Opinion

Alison Frankel

Sotheby’s lesson: Poison pills not panacea for embattled boards

By Alison Frankel
May 5, 2014

Sotheby’s may have won its litigation battle with activist investor Dan Loeb of Third Point, but Loeb won his war with the auction house.

On Friday, Vice-Chancellor Donald Parsons of Delaware Chancery Court denied motions by Loeb and pension fund investors to block Sotheby’s from convening its annual shareholder meeting on May 6. Parsons held that the auction house’s board legitimately perceived a takeover threat last October, when it adopted a poison pill designed to fend off activist hedge funds, including Third Point, that were snapping up Sotheby’s stock. Parsons said he has policy concerns about a pill that discriminates against activist investors. But because the board’s primary intention was takeover defense, not to interfere with shareholder voting rights, directors are entitled to deference under Delaware’s 1985 precedent in Unocal v. Mesa Petroleum. Parson’s ruling is a vindication of the controversial Sotheby’s pill, which was set to trigger when an activist investor acquired 10 percent of the company’s shares but permitted a passive investor to amass 20 percent.

Nevertheless, in a settlement announced on Monday, Sotheby’s gave Loeb most of what he wanted in the proxy contest and the pill litigation. Faced with the prospect of losing to the activist investor in shareholder voting for three board seats, the auction house agreed to expand its board to include Loeb and the two other board candidates he had proposed. Sotheby’s also said it would terminate the troublesome poison pill. In exchange, Loeb conceded only that he would drop the proxy contest and the litigation and that he would cap his fund’s ownership of Sotheby’s shares at 15 percent.

This peculiar turn of events has the paradoxical effect of simultaneously affirming the broad discretion of corporate boards to adopt poison pills to ward off the prospect of takeover by aggressive hedge funds while also highlighting the limited effectiveness of these pills in a contest for shareholder votes. The next board of a public company targeted by an activist like Loeb will have to ask itself: If there’s a good chance that institutional investors and shareholder advisory services will ally with the hedge fund activist — as they are increasingly likely to do — does it really make sense to spend time and money to adopt and defend an anti-activist poison pill?

The pill might even backfire on corporate boards. That’s arguably what happened to Sotheby’s. A couple of public pension funds, which typically maintain a low profile in these activist investor fights, filed a shareholder class action that paralleled Loeb’s suit to invalidate the Sotheby’s pill, suggesting that at least some shareholders (or, at least, their lawyers in the plaintiffs’ bar) were offended by the device.

Others may have been disturbed by the evidence that emerged in the litigation over the pill. As Dealbook reported after the injunction hearing before Parsons on April 29, one of Sotheby’s directors described the board in an email as “too comfortable, too chummy and not doing its job.” (The same director, who is retiring from the auction house’s board, also said that executive compensation was “red meat for the dogs.”) Vice-Chancellor Parsons’ opinion recounts several emails in which Sotheby’s chairman and CEO, William Ruprecht, referred to Loeb as “scum” or a “scumbag.”

We don’t know for sure whether the pension fund suit or the awkward emails would have affected the shareholder vote for board seats. According to Parsons’ opinion, Sotheby’s had been bracing for a loss in the proxy contest since at least March, when its largest institutional shareholder, BlackRock, warned that Loeb was likely to succeed in replacing three Sotheby’s board members with his slate. Sotheby’s financial adviser, Goldman Sachs, and proxy adviser, CamberView, considered the vote a tossup. But Sotheby’s cause certainly wasn’t helped by the litigation challenge to the pill that Loeb’s lawyers at Willkie Farr & Gallagher; Morris, Nichols, Arsht & Tunnell and Dontzin Nagy & Fleissig launched in late May.

Of course, Loeb and the pension funds that ended up litigating alongside him (represented by Bernstein Litowitz Berger & Grossmann and Grant & Eisenhofer) faced their own risks in the litigation. They asked Vice-Chancellor Parsons to evaluate the board’s decision to adopt the pill under the Delaware Supreme Court’s investor-friendly standard in Blasius Industries v. Atlas, which requires a board to provide a “compelling justification” for actions aimed at interfering with shareholder voting rights. Sotheby’s pill, they argued, deserved scrutiny under the Blasius standard because it was intended to sway the proxy vote for board seats.

Parsons said, however, that Delaware courts have never judged an anti-takeover poison pill under the Blasius standard. Instead, he applied the two-pronged Unocal test, which upholds boards’ rights to adopt defensive measures as long as their corporation faces a takeover threat and the poison pill is proportional to that threat. Parsons concluded that the Sotheby’s board legitimately perceived a threat in October 2013 from a “wolf pack” of hedge funds (to use the phraseology of Sotheby’s lawyers at Wachtell, Lipton, Rosen & Katz) all buying blocks of its shares at the same time. He also said that the plan was probably a reasonable response to the possibility of Loeb or another hedge fund acquiring control of the auction house.

The vice-chancellor was more bothered by Sotheby’s refusal to waive the 10 percent trigger for the pill when Loeb formally requested a waiver in March 2014. Loeb was only asking to be treated as Sotheby’s would treat a non-activist investor, Parsons said, so the auction house’s refusal was troubling. But the judge reluctantly concluded that the Sotheby’s board might have had a legitimate fear that “enabling individuals or entities, such as Loeb and Third Point, to obtain 20 percent as opposed to 10 percent ownership interests in the company could effectively allow those persons to exercise disproportionate control and influence over major corporate decisions.”

For shareholders and activists, Parsons’ opinion sets problematic precedent. Remember, Loeb hadn’t actually threatened to acquire Sotheby’s. He’d only called for management and governance changes at the time the pill was adopted. And his vehicle to effect change was a contest for shareholder votes. But under Parsons’ analysis, Unocal deference still applies to the adoption of a poison pill, even one that distinguishes between activist and passive investors. (Sotheby’s is apparently not the only company to have enacted such a pill, though it’s the first whose two-tiered, anti-activist pill was challenged in court.)

I’d argue, however, that Sotheby’s and its pill were the bigger losers. The company would not have settled with Loeb if it hadn’t been reasonably sure that his slate was going to be elected at the annual shareholder meeting. The pill, in other words, didn’t work. Loeb was limited to a 10 percent stake, but he was still on the verge of winning control of three board seats when Sotheby’s caved in. It’s true that by settling, the Loeb slate will join Sotheby’s directors on an expanded board rather than replacing three of the auction house’s nominees. That will dilute the Loeb block’s power a bit. On the other hand, Sotheby’s board can no longer pretend that Loeb is a “scumbag” to be excluded from control at all costs.

In the Sotheby’s case, in other words, corporate boards obtained legal precedent that permits them to fend off activist investors with the same defensive weapons they’d use in any other hostile takeover attempt. But they also found out that conventional weapons can’t assure victory against hedge funds working with other shareholders. For board members, that’s a very scary precedent.

(Reporting by Alison Frankel)

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