Continuing Director Change of Control Provisions in Debt Agreements:  Potential Issues for Borrowers Continuing Director Change of Control Provisions in Debt Agreements:  Potential Issues for Borrowers

Continuing Director Change of Control Provisions in Debt Agreements: Potential Issues for Borrowers and Lenders

In Pontiac General Employees Retirement System v. Healthways, Inc., [1] the Court of Chancery of the State of Delaware denied a motion to dismiss a claim brought against a lender alleging that the lender aided and abetted a breach of fiduciary duty by the directors of its borrower in connection with “continuing director” language included in a change of control provision in the credit agreement between the lender and the borrower.  The Healthways case continues a line of cases in which Delaware courts have expressed great concern as to whether such provisions coerce stockholders to vote to retain incumbent directors.  These cases raise serious questions regarding these provisions.
Credit agreements and indentures frequently include a provision that allows lenders to put (or accelerate) their debt upon the occurrence of a “change of control” of the borrower.  For public company borrowers, “change of control” is frequently defined to include a provision that a change of control occurs when “continuing directors” cease to constitute a majority of the board of directors of the borrower.  “Continuing directors” is typically defined to mean persons who were on the board when the debt contract was entered into or replacement directors who were nominated (or whose election was approved) by a majority of the directors who were either in office when the debt contract was entered into or whose nomination (or election) was previously so approved.  Certain definitions require that the board turnover must occur within a specified period (often, two years) in order for the provision to be triggered.
Many debt contracts contain a qualification that would exclude from the definition of “continuing director” any person whose nomination for election to the board occurs as a result of an actual or threatened proxy fight.
Over the past several years, Delaware courts have expressed skepticism about these provisions, viewing them as a possible infringement on the ability of stockholders to vote for directors in that such provisions may coerce stockholders to vote for incumbent directors in order to avoid triggering a put or acceleration of the debt.
In 2009, the Delaware Court of Chancery examined a continuing director provision in the Amylin case.[2]  The court suggested that such provisions “might be unenforceable as against public policy.”
The Amylin case is instructive as to how a public company board might deal with such a provision.  In Amylin, the board purported to “approve” (for purposes of its debt agreements) a slate of directors nominated by dissident stockholders, even though the board was publicly opposing that slate in a proxy contest (in fact, the board was proposing a competing slate).  The trustee under the company’s debt indenture objected to the board’s ability to so “approve” the dissident nominees, arguing that to do so was inconsistent with the terms of the indenture.  The court held that the board could indeed do so as a contractual matter if it determined in good faith “that the election of one or more of the dissident nominees would not be materially adverse to the interests of the corporation or its stockholders.” [3]
Notably, the “continuing director” provision in the Amylin indenture did not contain language excluding persons nominated in a proxy contest.  The lack of this exclusion made the way clear for the board to avoid triggering the change of control put by approving the dissident slate even as it backed a competing slate.
Due to the procedural posture of the Amylin case, the court did not render a definitive decision on the question of whether the directors had satisfied their fiduciary duty of loyalty in approving the dissident slate.  Although the court held that the directors did not breach their fiduciary duty of care in allowing the change of control provision to be included in the indenture, the court stated that it was troubled by the existence of such provisions and suggested that such provisions be highlighted to the board by counsel at the time when the board is asked to approve a debt agreement containing such a provision.
In 2013, in the SandRidge case,[4] the Delaware Court of Chancery further expanded on some of the issues discussed in Amylin.  Like Amylin, SandRidge involved a proxy contest, but unlike the situation in Amylin, in SandRidge the board had not approved the dissident slate in order to avoid triggering change of control puts in the company’s indentures.  The court severely criticized the board’s conduct, holding that “a board may only fail to approve a dissident slate if the board determines that that passing control to the slate would constitute a breach of the duty of loyalty, in particular, because the proposed slate poses a danger that the company would not honor its legal duty to repay its creditors” (emphasis in original).  The court suggested that withholding approval could be appropriate in limited circumstances, such as when the proposed new board consisted of “known looters” or persons of suspect integrity, of if the proposed board posed “such a material threat of harm to the corporation that it would constitute a ‘breach of the directors’ duty of loyalty to the corporation and its stockholders’ to ‘pass control’ to them.”[5]  Absent such circumstances, the court stated that the board must approve the dissident slate.
