Military strategy and takeover strategy share a few things in common. At some point, generals and M&A lawyers each must recognize that the old technology no longer works as it did in the past and can no longer dominate the battlefield. For example, in the Ukraine war, it has become obvious that battle tanks are vulnerable and do not reign supreme. Correspondingly, in the takeover war, the poison pill is no longer the absolute showstopper it once was and can be outflanked by activist hedge funds seeking to run a proxy contest — even if only for a minority of the board.
Legal developments have accelerated the pace of change, and two stand out: First, at the state level, last year in In re Williams Cos. Stockholder Litig.,[1] the Delaware Chancery Court curbed the use of the poison pill against smaller activists by invalidating a poison pill set at the 5% ownership level where no specific threat to the corporation (other than the pandemic) was advanced as a “threat.” Second, on the federal level, SEC Rule 14a-19 has just become effective, and we are entering the brave new world of the universal proxy card.[2] Many commentators have predicted (accurately, I believe) that its advent will mean more proxy contests, often by much smaller activists seeking only a small number of board seats. These smaller activists may often be working in concert with even smaller entities – sometimes called “sidecar vehicles” – that are formed by those same hedge funds principally to invest in the target in parallel with their flagship fund (but the details surrounding those vehicles do not clearly need to be disclosed for purposes of the Williams Act).
On this altered landscape in which more and smaller proxy contests for a minority of the board may be launched (or at least threatened), some fear that low visibility figures may exercise disproportionate influence, possibly funding such contests, without ever emerging into public view or becoming known to the voting shareholders. The reality of this threat can be debated, but the takeover defense bar is beginning to respond. This column will examine the defense devised by Masimo Corp., a publicly held medical technology company, to resist a proxy contest threatened by Politan Capital Management LP, an activist hedge fund. The architect of this campaign was Eduardo Gallardo, the head of the M&A department at Paul Hastings LLP, and, in my view, one of the more creative experts in this field. His response was an “advance notice” bylaw that would require any person (including any hedge fund) seeking to nominate a candidate for election to the board to disclose the identity of (and much additional data about) any limited partner or other investor who owned 5% or more of the hedge fund, as well as all investors in any sidecar vehicle. In addition, the bylaw would require the hedge fund to disclose if any of the 5% investors in it were invested in “principal competitors” of the target firm or a “counterparty to any litigation” with the target. Allegedly shocked by these requirements, the hedge fund community has asserted that information about their limited partners must remain confidential, and, if such disclosure were required, this might make it impossible (or at least more difficult) for them to raise capital for their proxy campaigns. In short, they claim that more disclosure means fewer contests.
But why are institutional investors fearful of the disclosure of less than 5% limited partners and sidecar investors? One possible reason might be that some investors – say, public pension funds – would be politically embarrassed if they had to disclose their involvement in a proxy fight that sought a restructuring likely to result in a major reduction in employment at the target company. Other variations on this theme are easy to imagine, as public funds live in a politicized environment.
Before examining the merits of the debate, it is useful to step back and draw an analogy to a political campaign contest. Suppose, in a contested primary, a half dozen credible candidates are running. One has the support (and considerable financial backing) of Donald J. Trump, but assume further that nothing requires the disclosure of his identity, the amount of his financial support, or possible agreements that he has with the candidate. Under these conditions are voters being denied material information that might influence their vote? Turning back to the proxy contest election, should the same arguments justify requiring supporters of the insurgent candidate to disclose not only their own identity, but the fact that they have 5% or greater limited partners who are significantly supporting the insurgent’s campaign? One can see why this might constitute material information.
In the world of proxy contests, the SEC may not yet require such disclosure, but that only frames the broader question: Can the corporation require additional disclosures not mandated by the SEC if it feels such information would be material to its shareholders? Here, the response of the hedge fund community has been that if such disclosures were required, they would lose the financial support of these investors (and fewer proxy contests would be brought); this is a disturbing argument that proves too much because it seems to concede that these invisible investors do supply substantial financial support – in short, their assistance is material. Also, if hedge funds do arrange for support from sidecar investors who own little or no interest in the hedge fund, but do make a parallel contribution in support of the insurgent candidate, why should this information escape disclosure? It may be that these practices in the past were too infrequent for the SEC to notice.
Arguably, the SEC only mandates the minimum that must be disclosed, and much more could be material. In this light, can the target company seek to fill this gap by requiring more information? Existing Delaware law seems to support such a target corporation-triggered self-help remedy.[3] Still, hedge funds may respond: If 5% is too small a stake to justify the use of a poison pill, why is it sufficient to uphold an advance notice bylaw that could potentially work to deny shareholders the ability to elect an insurgent director?
This question, however, can be answered: Poison pills threaten a financially catastrophic impact, as they are highly dilutive. They are thus a disproportionate weapon to invoke in a mere corporate governance dispute or a contest over a single director. In contrast, an advance notice bylaw merely requires the nominating person to make disclosures (which a Delaware court can certainly review in order to protect insurgents from pure harassment). If the nominating person were required (as some Delaware cases already require) to fill out a target-drafted questionnaire that discloses the identity of those owning a 5% or greater share in the hedge fund and the identity of others known to it to be supporting the insurgent, this does not threaten anything like the financial penalty that a poison pill does. Rather, it advances the goal of greater transparency in elections and permits a Delaware court to strike fair balances.
The hedge funds’ apparent claim that such disclosure represents an “existential threat” to them sounds as if Chicken Little has entered the debate. Such claims are easily asserted but less easily proven, and they tend to be self-serving. Once, bidders asserted that the Williams Act’s 5% threshold for disclosure of beneficial ownership would chill takeovers. Experience has shown otherwise. Similarly, Chicken Little-like predictions that the sky will fall in on proxy contests if limited partners must be disclosed needs to be viewed skeptically.
