Posted by Mark D. Gerstein, Latham & Watkins LLP, on
Monday July 7, 2014 at
Mark D. Gerstein is a partner
in the Chicago office of Latham & Watkins LLP and Global Chair of
that firm’s Mergers and Acquisitions Group. This post is based on
a Latham & Watkins M&A Commentary by Mr. Gerstein,
Bradley C. Faris,
Timothy P. FitzSimons, and
John M. Newell. This post is
part of the
Delaware law series, which is
cosponsored by the Forum and Corporation Service Company; links to
other posts in the series are available
Increasingly, some activist hedge funds are looking to sell their
stock positions back to target companies. How should the board respond
The Rise and
Fall of Greenmail
heyday of takeovers in the 1980s, so-called corporate raiders would often
amass a sizable stock position in a target company, and then threaten or
commence a hostile offer for the company. In some cases, the bidder would
then approach the target and offer to drop the hostile bid if the target
bought back its stock at a significant premium to current market prices.
Since target companies had fewer available takeover defenses at that time
to fend off opportunistic hostile offers and other abusive takeover
transactions, the company might agree to repurchase the shares in order to
entice the bidder to withdraw. This practice was referred to as
“greenmail,” and some corporate raiders found greenmail easier, and more
profitable, than the hostile takeover itself.
Some of the
boards of directors of the target companies that paid greenmailers were
sued by their stockholders, who alleged that the payments were made for
the purpose of management entrenchment, the boards impermissibly favored
the greenmailers over other stockholders and the price paid was excessive.
However, Delaware courts generally upheld the board’s decision to pay
greenmail, on the grounds that it was a reasonable response by the board
to the threat of an abusive or coercive hostile takeover.
Nevertheless, there was widespread outcry about the practice from target
companies, institutional investors and the investing public. Federal and
state laws were enacted in an effort to prohibit or restrict the payment
 Also, companies developed more
effective takeover defenses, making greenmail unnecessary as a defense. By
the end of the 1980s, greenmailing was relegated to the sidelines of
the Age of Activist Investing
greenmail has largely disappeared in the hostile takeover arena, the
recent explosion of activist investing by hedge funds has brought about a
related phenomenon, which can be referred to as “hushmail.” Texas
businessman H. Ross Perot coined the term in 1986, using it to describe an
offer made to him by General Motors to buy out his GM stock at a premium
price, in exchange for his agreement to stop publicly criticizing GM’s
hedge funds often start their campaigns against public company targets by
taking large stock positions and then publicly agitating for changes, such
as stock repurchases, extraordinary dividends, dispositions of non-core
businesses or an outright sale of the company. There is often an implicit
or explicit threat of a proxy contest to remove some or all of the target
board members and management if their demands are not met. Ultimately, the
activist may receive one or more seats on the target company board, either
through a settlement with the target, or success at a stockholder meeting.
period of time pressing its case, the activist may desire to exit the
investment. However, if it were to dump its shares in the market in large
volume, the stock price realized in the sale may suffer. The situation
becomes trickier for activists that have obtained board representation,
because insider trading policies and SEC rules may significantly restrict
their ability to dispose of shares quickly.
In order to
exit quickly at the highest possible price, the activist sometimes seeks
to have the target company buy back its stock. The buyback price is
typically at a slight discount to the current market price, but
occasionally it is at a premium. As part of the purchase agreement, the
activist may enter into a standstill and non-disparagement agreement with
the target. If the activist has representatives on the board of the
target, the representatives typically would resign their director
positions after the repurchase, given the activist’s lack of ongoing
In the last
year, there have been numerous examples of companies buying back stock
from activist investors.
 For example, in April 2014,
activist investor KSA Capital sold a 9 percent block of shares back to AEP
Industries at a 4.5 percent premium to the current market price. After the
buyback, KSA still owned 21 percent of the outstanding stock. As part of
the deal, KSA signed a two-year standstill and non-disparagement agreement
with AEP, and agreed to vote its remaining block in favor of director
nominees nominated by the AEP board at the next two annual meetings of
modern era, activist hedge funds often proclaim that they are working to
enhance value for all stockholders, and deny that they are seeking only
personal financial gain. Activist investors have worked hard in recent
years to improve their image with institutional investors, the investing
public and companies.
a stock buyback, are activists breaking bad? Not unlike Walter White, who
made the journey from devoted family man to antihero, an activist investor
who seeks a hushmail buyout can fairly be said to be putting the
activist’s short-term interest in liquidity ahead of the interests of
other stockholders, who are not offered the same deal. If activists
increasingly seek hushmail buybacks, especially at premium prices, they
run the risk of creating a broader market backlash, such as what occurred
with the demonization of greenmailers in the 1980s.
