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In recent years, the threat posed by a challenge to corporate control has receded in the minds of corporate CEOs and general counsel. Although contests for corporate control are now less visible, they remain an ever-present danger to a public company whose shares are undervalued by the marketplace. Challenges to control occur in two ways: a hostile tender offer and/or proxy contest or, in the case where the corporation has entered into a negotiated transaction, an overbid. This past year overbids were quite common. The year also witnessed an increase in proxy fight activity. Through June 30, at least 12 proxy contests for board seats were commenced, with management losses suffered at companies including Lone Star Steakhouse and Saloon, Suburban Lodges of America and ICN Pharmaceuticals. To the extent that they have not recently done so, public companies should have their takeover defenses reviewed by experienced takeover counsel. As this article explains, mistakes are lurking in, and/or refinements could improve, the defenses that many companies are relying on. Such defenses ensure that incumbent management and directors will have the opportunity to make their case to stockholders in an orderly, effective manner, allowing stockholders to make rational determinations about the future of the corporation. Likewise, mistakes are commonly made in change-in-control provisions in management employment agreements that are intended to provide management with the ability to negotiate a transaction that benefits the stockholders without being forced to rely on that same acquirer for existing management’s future financial livelihood. Failure to pay attention to these issues in advance can have serious adverse consequences that cannot be cured once a threat to corporate control has emerged. ‘BEAR HUGS’ The effects of threatened unsolicited offers (“bear hugs”) and proxy contests are not limited to those companies where the contest actually takes place. Many would-be acquirers use the threats of a bear hug and a proxy contest as a lever to force the target company to negotiate, or otherwise to explore potential transactions with third parties, as an alternative to facing a contest that incumbent management fears it will lose. In the past year, a number of companies have chosen (or been compelled to accept) sales to white knights when threatened with a proxy contest. With the rapid decline in public company valuations since early 2000, it is a fair bet that the upcoming proxy season in 2002 will be accompanied by many more challenges to corporate control than in previous years. Now that market valuations have declined, value investors are re-emerging in the marketplace after years of disfavor. As the expense of the executive suite and the management team that occupies it represents a greater percentage of the company’s market capitalization than in previous years, companies that are being undervalued by the public markets will be more likely to find themselves challenged by insurgent stockholders or would-be acquirers. Notwithstanding these trends, years of relative quiet in the area of challenges to corporate control have resulted in many public companies having paid less attention to the threat of a challenge to corporate control than they should. Based on our experience, the uptick in proxy activity will find large numbers of corporations unprepared for the challenge, due to a general failure among many corporations to address basic issues of corporate housekeeping that can be crucial in defending the corporation. With the advent of the poison pill and state anti-takeover statutes, the day of quick-strike, hostile tender offers has long passed. The tender offer has become a largely symbolic weapon in the arsenal of a potential corporate suitor, except in the case of announced negotiated transactions where the new unsolicited suitor offers a higher price. With the company for sale, the poison pill often provides little or nothing in the way of protection. In contrast, however, where a board determines in good faith that a sale of the company is not in the best interests of the stockholders, that determination is protected by the business judgment rule. Having determined that a company should not be sold, directors can rest comfortably behind a poison pill with the knowledge that the corporation is immune from takeover without the consent of its directors. See Moran v. Household Int’l Inc., 500 A.2d 1346 (Del. 1985); Leonard Loventhal Account v. Hilton Hotels Corp., C.A. No. 17803, 2000 WL 1528909 (Del. Ch. 2000). Moreover, companies have the means to adopt a poison pill at any time, and courts will uphold such an adoption even where it is done after the tender offer has already been commenced. See MacAndrews & Forbes Holdings v. Revlon, 501 A.2d 1239 (Del. Ch. 1985), aff’d, 506 A.2d 173 (Del. 1986). Delaware courts have criticized efforts by corporations to neutralize the threat of a proxy contest with so-called “dead hand” pills pursuant to which an existing board of directors sought to endow itself with the exclusive right to redeem the poison pill, thereby precluding any future directors from redeeming the poison pill as would be necessary to permit a sale of the company. See Carmody v. Toll Brothers Inc., 723 A.2d 1180, 1193 (Del. Ch. 1998). Had they been upheld, such “dead hand” poison pills would have removed the threat of a tender offer by precluding future directors from diffusing the corporate minefield that had been set by existing directors. As Vice-Chancellor Jacobs of the Delaware Court of Chancery has noted, however, these “dead hand” pills cannot be reconciled with the Delaware Supreme Court’s premise in approving poison pills — if a board refused to redeem the rights plan, the shareholders “could exercise their prerogative to remove and replace the board.” Carmody. PROXY CONTESTS Ultimately, the only way around the will of the corporation’s directors is to have them removed through a proxy contest. A potential acquirer can announce a tender offer, but the tender offer cannot be consummated in the face of a poison pill. To circumvent the poison pill, the tender offerer must also solicit proxies to remove and replace the incumbent board of directors with a slate of the acquirer’s nominees who are dedicated to redeem the poison