The Delaware Chancery Court has just issued an opinion holding the board of The Williams Companies in breach of its fiduciary duties and invalidating the Stockholder Rights Plan (“poison pill”) adopted by the board at the height of the economic disruption and stock market volatility caused by the Covid-19 pandemic. The court did not change the law in Delaware on poison pills, but concluded that the board’s reasons for adopting the defensive measure and the unique features of this particular device (e.g., a 5% threshold and a broad concept of when activist stockholders may be deemed to be “acting in concert”) were not justifiable.
Key Takeaways from the Decision
• Poison pills continue to be valid in Delaware, but they are “nuclear weapons” in a takeover defense arsenal and have to be handled “with the delicacy they deserve”;
• As well established in Delaware, when the decision to adopt a poison pill is challenged, the court will not defer to the board’s business judgment, but will apply intermediate scrutiny, and the board will bear the burden of proof to justify its actions;
• The board needs to have reasonable grounds for identifying a threat to the corporate enterprise;
• The threat that the board is trying to address with a poison pill cannot be hypothetical, but has to be real;
• A possibility that a significant drop in stock price may entice an activist stockholder to acquire a stake in the company which may lead to a potential disruption is not enough to pose a threat to justify adoption of a pill;
• A poison pill cannot be adopted in anticipation of a potential activist stockholder’s actions to insulate management of the company even in the most difficult economic environment;
• Even if the threat is real, the board’s response (in this case the features of the poison pill as a defensive device) cannot be draconian and must be reasonable and proportionate to the threat posed;
• Although a poison pill is set in dense legal documents, the court held that the board is required to review them and at a minimum understand its key features and effects;
• To enable the board to have a proper understanding of a complex instrument such as a poison pill, it is advisable to have deliberations over a couple of meetings at which the instrument is discussed, with the second meeting involving substantive deliberations.
Background of the Case
The Williams Companies experienced what many companies did in March 2020 as the Covid-19 pandemic upended all spheres of human life, forced a worldwide lockdown, brought businesses to a grinding halt and caused massive drop in stock prices. Williams had an additional issue to deal with: an oil price war among major oil producing powers that hit in early March as well. As a result of this double impact, Williams’ stock price fell by about 55% (from $24 in January to $11 by the third week of March).
The Williams board was concerned that such a dramatic drop in its stock price presented an opportunity for an activist stockholder to accumulate quickly a significant amount of stock and start putting pressure on the board and the company’s management. Williams had experience with activist investors before and the board and the management were concerned about the disruption an activist’s presence could have been caused.
In light of these concerns, the Williams board and management concluded that they needed to consider a poison pill to protect against a potential threat of an activist coming into its stock and to “insulate” management from dealing with activists during the highly uncertain times. The poison pill that Williams ultimately adopted had a 5% trigger threshold, a one-year term, an “acting in concert” concept for purposes of determining if the aggregate number of shares held by stockholders who fall in this category exceeds 5% and an exemption for passive investors.
Reaction to the adoption of the pill with these features was negative. Two of Williams’ largest institutional stockholders (BlackRock and Vanguard) reached out to the company shortly after the announcement and ISS recommended that stockholders vote against the re-election of the chairman of the board. ISS noted that the pill was not a reaction to an actual threat and asked why the board did not consider a more standard pill with a higher trigger.
The Poison Pill Basics
A poison pill was developed as a defensive device during the takeover battles of the 1980s. In a nutshell, at the core of a poison pill is an instrument that is very similar to a warrant and is legally referred to as a “right.” The legal document that governs how the rights work is called a Stockholder Rights Agreement and is a contract between the company issuing the rights and a Rights Agent (an administrator that looks after the interests of the rights holders). Adoption of the Rights Plan is simple: the board approves it and declares a dividend of one right for one share of common stock. Rights will attach to the shares and will trade with them without any action on the part of the stockholder that owns the stock. The exercise price of the rights is set to be deeply out of the money at the time of adoption, and at this time, each right is exercisable for one share of common stock (or its equivalent). The rights get “triggered” when someone acquires the number of shares of the company’s stock specified in the Rights Plan as a percentage of the outstanding shares. Typically, the threshold is set between 10% and 20% for Delaware corporations (and in some jurisdictions, such as New York, the threshold cannot be lower than 20%). The rare exception to this typical range are the so called NOL poison pills that were developed to protect valuable tax assets of a company (primarily New Operating Losses) where a 5% trigger is used because of the specifics of tax rules governing NOLs.
