Poison Pill’s Relevance in the Age of Shareholder Activism

When we look back 20 years from now, the lawsuit by Daniel S. Loeb and his Third Point hedge fund against Sotheby’s may well be the tipping point in how far companies can go to defend themselves against shareholder activists.

Sotheby’s has become a hedge fund hotel as a number of funds, including Eton Park and Marcato Capital Management, have taken positions in the company. Leading the charge is Third Point, which has taken a 9.62 percent position in the auction house and is running a proxy contest to replace three of Sotheby’s directors, comparing Sotheby’s to “an old master painting in desperate need of restoration.”

Sotheby’s has based its defense on an increasingly common tactic: a low-threshold poison pill. Back in October, it adopted a poison pill that effectively limits the ownership by any single investor in the company. But Sotheby’s pill is clearly aimed at the hedge funds, and Mr. Loeb in particular. The pill set two different limits for ownership â€" a 20 percent limit for passive investors like mutual funds and a lower 10 percent threshold for activist shareholders. The poison pill lasts for only a year, but it can be renewed at will.

Third Point has sued Sotheby’s in Delaware Chancery Court in March, challenging the poison pill as illegal since it limits the hedge fund’s ability to purchase more shares and thus have a greater likelihood of winning the proxy contest.

The Sotheby’s defense is part of a new turn in the use of poison pills against activists.

Poison pills were invented to fight off hostile raiders intent on taking control of a company. This was back in the 1980s when the raiders were literally that â€" investors who would take control of a company, perhaps “stripping” it off of its assets as the Carl Icahn did with TWA. Poison pills were challenged in the courts as unduly restricting the right of shareholders to sell their shares and reap a fat takeover premium, but the pill was upheld most prominently by the Delaware Supreme Court back in 1986. Since that time, poison pills have become common and are almost always adopted by companies faced with a hostile takeover.

But hostile takeovers are now rare events. Instead, shareholder activism has taken over with a vengeance, with even Carl Icahn reinventing himself as a shareholder advocate.

Just as the hostile raiders are reinventing themselves, the tools invented to fight off hostile raiders are now being reworked and used to fight off activists like Mr. Loeb.

The question now is whether the old cases upholding the poison pill will still apply in the case of activism. This is the fundamental question in the Sotheby’s case.

Most companies, including Sotheby’s are incorporated in Delaware, and so subject to Delaware law. Under Delaware law established primarily back in the 1980s, Delaware courts will review the legality of a poison pill under the so-called Unocal standard. This standard was first put forward in litigation involving the hostile bid by T. Boone Picken’s Mesa Petroleum for the Unocal Corporation in 1985.

When a corporate board adopts a defense against a takeover like a poison pill, the Unocal standard requires that the board show that it is acting against a threat to the company and that the board’s actions are reasonable to the threat posed.

That’s the legal standard, and it appears to apply some limits on what a board can do in response to a hostile takeover. But in practice, the Delaware courts have repeatedly held that a poison pill is a valid response to a hostile takeover. The issue came up most recently in 2011 in Air Products’ hostile bid for Airgas. In that case, a Delaware court held that a board could put a poison pill in place to block a hostile bid even if the hostile offer was fair and the target company’s shareholders appeared willing to accept the offer. The court reasoned that Delaware law gave boards the power to make such judgments. If shareholders did not like it, they could eventually replace the directors. In other words, the channel for a company’s change of control today is through the board.

This is the historical background for the Sotheby’s case. But in a shareholder activism situation, the motivations are different than in a hostile takeover. In a hostile takeover, the company is about to undergo a change of control that will end its independence. Back in the 1980s â€" the era of Gordon Gekko and the hostile raider â€" this may have led to the death of the company through liquidation (at least that was the popular perception). From that perspective, the corporation might be harmed if the takeover occurred or shareholders would lose their ability to influence or own the company. The poison pill thus made sense because it allowed an independent board to make more sober decisions about the long-term future and value of the company.

But with shareholder activism, the issue is about steering the future direction of the company, not eliminating shareholders or the company itself. The company’s future independence or survival is not the primary question.

Though the issues may be different, shareholder activism is as debated now as takeovers were back in the 1980s. Critics of shareholder activists argue that they are forcing the company to take short-term actions that are detrimental to the long-term interests of both shareholders and companies.

A number of studies have found that is not the case and that activism does create long-term shareholder value. Clearly, though, there is still questionable corporate activism like the proposals by Mr. Icahn and David Einhorn’s hedge fund Greenlight Capital on what Apple should do with its cash hoard.

The studies are not definitive and the debate continues over whether activism poses the same threat as the hostile takeover. There is one clear difference â€" activism is about enhancing shareholder value, while in a hostile takeover the claim was that shareholders were being taken advantage of.

This is what is at stake in the Sotheby’s case. Should the same legal standards developed in the 1980s to fight a different perceived threat apply to a very 2014 phenomenon?

In at least one prior case involving Ron Burkle’s private equity firm Yucaipa and Barnes and Noble, a Delaware court upheld a poison pill that limited Yucaipa to a 20 percent stake while allowing Barnes & Noble’s chief executive, Leonard Riggio, a 30 percent stake. But the court in that case based its holding on the fact that the poison pill prevented a “creeping acquisition” while giving Mr. Burkle the chance to run an “effective proxy contest.”

Mr. Loeb’s Third Point is not out to acquire the company and, to avoid running afoul of the Barnes & Noble decision, is claiming that its acquisition of Sotheby’s shares is about being able to run an effective proxy contest and, therefore, the poison pill is not a reasonable response. Third Point stated in its complaint that “the Board has no genuine concern with a takeover attempt” and instead is trying to “thwart Third Point, Sotheby’s largest stockholder, from effectively running a slate of director candidates.”

Sotheby’s is trying to differentiate its case from the prior cases upholding the poison pill. Sotheby’s will probably argue differently and has instead stated that the poison pill was adopted “to protect stockholders from coercive or otherwise unfair takeover tactics.” Sotheby’s is simply trying to apply the old law that clearly allows the company to adopt a poison pill. Even if the old law applies, Sotheby’s will simply be arguing that shareholder activism is a sufficient threat to justify the pill.

That’s the big difference between the two positions. There is a hearing on the case on April 29. The question now is whether the judge in the matter, Vice Chancellor Donald F. Parsons Jr., upholds the old law or decides to rule the pill illegal and create new laws to deal with the new phenomenon of shareholder activism. It is truly the corporate question of our time.