In fairness, however, the Masimo bylaw goes beyond simply the identification of 5% plus limited partners in the nominating stockholder. What most concerns the activist community appears to be the attempt of the Masimo bylaw to obtain disclosure about the recent track record of the activist seeking a board seat. What similar campaigns has it launched at other companies? To this end, the Masimo bylaw’s critical term – “Covered Person” – includes persons “Acting in Concert” (as defined) with the nominating shareholder, even though they do not have any express agreement. In part, the intent here appears to have been to identify shareholders who have a special agenda (say, environmental activism) and have developed an ongoing association with the nominating person in order to pursue a common agenda (which may have little to do with the maximization of shareholder value). Corporate management’s apparent premise here is that, with universal proxy voting, such informal alliances with single-issue activists may become more common and that shareholders deserve information about such associations.
Thus, the Masimo bylaw deems the nominating shareholder to be “Acting in Concert” with a person if the nominating shareholder “has knowingly acted (whether or not pursuant to an express agreement, arrangement or understanding) at any time during the prior two years in concert with such Person (or Control Person thereof) in relation to matters (whether or not specific to the Corporation) that will be material to the…solicitation of stockholders, including, without limitation, matters of social, labor, environmental and governance policy.” This provision is indeed broad, but there is a carve-out so that hedge funds and other professional investors could seldom, if ever, be deemed to be “Acting in Concert” with the nominating person. The concern animating this provision seems to be that, with universal proxy cards, informal understandings will develop between traditional nominating shareholders and ideologically motivated activists. Will they? It seems too early to make a confident prediction, but courts can reject bylaws that seem intent only on imposing an undue burden.
How will Delaware respond to this new twist on advance notice bylaws? In general, the Delaware courts have accepted them, at least in the absence of facts showing “inequitable circumstances.”[4] Earlier this year, the Delaware Chancery Court found that a target company was entitled to reject a plaintiff’s nomination notice where the plaintiff did not fill out the company’s questionnaire and return it with the nomination notice.[5] Last year, the Chancery Court similarly held that the plaintiff’s nomination notice was deficient where it did not disclose the shareholders known to the nominating person who were supporting the nomination.[6] This is exactly what the Masimo bylaw also requires.
In short, a Delaware corporation appears entitled to demand considerable information from a nominating person. This does not mean that a corporation could not require too much information, and a timely suit brought by a would-be nominating shareholder to challenge such a bylaw should receive a careful hearing from the Chancery Court. But the argument that limited partners and other persons with some relationship to the nominating person have some right of privacy that entitles them to escape disclosure is overbroad. Even when they hold only 5%, limited partners are not the weak, passive creatures of traditional limited partnership law. Rather, they may have a fat pocketbook that the nominating person is relying upon to finance its proxy contest. The company’s shareholders are entitled to know of any such arrangements, including what has happened in the recent past.
Finally, advance notice bylaws do not fit the classic Unocal pattern that requires the board to first identify a “threat” and then respond to it proportionately. Yes, Blasius Industries is still an important cornerstone of Delaware law;[7] but it should not be triggered merely by a requirement that the nominating person file a reasonable questionnaire, disclosing material information. Thus, although it may be advisable that the board adopt its bylaw well before any specific insurgent appears, advance notice bylaws, as they are now being revised, seem likely to provide better disclosure to shareholders. Absent bylaws that place high burdens on the nominating person, this is a self-help remedy that ultimately allows shareholders to decide for themselves (and, unlike the poison pill, does not threaten economic disaster to the insurgent). Predictably, we will soon see decisions on these bylaws, and courts need to understand the changed circumstances and balance them.
ENDNOTES
[1] 2021 Del. Ch. LEXIS 34 (February 26, 2021).
[2] These are not the only factors in the new popularity of the proxy contest. The massive destaggering of corporate boards over the last decade has also made the proxy contest more effective, as has the extraordinary increase in shareholder concentration (as shown by the rise of the Big Three). But the two factors listed above are very recent.
[3] Several recent Delaware decisions have upheld the corporation’s right to require in its bylaws that a nominating shareholder submit a questionnaire specified in the bylaw, or to require it to identify other shareholders known by the nominating shareholder to support the insurgent’s proxy contest, or to supply other supplemental information. See, e.g., Strategic Investment Opportunities LLC v. Lee Enterprises, Incorporated, 2022 WL 453607 (Del. Ch. Feb. 14, 2022); Rosenbaum v. CytoDyn. Inc., 2021 WL 4775140 (Del. Ch. Oct 13, 2021); BlackRock Credit Allocation Income Trust, et al. v. Saba Capital Master Funds, Ltd., 224 A. 3d 964 (Del. 2020).
[4] See AB Value Partners, LP v. Kreisler Manufacturing Corporation, et al., C.A. No. 10434-VCP (Del. Ch. 2014) (advance notice bylaws will only be enjoined where plaintiff can show “inequitable circumstances”).
[5] See Strategic Investment Opportunities LLC v. Lee Enterprises, Incorporated, supra note 3.
[6] Rosenbaum v. CytoDyn, Inc., supra note 3.
[7] Blasius Industries, Inc. v. Atlas Corp., 564 A.2d 651 (Del. Ch. 1988).
This post comes to us from John C. Coffee, Jr., the Adolf A. Berle Professor of Law at Columbia University Law School and Director of its Center on Corporate Governance.