Background
In late October 1999, the Shorewood Packaging Corporation, a Delaware corporation, made an all-cash offer for all shares of the Chesapeake Corporation, a Virginia corporation. Chesapeake responded by offering to purchase all of Shorewood's shares for a 40 percent premium over then current trading levels.
After concluding that the Chesapeake offer was inadequate, the Shorewood board adopted a series of defensive bylaws to supplement the company's pre-existing poison pill. These amendments were specifically designed to make it more difficult for Chesapeake to eliminate Shorewood's classified board structure, remove the incumbent directors and take control of the new board. The most significant of these amendments was a two-thirds supermajority voting requirement for shareholder-initiated bylaw changes. At the time, management insiders had the ability to control almost 24 percent of Shorewood's outstanding shares.
Chesapeake subsequently purchased 14.9 percent of Shorewood's outstanding shares from Ariel Capital Management, Inc., Shorewood's largest shareholder. On December 3, Chesapeake commenced an all-shares tender offer for Shorewood at $17.25 per share, announced a consent solicitation to amend Shorewood's bylaws to eliminate the classified board provision, remove the sitting members of the Shorewood board and elect a new board and also initiated litigation to enjoin the defensive bylaws.
On December 15, the Shorewood board unanimously rejected the Chesapeake tender offer as inadequate. Early returns showed that less than one percent of the Shorewood shares had been tendered to Chesapeake. The Court expedited Chesapeake's litigation and the parties agreed to conduct a trial limited to the validity of the supermajority bylaw and two of defendants' counterclaims. A little over one week before trial, the Shorewood board reduced the supermajority voting requirement from two-thirds to 60 percent.
Shorewood's "Unusual Presentation"
Before evaluating the evidence presented at trial, Vice Chancellor Strine observed that Shorewood's "unusual presentation" of its case had hindered the court's ability to evaluate the supermajority bylaw's validity. The Court's decision suggests that this litigation approach undermined the board's effort to convince the Vice Chancellor that the supermajority bylaw was justified.
First, the Court stated that the defendants had elected not to present testimony at trial from any of Shorewood's "key insiders," offering instead only the testimony of two directors who first joined the board in 1999. The Court observed that '"[t]he production of weak evidence when strong is, or should have been, available can lead only to the conclusion that the strong would have been adverse."' (quoting Kahn v. Lynch Communications Sys., 638 A.2d 1110 (Del. 1994)).
Second, the Court stated that Shorewood had invoked the business strategy and attorney-client privileges "whenever it could," thus keeping "virtually all" of the professional advice given the board - both from their legal and investment banking advisors - from the plaintiffs and the Court. Although Shorewood had refused to disclose this advice, the Court noted that defendants had nevertheless "attempted to use some of this concealed advice as a sword." For example, the defendants sought to establish that they had hired investment bankers to explore strategic alternatives, yet consistently refused to allow Chesapeake to inquire "even as to the basic nature of those alternatives." The Court held it would be "inequitable" to allow the defendants to use the hiring of advisors to support their defense, stating "the only fair way to proceed is not to give any weight to any advice of this nature or to defendants' supposed search for alternatives. The potential for abuse is simply too great."
The Appropriate Standard of Review
As a threshold issue, the court addressed the appropriate standard of review to govern its examination of the supermajority bylaw's validity. The defendants argued that the standard of review set forth in Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946 (Del. 1985) should apply. Under Unocal, the courts apply enhanced scrutiny to defensive conduct by directors; the board must show that it had reasonable grounds to believe that a danger to corporate policy and effectiveness existed and that the defensive measures adopted were reasonable in relation to the threat posed. Chesapeake, however, argued that the standard articulated in Blasius Industries, Inc. v. Atlas Corp., 564 A.2d 651, 661-62 (Del. Ch. 1988) should be employed under which directors who act "for the sole or primary purpose of thwarting a shareholder vote" must overcome the "heavy burden of demonstrating a compelling justification for such action." The Court agreed with the defendants, holding that because of the bylaw's defensive origin, the Unocal standard should apply.
However, the Court noted the "overlap" and "interrelationship" between the two standards and observed that "one might reasonably question to what extent the Blasius 'compelling justification' standard of review is necessary as a lens independent of or to be used within the Unocal frame." The Court suggested that rather than have an additional standard of review, "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."
Nevertheless, stating he was obligated to apply the law as it exists, Vice Chancellor Strine examined the supermajority bylaw's validity, first "employing purely the Unocal standard" and then determining whether the Blasius compelling justification standard is implicated.
