Proxy Puts: Consider With Caution
Directors of a Delaware corporation that enters into a financing agreement with a lender may breach their fiduciary duties if the financing agreement contains a common provision allowing the lender to accelerate and demand full payment of the indebtedness upon a substantial change in the composition of the board of directors. Moreover, the lender may be liable for aiding and abetting the directors' breach of fiduciary duty. Vice Chancellor J. Travis Laster's transcript ruling in Pontiac General Employees Retirement Fund v. Healthways, C.A. No. 9789-VCL transcript (Del. Ch. Nov. 3, 2014), denied the motions of the defendant directors and the lender to dismiss claims based on similar facts and allowed the action to proceed. The ruling and accompanying reasoning severely constrict the permissible use of the so-called "proxy put" often contained in corporate financing agreements.
A "proxy put" is a term used to refer to a change-of-control covenant contained in a financing contract that provides upon a triggering event, usually a change in control of the board, for some action to occur, typically accelerated debt repayment. As a result, these provisions have an entrenchment effect.
The plaintiff in Healthways brought a class and derivative suit alleging that in 2012, the board of directors, aided and abetted by Healthways' lender, breached their fiduciary duties when they caused Healthways to enter into a fifth amendment to its revolving credit and term loan agreement. This amendment enhanced an existing "change of control" default provision by providing that any person nominated to the board as a result of an actual or threatened proxy solicitation could not be a "continuing director." The "change of control" default provision was triggered if for any period of 24 consecutive months a majority of the members of the board of directors ceased to be composed of "continuing directors." The complaint alleged this amendment occurred at a time of significant shareholder activism for the company, with the company having faced, and continuing to face, the risk of a proxy contest. As a result of stockholder pressure, the corporation's 11-member board already contained three "non-continuing" directors. Finally, the complaint alleged that there had been no substantial negotiation about the proxy put or any indication that the company received "extraordinarily valuable economic benefits" that might otherwise justify the proxy put.
The Court of Chancery first rejected the individual defendants' argument that the case was not ripe and would not be ripe until subsequent events occurred that actually triggered the debt acceleration. In the court's view, the proxy put's effect on decision-making about whether to run a proxy contest and how to negotiate for potential board representation created an actual deterrent and had an entrenching effect that presented a ripe dispute. Ripeness did not depend on how the directors and lender acted in the future with respect to a potential waiver of the proxy put.
The court rejected the argument, however, that its ruling would constitute a determination that merely entering into an agreement containing a proxy put would be a per se breach of fiduciary duty. Rather, the court said specific factual allegations regarding the circumstances surrounding the proxy put amendment, including addition of a dead hand provision, stated a reasonably conceivable claim for breach of fiduciary duty by the individual defendants.
With respect to the aiding and abetting claim against the lender, the court rejected the argument that as an arm's-length counterparty, the lender had an unlimited privilege to negotiate freely for the best deal it could get. Acknowledging an arm's-length privilege, the court said it did not allow a lender to propose or insist on terms that take advantage of a conflict of interest faced by the fiduciary counterparty. Because of the entrenchment feature of a proxy put, the court found that introduction of such a provision into the agreement puts the lender at risk and removes it from an absolute arm's-length negotiation privilege. Further, the court found that the "knowing" element of an aiding and abetting claim was met for Rule 12(b)(6) purposes, stating that lenders were on notice from the court's previous decisions in San Antonio Fire & Police Pension Fund v. Amylin Pharmaceuticals, C.A. No. 4446 VCL (Del. Ch. May 12, 2009),and Kallick v. SandRidge Energy, C.A. No. 8182-CS (Del. Ch. March 8, 2013), that proxy put provisions are highly suspect and could potentially lead to a breach of duty on the part of the fiduciary counterparties to the credit agreement.
In view of the Delaware trilogy of Healthways, SandRidge and Amylin, considerable doubt and risk remain as to the viability of continuing director provisions. Although decided in a motion to dismiss context and not on a full trial record, the ruling serves as a cautionary warning. From a lender's perspective, the credit risk concerns justifying change-in-control provisions may be better addressed by other purely financial covenants involving cash flow, earnings and debt levels, and investment and dividend restrictions. Negotiation for these purely financial terms falls within privileged arm's-length bargaining because it does not create conflicting interests for the counterparty fiduciaries.
From the fiduciary perspective of the officers and directors, dead hand provisions like those challenged in Healthways, which provide limited director discretion to address a potential change in control and protect the corporation from looting or other imprudent conduct, pose real liability risk. Unless the lender insists on a continuing director provision and there is a real negotiation to obtain actual economic benefits for the corporation, the cost of such provisions may well outweigh the potential benefits.