“Dead Hand Proxy Puts” Garner Increased Stockholder Scrutiny In Delaware
A ruling last fall by the Delaware Chancery Court has prompted a wave of 8 Del. C. § 220 books and records inspection demands on (and threatened litigation against) Delaware corporations that have entered into credit agreements containing so-called “dead hand proxy put” provisions. A “dead hand proxy put” provision allows the corporation’s lenders to demand immediate payment of all outstanding debt if, within a specified measuring period, a majority of incumbent board members is replaced in a threatened or actual contested election. In Pontiac General Employees Retirement System v. Healthways, Inc., C.A. No. 9789-VCL (Del. Ch. Oct. 14, 2014) (transcript ruling), the Court declined to dismiss a breach-of-fiduciary-duty challenge to a “dead hand proxy put,” even where the exercise of the provision was not imminent. The Court held that the complaint adequately alleged facts showing the provision had caused a present injury to the corporation’s stockholders by deterring a possible stockholder-led proxy contest. Other than the facts alleged, the ruling left uncertain the attendant circumstances needed to state a mature “dead hand proxy put” claim. As a result, all public company boards with credit agreements containing “dead hand proxy puts” now face Section 220 books and records inspection demands, and potential litigation.
Credit agreements often contain default terms based upon changes in control of the borrower, including when the borrower’s “continuing directors” no longer constitute a majority of the board of directors. These basic “proxy puts” define a “continuing director” to include incumbent board members and those whose election or nomination the incumbent directors have “approved.” As a credit agreement default can materially injure a corporation, the incumbent board members’ ability to ultimately withhold the “approval” needed to avoid default when faced with a proxy challenge has received attention from the Delaware courts. See Kallick v. Sandridge Energy, Inc., 68 A.3d 242, 246 (Del Ch. 2013) (allowing non-approval only when the incumbent board “determines that the director candidates running against them posed such a material threat of harm to the corporation that it would constitute a breach of the directors’ duty of loyalty . . . to pass control to them) (internal quotations omitted). But the mere presence of a basic “proxy put” in a credit agreement would not appear likely to warrant judicial intervention under Delaware’s ripeness doctrine.
In Healthways, the company’s credit agreement initially contained a basic “proxy put” provision, allowing the incumbent board the ability to approve proxy candidates and avoid default. In October 2012, Healthways’ stockholders overwhelmingly backed a precatory proposal to declassify the board, despite the board’s opposition. Healthways proceeded to phase out the staggered board over a period of three years, with a majority on its eleven-seat board subject to election in 2015. Two weeks after the October 2012 stockholder vote, Healthways and its lenders’ administrative agent, SunTrust Bank, amended the credit agreement, adding a so-called “dead hand” feature to the definition of “continuing director” to exclude those directors whose nomination or assumption of office results from an actual or threatened proxy contest, even if the incumbent board “approves” such directors.
Meanwhile, stockholders continued to pressure the Healthways board. In January 2014, a 10% stockholder disclosed its intent to commence a proxy contest that, after negotiations, resulted in the appointment of three new directors, none of whom qualified as “continuing directors” under the new “dead hand proxy put.” In June 2014, after plaintiff Pontiac’s Section 220 demand for records produced no documents showing Healthways obtained any economic value in return for the “dead hand” feature, it sued the Healthways’ directors for breach of fiduciary duty and SunTrust for aiding and abetting.
The director defendants moved to dismiss for lack of ripeness, noting the number of contingencies that would need to occur before default. The Chancery Court, however, denied the motion, likening a “dead hand proxy put” to a “Sword of Damocles” that, by its very existence, injuriously affects stockholder decision-making about whether to run a proxy contest or negotiate for board representation. It viewed this entrenching effect, and the non-“continuing director” status of Healthways’ three new directors, as present harms. The Chancery Court stressed, however, that its ruling did not rely upon any per se notion of illegality, but rather rested on the specific facts alleged “including the rise of stockholder opposition, the identified insurgency, the change from the historical practice in the company’s debt instruments, the lack of any document produced to date suggesting informed consideration of this feature, [and] the lack of any document produced to date suggesting negotiation with respect to this feature.”
Other than the specific facts alleged in Healthways, the attendant circumstances upon which a “dead hand proxy put” claim may satisfy the ripeness doctrine remain uncertain. This has led to numerous stockholder enforcement threats, including the issuance of myriad Section 220 demands solely because the corporation’s credit agreement contains a “dead hand proxy put.” This likely will continue. As lenders presumably value the “dead hand” feature to allow them to better avoid change-in-control risks, the Section 220 inspections will likely focus on the value, if any, the directors obtained in exchange for agreeing to the provision at the time of its adoption. But any facts that show a claim is ripe will equally bear on when the applicable limitations period began to run. Hence, depending upon the theory of potential liability advanced by the Section 220 plaintiff, including when the alleged “dead hand proxy put” claim ripened, the corporation will want to explore whether the statute of limitations already bars the claim, and renders the Section 220 inspection improper.