Delaware Supreme Court Clarifies Limits on Defensive Measures that Impair Stockholder Vote
January 28, 2003
The Delaware Supreme Court’s January 7, 2003, decision in MM Companies, Inc. v. Liquid Audio, Inc. clarifies the limits of a target board’s ability to take defensive actions that impair the stockholder vote when fending off a hostile takeover bid.
The case involved a contest for control of Liquid Audio, Inc., commenced by one of its shareholders, MM Companies, Inc. After its takeover offer was rejected by the Liquid Audio board in December 2001, MM notified Liquid Audio that it would nominate its own candidates for the two board seats up for election at the next annual meeting (Liquid Audio’s board initially consisted of five members, separated into three different classes). MM also introduced a proposal to increase the size of the board by four directors and to fill those positions with its own nominees, which would have given MM majority control of the board. In response, prior to the 2002 annual meeting, Liquid Audio amended its bylaws to increase the size of the board to seven members from five and named two individuals to fill those positions. At the meeting, MM’s two nominees were elected, but its other proposals were not approved. MM sued, alleging that the board expansion and appointment of new directors frustrated its attempt to gain a substantial presence on the board for at least a year and guaranteed that MM could not gain control of the board for at least two years.
Two principals of law were implicated in this contest for corporate control. First, the "enhanced scrutiny" standard first announced in Unocal Corp. v. Mesa Petroleum Co. applies to defensive actions. Unocal and its progeny require that defensive measures taken in response to perceived threats to corporate policy and effectiveness must be proportionate to the threat posed. Proportionality, in turn, requires that the defensive action not be coercive (i.e., force a management-sponsored alternative upon shareholders) or preclusive (i.e., make it impossible for the shareholders to vote in favor of the hostile proposal) and must fall within a range of reasonableness. The lower court upheld Liquid Audio’s conduct under Unocal, finding, among other things, that the expansion of the board just prior to the annual meeting was not preclusive because the choices that Liquid Audio’s shareholders had before the board expansion (i.e., whether to vote for MM’s nominees and other proposals) were the same as they had after.
However, the Liquid Audio board’s action also raised an issue under a second legal doctrine. In Blasius Industries, Inc. v. Atlas Corp., the court noted that the shareholder franchise is the ideological underpinning of directorial power and, therefore, held that a board’s action designed principally to interfere with or frustrate a shareholder vote would only be upheld if there was a "compelling justification." The compelling justification standard of review is a stringent test, practically guaranteeing that the conduct in question will be struck down. (In Blasius, the incumbent directors, despite their good faith belief that the bidder’s proposed recapitalization would saddle the company with too much debt, were not justified in expanding the board to defeat a proxy contest.) On the other hand, a large body of precedent upholds various defensive measures under Unocal’s enhanced scrutiny doctrine (see, e.g., the court’s decision in Unitrin, Inc. v. American General Corp., upholding a stock repurchase program that gave management an effective blocking position). Because enhanced scrutiny review differs from, and may be more permissive than, compelling justification review, the application of one standard instead of the other could determine the outcome of a challenge.
Blasius within Unocal
Liquid Audio clarifies that Blasius and Unocal, rather than being mutually exclusive, complement each other. Once the lower court had determined that Liquid Audio’s conduct was neither coercive nor preclusive, it proceeded directly to assess whether the conduct fell within a range of reasonableness. It was at this point, however, that the Delaware Supreme Court interjected the Blasius analysis. In particular, when a board takes a defensive measure, and the primary purpose of such measure is to impede the effective exercise of the shareholder vote, the board must demonstrate a compelling justification. Once this test is met, the courts will then review the proportionality and reasonableness of the measure under Unocal. Blasius, in short, must be applied within, or in addition to, Unocal if the primary purpose of a board’s conduct is to impair the stockholder franchise.
The court found that the primary purpose of Liquid Audio’s bylaws amendment to provide for a board of seven and the subsequent appointment of two additional members, on the eve of a contested election, was to interfere with and impede the effective exercise of the stockholder franchise. These actions had the effect of diminishing the influence of MM’s two nominees on a five-member board by eliminating the possibility of a deadlock or of MM controlling the board if one or two incumbent directors resigned. Since Liquid Audio did not provide any compelling justification, the court held that its defensive measures should have been invalidated. The court noted that defensive actions requiring compelling justification review need not actually prevent the contesting shareholders from gaining seats on a board and the election itself need not involve a contest for outright control. Rather, the critical factor is whether the primary purpose of the target company’s action was to impede the effectiveness of the stockholder vote.
Implications
Liquid Audio, in a technical sense, did not extend the circumstances in which the stringent compelling justification standard of review would apply and so does not make new law. Nonetheless, by emphasizing the importance of the purpose of a defensive measure (a fact-based determination often resolved in litigation) and clarifying how the "compelling justification" standard can supplement review under Unocal, Liquid Audio may give new fodder to hostile bidders when a defensive action touches upon the stockholder vote.
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