We study the impact of Dead Hand Proxy Puts on shareholder value. Courts and commentators have characterized these terms as defenses against hedge fund activism that threaten to reduce firm value by entrenching underperforming managers and thereby increasing managerial agency costs. Our findings contradict this view. Using three court cases as a natural experiment, we find that shareholders do not react negatively to the inclusion of a Dead Hand Proxy Put in a firm’s loan agreements. Not only do Dead Hand Proxy Puts not destroy firm value, they may even preserve it by deterring activists who would seek to extract wealth from creditors and other nonshareholder constituencies. We develop the policy implications of these findings and offer a direction for the evolution of legal doctrine in this area.
Hedge fund activism is now a defining force in corporate governance. Having risen sharply over the last decade,1 hedge fund activism has entered a “second wave”2 or “golden age.”3 Activist hedge funds, acting alone or in “packs,”4 accumulate significant stakes in public companies5 and then seek institutional support in putting pressure on boards.6 Activists target firms they perceive to be undervalued and attempt to increase value through financial restructuring or through changes to management and business strategy.7
Shareholders benefit from hedge fund activism, at least in the short term.8 But creditors, in general, do not. From a creditor’s perspective, activist interventions threaten to increase repayment risk, either by leveraging up the firm to increase payouts to shareholders or through subtle changes in business strategy that have the effect of shifting risk to creditors and other constituencies.9 And incumbent managers, who typically lose their jobs after successful interventions, take an even less charitable view of hedge fund activism.10 The proliferation of defensive devices aimed at hedge fund activism is therefore unsurprising. Companies have adopted structural defenses to deter activists, such as low-threshold poison pills11 and bylaw amendments.12 In addition to these structural defenses, but perhaps less widely noticed, firms have begun to embed defenses against activists in their ordinary business contracts.13 This Article studies one such contractual term—the Dead Hand Proxy Put.
Dead Hand Proxy Puts trigger default and immediate repayment of corporate indebtedness in the event that a dissident slate of prospective directors wins a majority of seats on the target company’s board.14 Moreover, a Dead Head Proxy Put provides that only the creditor, not the shareholders or incumbent management, can waive the provision.15 The provision thus threatens to impose a significant cost on the corporation—repayment of the company’s outstanding indebtedness—if the incumbent board loses control in a proxy fight.16
The proxy fight is the activist’s ultimate weapon.17 Unlike bidders in a takeover battle, the activist’s endgame is not to buy the company but rather to exert control with a minority ownership interest—often no more than 10 percent of the target company’s outstanding shares.18 As a result, activists, unlike would-be acquirors, do not have sufficient financial backing to replace the company’s entire capital structure. The prospect of repaying the company’s outstanding debt can thus have a heavy deterrent effect on hedge fund activism. Moreover, once in place, the Dead Hand Proxy Put creates a strong incentive for shareholders to vote against an activist’s nominees in order to avoid forcing the corporation to incur the cost of repaying its debt.19 Furthermore, because only creditors can waive the provision, the incumbent board is powerless to prevent the default from occurring.20
Seizing on the defensive potential of the provision, the Delaware Court of Chancery moved to restrict it in a trio of recent rulings. In the first case, San Antonio Fire & Police Pension Fund v Amylin Pharmaceuticals, Inc,21 the court criticized the provision’s “eviscerating effect on the shareholder franchise” which might render it “unenforceable as against public policy.”22 In the second case, Kallick v Sandridge Energy, Inc,23 the court warned that the failure to approve dissident nominees could amount to a breach of fiduciary duty.24 Finally, in the third ruling, Pontiac General Employees Retirement System v Ballantine25 (“Healthways”), the court held that the deterrent effect of Dead Hand Proxy Puts allowed them to be challenged as a breach of fiduciary duty when adopted,26 thus unleashing a flood of shareholder claims aimed at eliminating the provision wherever it could be found.27
Commentators have likewise drawn on the analogy to takeover defense to criticize the potential of Dead Hand Proxy Puts to ward off activism and entrench underperforming managers.28 The premise animating the view of courts and commentators alike is that defensive provisions insulate managers from the market for corporate control, thereby increasing managerial agency costs and destroying firm value.29 Dead Hand Proxy Puts, in other words, function as entrenchment devices and, as such, destroy shareholder value.
