• Evaluate an offer;
• Communicate with shareholders;
• Negotiate with a potential buyer to preserve the company’s long-term objectives and/or achieve the best available price for the company’s shareholders;
• Protect a preferred alternative transaction that is consistent with the company’s long-term strategic objectives; and
• Otherwise maximize shareholder value.

While our discussion uses concepts from Delaware law, similar defenses are permitted by most other states.

A dual-class common stock structure is created through a restructuring, usually prior to or concurrent with an IPO. The restructuring converts the common shares of pre-IPO shareholders into Class B shares with ten votes per share, and creates Class A shares with one vote per share that will be sold in the IPO and used for equity compensation, capital raising and acquisition purposes after the IPO.

• Class A and Class B shares are intended to be equal from an economic perspective with respect to dividends, stock splits and treatment in a change of control.
• Class B shares are not publicly traded and will automatically convert to Class A shares upon a post-IPO transfer or, in some instances, upon the occurrence of one or more trigger events, such as after a fixed period of years following the IPO or when the insiders at the time of the IPO hold below a certain percentage of the company’s total outstanding shares.

Staggered Board terms prevent hostile acquirers from taking control of the company by replacing the entire Board at one time. This structure may deter certain types of takeover tactics, including proxy fights and tender offers for less than all of a company’s shares. A staggered Board alone will not usually deter an any-and-all cash tender offer – an offer made to all the shareholders to buy all their shares at the same price – because most Board members will not oppose an offeror that has acquired a majority of the company’s shares.

Supermajority Removal Provisions

If a company declines to implement a staggered Board, it may otherwise limit shareholders’ ability to remove Board members. For example, the company may amend its certificate or articles of incorporation to stipulate that a director may be removed only for cause and/or to increase the percentage vote of the shareholders required for removal of a director from a simple majority to 75% or 80%.

A standard shareholder rights plan results from a Board’s declaration of a special dividend of one right per share of common stock. While differences among plans exist, most shareholder rights plans contain the following common principal features:

• If a bidder acquires a set percentage of the company’s stock, usually ranging between 10% and 20% (the Board sets the trigger threshold), the rights allow common shareholders, except the bidder, to purchase shares of a new series of common or preferred stock of the company at a discount. This is called a flip-in provision.
• If, after a bidder acquires stock in excess of the trigger threshold, the company merges or sells more than 50% of its assets, the rights allow common shareholders to purchase shares of the acquiring company at a discount. This is called a flip-over provision.
• The Board can facilitate a friendly transaction by redeeming the rights at a nominal cost or by waiving the application of the plan to a favored bidder before that bidder crosses the trigger threshold.
• Once an acquiring company crosses the trigger threshold, the Board can exchange each right, except rights held by the bidder, for a specified percentage of the securities issuable on exercise of the rights. Exchange provisions require the reservation of fewer shares of common stock, do not require cash to exercise, and result in automatic and definite dilution.

A company can adopt a shareholder rights plan through Board action at any time if sufficient authorized, unissued preferred stock shares or common stock shares are available under the certificate or articles of incorporation for issuance pursuant to the rights plan. To implement a preferred stock shareholder rights plan, the certificate or articles of incorporation of the company must authorize blank check preferred stock.

Shareholder rights plans are proven and effective tools in defending against takeover attempts and inadequate acquisition offers. However, they are not designed to, and will not, deter all hostile takeover attempts. Specifically, a shareholder rights plan will not prevent a successful proxy contest for control of a company’s Board, nor can it override the fiduciary obligations of the Board to consider a fairly priced, any-and-all cash tender offer for the company’s shares. A shareholder rights plan will, however, encourage a potential acquirer to negotiate with the company’s Board as an alternative to triggering the rights and thereby diluting the interest of the bidder in the target company.

The Delaware Court of Chancery has reaffirmed the validity of shareholder rights plans as a permissible defensive measure for a Delaware corporation faced with a takeover proposal its Board finds inadequate. In Air Products & Chemicals, Inc. v. Airgas, Inc., the court confirmed that while a Board cannot “just say never” to a hostile tender offer, the Board can utilize a rights plan to reject a hostile offer and adhere to its existing strategic plan if the Board is acting in good faith with a reasonable factual basis for its decision.

