In the face of increasing investor activism, companies have adopted a number of defensive measures. Among these measures are a particular type of provision found in many corporate borrowers loan agreements – requiring the company to repay loans before they are due if a majority of the board is ousted – that are drawing increasing scrutiny. As these types of provisions have become more common, they have also attracted litigation. The boards of nearly a dozen companies have been hit with lawsuits alleging that the directors violated their fiduciary duties by allowing their companies to enter into credit agreements with these provisions. Developments in these cases may have implications for corporate boards. At a minimum the number of lawsuits that have been filed against corporate boards may have implications for D&O insurance underwriters.
The provisions in question allow the corporate lender to declare the loan in default and accelerate the debt if during a specified period a majority of the board turns over or is composed of “non-continuing directors.” Lenders and their advocates contend that they require these provisions because they want the certainty of knowing that they can accelerate the debt and cash out if a company’s leadership is replaced.
Behind this preference is a concern that if leadership is replaced, particularly as a result of an activist campaign, the new leadership may take steps (such as instituting debt-funded share buybacks or dividends) that could undermine the lender’s security and even lower the company’s credit rating. As Liz Hoffman discussed in her April 29, 2015 Wall Street Journal article about these kinds of provisions, among the companies that have seen their credit ratings lowered or placed in review in the wake of activist campaigns are Darden Restaurants, eBay, and DuPont.
But shareholder advocates question these kinds of provisions as being intended to protect entrenched management by using the threat of a loan default as a way to try to restrain shareholders from trying to replace directors. As the Journal article noted, the possibility that these kinds of provisions could shield directors “has earned them the nickname ‘proxy puts’,” in reference to the campaigns, known as proxy fights, waged by activists to try to replace directors. Owing to their alleged tendency to protect incumbent board members, investor advocates and plaintiffs’ attorneys’ refer to them as “dead hand poison puts.”
These kinds of provisions have not only drawn the ire of corporate activists, they have also attracted litigation brought by shareholders and activists seeking to challenge the provisions. According to the Journal article, in recent months, plaintiffs’ lawyers have filed as many as ten lawsuits against corporate boards and their company’s lenders, seeking to challenge these provisions. Among the companies to have been hit with these kinds of lawsuits are MGM Resorts International and retailer HSN.
Among these recently filed suits was the shareholders derivative lawsuit filed in Delaware Chancery Court action June 2014 by a shareholder of Healthways, Inc. against the companies board of directors and against the company as nominal defendant. The complaint also named the company’s lender, Sun Trust Bank as a defendant. A copy of the complaint can be found here.
The complaint alleged that the company’s board had breached their fiduciary duty by allowing the company to enter a credit agreement with the bank that had a proxy put provision. The complaint alleged that SunTrust had aided and abetted the board’s breach. The complaint sought a declaratory judgment that the loan provision was invalid and unenforceable and an order enjoining the defendants from enforcing the proxy put. The defendants moved to dismiss.
In an October 14, 2014 bench ruling (here), Vice Chancellor Travis Laster denied the defendants’ motion to dismiss, citing a line of Delaware court cases questioning the use of “proxy put” provisions and observing that the provision’s mere existence “necessarily has an effect on people’s decision making” about whether to attempt a proxy context, likening the provision to a “Sword of Damocles.”
Interestingly, Judge Laster not only denied the directors’ motion to dismiss but he also declined to dismiss SunTrust. While Judge Laster emphasized that his ruling was based solely on the allegations on the complaint at the preliminary motions stage, he noted that, according to the complaint, the company’s entry into the credit agreement occurred shortly after the threat of a proxy contest had occurred, based upon which the court found that the allegations were sufficient “knowing participation” for the aiding and abetting claim to survive.
According to the Journal article to which I linked above, in February 2015, Healthways and SunTrust agreed to remove the proxy put provision from their loan agreement. As part of their settlement, which is subject to court approval, the defendants agreed to pay up to $1.2 million to the shareholders’ lawyers. UPDATE: At a May 8, 2015 hearing, Vice Chancellor Laster approved the settlement. At the settlement hearing, Laster provided commentary on his dismissal motion ruling, stating his view that his ruling has been misinterpreted. The transcript can be found here. The relevant section is on pages 34-36.
An October 27, 2014 memo from the Sullivan and Cromwell law firm about Judge Laster’s ruling in the Healthways case can be found here. In January 2015, University of Denver Law School Professor Jay Brown had a five-part series about the case on his Race to the Bottom blog, which can be found here.
The increased scrutiny and the outcome of cases like Healthways have encouraged some lenders and companies to agree to remove these provisions. However, according to the Journal, some banks are pushing back and many banks apparently are still insisting on including the provisions. Since the beginning of 2014, nearly 200 companies have entered new loan agreements that included a proxy put provision.
As Professor Brown said in his blog post series with respect to Chancellor Laster’s ruling in the Healthways case, “By denying the motion to dismiss, the court has announced that boards putting in place dead hand poison puts will confront litigation risk.” Professor Brown noted that this risk applied not only to the boards of companies that enter loan agreements with these types of provisions, but also to the bank that required the provision in its lending documents.
The fact that there have been numerous lawsuits already, including one in which the motion to dismiss recently was denied, and the fact so many companies have nonetheless entered into agreements requiring these kinds of provisions, suggests that there will be further litigation over these issues.
For that reason, these developments should be of concern to D&O insurance underwriters. Because these lawsuits name as defendants the boards of directors of the companies involved, these suits presumptively trigger the companies’ D&O insurance policies. While these kinds of claims do not appear to represent a severity exposure, they could (at least to some extent) represent a frequency exposure. At a minimum, for the D&O insurers these lawsuits present a risk of defense cost exposure, as well as a risk of being called upon to pay the plaintiffs’ attorneys’ fees. (For a discussion of the issues involved in whether a D&O insurance policy provides coverage for a plaintiffs’ fee award amount in a derivative lawsuit settlement, refer here).
The details regarding companies’ credit facilities are detailed in companies’ periodic filings with the SEC. If a company’s loan agreement includes a proxy put provision, the existence of the provision typically would be disclosed in the company’s SEC filings. Accordingly, it would appear to be a prudent underwriting practice to include within its review of the company’s description of the company’s credit arrangement a scan to see whether the company’s loan agreements include a proxy put provision.