When the acquiror exceeds that threshold, i.e. triggers the poison pill, the Rights Plan immediately and automatically changes two key features of the rights:
• Instead of being exercisable for one share of common stock (or equivalent), each right becomes exercisable for such number of shares as the exercise price allows to buy at a 50% discount to then current market price.
• The acquiror that crossed that threshold cannot exercise the rights that were attached to the shares that it acquired.
This change causes a dramatic dilution to the acquiror and is the main deterrent of the modern poison pill. This is what makes a poison pill a “nuclear weapon.”
The Chancery Court’s Holding
In a 90-page decision, Vice Chancellor McCormick analyzed the process the board used to adopt the poison pill, whether the board had reasonable grounds for determining a threat, and examined key features of the poison pill. The court then looked at whether the poison pill, given its features and assuming a threat existed, was reasonable and proportional to the threat posed. The court’s analysis was performed under the Unocal standard of intermediate review of the board’s decision, meaning that the court did not defer to the board’s business judgement, but instead pursued an inquiry where directors had to demonstrate that (i) they acted in good faith to achieve a “legitimate corporate objective” and conducted a reasonable investigation, and (ii) the defensive measures they adopted were “reasonable in relation to the threat posed,” if based on the investigation they had grounds for concluding that a threat to the corporate enterprise existed.
The Board’s Process and the Identified Threat
The court has carefully evaluated the board’s process and concluded that although some aspects of the process may not have been perfect, nothing about the process was unreasonable. The real issue the court found was not the process that directors followed, but the threats they identified. The court examined three threats that the board was concerned about; (1) a possibility of stockholder activism during a time of market uncertainty and low stock price, (2) a potential threat that if an activist were to acquire a stake in the company, it might pursue “short-term agendas” or distract management, and (3) possible rapid accumulation of over 5% of the stock and the desire to have the poison pill serve as an early detection device to “to plug the gap” in the federal securities laws disclosure regime (that provides enough of a delay in disclosure so that someone can significantly surpass the 5% disclosure threshold before it becomes publicly known). The court ultimately concluded that each of these threats were hypothetical. The court then looked at whether hypothetical threats present legitimate corporate objectives under Delaware law and concluded that at least the first two do not, and with respect to the third one, the court decided not to address it, but instead assumed that it may constitute a legitimate objective to analyze whether the poison pill was a proportional response.
Features of the Williams’ Pill that Led to its Invalidation
In looking at whether the poison pill that the Williams board adopted was within a range of reasonable responses to the threat, the court focused on a few key features. It first raised an objection to the 5% trigger threshold. The court noted that among the 21 poison pills adopted during the March-April 2020 market volatility, Williams’ pill was the only one with the 5% trigger level, and out of prior precedents identified by the company’s advisors, there was only one other instance where a trigger of a non-NOL poison pill was set at 5%, and in that instance the company was facing an activist campaign by a 7% stockholder.
The court then focused on other provisions of the instrument and zeroed in on the “acting in concert” provision. The court viewed this provision as too broad where potentially benign stockholder communications could be swept up, and pointed to the board’s discretion in determining factors that can trigger the pill.
Among other concerns raised by the court, was an exemption from the pill for passive investors that the court deemed to be too narrow, pointing out that BlackRock raising concerns with the Company about the pill could make the institutional stockholder not fitting the definition.
The court ultimately concluded that directors failed to show that the pill’s features fell within the range of reasonable responses, found that the Stockholder Rights Plan is unenforceable because directors breached their fiduciary duties and issued a permanent injunction against continued operation of the poison pill.