for the court was that Third Point had not asked for a waiver of the entire pill, which would once again raise a concern about a creeping takeover. Rather, Third Point had only asked for a waiver of the 10% threshold, which would still cap its holdings at 20%. This negated the threat of creeping control, whether Third Point were to acquire shares individually or as part of a wolf pack.

Nevertheless, the court held that the board had made a showing that a threat of negative control was legally cognizable and objectively reasonable. Typically, "negative control" refers to an explicit veto right through contract or a level of share ownership or board representation that does not amount to majority control, but that is still sufficient to block certain actions. However, the court held that the Sotheby's board had legitimate concerns that allowing an activist investor like Third Point to obtain 20% ownership would give it disproportionate control and influence that ought to be acquired through payment of a premium.

The court acknowledged that extending the concept of negative control past explicit veto rights and into an area of "effective negative control" can give companies license to use that rationale as a justification for any defensive action. However, the court felt comfortable extending that concept here precisely because of the "aggressive and domineering manner" in which Loeb had conducted himself. That behavior, combined with 20% ownership (which would make Third Point the largest stockholder of Sotheby's by far), was enough for the court in this situation to recognize negative control as a legally cognizable threat.

Enforcement of Rights Plan "Uncomfortably Close" under Blasius

In a lengthy footnote, the court added that it found the question of whether the board had enforced the 10% trigger against Third Point for the primary purpose of interfering with Third Point's franchise "uncomfortably close." In particular, the court highlighted that the board decided not to grant the waiver soon after it learned from its proxy advisors that doing so would hand Third Point victory in the proxy contest. However, the court again cited to Moran and Selectica for the proposition that rights plans are typically reviewed under Unocal, even when there is some incidental loss of stockholder franchise. But the court added that the plaintiffs' claim on this point was colorable and raised policy considerations that justified further review in the future.

Proportionality Prong Satisfied with Reasonable Decision

For the reasons discussed in relation to Blasius and the adoption of the plan, the court reiterated that the Unitrin factor of avoiding preclusive or coercive action had been satisfied. The court also found that the refusal to allow Third Point to acquire up to 20% of Sotheby's stock fell within the range of reasonableness. Although it is conceivable that some level of ownership between 10% and 20% would have been optimal, the courts only require "a reasonable decision, not a perfect decision" (Paramount Commc’ns Inc. v. QVC Network Inc., 637 A.2d 34, 45 (Del. 1994)).

Imminent, Irreparable Harm

Although the court concluded that Third Point had not made a showing of probable success on the merits, it nevertheless analyzed the questions of harm and equities in the event that Third Point had been able to demonstrate a likelihood of success.

The plaintiffs presented several theories for how they would suffer imminent, irreparable harm if the rights plan were left in place ahead of the annual meeting. The court agreed with the plaintiffs that the reduced chances of winning the proxy contest would have qualified as a threat of irreparable harm. Because the proxy contest was so close, a swing of 10% ownership would be significant. Even though Third Point could not be sure that each share it would purchase would be sold to it by a stockholder who had planned to vote against it, the votes it would acquire would likely number enough as to be significant.

The court here also rejected the defendants' response that the meeting could still go on regardless of whether the rights plan had been improperly enforced, because the court could always throw out the results of the meeting and order a new election. The court cited to the decision in American Pacific Corp. v. Super Foods Services, Inc., which stated that the harm from a flawed vote cannot be easily remedied with a second meeting. The effect of holding a second meeting, even though to the stockholders' benefit, "is to create an insurmountable obstacle of confusion and antipathy" (, at *326 (Del. Ch. 1982)).

Finally, the court ruled that the balance of equities would have favored the plaintiffs had they established a likelihood of success on the merits. The court acknowledged that the threat of an ongoing proxy contest was credible, but that this was outweighed by the protection of the stockholder franchise.

Practical Implications

The Third Point decision directly addresses the most current issue of corporate governance facing public companies, which is the application of traditional takeover defenses against shareholder activists. The plaintiffs had stressed that the issue presented a novel question of law, given that the Sotheby's board had implemented a two-tier rights plan aimed squarely at shareholder activists, even as Third Point did not intend to take over the company. In the plaintiffs' view, the poison pill was an inappropriate response, because all Third Point was attempting to do was elect its preferred candidates and introduce new views into the boardroom.

While expressing certain reservations, the court essentially declined the invitation to treat the issue as an entirely new and unprecedented situation. The court instead followed the lead of Moran and applied the Unocal standard, with the Unitrin gloss, to poison pills. In so doing, the court expanded the universe of potential justifications for enforcement of poison pills against shareholder activists to include the threat of effective negative control.

The decision also implicitly advises against a common activist tactic of behaving with a certain bluster or aggressiveness. The court was comfortable enough to extend the concept of negative control precisely because of Loeb's conduct in the weeks and months leading up to the hearing. It is not hard to imagine that the court would have been more reticent to do so had it not been convinced of Loeb's intentions to enforce his will in outsize proportion to his stake in the company.

Postscript

On May 5, 2014, Sotheby's and Third Point announced that they had reached an agreement to resolve their dispute. Under the agreement:

Sotheby's will allow Third Point to increase its ownership to 15% of the outstanding stock.
Rather that conducting a proxy contest for three seats, the board will expand from 12 members to 15, with Third Point's three nominees being appointed to the board and added to the company's slate.
The meeting, which had been scheduled for May 6, would be convened and adjourned to allow updated solicitation materials to be distributed.

Sotheby's subsequently announced that the meeting had been adjourned to May 29, 2014.

Third Point v. Ruprecht: Creeping Control and Negative Control Upheld as Defenses for Two-tier Poison Pill | Practical Law