Corporate Update

Delaware Chancery Court Confirms Validity of Barnes & Noble’s Shareholder Rights Plan

On August 12, 2010, Vice Chancellor Strine issued his opinion in Yucaipa American Alliance Fund II, L.P. v. Riggio, in which the court affirmed the validity of a shareholder rights plan applying the Unocal standard of review. The opinion is noteworthy because it reaffirms the standard to be applied in reviewing the adoption of shareholder rights plans, addresses whether, in adopting a defensive measure, a board of directors acted reasonably in concluding that a large shareholder presented a threat even though that shareholder had not proposed a takeover, confirms that existing large shareholders may be subject to higher triggering thresholds as compared to other shareholders and provides directors with helpful guidance when considering the adoption of rights plans in the future.

Background

The case was brought by Yucaipa American Alliance Fund, a fund controlled by Ronald Burkle, against Barnes & Noble, Inc. (“B&N”) and the members of B&N’s board of directors alleging that the board of directors had breached its fiduciary duties in adopting a shareholder rights plan in November 2009. In 2008 Yucaipa acquired 8% of B&N’s common stock and met with Leonard Riggio, B&N’s founder and largest shareholder controlling an approximately 30% stake in B&N. At this meeting, Burkle presented to Riggio his ideas for improving B&N’s financial performance, including certain strategic alternatives for B&N. B&N did not implement any of these ideas and in August 2009 announced its acquisition of an independent college bookstore company owned by Riggio. Burkle expressed to Riggio his objection to this transaction and in November 2009 Yucaipa quickly increased its stake in B&N to nearly 18%. In its Schedule 13D announcing the accumulation of shares, Yucaipa criticized B&N’s board of directors and management and indicated, among other things, that it reserved the right to make a proposal to acquire all of B&N’s outstanding shares and to propose other merger transactions involving B&N. In response, the B&N board of directors adopted a shareholder rights plan that would be triggered if a person acquired beneficial ownership of more than 20% of B&N’s common stock. Under the plan, Riggio was grandfathered at his then current ownership percentage, but the plan would generally be triggered if he acquired additional B&N stock. Prior to filing its complaint, Yucaipa sought some clarification regarding certain of the provisions and demanded that the plan be amended to allow Yucaipa to acquire beneficial ownership of up to 37% of B&N’s outstanding common stock (the aggregate percentage of stock controlled by Riggio and the directors, officers and employees of B&N), which proposal the B&N board rejected. In addition, during this time period, Altetheia Research and Management, an institutional investor that historically invested along with Burkle, increased its stake in B&N from 6.4% to 17.4%.

Analysis

The first issue the court addressed was the proper standard of review when analyzing a board’s decision to adopt a shareholder rights plan. The court rejected Yucaipa’s attempt to “reverse decades of settled law” by asserting that the board’s decision to adopt the shareholder rights plan should be subject to entire fairness review. Yucaipa’s argument was based on a theory that Riggio stood on both sides of the transaction because Riggio was on the board of directors that approved the rights plan and Riggio benefited from the adoption of such rights plan in that Riggio’s threshold was higher than the threshold that applied to any other shareholder. The court noted, however, that other than grandfathering Riggio at his current ownership level the plan did not confer upon Riggio any additional benefit, and the act of grandfathering Riggio at his current ownership level was a reasonable approach under the circumstances. In fact, the plan the B&N board adopted restricted Riggio from acquiring any more shares of B&N stock (except in limited circumstances, for example acquiring shares upon the exercise of options). “The decision of a board to adopt a rights plan that does not take the legally dubious and extreme step of stripping an existing equity holder of his existing equity stake but that restricts that holder to his existing level of ownership and restricts others to a lower level is not the type of self-dealing transaction that invokes entire fairness.” Ultimately, the court held that the two-pronged Unocal test was the proper standard to apply when analyzing a board of directors’ actions in adopting a shareholder rights plan. Under Unocal, a board’s decision will not be second guessed by the court if (1) the board adopting the plan had “reasonable grounds for believing that a danger to corporate policy and effectiveness existed” and (2) the response was reasonable in relation to the threat posed.