The Issue of Substantive Coercion
At the outset of his opinion, Vice Chancellor Strine offered a series of "preliminary thoughts" on the use of "substantive coercion" as a threat justifying defensive measures. Substantive coercion refers to the threat posed by a tender offer which the board has concluded provides shareholders with less value than they will ultimately receive from implementation of the company's strategic plan (even though the market has not yet accepted that rationale) thereby creating a risk that shareholders will tender as a result of confusion about the company's true value.
While the Court noted that remedies for such shareholder confusion might be providing the market with adequate information or allowing the board additional time to search for a better alternative, it recognized that the Delaware courts had authorized defensive responses that "arguably go far beyond" such remedies, citing Unitrin, Inc. v. American General Corp., 651 A.2d 1361 (Del. 1995), where the Delaware Supreme Court held that a stock repurchase program did not necessarily constitute a disproportionate response to an all-cash, all-shares premium tender offer.
Vice Chancellor Strine stated that despite the leeway granted a board, he was nevertheless obligated to undertake a "serious examination" of the legitimacy of the board's identification of substantive coercion as a threat to "ensure that the threat is real and that the board asserting the threat is not imagining or exaggerating it." He warned that such scrutiny was particularly important given that substantive coercion "can be invoked by a corporate board in almost every situation" as "[t]here is virtually no CEO in America who does not believe that the market is not valuing her company properly" and directors can easily assert that they possess greater knowledge about the company than the shareholders. The "threat that stockholders will be confused or wrongly eschew management's advice is omnipresent" and therefore the use of this defense "could easily be subject to abuse."
As further justification for undertaking a meaningful review of the legitimacy of the substantive coercion defense, the Court cited the possibility that even well-intentioned interested directors could "subconsciously be motivated by the profoundly negative effect a takeover could have on their personal bottom lines and careers" and the fact that the defense is generally asserted where the tender offer involves a substantial premium over prior trading levels. In analyzing assertions of shareholder confusion, Vice Chancellor Strine suggested that "[o]ur law should also hesitate to ascribe rube-like qualities to stockholders. If stockholders are presumed competent to buy stock in the first place, why are they not presumed competent to decide when to sell in a tender offer after an adequate time for deliberation has been afforded them?"
Vice Chancellor Strine acknowledged, however, that Unitrin did mandate "a reasonable degree of deference to a properly functioning board that identifies a threat and adopts proportionate defenses after a careful and good faith inquiry."
The Unocal Standard
The Court stated that under Unocal, the Shorewood board was required to establish that: (i) it had reasonable grounds to believe that Chesapeake's bid threatened corporate policy and effectiveness; and (ii) the defensive measures adopted were reasonable in relation to that threat. While the Court noted that a majority of outside independent directors "materially enhance[s]" a board's ability to satisfy this standard, Shorewood's board was entitled to less deference because six of its nine members were not independent.
Prong One of Unocal: The Threat to Shorewood
The Court addressed the two major threats relied upon by the Shorewood board to justify its supermajority bylaw: (i) price inadequacy; and (ii) the risk of stockholder confusion.
As to price inadequacy, the Court stated that the board made a reasoned judgment that Chesapeake's $16.50 per share offer and $17.25 per share tender offer were inadequate. However, with respect to the gravity of the danger posed by the tender offer, the Court concluded that defendants had not shown it was "a particularly dangerous one" in light of: (i) Shorewood's poison pill, (ii) Chesapeake's indication that its offer was negotiable, (iii) the board's failure to demonstrate that its current strategic plans would generate a higher realizable value in the relatively near future than $17.25, and (iv) the offer's lack of structural coercion. The Court noted that Shorewood's assertion of the business strategy privilege had "cut off any ability of the court to assess how inadequate the Chesapeake offer really is."
But as to the risk of shareholder confusion, the Court held that the Shorewood board "has not come close" to satisfying its burden that "it identified this threat at any time" in good faith following reasonable investigation. Vice Chancellor Strine stated that the defendants themselves had admitted that Shorewood had already disclosed all material information regarding the business factors that shareholders, in the board's view, might have failed to understand. Furthermore, in its deliberations, the directors seemed to have "slighted, if not totally disregarded, key issues" such as that:
(i) institutional investors and management held over 80 percent of Shorewood stock; (ii) analysts followed Shorewood and were regularly briefed by management on the company's strategy and initiatives; (iii) Shorewood had disclosed information about these strategic issues; (iv) analysts had already factored these strategic issues into their reports; and (v) Shorewood's board had the opportunity to address any confusion through more complete and consistent disclosures to stockholders.