We set out in this Article to test that proposition. If the prevailing view of courts and commentators is correct, the Dead Hand Proxy Put should decrease share price. We refer to this as the “entrenchment hypothesis” and devise a quasi-experimental research design to test it. Drawing on an original, hand-collected dataset of publicly traded firms that have adopted Dead Hand Proxy Puts, we analyze shareholder reactions to each of the Delaware Court of Chancery’s three Dead Hand Proxy Put rulings, comparing results for companies that have adopted the provision with results for companies that have not. Because the entrenchment hypothesis predicts a negative shareholder reaction to the provision and because each ruling restricts the provision, we predicted a positive share price reaction to each decision. We fail to find this, however, regardless of whether the companies are incorporated in Delaware and regardless of whether the companies are targets of shareholder activism.30 We find that shareholders do not react negatively to the inclusion of a Dead Hand Proxy Put in a firm’s loan agreements and, in at least some instances, they react positively to the provision. Our results thus fail to support the entrenchment hypothesis.
What explains these results? First, building on our companion paper finding that creditors discount the price of debt for firms that agree to the provision, Dead Hand Proxy Puts provide an important firm-level benefit.31 Nevertheless, our results are inconsistent with a simple story in which the benefit shareholders receive from the reduction in the cost of debt offsets the harm they suffer from the entrenchment potential of the provision.32 Instead, more persuasive explanations for our results emerge from a close focus on the nature of the compromise underlying the provision, from which a number of possibilities emerge. One possibility is that shareholders heavily discount the value of their votes and therefore are willing to trade their future value in exchange for an immediate discount in the cost of debt.33 Alternatively, the Dead Hand Proxy Put may represent an arrangement that effectively deputizes creditors as gatekeepers over beneficial versus destructive forms of shareholder activism.34
Fortunately, these alternative explanations point in a single direction for the formulation of legal policy. We have strong evidence of firm-level benefits from Dead Hand Proxy Puts and no evidence that the provision transfers value from shareholders to creditors (or managers). The provision, in other words, may create value rather than merely redistribute it. Dead Hand Proxy Puts should therefore not be banned, and entrepreneurial lawyers should not be rewarded for pressuring firms to eliminate them.35 Instead, courts should allow the provision to be liberally adopted. Nevertheless, due to the risk that managers will collude with creditors to use the provision for entrenchment rather than creditor protection, courts should scrutinize the conduct of boards when the provision is used in the context of a proxy fight, inquiring into whether waiver was sought, whether it was granted, and if not, whether it was validly denied.
From this Introduction, our Article proceeds as follows. Part I places Dead Hand Proxy Puts in context by reviewing the literature on hedge fund activism and private-ordering responses to it. Part II describes current judicial attitudes toward the provision. Part III presents the data used in our empirical analysis of Dead Hand Proxy Puts and supplies evidence on the effect of the provision on the price of debt. Part IV reports the results of our empirical tests on the effect of Dead Hand Proxy Puts on shareholder value. Part V evaluates possible explanations for our findings, and Part VI considers their implications for legal policy.
- 1. See John C. Coffee Jr and Darius Palia, The Wolf at the Door: The Impact of Hedge Fund Activism on Corporate Governance, 41 J Corp L 545, 553–56 (2016).
- 2. C.N.V. Krishnan, Frank Partnoy, and Randall S. Thomas, The Second Wave of Hedge Fund Activism: The Importance of Reputation, Clout, and Expertise, 40 J Corp Fin 296, 299–300 (2016).
- 3. Lucian A. Bebchuk, Alon Brav, and Wei Jiang, The Long-Term Effects of Hedge Fund Activism, 115 Colum L Rev 1085, 1087 (2015) (noting that “the media has been increasingly referring to the current era as ‘the golden age of activist investing’”).