Notwithstanding the reputational risks to activists, hushmail demands seem
to be on the rise. Public companies need to be prepared to consider
whether a buyback from an activist (whether framed as hushmail or
otherwise) is in the best interests of the company and its stockholders,
even if the motivations of the activist are self-interested.
many situations in which a buyback could be viewed as beneficial to the
company, particularly if the company had previously authorized or was
already considering repurchasing its stock and the opportunity exists to
do so at a discount to market value. In situations in which the activist’s
board representatives demand that the company implement a business
strategy or financial transaction that the other members of the board have
clearly rejected, then a buyback may be the most expeditious path to a
resolution of the controversy in the best interests of the company and its
stockholders, particularly in situations where the activist board member
has become disruptive to the proper function of the board and the
company’s ability to execute its business strategy.
Consider in Reviewing a Buyback of Stock From an Activist
buyback must be undertaken carefully, after appropriate review by the
board of a number of important factors. If a board approves a repurchase
of stock from an activist investor, it may face criticism from
stockholders on the grounds that the opportunity to sell is not made
available to all stockholders, the stock repurchase is motivated by
management entrenchment, and the repurchase price is excessively high and
therefore unfair to the company or its other stockholders.
It is well
established that a Delaware corporation has the power to deal in its own
stock and that the corporation may deal selectively with its stockholders
in the acquisition of shares. As discussed below, the Delaware courts have
long held that there are a variety of sound reasons why a board may agree
to buy back its shares from a dissident stockholder, even at a premium to
the current market price. Assuming that management entrenchment and
stockholder disenfranchisement are not the primary purposes of the stock
buyback, the board’s decision to authorize the buyback should receive the
benefit of the business judgment rule.
Supreme Court has held that, if a stock buyback is not made in response to
an actual or potential threat to corporate policy, then, “in the absence
of evidence of fraud or unfairness, a corporation’s repurchase of its
capital stock at a premium over market from a dissident stockholder is
entitled to the protection of the business judgment rule.”
applicable standard of review of the board’s decision will therefore turn
initially on whether or not the purpose of the buyback was a defensive
response against an actual or potential threat to corporate control. If it
is viewed as defensive, the board’s actions may be subject to enhanced
scrutiny review under the Delaware law. The board should carefully
consider and document the reasons for entering into the transaction in
order to create an effective record of its rationale for approving the
buyback. If the board is composed of a majority of outside directors, and
advised by expert legal and financial advisors, it will help to establish
that the board acted in good faith and made a reasonable investigation.
following are several examples of typical stock buyback scenarios, and how
the board’s actions have been evaluated by courts in the past.
Buyback as a
Favorable Financial Transaction
primary reason that the board decides to buy back shares from a dissident
stockholder is because the board determines, in the exercise of its
business judgment, that it is desirable from a capital allocation
standpoint for the company to buy back stock at the present time. If a
buyback makes financial sense, the board may determine that a repurchase
of a block from a large stockholder who is eager to sell is a more
efficient method to execute the repurchase than buying shares in the
market. In that regard, if the company has an existing stock buyback
program in place, the program may provide additional support for the
board’s position that the repurchase from the activist is being done for
financial rather than defensive reasons. In the absence of entrenchment
motives or an outside threat to control of the company, the board’s
decision should be entitled to the protection of the business judgment
Address an Internal Rift Caused by a Dissident Stockholder
reason to buy back shares from a dissident stockholder could be that the
stockholder is a source of controversy or friction with consequences
adverse to the interests of the company and its stockholders generally,
and the board wishes to buy out the stockholder to remove the source of
the dispute. In the Delaware Supreme Court case of Grobow v. Perot,
 referenced earlier, Perot was a
director of General Motors, the chairman of GM’s EDS division and also one
of GM’s most outspoken critics. Perot demanded that the GM board either
give him full control of the EDS division, or buy him out of his GM stock.
When GM offered to buy him out, Perot proposed that he be paid double
the current market value for his shares. To Perot’s surprise, GM agreed.
found that the primary purpose of the GM board’s decision was not to “buy
Perot’s silence,” but to “rid itself of the principal cause of the growing
internal policy dispute over EDS’s management and direction.” Concluding
that there was no outside threat to control of GM that would trigger a
concern that the directors were acting in their self-interest, the court
ruled that the business judgment rule was applicable and the board’s
actions were not subject to enhanced scrutiny.
cases, activist hedge funds may present an actual or potential threat to
corporate policy and effectiveness. A buyout of the activist’s shares may
be considered a defensive action by the board in response to the threat,
which could trigger a heightened standard of review of the board’s
actions. Under the Delaware law principles established in the well-known
cases of Unocal Corp. v. Mesa Petroleum Co. and Unitrin v.
American General Corp., “if the directors initiated the repurchase in
response to a threat to corporate policy related to a potential change in
control of the corporation,” then “a heightened standard of judicial
review applies because of the temptation for directors to seek to remain
at the corporate helm in order to protect their own powers and
heightened standard of review under Unocal/Unitrin consists of two
prongs. The first is “a reasonableness test, which is satisfied by a
demonstration that the board of directors had reasonable grounds for
believing that a danger to corporate policy and effectiveness existed.”
