Recent Developments In Judicial Review of Interference With Stockholder Franchise: Chesapeake Corp. v. Shore

Corporate boards are subject to heightened judicial scrutiny when they respond to circumstances portending a potential change of control of the corporation. The standard of judicial review in such cases was addressed by the Delaware Supreme Court in Unocal Corp. v. Mesa Petroleum Co.¹ A subsequent Chancery Court decision in Blasius Indus., Inc. v. Atlas Corp.² articulated an even higher standard of scrutiny where a board's actions have the primary purpose of impairing the stockholder franchise. Following Blasius, Delaware courts have struggled with the question of whether and how Blasius should be applied in cases involving defensive responses that impact on stockholder voting rights. Specifically, will Blasius be treated as a standard of review independent of Unocal or should the Blasius analysis be incorporated within the framework of Unocal? In the recent case of Chesapeake Corp. v. Shore,³ the Delaware Chancery Court confronted the ambiguity of precedent and attempted to reconcile the issue of Blasius' status in the context of Unocal.

The Heightened Scrutiny Standard

It is well established that in the course of making business decisions, corporate directors have fiduciary duties requiring them to act in the best interests of the corporation and its stockholders. The duty of care requires a director to act on an informed basis while making decisions in the honest belief that they are in the best interests of the company; the duty of loyalty proscribes self-dealing and any form of misappropriation of assets entrusted to the supervision and management of a director.⁴

In Delaware, a board of directors is entitled to take steps to defend a corporation against certain threats from unsolicited offers. Delaware courts have recognized, however, that directors are often presented with an " 'inherent conflict of interest' when confronted with a potential for a change in corporate control '[b]ecause of the omnipresent specter that a board may be acting primarily in its own interests, rather than those of the corporation and its shareholders.' "⁵ Thus, under the standard established by the Delaware Supreme Court in Unocal, when directors address a pending threat to corporate control with defensive measures, they have the initial burden of showing that (1) there were reasonable grounds for believing that a danger to corporate policy and effectiveness existed warranting a defensive response and (2) their actions were "reasonable in relation to the threat posed."⁶ If the board makes such a showing, the burden shifts back to the party challenging the transaction. In Unitrin, Inc. v. American Gen. Corp., the Delaware Supreme Court held that unless a defensive measure is "coercive or preclusive," the board's actions need to fall within a "range of reasonableness" to be upheld.⁷

Blasius

The Delaware courts also have given heightened scrutiny where measures adopted by the board of directors implicate the stockholder franchise. The leading case in this area is Blasius Indus., Inc. v. Atlas Corp.⁸ The plaintiff in that case, Blasius Industries, the largest stockholder of Atlas Corporation, proposed to management that Atlas engage in a series of transactions involving a leveraged recapitalization and a distribution of cash to shareholders. The Atlas board, consisting of seven directors, rejected the Blasius proposal. Blasius then commenced a consent solicitation to take control of the Atlas board. The Blasius consent solicitation proposed to increase the size of the Atlas board from seven to fifteen members (the maximum number permitted under the Atlas charter) and nominate eight directors to fill a majority of the proposed seats. In order to prevent Blasius from gaining control of the corporation through the consent solicitation, Atlas' directors adopted a bylaw amendment adding two new seats to the board and appointing two new directors. With only six seats on the board now available, it was impossible for Blasius to elect a majority of the board through the consent solicitation.

In attempting to determine what standard of review to apply to the challenge of Atlas' actions, Chancellor Allen initially addressed the applicability of the Delaware Supreme Court's decision in Schnell v. Chris-Craft Indus., Inc.⁹ In Schnell, the court invalidated what it found to be an attempt by directors "to utilize the corporate machinery and the Delaware Law for the purpose of perpetuating itself in office."¹⁰ Chancellor Allen concluded that, unlike the board in Schnell, the Atlas board acted in good faith "in order to thwart implementation of the recapitalization that it feared, reasonably, would cause great injury to the Company."

In his analysis of the Atlas board's actions, however, Chancellor Allen observed that "[a]ction designed principally to interfere with the effectiveness of a vote inevitably involves a conflict between the board and a shareholder majority." The court held that this conflict should not be left to the board to resolve even if it acts in good faith. Thus, the court found, when a board acts "for the sole or primary purpose of thwarting a shareholder vote," it must overcome "the heavy burden of demonstrating a compelling justification for such action." In Blasius, the Atlas board was not able to satisfy that standard. In the court's view, the board faced a consent solicitation by a 9% shareholder, not a coercive action undertaken against the interests of a distinct shareholder constituency (such as a public minority) by a powerful shareholder. Moreover, the court concluded, the board had adequate time to inform the Atlas shareholders of its views on the merits of the Blasius proposal.