- 4. See, for example, Alon Brav, Amil Dasgupta, and Richmond Mathews, Wolf Pack Activism *2, 11–34 (CEPR Discussion Paper No DP11507, Sept 2016), archived at http://perma.cc/D5PK-HWV7 (modeling conditions under which institutional investors may “act in groups to magnify each other’s influence,” forming “so-called ‘wolf packs’”); Marco Becht, et al, The Returns to Hedge Fund Activism: An International Study *10, 18, 42 (ECGI Finance Working Paper No 402/2014, Mar 2015), archived at http://perma.cc/3UB8-Q7E2 (finding that wolf packs are disclosed in 21.7 percent of activist events and that, when they are disclosed, wolf packs hold 13.4 percent of the target stock in aggregate, compared to approximately 8 percent holdings for hedge funds acting alone). But see Yu Ting Forester Wong, Wolves at the Door: A Closer Look at Hedge-Fund Activism *8–11, 45–47 (Columbia Business School Research Paper No 16-11, Oct 2016), archived at http://perma.cc/LXV8-GG84 (suggesting that wolf pack activity may be inferred when not disclosed).
- 5. See Lucian A. Bebchuk, et al, Pre-Disclosure Accumulations by Activist Investors: Evidence and Policy, 39 J Corp L 1, 4–5, 7–9 (2013) (analyzing activist investor 13D filings from 1994 through 2007 and finding that “hedge fund activists typically disclose substantially less than 10% ownership, with a median stake of 6.3%”).
- 6. Stuart L. Gillan and Laura T. Starks, The Evolution of Shareholder Activism in the United States, 19 J Applied Corp Fin 55, 55 (2007) (defining activists as “investors who, dissatisfied with some aspect of a company’s management or operations, try to bring about change within the company without a change in control”). See also Part I.A.
- 7. See Alon Brav, Wei Jiang, and Hyunseob Kim, Hedge Fund Activism: A Review, 4 Found & Trends Fin 185, 197–202 (2009) (summarizing objectives and strategies of hedge fund activists); Robin Greenwood and Michael Schor, Investor Activism and Takeovers, 92 J Fin Econ 362, 368–72 (2009) (finding that excess returns from hedge fund activism are most associated with the activist strategy of forcing target firms into a takeover).
- 8. See text accompanying notes 38–40.
- 9. See Kevin Miller, Food for Thought: Conflicting Views on the “Knowing Participation” Element of Aiding & Abetting Claims, 9 Deal Lawyers 1, 1 (Mar–Apr 2015) (“From the banks’ perspective, the election of a dissident stockholder’s nominees as a majority of the board of the borrower is likely to result in a material change in the business strategy and objectives of the board.”). See also text accompanying notes 49–52.
- 10. See Alon Brav, et al, Hedge Fund Activism, Corporate Governance, and Firm Performance, 63 J Fin 1729, 1732 (2008) (“[H]edge fund activism is not kind to CEOs of target firms. During the year after the announcement of activism, average CEO pay declines by about $1 million [ ], and the CEO turnover rate increases by almost 10 percentage points.”).
- 11. See, for example, Third Point LLC v Ruprecht, 2014 WL 1922029, *11–12 (Del Ch). See also Yucaipa American Alliance Fund II, LP v Riggio, 1 A3d 310, 359 n 254 (Del Ch 2010).
- 12. See Matthew D. Cain, et al, How Corporate Governance Is Made: The Case of the Golden Leash, 164 U Pa L Rev 649, 671–77 (2016) (describing the evolution of the golden leash bylaw, designed to prevent activists from providing incentive pay to their board nominees). Managers have also lobbied to close the ten-day 13D disclosure window in order to limit activists’ accumulation of shares. See Wachtell, Lipton, Rosen & Katz, Petition for Rulemaking under Section 13 of the Securities Exchange Act of 1934 *3–7 (Mar 7, 2011), archived at http://perma.cc/D8XP-4DYW (advocating closing the ten-day filing window under Section 13(d)). See also generally 15 USC § 78m(d) (requiring disclosure of acquisitions of block holdings over 5 percent); 17 CFR § 240.13d–1 (providing for filing within ten days of accumulation of the 5 percent block).
