the M&A journal Picking Your Poison Since their development more than 25 years ago, stockholder rights plans have been one of the more-effective defensive measures available to corporations. However, after the Children s Investment Fund s proxy fight with CSX and attempts by others to use derivatives in connection with takeover attempts, hostile offers and stockholder activism, corporations and their advisors are considering how to adapt existing defensive measures to address the use of derivatives and other forms of synthetic ownership. For some measures, such as bylaws that require the disclosure of beneficial ownership in connection with stockholder proposals, it is a simple matter of expanding disclosure. In contrast, poison pills represent a more challenging issue because rights plans involve not only measuring derivative ownership but also determining whether the triggering of such pills will have a dilutive impact on shares underlying derivative ownership and the practicality of identifying such shares in a time frame that will not have catastrophic impact on the market for the corporation s capital stock. A board considering adopting a poison pill that will include derivatives needs to assess the potential impact on the liquidity and value of the corporation s capital stock as well as the ability to administer the rights plan in the event the pill is triggered. Do traditional rights plans cover synthetic ownership? Maybe. Most rights plans will include as one of the prongs of beneficial ownership the definition of beneficial ownership under Rule 13d-3 promulgated pursuant to the Securities Exchange Act of 1934. In CSX Corp. v. The Children s Investment Fund Management (UK) LLP, 1 a U.S. District Court for the Southern District of New York avoided determining whether the ownership of total return swaps ( TRS ) constituted beneficial ownership of the underlying common stock held by the counterparty by instead concluding that use of TRSs without disclosure was an attempt to avoid the disclosure obligations under Regulation 13D and thus constituted beneficial ownership pursuant to Rule 13d-3(b). This ambiguity may be clarified as a result of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act ), which empowers the SEC to clarify by rule what forms of synthetic ownership constitute beneficial ownership under Section 13 of the Securities Exchange Act of 1934, as amended. Such clarification, as a result of the Dodd-Frank Act or otherwise, could transform most existing rights plans into poison pills covering synthetic ownership ( Derivative Rights Plans ) and require that corporations seeking to adopt or retain rights plans that do not consider synthetic ownership to explicitly carve-out such ownership. Rights plans that are automatically transformed would lack specific mechanics to address the difficulties in identifying the shares underlying synthetic ownership. A board considering Current Approaches to Derivative Rights Plans Most, if not all, Derivative Rights Plans that have been adopted only make changes to the definition of beneficial ownership (including through the use of other terms incorporated therein) and rely on the general mechanics of traditional rights plans to address the impact of synthetic ownership by an acquiring person. The adopting a poison pill that will include derivatives needs to assess the potential impact on the liquidity and value of the corporation s capital stock. 1 CSX Corporation v. The Children s Investment Fund Management (UK) LLP, et al., 08 Civ 2764 (LAK) (S.D.N.Y. June 11, 2008). Reprinted with permission of The M&A Journal. 11
continued lack of clarifying mechanics create uncertainty and differences in interpretations as to whether, absent explicit direction, the default would be to dilute as well as to count the shares that underlie synthetic ownership. For example, the rights plan adopted by Micrel, Inc. 2 includes in the definition of beneficial ownership any securities: that are the subject of a derivative transaction entered into by such Person, or derivative security acquired by such Person, which gives such Person the economic equivalent of ownership of an amount of such securities due to the fact that the value of the derivative is explicitly determined by reference to the price or value of such securities, without regard to whether (a) such derivative conveys any voting rights in such securities to such Person, (b) the derivative is required to be, or capable of being, settled through delivery of such securities, or (c) such Person may have entered into other transactions that hedge the economic effect of such derivative. In determining the number of Common Shares deemed Beneficially Owned by virtue of the operation of this Section 1.3(iv), the subject Person shall be deemed to Beneficially Own (without duplication) the number of Common Shares that are synthetically owned pursuant to such derivative transactions or such derivative securities. Furthermore, under the Micrel plan, like most rights plans, any rights (which would be registered securities) beneficially owned by an Acquiring Person are void. Thus, while the rights relating to shares that underlie the short side of synthetic interest may be beneficially owned by the actual owner of the underlying common stock, the rights are also beneficially owned by the long party to the synthetic transaction. As a result, at the very least, the better argument would be that Micrel s poison pill dilutes the shares held by the counterparty to a synthetic transaction with an Acquiring Person 3. However, the members of the firm that drafted Micrel s plan have written that Micrel s plan and similar plans do not dilute the counterparty. 