pill, thereby clearing the way for the company’s stockholders to receive the consideration promised by the acquirer’s tender offer. Thus, the proxy contest provides an end run around the company’s poison pill by permitting election of a new set of directors who can remove the poison pill as an impediment to the tender offer. Defense against such a contest requires a well-conceived public relations campaign designed to win the hearts, minds and pocketbooks of the company’s stockholders. A good defense also requires advance planning with respect to a number of legal issues that can mean the difference between winning, losing or having to fold before the game even gets played. Although the “dead hand” poison pill appears to have been rejected by the Delaware courts as too effective a takeover defense, a number of structural defensive protections are available to corporations that plan ahead for the possibility of a proxy contest. These protections include some combination of staggered boards of directors, advance notice bylaws, provisions eliminating stockholders’ ability to act by written consent or to act by way of special meeting, and limitations on the stockholders’ ability to expand the board of directors. In addition, employment arrangements should fully protect management in the event of a change of control. Where a corporation has a board that is staggered over a three-year period, and the stagger has been implemented effectively without the sort of “gaffes” identified in this article, an insurgent can never take control in less than 12 months because the insurgent must win two separate election contests, separated in time by at least 12 months. Such a long, costly fight is daunting to most would-be raiders, who must recognize that even if successful in the first of the two contests, incumbent management will retain control of the corporate machinery and pocketbook for an additional 12 months, during which management will seek to use every advantage legally available to prevail in the second contest and thereby preserve control. As the threat of corporate contests for control has receded from the forefront of the minds of corporate executives, the structural defenses in place across corporate America have fallen into disrepair. A recent discussion paper written by Harvard Law School Professor John C. Coates IV found that 18 percent of a group of corporations that had gone public as recently as the 1990s had “gaffes” in their takeover defenses that were best explained by mistakes in lawyering. See John C. Coates IV, “Explaining Variation in Takeover Defenses: Failure in the Corporate Law Market.” Such mistakes included unexplainable contradictions between corporate charters on the one hand and state corporate law or corporate bylaws on the other, which contradictions resulted in charter or bylaw provisions not having the legal effect that was intended. We have also found such “gaffes” in employment arrangements, which can severely disappoint legitimate expectations on the part of management in the event of a change of control. Such “gaffes” can have disastrous consequences for stockholders. For example, Barrett Resources Corp. recently received a hostile bid from Royal Dutch/Shell. Presumably, Barrett took some comfort from a bylaw provision that precluded shareholder action by consent. Any such comfort was short-lived, however, because such a bylaw contradicts Section 228 of the Delaware General Corporation Law, which permits stockholders to act by consent in lieu of a meeting, unless otherwise set forth in the certificate of incorporation. Thus, Barrett’s bylaw was likely without effect. To eliminate the ability of stockholders to act by written consent, such a provision must be in the company’s charter. See Allen v. Prime Computer Inc., 540 A.2d 417, 420 (Del. 1988). As part of its campaign to win Barrett, Shell brought suit against Barrett, challenging the consent bylaw. Before the court determined Shell’s claim, Barrett merged with a friendly bidder, presumably understanding that the bylaw provided no protection. Coates’ research also found a number of what he termed “functional mistakes” that permitted stockholders quite easily to circumvent defenses that corporations thought they had in place. For example, some corporate charters contained provisions for a staggered board of directors, yet also contained provisions that allowed shareholders to remove directors by written consent, which effectively vitiated any takeover protection afforded by the staggered elections. In such a corporation, an insurgent stockholder could avoid the stagger by soliciting proxies to remove the entire board regardless of when the board members were due for reelection. This consequence, which cannot rationally have been intended, effectively rendered the staggered board of no practical use in defending against a threat for corporate control. In the area of takeover defense, “an ounce of prevention is worth a pound of cure.” By the time the threat has materialized, it is too late to mend many of the structural defenses that should be available to the target corporation, and the besieged board will be reluctant to improve management’s compensation package in the heat of the battle. As noted above, the staggered board is only effective if care is taken with respect to other aspects of the corporate machinery. Once the insurgent indicates his hostile intentions, however, it is often too late for the corporation to correct the problem. In the case of flaws or desired changes in the corporate charter, such as adoption of a staggered board, companies should be considering such changes when they are in a position of strength with their stockholders. Once a threat to corporate control has emerged, management’s energies will be focusing on keeping control of the corporation, and management will have little standing with its stockholders to obtain a staggered board or other defensive tactic for the first time. Bylaw amendments often can be effected by the existing board of directors itself. Even in the case of such bylaw changes, however, the board will be subjected to far more scrutiny where changes are made in response to a particular threat. Recent cases make it difficult for the corporation to change the election machinery once a contest for control has begun or been threatened. The Delaware Supreme Court has held that where defensive measures purposely disenfranchise stockholders, in seeking to defend its actions, a board will be required to satisfy a far more exacting standard: “A board’s unilateral decision to adopt a defensive measure touching ‘upon issues of control’ that purposely disenfranchises its shareholders is strongly suspect … and cannot be sustained without a ‘compelling justification.’ ” Stroud v. Grace, 606 A.2d 75, 92 n.3 (Del. 1992).l For example, in Chesapeake Corp. v. Shore, 771 A.2d 293 (Del. Ch. 2000), Shorewood Packaging’s board of directors attempted to strengthen the company’s takeover defenses when confronted with the threat of a hostile takeover. To this end, the board made a number of amendments to the company’s bylaws, including adding a supermajority requirement for shareholder-initiated amendments to the bylaws (the “supermajority bylaw”). The supermajority bylaw initially required shareholder proposals to win 66 2/3 percent of the vote, but this was later reduced by the board to 60 percent. The court determined that Shorewood’s board had adopted the supermajority bylaw “to impair Chesapeake’s ability to win the Consent Solicitation,” according to court papers. Applying the “compelling justification” standard (as a court must where the primary purpose of a board action is “impeding the exercise of stockholder voting power,” Blasius Indus. v. Atlas Corp., 564 A.2d 651, 661 (Del. Ch. 1988)), the Chesapeake court invalidated the supermajority bylaw, holding that “the mild threat posed to Shorewood by Chesapeake’s all-shares, all-cash tender offer does not provide a compelling justification for the [supermajority bylaw].” One procedural defense — the advance notice bylaw — can be rendered largely ineffective unless the corporation’s bylaws have been altered in recent years to guard against innovations in the takeover game. An advance-notice bylaw is a provision that requires a stockholder to give advance notice to the corporation before soliciting proxies in favor of opposition directors or for a stockholder proposal. In a proxy contest mounted by one of our clients, however, we were able to bypass such a bylaw where the target company’s bylaws contained a high quorum requirement for its annual meeting. When the company initially refused to waive the advance-notice bylaw, our client solicited proxies for the meeting that provided that the proxies would not be cast at the meeting unless the target waived the advance-notice bylaw. The proxy contest was conducted with the knowledge and approval of the Securities and Exchange Commission. By threatening this novel campaign to boycott the meeting, our client was able to pressure the target into so waiving or otherwise face the threat of embarrassment in not having sufficient votes at the meeting to constitute a quorum. An antidote exists to our client’s maneuver in the form of a bylaw change to reduce the quorum requirement to a lower threshold that makes it impossible for the insurgent to block the meeting. Yet, bylaws that have not been updated in recent years are unlikely to have been sensitive to this new strategy in corporate takeovers. And in light of recent Delaware law, courts may not approve a change in the quorum requirement once the issue has emerged in connection with a particular solicitation. Still other takeover defenses may provide little protection, or subject corporations to unintended adverse risks. As discussed above, corporations cannot rely on the efficacy of the “dead hand” feature of poison pills in light of the criticisms that have been visited on such provisions by the Delaware courts. Similarly, many states, including Delaware, Massachusetts, Indiana, Nevada and Pennsylvania, have control-share acquisition statutes under which a shareholder who acquires more than a certain percentage of shares cannot obtain voting rights unless the shareholders approve the acquisition. Corporations in these states may “opt out” of such statutes, and although counterintuitive, it is often advisable to do so. The problem with such statutes is that they provide little additional protection to stockholders that is not already available from a standard poison pill. What they do allow, however, is for a potential bidder to call a special meeting of the target’s shareholders to consider granting the bidder voting rights. Such a meeting operates as a referendum on existing management and provides the bidder with a wonderful public relations opportunity to take the bidder’s case directly to stockholders. In such a contest, the target has little to gain and much to lose. Thus, it may be advisable for potential target companies in states with control-share acquisition statutes to “opt out” of the statute’s applicability. In sum, takeover defense is not an issue of the past. While lower levels of proxy activity in recent years have made the question of takeover defenses a low priority, proxy contests are a real danger and probably will become more frequent in the upcoming proxy season. Given the importance of what is at stake, no corporate counsel should put himself or herself in the position where mistakes in the corporation’s defenses are identified when it is too late to have those mistakes fixed. Further, corporate counsel should be able to assure management that its expectations under its employment agreements, including its options and supplemental retirement plans, will be realized. A takeover checkup by experienced takeover counsel is a quick, relatively inexpensive way to ensure that the corporation has whatever defenses are legally available, and expectations will be dashed. No general counsel should do without one. This article previously appeared in The Corporate Counsellor, an American Lawyer Media publication. Scott A. Edelman, Lawrence Lederman and Michael H. Diamond are partners at Milbank Tweed, who are actively involved in providing corporate advice with respect to matters of takeover defense and corporate governance to clients throughout the United States. Their e-mail addresses are, respectively: Edelman (N.Y. office), e-mail: [email protected]; Lederman (N.Y. office), e-mail:[email protected]; Diamond (Los Angeles office), e-mail:[email protected] Stacey J. Rappaport, an associate at Milbank Tweed, assisted in the preparation of this article.

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