A decision of the Delaware Chancery Court last fall has set off a wave of books and records inspection demands by stockholders, as well as threatened litigation, for Delaware corporations that have entered into credit agreements containing “dead hand proxy put” provisions. A “dead hand proxy put” allows the lender to demand immediate repayment of the outstanding debt if a majority of the borrower’s incumbent directors are replaced within a specified time period. 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-based challenge to a dead hand proxy put provision, finding that the facts alleged showed the provision had caused injury to the corporation by deterring a stockholder-led proxy contest.
Default terms in credit agreements based on a change in control of the borrower are common, and typically trigger when the borrower’s “continuing directors” no longer constitute a majority of the board. In a basic proxy put, “continuing director” is defined to include new directors whose election the incumbent directors have “approved”. Case law has held that, because of the adverse consequences of default for the company, incumbent directors discretion to withhold approval is limited by their fiduciary duty to the corporation (even where the election is contested and the new directors are replacing the incumbent directors).[1]
In a dead hand proxy put, no exception is provided for “approved” directors. By making loan default inevitable on any change in the majority of the directors, the dead hand proxy put provides greater protection for the creditor, but it also creates a potential deterrent to proxy activity. It is this deterrent effect that has attracted judicial attention.
In Healthways, the corporation had an existing credit agreement which contained a basic proxy put. Following a meeting at which stockholders overwhelmingly backed a precatory proposal (opposed by the board) to declassify the board, the credit agreement was amended to add a “dead hand” feature. Stockholder pressure on the company’s board continued, and, after a books and records request by a stockholder failed to disclose any documents demonstrating that the company had obtained value in exchange for the addition of the “dead hand” feature, the stockholder ultimately sued the directors for breach of fiduciary duty, and the lenders’ administrative agent for aiding and abetting.
The defendants moved to dismiss the claim for lack of ripeness, but the Court disagreed, observing that “[a] truly effective deterrent is never triggered”. The Court characterized the “dead hand proxy put” provision as a Sword of Damocles, which necessarily cast a shadow over any negotiations and any decision to engage in a proxy contest. With respect to the lenders’ administrative agent, the Court also permitted that claim to proceed, noting that while an arm’s length third party was entitled to negotiate for the best deal it could get, it was not entitled to propose terms that took advantage of a conflict of interest faced by fiduciaries on the other side of the negotiating table. The Court characterized the dead hand provision as having a recognized entrenching effect, which should have put the defendants on notice.
Healthways does not hold that dead hand proxy put provisions are per se improper, and the decision was based on its specific facts and circumstances, which included “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, the lack of any document produced to date suggesting negotiation with respect to this feature”. However, the ruling opens the door for more claims of this type, particularly in circumstances where the corporation is unable to demonstrate that it obtained economic value in exchange for accepting a dead hand proxy put provision.
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[1] See for example Kallick v. Sandridge Energy, Inc., 68 A.3d 242, 246 (Del Ch. 2013): “[T]he incumbent board must respect its primary duty of loyalty to the corporation and its stockholders and may refuse to grant approval only if it 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 the corporation and its stockholders to pass control to them.” (Internal quotations omitted; citations omitted.)