The Court stated that by the time the Shorewood board had modified the bylaw before trial, the threat of confusion was even less as under one percent of the company's shares had been tendered to Chesapeake, analysts had continued to value the company at a price higher than the Chesapeake offer, the company's 14D-9 filing had addressed all of the strategic issues shareholders may not have understood and the directors themselves controlled the record date for the consent solicitation. For these reasons, "Shorewood seemed to be in an excellent position to win a vote on the merits, without additional procedural help. Yet on the day it adopted the final Supermajority Bylaw, the board never assessed whether the supposed threat of confusion still existed." Accordingly, Vice Chancellor Strine concluded that "the threat of confusion emerges more as a post hoc, litigation-inspired rationale ... than as a serious threat identified as a genuine concern by the board."
Prong Two of Unocal: Was the Bylaw a Proportionate Response?
The Court then examined whether the supermajority bylaw was a proportionate response to the threat identified by the board.
First, Vice Chancellor Strine held that the board had failed to show that the supermajority bylaw was not preclusive. It stated that the Shorewood directors "simply made no judgment at all whether it was 'realistically' attainable for Chesapeake to amend the Shorewood bylaws in the face" of the supermajority voting requirement. The Court noted that the board "did not even discuss this issue," citing as "an indication of how blind the Shorewood board was" to the bylaw's preclusive effect, its adoption of a two-thirds voting requirement although it was "mathematically impossible" for Chesapeake to prevail even in a consent solicitation involving a 90 percent turnout, assuming board opposition.
The Court stated that the board had failed to consider several other relevant issues, including the historic turnout in shareholder elections, the electorate's composition and the management holders' self-interest. "The board's impoverished deliberations were only once supplemented by expertise and that consisted of less than five minutes of input from a [proxy solicitor] who opined without much preparation that 95 percent of the electorate would vote. [He] appears to have been asked no questions and never was asked to advise whether an insurgent could realistically attain victory in the face of the Supermajority Bylaw."
Moreover, the Court held that the expert testimony at trial did not support Shorewood's arguments concerning the validity of the bylaw, assuming such evidence was relevant, noting that "post hoc analyses prepared for trial should not be able to buttress a board's Unocal showing in a situation where the board's own deliberations were grossly inadequate." It found unpersuasive the Shorewood expert's opinion that voter turnout for the consent solicitation would be 95 percent because, among other reasons, the expert did not account for the board's failure to order a list of non-objecting beneficial owners. The Court added that plaintiff's expert did not identify "any situation where an insurgent had been able to obtain a 60% supermajority when opposed by a 20-24% management block."
The Court also rejected the Shorewood board's argument that it subsequently selected 60 percent as a threshold voting requirement because such a majority would enable a majority of disinterested stockholders to decide whether the bylaws should be amended. The Court stated that while the board treated Ariel as an interested shareholder, it: (i) failed to consider whether its own members might be interested (by reason of their financial arrangements with the company) and would therefore oppose Chesapeake's solicitation, and (ii) ignored that they themselves had already committed to oppose the consent solicitation, thus rendering their votes unavailable to Chesapeake.
The Court therefore concluded that Chesapeake would be required to obtain "far higher" than 60 percent of the disinterested votes. Vice Chancellor Strine found no evidence to suggest that any insurgent could obtain such a high level of support in the face of management opposition, observing that such "disinterested majorities are more commonly associated with sham elections in dictatorships than contested elections in genuine republics."
The Court also rejected the board's attempt to show that the supermajority bylaw was within the range of reasonable responses, finding that it constituted "an extremely aggressive and overreaching response to a very mild threat." The Court cited Shorewood's poison pill, the defensive bylaws eliminating Chesapeake's ability to call a special meeting (thereby requiring an insurgent to proceed through the slower avenue of a consent solicitation) and the board's control over the record date as factors which would have allowed the board to address the threat through "less extreme and more proportionate options," such as an aggressive communications plan or accepting Chesapeake's offer to negotiate the price and structure of the offer.
Blasius Review
Vice Chandler Strine also held that the Blasius compelling justification standard applied because the primary purpose of the board's action was to impair Chesapeake's ability to prevail in the consent solicitation. The Court stated that the "mild threat" posed by the Chesapeake offer did not provide a compelling justification for the supermajority bylaw.
Defendants' Counterclaims
The Court dismissed the defendants' counterclaim that Delaware Code ' 141 prohibited Shorewood's shareholders from voting to eliminate the company's classified board structure and elect new directors on grounds that it ignored the plain language of the statute. To adopt the defendants' argument, the Court added, would "greatly frustrat[e]" the ability of shareholders "to implement a governance structure more immediately responsive to their will."
Vice Chancellor Strine also rejected the defendants' counterclaim that Chesapeake's agreement with Ariel rendered Chesapeake an interested shareholder and thus prohibited under Delaware Code ' 203 from entering into a business combination with Shorewood for three years.