The court also expressed its view that, due to the possible result of entrenching directors, “one would hope that any public company would bargain hard to exclude that toll on the stockholder franchise and only accede to the  . . . [continuing director change of control put] after hard negotiation and only for clear economic advantage.”  The court speculated that “[i]n ‘frothy’ credit financing markets there is reason  . . .  to suspect that the costs of such resistance would be insubstantial to non-existent.”[6]  The court also called on independent directors to “police aspects of agreements like this, to ensure that the company itself is not offering up these terms lightly precisely because of their entrenching utility, or accepting their proposal when there is no real need to do so.”
The court found that there was no basis for the board not to approve the dissident nominees, and enjoined the board from interfering with the dissident’s consent solicitation.
Healthways involved the disposition of motions to dismiss, and thus did not involve any findings of fact.  Unlike Amylin and SandRidge, Healthways included a claim by the plaintiffs that the lenders had aided and abetted a breach of fiduciary duty by the company’s board in connection with a continuing director change of control provision in the company’s syndicated credit agreement.  The credit agreement had historically included a continuing director change of control provision that did not have a provision disqualifying persons approved during a proxy contest.  The credit agreement had been amended in 2012 to add this disqualifying provision, which took away the ability of the board to “approve” dissident directors (as had been done in Amylin) during a proxy fight which took place after such amendment was entered into.  The amendment was entered into after the company’s stockholders had voted to de-stagger the board in response to a stockholder proposal.
Under Delaware law, a third party may be liable for aiding and abetting a breach of a corporate fiduciary’s duty to stockholders if the third party “knowingly participates” in the breach.[7]  Knowing participation in such a breach requires that the third party act with the knowledge that the conduct constitutes such a breach.[8]
In Healthways, the court held that the aiding and abetting claim had been adequately pleaded, and refused to dismiss the same, in effect leaving for subsequent proceedings the determination whether there had been a breach of fiduciary duty and, if so, whether the lender had knowingly participated in it.
Under Delaware law, there is a defense to aiding and abetting liability in the context of a breach of fiduciary duty if the third party is engaged in arm’s length negotiations.  The paradigm example of this is a bidder that negotiates a lower sales price for the acquisition of the company.  This defense is limited, and will not prevent liability in a situation where the third party “attempts to create or exploit conflicts of interest in the board” which would require the board to prefer its interests over those of the stockholders.[9]  In Healthways, the court stated that “when you are an arm’s length contractual counterparty, you are permitted, and the law allows you, to negotiate the best deal that you can get.  What it doesn’t allow you to do is to propose terms, insist on terms, demand terms, contemplate terms, incorporate terms that take advantage of a conflict of interest that the fiduciary counterparts of the other side of the negotiating table face.”
The court also noted that due to the Amylin and SandRidge cases, lenders generally should have been put “on notice” that continuing director change of control provisions were “highly suspect.”
Change of control provisions in debt agreements involving public companies frequently include two elements: a continuing directors provision and a provision providing that a change of control occurs if a stockholder (or a group of stockholders acting in concert) acquires a threshold percentage of stock (frequently, 20 or 25 percent).  The Amylin-SandRidge-Healthways line of cases does not affect the element dealing with the percentage threshold.  That said, the continuing director provision is designed to provide protection to lenders in situations where the percentage test has not been triggered, such as when a dissident stockholder who holds a share percentage below the prescribed threshold solicits proxies to change the composition of the board and take the company in a different direction from the one that the lenders had contemplated when they entered into the debt contract.
Delaware courts have viewed continuing director change of control provisions with extreme skepticism, and may be expected to continue to do so.  These courts have stated that (i) such provisions may be unenforceable as against public policy (particularly if they do not include language allowing the board the flexibility to approve insurgent slates), (ii) directors may breach their fiduciary duties by allowing these provisions to be included in debt agreements, (iii) absent extreme circumstances, directors have an affirmative duty to approve insurgent slates to avoid triggering a change of control put or acceleration and (iv) lenders may be liable for aiding and abetting such breaches of fiduciary duty if they knowingly participate in such breaches. 
