Market volatility arising from the COVID-19 pandemic may lead to increased hostile takeover activity and shareholder activism as some companies experience market valuations that they believe are not reflective of their intrinsic value. As boards of public companies broadly consider the business impact of COVID-19, we recommend they also work with management teams and counsel to evaluate their existing corporate structural defenses and consider whether to prepare or adopt a stockholder rights plan, or “poison pill.”
There has been a significant increase in the number of companies adopting rights plans in the past few weeks, and the institutional investor community and proxy advisory services such as ISS have recently acknowledged that the pandemic is likely a valid justification for putting in place a rights plan of limited duration. As with all defensive measures, careful board consideration within the fiduciary framework of Delaware law and thoughtful, clear, proactive communication with shareholders and the investment community will be critical for a company to achieve its objectives and receive positive market and court reaction to its decisions.
Poison pills are among the most potent tools available to public company boards to defend against hostile threats. A shareholder rights plan can fortify a company against abusive tactics by creating powerful economic incentives to engage with a board rather than proceed on a hostile basis. Poison pills are not perfect defenses – they don’t provide protection against proxy campaigns – but they have proven effective over time in deterring potential activists and acquirers from acquiring substantial equity stakes without board assent.
Boards should always be mindful of fiduciary duty concerns in any consideration of defensive strategies, including adoption of a poison pill. Well-crafted poison pills have repeatedly withstood challenge in Delaware courts. As a general rule, the board of a Delaware corporation has wide latitude to adopt a pill while there is no specific pending hostile threat (and such decision can enjoy “business judgment rule” judicial deference), and solid precedent on which to rely in defending the adoption of a poison pill as a reasonable response to a perceived hostile threat to corporate independence and effectiveness under the Unocal line of case law.
As with any important board matter, a board should approach decision-making about a rights plan in a thoughtful and structured way, particularly in light of the complex range of factors implicated by decisions related to defensive strategy. We offer here some guidelines for board deliberations to help boards navigate the complexity:
Context is Critical. A board should thoroughly consider the factors motivating its consideration of a rights plan and be prepared to explain those factors to the market. These factors may be general conditions arising from the current climate, such as stock price declines, business disruption and prospective financial distress. The impact of the pandemic is, of course, not evenly distributed among industries and companies, and businesses in the energy, transportation, lodging and entertainment industries may be under greater stock price pressure than those in other industries, such as technology or biotech/pharma. Justification for adopting defenses may also include specific stock accumulation or public agitation by activist investors, or unwanted overtures from a potential acquirer.
Understand the Threat. A board’s deliberations regarding a rights plan and the factors identified above should be based on the threat those factors pose to business planning and preservation of shareholder value. Activist stock accumulations are often tied to short-term agendas that are incompatible with longer term corporate goals. They can also destabilize a company and lead to contests for corporate control that distract from core corporate missions and consume valuable resources. Similarly, hostile acquisition proposals may seek to take advantage of a short-term depressed market valuation by providing a premium to current market price while nonetheless undervaluing the corporation’s long-term intrinsic value.
Communicate Effectively. It is critical for a board to explain how its decision to adopt a rights plan protects the company and promotes stockholder value. Market reaction to adoption of a rights plan will of course depend on the circumstances in which it is adopted. Boards may influence market reception by carefully designing the poison pill, setting its key terms such as duration and ownership trigger threshold and articulating the reasons for adoption in a manner that underscores the need for the rights plan to protect the company’s fundamental value through uncertain times.
Anticipate Proxy Adviser Response. In considering rights plans, boards should take note of the general skepticism of Institutional Shareholder Services, Glass Lewis and other proxy advisory firms toward defensive measures generally, and rights plans in particular, that have not been approved by a company’s shareholders. On April 8, 2020, ISS issued guidance stating that the COVID-19 crisis does not change its fundamental institutional perspective that rights plans with a duration of less than one year will be evaluated on a case-by-case basis considering the disclosed rationale for adopting the plan and other relevant factors. But ISS also noted in the April release that the pandemic “is likely to be considered valid justification in most cases” for short-term pills.
Tailor Poison Pill Terms to Fit the Context and Threat. Boards should ensure that their adoption and use of a poison pill are reasonable responses to reasonably perceived threats. They should also set the poison pill’s trigger threshold and duration—the key substantive provisions of a shareholder rights plan—at appropriate levels in light of those threats.
- Trigger Threshold. A poison pill’s trigger threshold is the level of stock ownership at which the pill is activated. We recommend that boards consider following current market practice for larger companies by setting triggers in the range of 10-15%, absent special circumstances. Companies may also consider whether actual or potential “wolf pack” coordination or creeping accumulation of stock among a group of activist investors would be discouraged by inclusion of an “acting in concert” feature that aggregates the ownership of coordinating parties. We also recommend that companies consider adopting a two-tiered threshold whereby passive investors (those filing on Schedule 13G) have a trigger set at 20% to facilitate stable institutional ownership during volatile market periods while setting a lower threshold—10% most commonly—for activist investors seeking changes in corporate policies. In the case of a rights plan aimed at preserving the value of existing net operating losses, the trigger threshold is usually set at 4.99%. Close monitoring of changes in the company’s stock ownership by a stock watch service can help inform, and justify, the level at which the trigger threshold is set.
- Duration. Most companies adopt rights plans that expire within one year in response to the policies of proxy advisory firms to recommend “withhold” votes against directors standing for reelection at companies with pills with longer durations that are adopted without shareholder approval. Although it is currently impossible to predict when the current COVID-19 driven market conditions will improve, it can be expected that if a company remains under threat one year following adoption of a rights plan, it can revisit its toolkit of corporate defenses and determine whether seeking shareholder approval to extend a one-year rights plan is a viable option. We also recommend including features in the pill that allow for earlier redemption if market conditions improve or the company’s circumstances no longer require maintaining the pill.
Benchmarking. Since the onset of the coronavirus pandemic through April 10, 2020, 30 public companies across a variety of industries adopted rights plans, compared to a total of 35 for the entire year in 2019. Most (24) of these are traditional rights plans, and six are “NOL pills” designed to protect net operating loss carryforwards and other tax attributes. While terms and structures vary, these recent rights plans show a tendency toward lower (10%) trigger thresholds, and two-tier triggers with a higher threshold for passive investors. In addition, these recent rights plans have shown an increased tendency to include language that explicitly addresses ownership through derivative instruments as well as the issue of multiple holders “acting in concert.” Many of these recent pills have been accompanied by press releases explicitly referencing the impact of the coronavirus pandemic and resulting increased volatility in the trading of the company’s stock.
Plan Now. Companies for which adoption of a rights plan may be appropriate in the medium-term should consider beginning the process of evaluating defenses and preparing the documentation necessary to implement a rights plan now, even if the board is not yet ready to adopt the plan. Beginning this work on a “clear day” will facilitate board education regarding the company’s defensive posture and help support the fiduciary underpinnings of future board action. Advance work will also allow a board to act swiftly in the event a specific threat emerges.