Post-Blasius Cases

On several occasions, Delaware courts have dealt with the application of the Blasius standard of review in cases where Unocal also would govern. Frequently, a hostile tender offer is joined with a proxy contest or consent solicitation, and board actions taken in response to a hostile tender offer often indirectly interfere with stockholder voting. In these cases, it is difficult to distinguish a board's legitimate attempt to counter a hostile tender offer, which is governed by the Unocal standard, with an impermissible attempt to impede stockholder voting, which is reviewed under the more rigorous Blasius standard. Thus, the issue before the court is whether Blasius' high, even onerous level of scrutiny an independent standard unto itself or a factor to be considered in the application of Unocal's more exacting standard.

In Stahl v. Apple Bancorp, Inc.,¹¹ for example, Chancellor Allen applied an arguably narrow reading of his decision in Blasius when he reviewed a board decision to defer the planned, but not declared, date of an annual meeting in response to a 30% stockholder's announced tender offer and proxy contest. The Chancellor declined to invoke Blasius' "close judicial scrutiny," stating that his earlier decision did not "represent new law" and that its reference to "compelling justification" simply reflected earlier cases' emphasis on the importance of voting rights. The court then upheld the board's actions under Unocal.

In another Chancery Court case, Kidsco v. Dinsmore,¹² a board, when faced with a simultaneous shareholder vote to adopt a board-approved merger agreement and a proxy contest by an insurgent shareholder to remove the board and elect new directors, delayed the proxy contest for 25 days. The target board argued that it delayed the proxy contest not to entrench itself, but to allow stockholders more time to consider the merger agreement without the distractions of a competing proxy contest. The court reviewed the Blasius standard but did not apply it, as it determined that the primary purpose of the board's actions was not to preclude effective stockholder action. Rather, the court accepted the board's argument regarding the reasons for its defensive measure and applied Unocal in upholding the board's actions. In the same vein, the Chancery Court did not apply Blasius in H.F. Ahmanson & Co. v. Great Western Fin. Corp.¹³ In that case, the court determined that a 50-day delay in holding an annual meeting would not frustrate the full exercise of the franchise by stockholders. For that reason, it found Blasius "inapplicable" and sustained the delay under Unocal.

The Delaware Supreme Court has acknowledged the Blasius doctrine in a line of cases, but has noted that the burden it imposes "is quite onerous, and is therefore applied rarely."¹⁴ In Stroud v. Grace,¹⁵ the Delaware Supreme Court reviewed a bylaw amendment requiring advance notice for the nomination of directors and permitting disqualification by current board members of the stockholders' nominees at any time before the election. The court held Unocal to apply to any defensive measure that touched upon an issue of a board's control, regardless of whether the measure affected stockholder voting. Stroud cited Blasius' admonition on the importance of protecting the stockholder franchise, but it did so "within Unocal's requirement that any defensive measure be proportionate and 'reasonable in relation to the threat posed.' " The court held that Blasius was applicable only when the board's "primary purpose" was interfering with or impeding exercise of the stockholder franchise. The board, it concluded, could not have had such a primary purpose because its members owned an absolute majority of the firm's stock and faced no threat to their control.

The Delaware Supreme Court voiced similar acceptance of the "basic tenets" of Blasius in Unitrin. In that case, the court reviewed a stock repurchase program undertaken as a defensive measure by the Unitrin board after rejecting as inadequate a bid by the American General Corp. for all of Unitrin's shares at a 30% premium above the market price. Under the terms of the program, Unitrin would repurchase up to 10 million of the corporation's 51.8 million outstanding shares, and the resulting percentage of Unitrin shares held by directors would increase from 23% to 28%. The court explicitly stated that it began its examination of the repurchase program "mindful of the special import of protecting the shareholder's franchise within Unocal's requirement that a defensive response be reasonable and proportionate," citing Blasius. However, the court did not mention Blasius again during the remainder of its opinion or apply the Blasius test. Rather, the court applied the Unocal standard, holding that the planned stock repurchase program would not have a preclusive effect on American General's ability to win a proxy contest. For the court, a preclusive measure would make American General's success either "mathematically impossible or realistically unattainable."¹⁶

In Carmody v. Toll Bros., Inc.,¹⁷ the Chancery Court reviewed a complaint attacking a "dead hand" poison pill, which could be redeemed only by the incumbent directors. The court conducted its analysis by looking at the standards of both Blasius and Unocal. Because the court held that the poison pill coerced stockholders to vote for incumbent directors as the only means of having a board that was authorized to redeem the pill, the court found the complaint asserted claims under both precedents. Blasius, it reasoned, covered a claim that directors unilaterally "create[d] a structure in which stockholder voting is either impotent or self defeating." At the same time, the coercive scheme was deemed sufficient to fall under Unocal's proscription of "disproportionate and unreasonable" defensive measures.

