The Delaware Chancery Court recently struck down a supermajority bylaw adopted by a board of directors as a defensive response to the possibility of a hostile takeover attempt because the bylaw represented an "extremely aggressive" reaction that was not in proportion to the mild threat presented by an inadequately priced tender offer.
In early 1999, the management of two companies in the specialty packaging industry, Chesapeake Corporation ("Chesapeake") and Shorewood Packaging Corporation ("Shorewood"), each concluded that a merger with the other would be in the best interests of both. The respective boards, however, could not agree on which company should acquire the other and who should manage the resulting company. A contest for control ensued, with each company rejecting competing bids by the other.
In recognition that Chesapeake might attempt to gain control of Shorewood through a proxy fight or contested tender offer, the Shorewood board adopted a number of defensive bylaws designed to make it more difficult for Chesapeake to amend Shorewood's bylaws to unseat Shorewood's sitting board and install a new board amenable to its offer. These bylaws, among other things, eliminated the ability of stockholders to call special meetings and gave the Shorewood board control over the record date for any consent solicitation. The most important of these new measures was a bylaw that raised the percentage of votes required to amend the bylaws from a simple majority to 66-2/3% of outstanding shares (the "Supermajority Bylaw"). Because Shorewood's management controlled 24% of the company's stock, the supermajority bylaw made it mathematically impossible for Chesapeake to prevail in a consent solicitation without management's support, assuming only a 90% turnout.
In response, Chesapeake raised its offer, commenced a tender offer and consent solicitation, and commenced suit seeking to enjoin enforcement of the Supermajority Bylaw. On the eve of trial, the Shorewood board lowered the Supermajority Bylaw requirement from 66-2/3% to 60%.
In determining whether the Supermajority Bylaw was valid, the Delaware Chancery Court first applied the standard of review set forth in Unocal v. Mesa Petroleum Co. The court stated that when a corporation such as Shorewood opposes or defends against a hostile bid, to survive Unocal review, the corporation must establish that: (1) the board "after a reasonable investigation, . . . determined in good faith, that the [tender offer] presented a threat . . . that warranted a defensive response;" and (2) the defensive response taken was reasonable in relation to the threat posed.
As to the first prong, Shorewood identified two threats posed by the tender offer: (1) the price offered by Chesapeake was inadequate; and (2) there was a risk that Shorewood stockholders would not understand that the offer price was inadequate and would tender their shares as a result. The court found that Shorewood presented sufficient evidence to support its assertion that the price Chesapeake offered was inadequate. The court, however, rejected the contention that there was any realistic threat of shareholder confusion. As the court observed, Shorewood had mostly institutional investors who were not likely to be easily confused. Moreover, the court noted that by the time the Shorewood board voted on the Supermajority Bylaw, it knew that less than 1% of Shorewood's shares had been tendered to Chesapeake.
The court then considered whether the Supermajority Bylaw represented a proportionate response to the threat of price inadequacy. To pass muster under this prong of the Unocal test, the court stated that Shorewood must establish that the Supermajority Bylaw was not preclusive and that it was within a range of reasonable defensive responses. The court concluded that the Supermajority Bylaw failed on both counts. First, the court found that whether the Supermajority Bylaw required 60% or 66-2/3%, "victory is not realistically attainable" for Chesapeake in a solicitation. The court further found that the Shorewood board had failed to consider whether an outsider would have any possibility of success under the Supermajority Bylaw. Second, the court deemed the Supermajority Bylaw an "extremely aggressive and overreaching response to a very mild threat." The court noted that an aggressive communications plan or negotiations with Chesapeake to raise its offer price would have been more reasonable responses. Thus, the court held that the Supermajority Bylaw did not withstand scrutiny under Unocal.
Because the court found that the Shorewood board had clearly acted to interfere with or impede the exercise of the shareholder franchise, the court went on to review the Supermajority Bylaw under the standard set forth in Blasius Industries, Inc. v. Atlas Corp. Under such analysis, the Supermajority Bylaw could survive scrutiny only if there were a "compelling justification" for its adoption. Having already concluded that the threat of inadequate price was a mild one, the court held that no compelling justification was shown for the adoption of the Supermajority Bylaw. As the court noted, "[t]he defendants' belief that -- because of their superior access to company information - they 'know[ ] better than . . . the stockholders' about 'who should comprise the board of directors' provides no legitimate justification at all."
The court concluded that the information available to the Shorewood board in determining whether to adopt the Supermajority Bylaw was "grossly inadequate" and that the primary intent of the Shorewood board in adopting the Supermajority Bylaw was to entrench itself in power. The court thus ordered that partial final judgment be entered in Chesapeake's favor enjoining the Supermajority Bylaw. *
Chesapeake Corp. v. Shore, No. CIV. A. 17626, 2000 WL 193119 (Del. Ch. Feb. 11, 2000).