- 13. See Jennifer Arlen and Eric Talley, Unregulable Defenses and the Perils of Shareholder Choice, 152 U Pa L Rev 577, 597–605 (2003) (coining the term “embedded defenses” to describe defensive provisions that appear in ordinary contracts, such as loans and employment agreements, rather than the firm’s organizational documents, thereby intertwining the interests of shareholders and managers with third-party rights). Aside from the Dead Hand Proxy Put, a recent example of an embedded defense to hedge fund activism is the “Proxy Penalty” provision of certain intragroup contracts. See, for example, Ashford Hospitality Prime, Inc v Sessa Capital (Master), LP, 2016 WL 7852507, *1–2, 4 (ND Tex) (describing the “Proxy Penalty” provision of a management agreement involving a publicly traded real estate investment trust (REIT) that would cost the parent company “hundreds of millions” of dollars if triggered and therefore heavily impacted a proxy contest).
- 14. See notes 57–58 and accompanying text.
- 15. See Part I.B.2.
- 16. The cost is significant, but not necessarily preclusive. See notes 175–79 and accompanying text.
- 17. This is not to say that there is a proxy fight for board control in every activist intervention. There is not. But the proxy fight is the threat against which negotiated outcomes are reached. Any device, such as the Dead Hand Proxy Put, that weakens the activist’s ability to take control in a proxy fight also weakens the activist’s hand at the bargaining table, regardless of whether a proxy fight is ultimately launched. See Russell Korobkin, Negotiation Theory and Strategy 140–44 (Wolters Kluwer 3d ed 2014).
- 18. Dionysia Katelouzou, Worldwide Hedge Fund Activism: Dimensions and Legal Determinants, 17 U Pa J Bus L 789, 800–01 (2015) (noting that “although hedge fund activism does not generally involve controlling blocks, it does involve large minority blocks with the median maximum activist blocks being around 10 percent”).
- 19. Even in campaigns in which the activist runs a “short slate,” seeking less than a majority of the board, the provision may encourage shareholders to vote against activist nominees in order to avoid triggering default in a subsequent election. See Coffee and Palia, 41 J Corp L at 560 (cited in note 1) (noting that “most proxy contests initiated by hedge funds today are for a minority of the board”).
- 20. More specifically, waiver is a realistic option for bank loans, but not for bonds. See Part I.B.2.
- 21. 983 A2d 304 (Del Ch 2009).
- 22. Id at 315.
- 23. 68 A3d 242 (Del Ch 2013).
- 24. Id at 261.
- 25. Transcript of Oral Argument on Defendants’ Motions to Dismiss and Rulings of the Court, Pontiac General Employees Retirement System v Ballantine, Civil Action No 9789-VCL (Del Ch Oct 14, 2014) (available on Westlaw at 2014 WL 6388645) (“Healthways Transcript”).
- 26. Id at 74 (emphasizing that under a rights plan with a dead hand feature “the stockholders would be deterred, they would have the Sword of Damocles hanging over them, when they were deciding what to do with respect to a proxy contest. There wasn’t a requirement that an actually [sic] proxy contest be underway”).
- 27. See Liz Hoffman, Banks Feel the Heat from Lawsuits (Wall St J, Apr 28, 2015), online at http://www.wsj.com/articles/banks-feel-the-heat-from-lawsuits-1430259260 (visited Feb 15, 2017) (Perma archive unavailable). See also Plaintiffs’ Firms Seek Quick Money by Challenging “Dead Hand Proxy Puts” in Debt Agreements (Wilson Sonsini Goodrich & Rosati, June 9, 2015), archived at http://perma.cc/6653-M6WJ (referring to Dead Hand Proxy Put challenges as “the latest trend in strike suits”); T. Brad Davey and Christopher N. Kelly, Dead Hand Proxy ‘Puts’ Face Continued Scrutiny from Plaintiffs Bar (Bloomberg BNA, June 12, 2015), archived at http://perma.cc/PB98-GEBL (referring to Dead Hand Proxy Puts as the “target du jour” for shareholder plaintiffs).
