In a typical activist campaign, the activist threatens to launch a proxy fight unless the board of directors agrees to take certain actions to increase shareholder value, such as selling off company assets or replacing the CEO. Increasingly, however, there are fewer proxy fights.  Instead, the activist and the board, behind closed doors, quickly agree to settle.  The activist withdraws the proxy-fight threat, and, in return, the board appoints directors designated by the activist.  This “cooperation agreement” allows the incumbent directors to keep their positions and the activist to claim victory.  It profoundly interferes, however, with the voting interests of the non-activist shareholders – who are given no opportunity to vote on the designated directors in a contested election.

In a new article, I argue that cooperation agreements raise serious issues of board entrenchment and shareholder disenfranchisement. Following the Delaware Supreme Court’s decision in Coster v. UIP Cos., Inc.,[1] boards should worry that approval of a cooperation agreement might violate the board’s fiduciary duties.

The Coster Standard of Review

Prior to Coster, board actions taken to interfere with the shareholder vote were scrutinized under the Blasius “compelling justification” standard of review.[2]  The strictness of the Blasius standard reflected judicial concern for the integrity of the shareholder vote.  While based on an important rationale of corporate democracy, because the compelling justification standard was viewed as outcome-determinative, Blasius was rarely applied by the Delaware courts.

In Coster, the Delaware Supreme Court held that Blasius was no longer an independent standard of review. Rather, if a plaintiff sues a board for taking an action that “interferes with the election of directors or a stockholder vote in a contest for corporate control,” courts must now apply a more stringent version of the Unocal “reasonableness” standard of review – used by courts to assess board action taken in defense of a hostile tender offer – to protect the integrity of the shareholder vote.[3]

The Coster court provided some guidance on how a more stringent version of Unocal should apply in defense of a proxy fight.  First, for Unocal’s threat prong, the Supreme Court made clear that the threat must be to “an important corporate interest or to the achievement of significant corporate benefit.”[4]  In addition, “the threat cannot be justified on the grounds that the board knows what it is the best interests of the stockholders.”[5]

Second, for Unocal’s proportionality prong, the court will scrutinize the board’s actions to determine if they are “tailor[ed] [in] response to only what is necessary to counter the threat.”[6]  The Coster court noted that in applying this prong, the “board’s response to the threat cannot deprive the stockholders of a vote or coerce the stockholders to vote a particular way.”[7]  In other words, shareholders must be permitted to elect the directors they want to elect.

Coster Should Be Applied to the Board’s Approval of Cooperation Agreements

To trigger Unocal review, plaintiffs must plead facts supporting a “reasonable inference” that the board “acted with a subjective motivation of defending against a perceived threat.”[8]  In making this determination, courts consider such factors as:  (1) the timing of the board’s actions; (2) whether the actions had a “potentially entrenching or defensive effect;” (3) whether there was a “looming” threat of proxy contest; (4) whether the board’s actions “were otherwise necessary to accomplish a legitimate goal;” (5) whether the board “requested the provision or provisions at issue;” and (6) “whether there was a clear alternative reason for acting.”[9]

All of these factors support the conclusion that a board’s approval of a cooperation agreement should be evaluated under Unocal.  First, board approval of the agreement takes place only after it has received a threat of a proxy fight from an activist.  In other words, the board is not acting on a “clear day.” Second, cooperation agreements promote entrenchment because they assure that the incumbent directors keep their board positions.  Moreover, since cooperation agreements lead to the withdrawal of a proxy fight, they have a defensive effect.  Third, when most such agreements are executed, the activist shareholder has already submitted a nomination notice to the company, meaning there is a real threat of a proxy contest.  Fourth, the whole purpose of a cooperation agreement is to fend off activist investors; no other “legitimate goal” of the company is advanced.  Fifth, cooperation agreements are entered into at the request, or with the approval, of the board.  Sixth, the only reason for entering into a cooperation agreement is to defend against a proxy fight.

