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Corporate boards today are witnessing an increase in shareholder activism and scrutiny of their corporate governance practices. The number of shareholder proposals seeking to terminate or restrict shareholder rights plans, for instance, reached an all-time high of approximately 100 proposals during 2003. According to Institutional Shareholders Service (ISS), this number dropped significantly to approximately 58 proposals in 2004, but it is clear that many companies have responded to shareholder complaints regarding “poison pills.” ISS 2004 Postseason Report at 7-8 (2004). Since last year, at least 40 companies, including Circuit City Stores Inc., Raytheon Co., FirstEnergy Corp. and The Goodyear Tire & Rubber Co., took action to dismantle or amend their poison pills. At the same time, offers such as Comcast’s $54 billion bid for Disney, Oracle’s renewed $7.7 billion bid for PeopleSoft and beverage maker SABMiller PLC’s $391 million bid for Harbin Brewery signal an uptick in hostile takeover attempts. Against this backdrop of heightened corporate governance and revived hostile M&A activity, the boards of companies that have poison pills or are contemplating one must consider whether the protective benefits a poison pill offers to shareholders continue to outweigh the risk of losing shareholder confidence that the directors and officers are “doing the right thing” in today’s corporate governance environment. Poison pills, or shareholder rights plans, are generally considered the most effective tool that a board can use to protect shareholders against abusive takeover tactics and are the most utilized defense among Standard & Poor’s 500 companies. Under the principal provision of a rights plan, if any person or group acquires a certain percentage of the company’s common stock (generally 10%, 15% or 20%), the company’s other shareholders are entitled to exercise rights to buy stock of the company at half price, thereby substantially diluting the acquiring person’s investment. Shareholder rights plans have both judicial and legislative support. Twenty-five states currently have statutes that endorse the adoption of a shareholder rights plan. The Delaware Supreme Court upheld the adoption of a poison pill as within the authority of a board of directors and concluded that the pill neither precludes hostile takeovers nor prevents proxy contests. See Moran v. Household Int’l Inc., 500 A.2d 1346, 1354-1355 (Del. 1988). A poison pill does not in any way lessen the board’s duty to consider unsolicited offers. When deciding whether to redeem a pill, the board is held to the same fiduciary standards as a board determining the appropriate response to a takeover bid if the company did not have a pill. See id. Many institutional shareholders believe that poison pills erode management accountability and shareholder value. They argue that poison pills effectively give the board, and not shareholders, who are the owners of the company, the power to decide whether and on what terms control of the company is sold when a company becomes the target of an unsolicited offer. In their view, the threat of a hostile takeover occurs when the management of a business with good fundamentals performs poorly and therefore the stock becomes undervalued. It is at this crucial time that many institutional shareholders believe that they should have the right to decide whether to sell their shares and not be shut out of the decision-making process by a poison pill. They believe that a rights plan removes the threat of a hostile takeover as a check on a company’s management and performance. In short, institutional shareholders claim that poison pills effectively allow management and the board to become entrenched. Further, some shareholders fear that having a poison pill in place will deter potential acquirors from proposing legitimate bids. For these reasons, many institutional shareholders argue that a company should seek shareholder approval of a poison pill as a show of good corporate practice. Many boards argue that poison pills assist the directors in fulfilling their fiduciary obligations to shareholders. Proponents assert that a target’s board is in a better position than shareholders to evaluate the fairness of an unsolicited bid in light of the company’s long-term plans and future potential. The board is legally vested with the responsibility of managing the business and affairs of the company, has direct access to the management team that is running the day-to-day business and can best assess the company’s present and future prospects. From a board’s perspective, a poison pill simply gives directors the time, flexibility and negotiating capacity to exercise their fiduciary obligations and use their superior knowledge to preserve and maximize shareholder value when an unsolicited offer is made. If, after due investigation and in the exercise of its business judgment, a board determines that redeeming the rights to facilitate a full and fair offer would be in the best interest of the company and its shareholders, the board would be legally obligated to do so. If, however, the board determines that a bid is inadequate or coercive, then the board will be positioned to negotiate a higher premium or shop for better strategic alternatives. Studies show, and Delaware courts have acknowledged, that poison pills foster bidding wars that result in higher premiums than those that are obtained for target companies without pills. See Georgeson & Co. Inc., Mergers and Acquisitions: Poison Pills and Shareholder Value, 1992-1996, www.georgeson.com/pdf/M&Apoisonpill.pdf; Paul M. Sherer, “CEO of Sealed Air Battles to Remove ‘Poison Pill’ Plan,” Wall St. J., April 28, 1999, at C1; Carmody v. Toll Bros., 723 A.2d 1182, 1185 (Del. Ch. 1998). In response to institutional shareholder pressure, some companies, including 3M Co., The Allstate Corp., Bristol-Myers Squibb Co. and Hewlett-Packard Co., have attempted to craft a compromise by eliminating their conventional poison pills and replacing them with a poison- pill policy that includes a “fiduciary out.” Such policies allow a target board to re-adopt a poison pill without shareholder approval if, while acting in accordance with their fiduciary duties, the directors determine that having the poison pill would be in the shareholders’ best interests. The policy would require shareholders