4 As discussed below, a board considering adopting a Derivative Rights Plan that does not include specific language regarding what impact the poison pill would have on shares that are beneficially owned due to synthetic ownership should consider the risks to the corporation as a result of any corresponding uncertainty or if there is a dispute over its effects. Types of Derivative Rights Plans and why only Full Dilution Plans avoid attempts to game the system Derivative Rights Plans can be divided primarily into two categories: (i) plans that measure synthetic ownership only for purposes of determining whether a person has become an acquiring person but do not include such ownership for determining which rights will be voided ( Trigger Plans ) and (ii) plans that include synthetic ownership for determining whether a person has become an acquiring person and determining which rights are void ( Full Dilution Plans ). Trigger Plans have a fundamental weakness in that they allow a potential activist or hostile buyer to strategically avoid the dilution threat through the use of synthetic ownership. A person who has beneficial ownership exclusively through synthetic ownership would suffer no dilution under a Trigger Plan. A Trigger Plan could be triggered through this strategy but have no dilutive impact on any stockholder. Further, if the corporation were to seek to adopt a Full Dilution Plan following a person entering into long synthetic positions which would represent beneficial ownership in excess of the desired threshold for the Full Dilution Plan, the corporation might be open to the risk that the need to grandfather beneficial ownership at the time of adoption would include conversion of synthetic ownership into direct ownership so long as beneficial ownership was not increased. In contrast, a Full Dilution Plan prevents such direct attempts at avoiding the dilution threat of a Derivative Rights Plan. A Full Dilution Plan does, however, remain vulnerable to synthetic ownership that is based on a naked hedge and, as discussed below, the corporation may face difficulties in determining which entity owns the underlying shares. Moreover, a Full Dilution Plan requires a board to consider (i) if the potential impact on third parties will reduce the num- 2 Form 8-K filed by Micrel, Inc. on March 28, 2008. 3 It is most likely that this would only apply to a number of rights synthetically owned by the Acquiring Person ; however the plan only clarifies this issue with respect to the common shares. 4 Gerstein, Mark et al. The Resurgent Rights Plan: Recent Poison Pill Developments and Trends, pp. 17-21 (April 2009). 12
the M&A journal ber of parties that are willing to offer derivatives with respect to the corporation s capital stock, the overall availability of such derivatives, and any related impact on liquidity of the corporation s capital stock and (ii) whether the administrative difficulties in identifying the shares underlying the synthetic ownership, which could involve secondary, tertiary or more distant indirect contractual relationships, impose a significant risk of an implementation delay similar to that suffered by Selectica, Inc. when its poison pill was triggered, as discussed below. Liquidity Impact of a Full Dilution Plan A Full Dilution Plan works by diluting third parties that are not part of a group with an acquiring person but that actually own the shares underlying the synthetic ownership of the acquiring person. Due to the markets for TRS and other forms of synthetic ownership, these shares may not be owned by the party contracting with the acquiring person but may be several steps removed through additional TRS or other forms of synthetic positions with other third parties. As a result, any party that owns shares of the applicable entity and is considering entering into a short position with respect to such shares will face the risk that it would be diluted by the Full Dilution Plan due to one of its direct or indirect counterparts becoming an acquiring person. As such, in addition to ensuring that the contract governing the synthetic position provides full indemnification from the direct counterparty in such situation, the party writing the TRS may charge an increased fee or require increased margin requirements to reflect the potential for an immediate and dramatic reduction in the value of such securities. Also, there may be a reduction in parties willing to take a short position in the shares of a corporation that has adopted a Full Dilution Plan once market participants understand and internalize the inherent potential risk in each short synthetic transaction relating to an applicable security. 5 A board would need to consider whether such effects, if any, on the direct market for synthetic ownership of its shares would materially impact the liquidity of the market for its shares. Potential Administrative Difficulties Potentially the most significant hurdle in adopting a Full Dilution Plan is whether the corporation will be able to determine who owns the shares underlying the synthetic ownership of the acquiring person. While the acquiring person s Schedule 13D would need to disclose the parties to the contracts establishing its synthetic positions, such counterparties may not own the underlying shares and/or if the counterparty (or its affiliates) own shares of the corporation, which shares underlie the synthetic position. Furthermore, the corporation will want to avoid delays in establishing ownership of the underlying shares, to avoid the fate of Selectica. Selectica had trading in its stock halted for almost one month while it sorted out which rights were valid and which rights were void following the triggering of its rights plan by Triology, Inc, a competitor of Selectica that, with its subsidiary Versata Enterprises, was engaged in a commercial dispute with Selectica. The lack of liquidity caused by a prolonged halt in trading could be highly disruptive to both the corporation and its investors. However, in the event the SEC, pursuant to the authority granted under the Dodd-Frank Act, adopts regulations providing for reporting obligations with respect to short positions, such regulations may enable corporations to promptly determine who beneficially owns the shares underlying the synthetic ownership of the acquiring person. In the absence of such additional regulations, one potential method to incentivize direct counterparties of the acquiring person to provide Selectica had trading in its stock halted for almost one month while it sorted out which rights were valid. 