In Selectica, Inc. v. Versata Enterprises, Inc., Trilogy and its subsidiary, Versata, had offered to acquire some or all of Selectica’s business, and were rejected. Trilogy began acquiring Selectica stock, and Selectica then lowered the trigger on its rights plan to 4.99%, allowing existing 5% or more shareholders to acquire up to an additional 0.5% without triggering the rights plan. Trilogy then bought more Selectica shares, exceeding the 4.99% trigger.

The Delaware Supreme Court held that the Selectica Board acted reasonably in determining that the NOL represented a significant business asset worth protecting, and found that the implementation of a NOL rights plan with a 4.99% trigger constituted an appropriate defensive response to the threats represented by Trilogy’s actions.

Two-Tiered Poison Pill to Address Creeping or Negative Control by Activists

In Third Point LLC v. Ruprecht, the Delaware Court of Chancery found that the possibility of “creeping control” and “negative control” from activist investors posed objectively reasonable threats to justify the adoption by Sotheby’s of a two-tiered shareholder rights plan that allowed passive institutional investors (those reporting ownership pursuant to Schedule 13G) to acquire up to a 20% interest in Sotheby’s, while permitting all other shareholders to acquire only up to a 10% interest, without triggering the rights plan. In an era of increasing shareholder activism, the court recognized the legitimate concerns of Sotheby’s Board that hedge funds would form a group to acquire a control block of Sotheby’s or that a single hedge fund would exercise disproportionate and negative control through a 20% ownership interest, without paying a control premium. Under the circumstances, the court concluded that the adoption of Sotheby’s rights plan was a reasonable response to a cognizable threat.

• Control share statutes prohibit an acquirer from voting shares of a target company’s stock after crossing specified ownership percentage thresholds. The acquirer may proceed if it obtains the approval of the target company’s shareholders to cross each ownership threshold.
• Business combination statutes prohibit the target company from entering into specified significant business transactions – mergers, sales of assets and other change-of-control transactions – with an acquirer for a three- to five-year period after the acquirer crosses a specified ownership percentage threshold. Under this regime, an acquirer may proceed if it obtains the approval of the target company’s Board prior to acquiring its ownership interest.
• Fair price statutes protect shareholders from the coercive effects of a two-tier tender offer by requiring approval of a second-stage merger by a supermajority shareholder vote. Alternatives to the shareholder vote include having a disinterested Board approve the transaction or ensuring that second-stage merger consideration equals the consideration paid in the first- stage tender offer, in terms of both amount and type of consideration.

Delaware Section 203: A Business Combination Statute

Section 203 of the Delaware General Corporation Law is a business combination statute. Section 203 limits any investor that acquires 15% or more of a company’s voting stock (thereby becoming an interested shareholder) from engaging in certain business combinations with the issuer for a period of three years following the date on which the investor becomes an interested shareholder, unless:

• The company’s Board has approved, before the acquirer becomes an interested shareholder, either the business combination or the transaction that resulted in the investor’s becoming an interested shareholder;
• Upon consummation of the transaction that made the investor an interested shareholder, the interested shareholder owned at least 85% of the voting stock outstanding at the time the interested shareholder began the transaction that resulted in its becoming an interested shareholder (excluding shares owned by persons who are both directors and officers and shares held in employee stock plans that do not provide plan participants with the opportunity to tender shares on a confidential basis); or
• The business combination is approved by the Board and authorized by the affirmative vote of at least 66-2/3% of the outstanding voting stock not owned by the interested shareholder (at a meeting, and not by written consent).

Section 203 defines a business combination broadly to include:

• Any merger or sale, or other disposition of 10% or more of the assets of a company, with or to an interested shareholder;
• Transactions resulting in the issuance or transfer to the interested shareholder of any stock of the company or its subsidiaries;
• Certain transactions that would result in increasing the proportionate share of the stock of a company or its subsidiaries owned by the interested shareholder; and
• Receipt by the interested shareholder of the benefit (except proportionately as a shareholder) of any loans, advances, guarantees, pledges or other financial benefits. 