Chesapeake

In the recent case of Chesapeake Corp. v. Shore,¹⁸ the Chancery Court again faced the issue of how to apply Blasius in the context of Unocal. This case involved a contest for control between the Chesapeake Corporation, a Virginia company, and the Shorewood Packaging Corporation, a Delaware company. Each of the companies made merger proposals to the other's board, and the offer and counteroffer were each rejected as inadequate. Shorewood had a "poison pill" in place but realized that it was potentially vulnerable to a joint tender offer and consent solicitation.

After rejecting the Chesapeake offer, the Shorewood board was concerned about the possibility that Chesapeake would mount a consent solicitation to amend the Shorewood bylaws to eliminate its classified structure, replace the entire board in a single consent solicitation and then eliminate the poison pill to permit the Chesapeake merger proposal to go forward. To preclude this possibility, the Shorewood board met by phone and adopted a package of defensive amendments to the bylaws: eliminating the right of stockholders to call special meetings; eliminating the ability of stockholders to remove directors without cause; adopting procedures regulating the consent solicitation process that gave the board significant leeway to determine a record date; eliminating the stockholders' ability to fill board vacancies; and most significantly, the imposition of a requirement that a 66 2/3% supermajority of Shorewood's outstanding stock was needed to amend the company's bylaws (the "Supermajority Bylaw"). Since Shorewood management beneficially owned 24% of Shorewood's outstanding shares, it was mathematically impossible for an insurgent to amend the bylaws in a consent solicitation under the new Supermajority Bylaw, assuming 90% participation.

Following the rejection of its offer to the Shorewood board, Chesapeake separately purchased 14.9% of Shorewood's stock from its largest stockholder, Ariel Capital Management, Inc. (which had owned over 20% of Shorewood's shares), and proceeded to make an all-cash tender offer for all the shares of Shorewood. At the same time, Chesapeake announced a consent solicitation to amend the bylaws to remove the classified board provision and replace the current board members with new members who would remove the impediments to its tender offer. The Shorewood board rejected the tender offer as inadequate. About a week before the trial of Shorewood's claim challenging the validity of the Supermajority Bylaw, the Shorewood board held a brief telephonic meeting in which it passed a resolution further amending the Supermajority Bylaw, reducing the required stockholder vote needed to amend the bylaws from 66 2/3% to 60%. In arriving at its calculations, the board treated Chesapeake and Ariel as "interested" investors without considering whether its own members were "interested" under the same standard.

At trial, Chesapeake argued that the Supermajority Bylaw was intended to have and did have the effect of disenfranchising Chesapeake and precluded it from conducting a successful consent solicitation. Chesapeake claimed that the board was trying to entrench itself, a violation of its duty of loyalty, and that the board was uninformed in making its decisions, a violation of its duty of care. Chesapeake argued that its claim should be reviewed under the compelling justification standard of Blasius because the directors' primary purpose in amending the bylaws was to impede the stockholders from exercising their franchise. Shorewood's directors argued, on the other hand, that the Unocal standard alone was applicable because the Supermajority Bylaw was a defensive measure against a hostile tender offer.

The Court's Analysis

The court reviewed Blasius and its progeny to determine the circumstances under which the compelling justification standard should be applied and the relationship between the Blasius and Unocal standards. In Blasius, the court recalled, Chancellor Allen had voided board actions undertaken "for the primary purpose of thwarting the exercise of a shareholder vote." In the eyes of the Chesapeake court, however, the situation in Blasius -- namely, a case in which it was undisputed that the board's actions precluded the election of a new board majority and that the board intended that effect -- was not the usual case. More typically, "the question of whether the board's actions are preclusive is . . . hotly contested," and it is difficult to distinguish those cases where a board's "primary purpose" is to preclude the exercise of the stockholder franchise and those cases where board actions influence the process in legitimate ways.

The Chesapeake court suggested that "it may be optimal simply for Delaware courts to infuse our Unocal analyses with the spirit animating Blasius and not hesitate to use our remedial powers where an inequitable distortion of corporate democracy has occurred." The court, however, chose to follow its reading of precedent and apply Unocal and Blasius separately in a two-step inquiry. First, due to the defensive nature of the Supermajority Bylaw, the court stated that it would look at the bylaw under the Unocal standard. Second, after assessing whether the bylaw was a proportionate response under Unocal, the court would determine whether Blasius' compelling justification standard would be applicable. The court deemed this sequence of review as necessary because the question of justification and preclusion in a Unocal analysis affects the question of "primary purpose" under Blasius.