5 The dilution risk to participants in the synthetic market for equity securities already exists regardless of whether a Full Dilution Plan is in place, as a corporation could adopt or amend its existing rights plan to become a Full Dilution Plan during the term of a synthetic contract and/or existing rights plans could be transformed into Full Dilution Plans in the event beneficial ownership under Rule 13d-3 is determined or amended to include synthetic ownership. 6 If this incentive were included, parties entering into synthetic positions in the applicable corporation s stock would need to require that all counterparties continuously provide updated information to identify the underlying shares and/or require that the owners of the underlying shares not dispose of such shares during the period of the synthetic position. 7 The acquiring person might consider entering into synthetic position with an entity that agrees it and its affiliates will not directly hold any corporation shares to limit the ability of the corporation to use the threat of dilution in order to force disclosure of the underlying shares. However, depending on the facts and circumstances, the corporation might argue that the failure to disclose the party with such entity covers such position could constitute an attempt to violate the disclosure obligations of Regulation 13D and thus violate Rule 13d-3(b). 13
continued the necessary information is to require that upon request of the corporation such parties must promptly identify the shares underlying the synthetic ownership of the acquiring person or such counterparty will be considered an acquiring person under the Full Dilution Plan. Treating an uncooperative counterparty as an acquiring person raises the potential threat of diluting all shares beneficially owned (including through synthetic ownership) by the acquiring person and, in many cases, be sufficient incentive for the counterparty to provide the necessary information to the corporation. 6, 7 A counterparty who could be treated as an acquiring person might assert that it is an innocent third party and challenge whether such treatment is a violation of the board s fiduciary duties. 8 However, each counterparty could avoid being treated as an acquiring person and limit its losses to the shares underlying the applicable synthetic ownership by identifying shares either in its or its direct or indirect counterparties possession 9 as the applicable shares. Thus, the only situation in which an economically rational counterparty would be treated as an acquiring person would be if it did not own a sufficient number of shares and thus its damages would potentially be less than if it could identify the applicable shares. Furthermore, any counterparty can protect itself against harm from a Full Dilution Plan (including one in which it could be treated as an acquiring person ) by requiring indemnification from its counterparties if it suffers dilution as a result of the other counterparties transactions. Evaluating the Risks In evaluating the benefits and risks of adopting a poison pill that will address synthetic ownership, a board of directors needs to consider both the immediate impact and the consequences in the event the plan is triggered. A board will need to consider how to weigh and discount those risks that would only surface in the event the pill was triggered to reflect the unlikelihood of such plan being triggered. In the history of modern poison pills, Selectica is the only corporation whose plan was triggered and the combination of circumstances surrounding such events would appear to be unlikely to replicate themselves, particularly as it relates to Derivative Rights Plans. 10 As such, a board of directors might determine that the deterrence of a Derivative Rights Plan outweighs the administrative risks in the event the plan is triggered, and focus more on the immediate impact of adopting such plan. Miss Kessler is our poison pill here at Tokan, Merle & Fender. Lee Lorenz/THE NeW YORKER COLLECTION/www.cartoonbank.com. All Rights Reserved. Daniel L. Serota 11 Special Counsel Sullivan & Cromwell MA 8 This risk may exist generally with respect to Full Dilution Plans as the only challenge in a Delaware court to a Full Dilution Plan (i) was on the basis of vagueness not whether it met a Unocal standard, (ii) was denied a preliminary injunction at least in part due to the lack of irreparable harm in waiting for a trial since the hostile bidder had withdrawn its offer and (iii) was settled prior to trial. In re Atmel Corporation Shareholders Litigation, Civil Action No. 4161-CC (Del. Ch.). 9 See footnote 7 regarding parties to synthetic transactions requiring its counterparties to provide information regarding the underlying shares. 10 Selectica s plan was designed to protect its net operating losses ( NOL ) tax credits and thus had a threshold of 5% (the threshold under the Internal Revenue Code for stockholders who will be considered in the evaluation of whether a change of control has occurred). This low threshold combined with Selectica s market cap of approximately $28 million at the time limited Trilogy Inc. s risk in triggering the pill as part of its strategy of forcing Selectica to settle unrelated commercial disputes and/or force the sale of Selectica to Trilogy. As synthetic ownership does not threaten the preservation of NOLs, Derivative Rights Plans would be used in the context of traditional corporate defense and normally would have thresholds in the 15% to 20% range, significantly increasing the cost of triggering such plans. 11 Daniel Serota (B.A., University of Michigan, 1998; J.D., Columbia University School of Law, 2001) is a special counsel in Sullivan & Cromwll LLP s general practice group specializing in Mergers and Acquisitions, Private Equity and Corporate Governance. Daniel was featured in the New York Times October 2, 2001 article The Facebook of Wall Street s Future as one of the approximately 100 individuals 40 years old or younger who make up the next generation of deal makers. The views expressed are those of the author and may not be representative of the views of Sullivan & Cromwell LLP or its clients. 14
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