A Delaware company may opt out of Section 203:

• If the company’s original certificate of incorporation contains a provision expressly electing not to be governed by Section 203; or
• If the company’s shareholders approve an amendment to its certificate of incorporation or bylaws expressly electing not to be governed by Section 203. This amendment must be approved by a majority of the outstanding shares entitled to vote, and it is not effective until 12 months after adoption. An opt-out amendment will not apply to any business combination with an investor that became an interested shareholder prior to the adoption of an opt-out amendment.

Common Stock

As a general matter, a public company should ensure that it always has an adequate number of authorized shares of common stock, taking into account both outstanding shares and the number of shares issuable upon conversion or exercise of outstanding or anticipated preferred stock, stock options and warrants. The company should maintain sufficient authorized, but unissued and unreserved, shares of common stock for:

• Current and future stock incentive plans;
• Potential stock splits and dividends;
• Strategic acquisitions; and
• Equity financings.

Blank Check Preferred Stock

The company’s certificate or articles of incorporation may authorize blank check preferred stock – a specified number of shares of authorized but undesignated preferred stock. Authorizing blank check preferred stock gives the Board the authority, without having to seek prior shareholder approval, to designate one or more series of preferred stock out of the undesignated shares and to establish the rights, preferences and privileges of each series.

Taken together, blank check preferred stock and a reserve of authorized but unissued shares of common stock provide target companies the flexibility to:

• Sell shares to a friendly party;
• Use the shares as consideration for a defensive reorganization or acquisition;
• Grant a friendly party a lockup option to acquire the shares; or
• Implement a shareholder rights plan.

Limitations on the Right to Call Special Shareholders’ Meetings

A company may defend against coercive takeover attempts by appropriately limiting the power of shareholders to call special shareholders’ meetings. Delaware law provides that only the Board and persons authorized in the company’s certificate of incorporation or bylaws may call a special meeting of shareholders.

Thus, absent authorizing language in a company’s certificate of incorporation or bylaws to the contrary, a Delaware company may entirely eliminate the right of shareholders to call a special shareholders’ meeting. In other states, however, a certain percentage of shareholders may have a statutory right to call a special shareholders’ meeting. A company incorporated outside Delaware may still increase the default percentage of shareholders required for shareholders’ meetings and, in some cases, entirely eliminate this right. Limiting the right of shareholders to call special meetings can ensure additional time to negotiate by preventing a would-be acquirer from electing a class of directors or gaining control of the Board until the company’s next annual shareholders’ meeting.

Advance Notice Bylaw Provisions

Advance notice bylaw provisions provide that shareholders seeking to bring business before, or to nominate directors for election at, any shareholders’ meeting must provide written notice of such action within a specified number of days (usually from 60 to 90 or 90 to 120) in advance of the meeting. Because only business contained in the meeting notice may be conducted at special shareholders’ meetings, these bylaw provisions can delay the efforts of coercive acquirers and prevent surprises at shareholders’ meetings

Delaware courts have upheld advance notice bylaw provisions as appropriate mechanisms to give shareholders an opportunity to evaluate shareholder proposals and to give the Board adequate time to make informed recommendations. However, advance notice bylaw provisions may not unduly restrict shareholder rights and must be implemented fairly.

Elimination of Shareholder Action by Written Consent

Under Delaware law, unless otherwise provided in a company’s certificate of incorporation, any action required or permitted to be taken by shareholders may be taken by written consent, without a meeting or shareholder vote. A valid written consent sets forth the action to be taken and is signed by the holders of outstanding stock having the requisite number of votes necessary to authorize the action at a shareholders’ meeting. The certificate of incorporation may prohibit shareholder action by written consent. Such a prohibition has the effect of confining shareholder consideration of proposed actions to shareholders’ meetings. As a result, the holder or holders of a majority of the voting stock of a company may not take preemptive, unilateral action by written consent, and may act only within the framework of a shareholders’ meeting.