The first question considered by the court under Unocal was whether there were reasonable grounds to believe that Chesapeake's bid posed a legitimate threat. The Shorewood board had identified two major threats to justify the Supermajority Bylaw: price inadequacy of the Chesapeake tender offer, or "substantive coercion," and the risk of stockholder confusion arising from simultaneous consideration of a merger and an electoral contest. The court identified a number of relevant factors in reviewing the claim of substantive coercion, such as the nature of the stockholders (e.g. institutional), the information available about the company and the transaction, and the ability of the stockholders to become informed about the company. The court then found that the stockholders of Shorewood were mostly institutions, that the company was followed by several major brokerage houses and analysts, and that the company's plans and objectives were adequately disclosed and disseminated to its stockholders. Thus, while the court believed that the Shorewood board had good-faith reasons to find the price inadequate, it was unconvinced of the threat of stockholder confusion since the board did not "come close to demonstrating" its identification of such a threat "in good faith" and "after a reasonable investigation." Among other things, the board did not even informally attempt a survey of its largest stockholders to confirm the existence of stockholder confusion. On the day it adopted the Supermajority Bylaw, no discussion of confusion or other threats occurred, and outside factors such as the stockholders' unreceptiveness to Chesapeake's offer and analyst valuations of Shorewood did not point to confusion as a threat. The inherent conflict of interest facing directors, the court explained, made it necessary for courts to ensure that the threat of substantive coercion was "real and that the board asserting the threat is not imagining or exaggerating it." Since the court rejected the claim of stockholder confusion, only the issue of price inadequacy passed the first prong of Unocal.

The second prong of Unocal, as embraced by Unitrin, requires that a defensive measure must not be preclusive or coercive and must be reasonable in relation to the threat posed. The court noted that the threat of substantive coercion could be addressed only by defensive measures that were "time-limited and confined to what is necessary to ensure that the board can tell its side of the story effectively." The court also found that the board's action was preclusive to the ability of Chesapeake to mount a successful consent solicitation. To reach this conclusion, the court first reviewed the board's deliberative process and found that the board did not review alternative defensive measures, did not discuss the possible impact of the amended Supermajority Bylaw, and did not review the extent of the threat on the mostly institutional stockholders of Shorewood. The court found the Supermajority Bylaw to be "an extremely aggressive and overreaching response to a very mild threat" and thus not a reasonable response. After all, the court noted, the poison pill already in place had given the board "breathing room and precluded the Tender Offer," and the board's control of the record date "guaranteed adequate time for communications and counter-solicitation efforts, as well as for the board to develop and consider strategic alternatives." In the court's view, the board did have more proportionate options available, such as an aggressive communications plan or acceptance of Chesapeake's offer to negotiate price. The court then reviewed expert testimony and determined that it was not realistic for Chesapeake to succeed, even at the reduced 60% vote requirement. Thus, the court held that the board's actions made the insurgents' efforts not " 'realistically' attainable," as Unitrin defined preclusive,19 and, accordingly, the Unocal test was not satisfied.

After determining that the board did not have an alternate basis or justifiable reason for its defensive measures, the court turned to the Blasius test. Because it could find no legitimate, alternate purpose for the defensive measure, the court found that the "primary purpose" of the Supermajority Bylaw "was to impair Chesapeake's ability to win the Consent Solicitation by increasing the required majority Chesapeake needed to obtain to preclusive levels." The court cited several factors in support of its determination: the board's application of a different standard to Chesapeake's self-interest than to its own; the mathematical impossibility of Chesapeake winning under the 66 2/3% Supermajority Bylaw; and the Shorewood board's failure to consider whether Chesapeake would have a "reasonable chance to succeed" with the 60% Supermajority Bylaw in place. The "mild threat" Chesapeake posed to Shorewood with its tender offer, the court said, was not a compelling justification for the Supermajority Bylaw.

Conclusion

Like many cases before it, Chesapeake raises the issue of how Blasius is related to Unocal. The court raised questions regarding Blasius' continued viability as an independent standard, suggesting that "it may be optimal simply for Delaware courts to infuse our Unocal analysis with the spirit animating Blasius and not hesitate to use our remedial powers where an inequitable distortion of corporate democracy has occurred." Still, it applied the precedent as a separate standard, leaving open the door for other cases to raise the same questions. The Chancery Court's decision in Hills Stores Co. v. Bozic,20 decided eleven days after Chesapeake, cited the recent precedent to "admit that our case law often determines whether Blasius applies by examining whether the challenged corporate action is coercive or preclusive of electoral action, an exercise that is duplicative of Unocal." The court called this practice "unwieldy and redundant" and declined to extend it to a situation involving "corporate action not directed specifically at the electoral process." It is apparent, therefore, that where the franchise is implicated, litigants should be prepared for a court to discuss Blasius, though it still remains to be determined under what circumstances its "compelling justification" standard will apply. *

Frank J. Scaturro, an associate at the Firm, assisted in the preparation of this article.