to ratify the pill the following year. If shareholders do not approve the pill, then the board must terminate the plan. With this policy, a target board can adopt a pill in response to unsolicited bids every year regardless of the company’s inability to obtain shareholder approval in previous ratification attempts, but the board must satisfy the same fiduciary obligations when deciding to re-adopt a pill as when they decide whether to redeem a conventional pill. Although institutional shareholders have had an adverse reaction to fiduciary-out policies because all of the initial decision-making power still lies with the board, companies argue that the ability to adopt the poison pill prior to shareholder ratification prevents a delay that could diminish a target board’s ability to respond to a bidder if shareholder approval was a prerequisite to the pill’s adoption. Effect of independent boards The emergence of the independent board may help companies argue that poison pills, if properly used, are beneficial to shareholders. ISS stated in its U.S. Proxy Voting Manual that “the key element to pill effectiveness may lie in the independence of the board.” ISS refers to two studies-one that found shareholder returns to be 24% higher when a target’s poison pill was coupled with an independent board than when the board was not independent, and the other that found that announcements of poison pills adopted by a board that had a majority of independent directors received positive stock market reaction whereas the reaction was negative if the board was not a majority independent. See James Cotter et al., “Independent Boards Enhance Target Shareholder Wealth During Tender Offers,” Directorship (November 1997), and James Brickley et al., “Outside Directors and the Adoption of Poison Pills,” 35 J. Fin. Econ. 371-390 (1994). Effective this year, the New York Stock Exchange, Nasdaq and the American Stock Exchange require the board of each listed company to have a majority of independent directors. The new listing standards may generate greater confidence in institutional shareholders that decisions regarding poison pills will be made in the best interests of shareholders and not in the interests of management or the board. In fact, some institutional shareholders have already shown support for Three-Year Independent Director Evaluation (TIDE) plans because such plans require a company’s independent directors to review an existing pill every three years to evaluate whether it is still in the shareholders’ best interest. In its Corporate Governance Rating System, ISS awards points to companies that have implemented TIDE plans. Because the new listing requirements go one step further and, in effect, require that all new rights plans, any modifications made to current plans and decisions about whether to redeem a poison pill be approved by independent boards, institutional shareholders may be more willing to accept the poison pill. The Securities and Exchange Commission (SEC) has proposed another means for institutional shareholders to ensure that their boards have a strong independent voice. In the SEC’s proposed Rule 14a-11, a shareholder who has beneficially owned 5% of the outstanding stock of a company for at least two years would be granted direct access to the proxy statement to nominate one to three directors, depending on the size of the current board, upon the occurrence of one of two triggering events. See Securities Exchange Act Release No. 34-48626 (Oct. 26, 2003). One of the triggering events would be if at least one of the company’s nominees for the board receives “withhold” votes from more than 35% of the votes cast at the company’s annual meeting. Thus, a qualifying shareholder who is unhappy with the incumbent board and is able to garner sufficient support to withhold the proper percentage of votes to trigger the rule could nominate a director for election to the board at any annual or special meeting held during the next year. If institutional shareholders who are displeased with a company’s performance exercise their right to influence the board, then, over time, their fears of a poison pill being abused by the board may diminish. Shareholders may also be encouraged by the unusual facts of two recent Delaware cases in which independent directors used poison pills as a check on management and other insiders. In James v. Furman, No. 597 (Del. Ch. July 26, 2004), a recently filed case in the court, the independent directors implemented a poison pill that would be triggered by the chairman’s exercise of his contractual right of first refusal to obtain additional stock that would give him a controlling interest in the company. In Hollinger Int’l Inc. v. Black, 844 A.2d 1022 (Del. Ch. 2004), the court upheld a poison pill that was adopted by the company’s independent directors to prevent Lord Conrad Black, the chairman of the board, chief executive officer, president and controlling shareholder of the company, from completing a proposed indirect sale of the company that was not approved by the board. Both of these cases demonstrate the willingness and ability of independent directors to use poison pills to act autonomously and to the disadvantage of management. Many argue that a poison pill is needed to aid a company at a crucial moment in its existence-when it has become the target of an unsolicited hostile takeover. No one can anticipate when or if such an event will occur, but boards do need to consider whether having the long-term protection that a pill offers outweighs any criticism that has traditionally come from institutional shareholders in the short term. The board independence requirements of today’s corporate governance regime may serve to aid boards in making this evaluation. The emergence of the independent board and increased scrutiny of governance procedures may increase confidence levels among institutional shareholders that poison pills will be administered properly by directors, thereby removing perhaps the greatest criticism of the pill-that it shifts decision-making power to a board of individuals whose interests may not be aligned with shareholders. William P. Mills III is a partner at New York’s Cadwalader, Wickersham & Taft and a member of the firm’s corporate/M&A department. Gwen J. Zeisler, an associate at the firm, assisted in the preparation of this article.

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