Supermajority Vote on Merger or Sale of Assets

Delaware law requires shareholder approval for any merger or sale of substantially all the assets of a company. A Delaware company’s certificate of incorporation or bylaws may include a supermajority provision requiring more than a simple majority (generally companies choose a percentage between 60% and 80%). A typical provision requires the affirmative vote of 66-2/3% of the voting shares for any merger or sale of substantially all the company’s assets if, at the time of the vote, the company has a controlling shareholder (i.e., a shareholder holding a substantial block of stock, such as 10%). A supermajority provision often requires a potential acquirer to obtain a greater number of shares in order to complete the acquisition.

In deciding whether to adopt a supermajority requirement for a merger or sale of substantially all of a company’s assets, it is important for a Board to consider the following:

• Too high a standard can allow minority holders to block favorable acquisitions and other transactions; and
• If a company is listed on an exchange, it may be subject to additional restrictions or listing requirements.

Supermajority Vote on Amendments to Certificate of Incorporation and Bylaws

The default rule under Delaware law provides that a simple majority of a company’s voting securities must approve any amendments to a company’s certificate of incorporation. A company’s certificate of incorporation or bylaws, however, may include so-called lock-in provisions that require supermajority voting on specified amendments to a company’s charter documents. Lock-in provisions force a hostile acquirer to control a greater number of shares in order to eliminate a company’s corporate structural defense provisions by amending the certificate of incorporation or bylaws. However, supermajority voting requirements reduce a company’s flexibility to make other desirable changes to its certificate of incorporation or bylaws. As a result, a company may choose to retain a majority approval requirement for amendments to most of the provisions of its certificate of incorporation and bylaws, and to establish a supermajority approval requirement only for amendments to those particular provisions that provide takeover protection, such as provisions dealing with:

• A classified Board;
• Removal of a director for cause;
• The right of shareholders to call special meetings; and
• Supermajority voting provisions for business combinations.

A company may also retain flexibility by providing that the supermajority approval is not required if the amendment is approved by a majority of directors serving before a controlling shareholder acquired its controlling stake in the company.

Change-of-control agreements can be stand-alone agreements or severance provisions included in employment agreements. They typically trigger a cash payment (or the automatic vesting of stock options, restricted stock or other noncash benefits) on the occurrence of a change-of-control event, including a merger, sale of assets or stock, or a change of the constituency of the Board. Single trigger agreements result in a severance payment becoming due on the occurrence of a change of control alone. The more common double trigger agreements result in a severance payment only if the triggering event is coupled with a significant change in job status or compensation (e.g., termination of employment or decrease in salary or responsibilities).

Some of the strongest protections against an unfriendly takeover are not special provisions in a company’s charter documents, but are, in this order:

• A significant block of stock held by friendly shareholders;
• A high stock price and price/earnings ratio;
• Strong state antitakeover statutes (protections under Delaware law are among the best available); and
• A shareholder rights plan.

Even with these elements in place, in order to keep pace with changes in applicable law, as well as the increasingly refined approach of shareholder activists and institutional shareholders, a Board should also protect the company through its overall efforts to prepare for an unsolicited acquisition proposal. To that end, a Board should periodically (at least annually) review:

• Its fiduciary duties in responding to an unsolicited acquisition inquiry;
• The merger and acquisition environment, in general and in the company’s industry;
• The company’s existing corporate structural defenses, including its shareholder rights plan; and
• The company’s strategic plan, projected financial performance and the composition of its shareholder base.

In advance of any unsolicited acquisition proposal, a Board should also:

• Identify a point person (often the CEO) to respond to takeover inquiries, with Board members instructed to refer inquiries to the point person;
• Identify a response team of key officers, in-house and outside legal counsel, a financial advisor and an investor relations firm; and
• Establish that the point person, and other executives and Board members, may not negotiate with a potential acquirer without seeking direction from the Board.

This advance preparation will put the Board in the strongest position to respond to an unsolicited acquisition proposal in a manner that will serve the best interests of the company’s shareholders.