 In reaching this determination,
the independent members of the board, with the advice of legal and
financial advisors, should make an investigation as to the threat posed,
and be able to articulate clearly the nature of the threat.
an activist hedge fund of a significant stock position may present a
number of legitimate threats to corporate policy and effectiveness.
Activist hedge funds often acquire large stock ownership positions through
open market purchases, sometimes without adequate disclosure of their
purchases and intentions. This could present a risk of “creeping control,”
in which effective control is acquired by the hedge fund without payment
of a control premium to the other stockholders. There can also be a threat
of “negative control,” in which the hedge fund has the ability effectively
to block corporate actions through voting power and other influence.
Activists and other hedge funds also sometimes work collectively to
acquire stock by means of “wolf pack” tactics, which can also present
further threats of creeping control and negative control.
prong of the Unocal/Unitrin analysis is a “proportionality test,
which is satisfied by a demonstration that the board of directors’
defensive response was reasonable in relation to the threat posed.” The
board’s defensive actions must not be “draconian, by being either
preclusive or coercive,” and must fall “within a range of reasonable
responses to the threat” posed.
repurchase of stock from an activist hedge fund, even at a premium, in
response to a threat of creeping control or negative control is neither
coercive nor preclusive. The other stockholders of the target are free to
mount their own proxy contest and are free to vote their shares as they
prong of Unocal/Unitrin also requires that the defensive action (in
this case, the stock buyback) must be within a range of reasonable
responses to the threat posed. The stock buyback would effectively
eliminate the threat from the particular dissident stockholder, but the
cost of doing so would have to be considered.
v. Good, the Delaware Supreme Court reviewed the settlement of a case
involving a 9.9 percent stockholder of Texaco, known as the Bass group.
The Bass group had suggested that it might increase its ownership to 20
percent or commence a hostile tender offer, at a time when Texaco’s board
viewed the stock as undervalued. The Texaco board identified a threat of
creeping control, as well as a possible hostile offer at an unfair price.
In response, Texaco bought back the Bass group’s stake at a 3 percent
premium to the current market price. The court found that the payment
“seem[ed] reasonable in relation to the immediate disruptive effect and
the potential long-term threat which the Bass group imposed. Clearly, that
was a benefit to the company and most of its stockholders.”
to buying back the activist’s stock, the target company may also require
that the activist enter into standstill and non-disparagement covenants.
If the perceived threat is creeping control by the hedge fund, or negative
control, then covenants preventing the activist from acquiring additional
shares, or working alone or with other stockholders to influence control
of the target through public criticism, should be considered to be
reasonable responses to the threats posed.
Responses to Hushmailers
rise of greenmail in the 1980s, some companies adopted charter or bylaw
amendments prohibiting the payment of greenmail. If hushmailing continues
its rise, companies may consider adopting similar provisions to address
hushmail, such as requiring disinterested stockholder approval of a stock
repurchase. Institutional investors are likely to be supportive of these
changes, because they should alleviate concerns about hushmail being paid
for entrenchment purposes, as well as concerns that activist stockholders
are getting special treatment not available to other stockholders.
 By declaring that a hushmail
payment is not an option, activist hedge funds seeking a quick payoff may
look elsewhere for a more vulnerable target. At the same time, these
changes may reduce the flexibility of the board in responding to hushmail
demands and, in that sense, may reduce the utility and benefits of this
hedge funds are increasingly seeking hushmail payments. In doing so, they
risk being painted as villains rather than heroes. Nevertheless, if the
target board believes that a repurchase of a significant block of stock
from an activist is in the best interests of all stockholders, there is a
path to do so under existing law.
In response to the widespread outbreak of greenmail in the mid-1980s,
several states, including New York, Ohio and Pennsylvania, adopted
corporate laws prohibiting the payment of greenmail without disinterested
stockholder approval. Congress amended the Internal Revenue Code to
provide for a 50 percent excise tax on greenmail payments in certain
limited situations. In addition, some corporations took matters into their
own hands, adopting charter and bylaw amendments prohibiting the payment
of greenmail without disinterested stockholder approval.
In the last 12 months, nine companies have repurchased shares from
activists, which is more than the previous six years combined, according
to data from FactSet SharkWatch.
See Grobow v. Perot, 539 A.2d 180, 189 (Del. 1988); See also
Polk v. Good, 507 A.2d 531, 536 (Del. 1986); Kahn v. Roberts,
A.2d 460, 465 (Del. 1996).
Kahn v. Roberts, supra, at 464.
Grobow v. Perot, supra, at 190.
Kahn v. Roberts, supra, at 465.
Unitrin, Inc. v. American General Corp., 651 A.2d 1361, 1373 (Del.
“Third Point LLC v. Ruprecht—Activism
Confronts the Rights Plan,” Latham & Watkins Client Alert, May 2014.
Unitrin, supra, at 1367.
Polk v. Good, supra, at 537.
The voting policies of proxy advisory firms ISS and Glass Lewis both
recommend in favor of anti-greenmail charter and bylaw provisions.
copyright and trademarks in content on this site are owned by their
respective owners. Other content © 2014 The President and Fellows of