Strangely enough, however, in an unpublished decision from 2016, the Delaware Chancery Court determined that plaintiffs had failed to adequately plead that a cooperation agreement constituted a defensive measure that implicated Unocal.[10]  In In re Ebix, Inc. Stockholder Litigation, Inc., the court conceded that the agreement could be viewed as causing entrenchment.  However, the Ebix court concluded that applying Unocal would “sponsor the enigmatic idea that the Board’s decision to dilute its own control of the corporation by surrendering board seats to insurgents is best viewed as a defensive measure.”[11]  This conclusion is clearly wrong. The court’s analysis of entrenchment and defensive effects improperly focused on the board’s so-called loss of power caused by a cooperation agreement.  Whether the incumbent board’s power is diluted by the defensive measure is irrelevant to assessing the entrenchment or defensive effects.  The effect of the cooperation agreement is to entrench and to defend, regardless of whether the incumbent board went from constituting 100 percent of the board to constituting, for example, 85 percent following the addition of two designated directors.

Moreover, the Ebix court focused on only one factor – whether the cooperation agreement had entrenching or defensive effects – in determining whether the plaintiffs had successfully pleaded a Unocal claim.  If the court had also considered the other five factors identified above, it would have presumably come to a different conclusion.

Applying Coster to the Approval of Cooperation Agreements

Post-Coster, the approval of cooperation agreements raises several significant problems for boards.  First, Coster imposed a more rigorous definition of a reasonable threat. Many of the concerns that have been historically identified as reasonable threats justifying a defensive response to an activist shareholder may not constitute cognizable threats under Coster, or are, at most, mild threats to the corporation.  For example, boards often attempt to justify their opposition to an activist’s proxy fight by arguing that the activist’s focus on short-termism will harm the company.  However, that seems to be just another example of a “board knows best” argument, which Coster rejected.  In addition, boards often point to disruptions to the company’s business operations as a threat justifying a cooperation agreement.  However, cooperation agreements also cause disruptions.  This is especially true when the company has agreed to form a special board committee charged with exploring the activist’s strategic vision, which is often the case. Therefore, any reduction in disruption due to the cessation of the proxy fight must be offset with the disruption due to the cooperation agreement.

In addition, a board will be unlikely to pass the more stringent proportionality prong.  Cooperation agreements are “preclusive.”  Their sole purpose is to make proxy fights unattainable.  The agreements accomplish this goal in two ways. First, the secrecy and speed with which an activist investor’s designated directors assume board seats prior to an annual meeting deprive all other stockholders of a contested vote.  A board might argue that a cooperation agreement is not preclusive because the activist’s designated directors will be subject to a vote at the next annual meeting.  However, herein lies the second part of the preclusive effect of cooperation agreements. They ensure that newly appointed board members effectively run as incumbents in uncontested elections at annual meetings. Directors who are nominated in an uncontested election are almost always elected, meaning that the activist’s designated directors are almost certain to get elected.

If board approval of cooperation agreements is found to constitute a breach of fiduciary duty, boards and activists will have to find a new way to interact.  Because boards will no longer be able to trade away director seats to avoid a proxy fight, this will create a new, uncertain, environment where actual proxy fights will no doubt play a much more important role in shareholder activism.

ENDNOTES

[1] Coster v. UIP Cos, Inc., 300 A.3d 656 (Del. 2023).

[2] Blasius Indus. v. Atlas Corp., 564 A.2d 651, 661 (Del. Ch. 1988).

[3] Coster, 300 A.3d at 672.

[4] Id.

[5] Id.

[6] Id. at 673.

[7] Id.

[8] In re Edgio, Inc. Stockholders Litig., 2023 WL 3167648, *15 (Del Ch. May 1, 2023).

[9] Id.

[10] In re Ebix, Inc. Stockholder Litig., 2016 WL 208402, *18 (Del. Ch. Jan. 15, 2016).

[11] Id. 

This post comes to us from Professor Jennifer O’Hare at the Villanova University Charles Widger School of Law. It is based on her article, “Against Activist Cooperation Agreements,” forthcoming in the Kentucky Law Journal and available here.