Yucaipa attacked the validity of the plan under the Unocal standard on two fronts. First, it claimed that the definition of “beneficial owner” in the rights plan was ambiguous and therefore unreasonable. Second, in a more traditional Unocal analysis, Yucaipa asserted that the response by the B&N board was not reasonable in response to the threat posed by Yucaipa. Regarding the definition of beneficial ownership, Yucaipa asserted that the rights plan was ambiguous because the definition of beneficial owner picked up shares owned by any person that Yucaipa had an “agreement, arrangement or understanding” with for the purposes of acquiring, holding, voting or disposing of shares. Yucaipa argued that this provision does not provide investors with reliable guidance as to whether certain actions will trigger the operation of the rights plan. The court disagreed, finding that the definition of beneficial ownership in the B&N’s rights plan was no different than the language incorporated in countless other rights plan including rights plans previously validated by the Delaware courts. Moreover, the court confirmed that it is reasonable for a board to prevent dissident shareholders who together hold more than the triggering threshold from jointly developing a slate of directors and agreeing to run and finance a proxy contest together.

With respect to its second attack on the B&N rights plan under Unocal, Yucaipa claimed that because it was only attempting to elect three members of the board in 2010 and was not attempting a takeover of the company, this case was distinct from corporate control cases. Accordingly, the 20% threshold adopted by the B&N board was unreasonable and the board should have adopted a higher level (37%). The court responded that the election of three directors in a classified board context is no “trifling” matter that gives the winner no influence. The court continued “the reality is that even the combination of a classified board and a rights plan are hardly show-stoppers in a vibrant American M&A market. Once an insurgent has won one election, the incumbent board majority’s ability to be intransigent in the face of shareholder sentiment is greatly limited.” The court also found that, based on Yucaipa’s and Aletheia’s actions and their respective Schedule 13D disclosures, B&N’s board was faced not only with a proxy fight but also the threat that Yucaipa, in combination with Aletheia or other institutional investors, could establish a control bloc without paying a control premium. Finally, the court determined that the rights plan does not “fundamentally restrict” Yucaipa from winning a proxy fight and, therefore, was not preclusive. Evidence at trial indicated that Yucaipa’s victory would be “realistically attainable” because the rights plan’s triggering threshold was relatively high at 20% and the plan did not prohibit Yucaipa from discussing its proxy plans with proxy advisory firms such as Risk Metrics. The court concluded that adoption of the rights plan by the B&N board was a good faith, reasonable response to a threat posed to B&N and its shareholders.

Conclusions

This is the second opinion in the last six months from the Delaware Chancery Court regarding shareholder rights plan and it shows the importance these defensive takeover tools play in the corporate landscape. While the opinion in Yucaipa generally reaffirms settled Delaware law regarding the analysis required when reviewing a shareholder rights plans, the opinion emphasizes certain legal points that all directors and practitioners should keep in mind.

• Unocal represents the proper standard of review. When considering whether to adopt a defensive measure, the standard remains whether the board reasonably believes a threat exists and whether the response is proportional to that threat. The opinion is clear that when a board acts in good faith with a non-preclusive response to a reasonably perceived threat, its actions will be protected by the business judgment rule.
  
• One size does not fit all. One size does not fit all when it comes to defensive measures under Delaware law. For example, in analyzing the proportionate response of B&N’s rights plan to the threat posed, the court cited to the recent Selectica case (analyzing the validity of a rights plan with a 5% triggering threshold) in which that court found that a rights plan is not preclusive where there is “a mathematical or theoretical possibility of winning a proxy contest.” The court in Yucaipa uses a different standard in determining if a rights plan is preclusive, asking whether the insurgent has a “fair” chance of winning a proxy contest. The plan, however, must be judged against the threat posed (i.e., fight for corporate control or protecting a corporate asset) and must consider the “real world” market considerations and circumstances of each particular situation.
  
• Process is important. A board of directors considering the adoption of a rights plan must remember to undertake a deliberative process when considering defensive measures. While ultimately determining the B&N board of directors acted in good faith in this case, the court questioned the board process because it did not establish a committee of independent directors to evaluate the rights plan, nor was Riggio asked to leave the meeting when the board deliberated about provisions that applied to Riggio.
  
• Higher triggering thresholds for existing shareholders are permissible. The court confirmed that a board can grandfather an existing shareholder at a higher threshold than the triggering threshold that applies to other shareholders. In setting the triggering threshold for the rights plan the board should consider, among other factors, the percentage ownership of the existing shareholder.