Corporate Governance

Yucaipa American Alliance Fund II, LP v. Riggio: The Growing Use of Poison Pills to Preclude a Proxy Contest (The Non-Threat Threat)

By J Robert Brown Jr.

As part of the analysis mandated by Unocal, the Chancery Court had to decide whether, in adopting the pill with the particular attributes, the board had in fact confronted a "legitimate threat."  One of the core problems with the threat issue was the fact that Barnes & Noble had a staggered board.  As a result, any "threat" posed by Yucaipa in a proxy contest could accomplish nothing more than the election of a minority of directors to the board.  The court, therefore, had to justify how the election of a minority of the board could pose a threat despite the inability to unilaterally implement any practice or policy ostensibly harmful to the company.

The court started by discounting the impact of a staggered board.  

• Although much has been made of the minor number of instances in which a classified board has impeded a committed acquirer willing to pay an attractive price, the reality is that even the combination of a classified board and a rights plan are hardly show-stoppers in a vibrant American M & A market.

But of course the issue is not whether a staggered board coupled with a poison pill is a "show stopper."  There is really no such thing as a show stopper if the price is high enough.  The issue was whether the board confronted a threat. The test for a threat is not whether a practice is a show stopper.

As for the threat, the court concluded that once "an insurgent has won one election, the incumbent board majority's ability to be intransigent in the face of stockholder sentiment is greatly limited."  In other words, the threat is not legal but psychological.  Because shareholders have spoken, the board may have less room to take actions inconsistent with the wishes of shareholders.  In other words, the threat was not the election of the directors themselves but the message sent by shareholders in electing the directors. 

Indeed, the court viewed the election as a referendum on incumbent management. 

• Although only three directors are up for reelection at the next Barnes & Noble annual meeting, these directors include the founder and Chairman, Leonard Riggio himself, the lead independent director Del Giudice, and Riggio's personal financial advisor, Zilavy. Thus, Yucaipa can make it a referendum about the likelihood of receiving a takeover bid, however, the economic effect of bid deterrence on the value of the firm is quite small.

But of course anytime there is a contested election, it is a referendum on incumbent management.  Nonetheless, that universal understanding seemed to be sufficient to establish the requisite threat.

Apparently aware of the weakness of the argument, the court added that the pill also prevented the formation of a shareholder block that could cause harm to the company.

• No doubt our law provides substantial protections for other investors in the event that a large stockholder with board representation proposes a going private transaction or engages in other forms of unfair value extraction, but that does not mean that the Barnes & Noble board was not entitled to take reasonable, non-preclusive action to ensure that an activist investor like Yucaipa did not amass, either singularly or in concert with another large stockholder, an effective control bloc that would allow it to make proposals under conditions in which it wielded great leverage to seek advantage for itself at the expense of other investors. Precisely by cabining Yucaipa at a substantial, but not overwhelming, level of voting influence, the board preserved for itself greater authority to protect the company's public stockholders.

But the court never clarified how this "block" would wield that leverage when it only controlled a minority of the board.  Moreover, even the directors elected by the shareholders making the proposal would have to meet their fiduciary obligations.  They could not approve an agreement that was in the best interests of the large shareholder but not in the best interests of all shareholders.

Yucaipa, by trying to negotiation with other shareholders to elect a minority of the board, would, if it succeeded, make it uncomfortable for the remaining directors.  But Yucaipa would have no abilty to implement any policy unless it was able to convince the other incumbent directors.  This case is essentially saying that the mere discomfort of the incumbent directors will constitute a threat sufficient to justify a poison pill that shuts down agreements among shareholders seeking to elect an alternative short slate of directors.

Primary materials are posted on the DU Corporate Governance web site.

Full post as published by The Race to the Bottom on September 08, 2010 (boomark / email).