Further, according to Vice Chancellor Laster, who ruled on the motions to dismiss in Healthways, there is “ample precedent” that should put lenders “on notice that these provisions  . . . [are] highly suspect and could potentially lead to a breach of duty on the part of the fiduciaries who were the counter-parties to a negotiation . . . .”  Vice Chancellor Laster also stated that the lender was “a party to an agreement containing an entrenching provision that creates a conflict of interest on the part of the fiduciaries on the other side of the negotiation” and that the prior cases “should have put people on notice that there was a potential problem here such that the inclusion of the provision was, for pleading-stage purposes, knowing.”
The courts have stopped short of declaring that continuing director change of control provisions always violate fiduciary duties, and have suggested some steps that a board may take to bolster an argument that fiduciary duties have not been breached in allowing such provisions to be in the company’s debt agreements.  These steps would seem to be a very narrow path, however; the courts in Amylin and SandRidge spoke of wanting to see evidence that substantial economic advantage had been obtained by the company in return for agreeing to include such a provision and that the inclusion only came after hard bargaining.
In light of these decisions, public company borrowers may be expected to strongly resist the inclusion of continuing director change of control provisions in their debt agreements.  Even if such a provision were included in a debt agreement without implicating a fiduciary duty issue, there could still be fiduciary duty issues after that point, if the provision were applied to the facts of a particular event.
Although lenders have valid business reasons to continue to seek protection from contested management changes, lenders should consider what benefit they will get from including continuing director change of control provisions, and whether the benefit is worth the risk.  The benefit may be slight, particularly given the expressed views of the Delaware courts that such provisions are more suspect if they do not permit a board to approve a dissident slate and that the board has an affirmative duty to so approve unless the dissidents pose a material threat of harm to the company.  The risks include having the provision be declared unenforceable and the possibility of aiding-and-abetting liability.
Lenders should also consider the possibility that situations may arise in which the lenders may be under pressure to waive[10] the benefits of such provisions if the borrower becomes the subject of a proxy fight or other battle for corporate control, in order to avoid being dragged into a lawsuit.  In syndicated facilities, a lender should consider whether its views on granting such a waiver are shared by enough other members of the syndicate to effect a waiver if the lender determines that a waiver is necessary to avoid the risk of litigation.
The Healthways court did not rule on the merits of the breach of fiduciary duty or the aiding-and-abetting claims or make any factual findings.  It may be that situations may exist where a continuing director change of control provision, in light of a particular company’s circumstances, would not create a breach of fiduciary duty on the part of directors or give rise to aiding-and-abetting liability on the part of the lenders benefitting from such provision.  However, it is difficult to predict the future, and lenders may find themselves dealing with the issues raised by this line of cases even when such issues had been thought unlikely to be implicated when the agreement was entered into.

This publication is intended for general information purposes only and does not and is not intended to constitute legal advice. The reader must consult with legal counsel to determine how laws or decisions discussed herein apply to the reader's specific circumstances.

[1] Case No. 9789-VCL transcript (Del. Ch. Oct. 14, 2014).
[2] San Antonio Fire & Police Pension Fund v. Amylin Pharmaceuticals, Inc., 983 A.2d 304 (Del. Ch. 2009).
[3] The Amylin court stressed that “it is important to recognize . . . that the directors are under absolutely no obligation to consider the interests of the noteholders in making this determination” (emphasis in original).
[4] Kallick v. SandRidge Energy, Inc., 68 A.3d 242 (Del. Ch. 2013).
[5] Quoting Amylin, supra.
[6] The court noted that that the company’s financial advisor had offered to underwrite a refinancing of the debt containing the change of control provision if the dissident slate was elected.
[7] Malpiede v. Townson, 780 A.2d 1075 (Del. 2001).
[8] Id.
[9] Id.
[10] The Amylin court noted that continuing director change of control provisions “are somewhat less concerning in syndicated lending agreements than they are in public debt instruments because of the relative ease with which consents or waivers are obtained in bank lending than in public debt instruments.”

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