- 28. See, for example, Stephen Byeff, Note, The Spirit of Blasius: Sandridge as an Antidote to the Poison Put, 115 Colum L Rev 375, 393–95 (2015); Danielle A. Rapaccioli, Note, Keeping Shareholder Activism Alive: A Comparative Approach to Outlawing Dead Hand Proxy Puts in Delaware, 84 Fordham L Rev 2947, 2982–86 (2016) (advocating banning Dead Hand Proxy Puts by analogy to dead hand poison pills); Steven Davidoff Solomon, A Defense against Hostile Takeovers Develops a Downside (NY Times, Nov 25, 2014), archived at http://perma.cc/7DFD-WJ8U (criticizing the transformation of proxy puts from a “well-intentioned way to protect debt holders” to a maneuver designed to “entrench existing boards”).
- 29. See Henry G. Manne, Mergers and the Market for Corporate Control, 73 J Polit Econ 110, 112–13 (1965) (describing the market for corporate control and the correlation between managerial efficiency and share value). See also Lucian Arye Bebchuk, Why Firms Adopt Antitakeover Arrangements, 152 U Pa L Rev 713, 720 (2003) (“When managers have less to fear from takeovers, they fail to reduce costs and have poorer operating performance, including lower profit margins, return on equity, and sales growth.”); Frank H. Easterbrook and Daniel R. Fischel, The Proper Role of a Target’s Management in Responding to a Tender Offer, 94 Harv L Rev 1161, 1174 (1981) (“[A]ny strategy designed to prevent tender offers reduces welfare.”).
- 30. See Part IV.B.
- 31. Sean J. Griffith and Natalia Reisel, Dead Hand Proxy Puts, Hedge Fund Activism, and the Cost of Capital *19–20 (unpublished manuscript, Sept 2016), archived at http://perma.cc/LK99-YMRX.
- 32. If the reduction in the price of debt simply offsets the entrenchment effects, we would expect a strong positive reaction to the cases from those firms with the provision in place. For such firms, any potential unenforceability of the provision would be a boon considering that they had already locked in the benefit of a lower cost of debt, now without the concomitant entrenchment burden. However, we do not find this reaction to the cases. See Part IV.B (reporting results of the event studies); Part V.D (rejecting the offset hypothesis).
- 33. See Part V.B.
- 34. See Part V.C.
- 35. Entrepreneurial lawyers are awarded fees on the basis of creating a “corporate benefit.” See Sean J. Griffith, Correcting Corporate Benefit: How to Fix Shareholder Litigation by Shifting the Doctrine on Fees, 56 BC L Rev 1, 19–26 (2015) (describing and critiquing court practices of awarding attorneys’ fees under the “corporate benefit” doctrine). See also generally John C. Coffee Jr, Entrepreneurial Litigation: Its Rise, Fall, and Future (Harvard 2015) (discussing the evolution of attorney-driven entrepreneurial litigation and making predictions for its future). However, our findings suggest the elimination of a Dead Hand Proxy Put produces no benefit and may in fact harm the corporation. See The Fire and Police Pension Fund, San Antonio v Stanzione, 2015 WL 881045, *1 (Del Ch) (awarding minimal attorneys’ fees for elimination of a Dead Hand Proxy Put). See also Opening Brief in Support of Plaintiff’s Application for an Order Dismissing this Action as Moot and for an Award of Attorneys’ Fees and Expenses, The Fire and Police Pension Fund, San Antonio v Stanzione, Civil Action No 10078-VCG, *1–2 (Del Ch filed Jan 14, 2015) (available on Westlaw at 2015 WL 230365) (“Stanzione Fee Petition”) (describing the nature of the case).