By Robert C. Hackney
Proxy Solicitation Rules
Another area of concern, related to the securities law, are the proxy solicitation rules that govern proxy contests. Solicitation of proxies by persons other than incumbent management has been an area that was virtually ignored years ago with a few well known exceptions. Takeover artists found it relatively easy to launch hostile tender offers and takeover attempts by the use of all cash tender offers with financing provided by huge pools of cash raised by the sale of junk bonds. By making offers directly to a target’s shareholders in the form of cash at a premium over the market price, corporate raiders found ready and willing sellers and consequently the tender offer was used as the most efficient means of taking control of the company. Because hostile tender offers generated so much outrage, inevitably Congress as well as numerous state legislatures began to get involved in the process. Consequently, large number of state legislatures have adopted state anti-takeover provisions in their state corporate laws.
In addition, Congress made changes in the tax laws that reduced the tax benefits of junk bonds and other financed acquisitions. Congress also passed a provision in the Internal Revenue Code which imposes a fifty percent tax penalty on greenmail profits by hostile bidders in tender offer situations. All of these circumstances reduced the tender offer as a viable takeover tool and because of these restrictions, the result has been that corporate raiders have looked once again to proxy contests as a method to acquire control of target companies. So, the greatest benefit to an acquiror of all of these statutory provisions that are detrimental to and discourage tender offers, is that they don’t prevent proxy contests.
When you look at the viability of a proxy contest, you have to take into consideration that if there is a shareholder’s rights plan, or a poison pill, as those plans have been frequently called, then you will find that in many cases a proxy contest will not trigger poison pill defenses. When it comes down to the cost effectiveness of a proxy contest, that also becomes an advantage for an acquiror because it is much less expensive than purchasing a controlling interest in a company.
When you look at the proxy contests that have occurred in the last few years, you find that they are not just made up of the disgruntled shareholder’s attempts to unseat the board of directors of a target company but they are also increasingly consisting of attempts to invalidate any takeover defenses, including poison pills and other corporate policies that may discourage takeovers, and in the eyes of disgruntled shareholders, limit shareholder value. It is not unusual now to see unhappy shareholders use Rule 14(a)(8) to have their proposals included in proxy statements distributed by the target company and these shareholder proposals frequently consist of attempts to get shareholder authorization for recapitalizations, restructuring, or changes in other ways that the target company does business.
In the past, the likelihood of a proxy contest being successful were minimal, but in today’s active marketplace, the institutional investors and other owners of large blocks of stock, are taking a more and more active role in the activities of their companies. There used to be a tendency for large shareholders to vote with their feet, and by that I mean that they would just get up and leave if they didn’t like the way things were going. They’d just sell their shares and move on to some other investment, but more and more we are seeing that insurance companies and other large institutions are not only more and more willing to listen to the dissonance, but may in fact be the ones leading the charge.
The law with regard to proxy solicitation
The Securities Exchange Act of 1934 under Section 14(a) of that Act governs the solicitation of proxies and makes it unlawful for any person by use of the mails or by any means or instrumentality of interstate commerce or of any facility of a national securities exchange or otherwise in contravention of rules and regulations prescribed by the SEC to solicit or to permit the use of his name to solicit any proxy or consent or authorization in respect of any security other than an exempt security registered pursuant to Section 12 of the ’34 Act. Generally, Section 12 of the ’34 Act deals with companies that are governed by the reporting requirements of the ’34 Act which is all Nasdaq companies as well as all companies listed on both the American and the New York Stock Exchange.
The term “solicit” and the term “solicitation” are defined to include any request for a proxy whether or not accompanied by or included in a form of proxy and any request to execute or not execute or to revoke a proxy or the furnishing of a form of proxy or other communication to stockholders under circumstances reasonably calculated to result in the procurement, withholding, or revocation of a proxy.
The term “solicit” or “solicitation” does not apply to the furnishing of a form of proxy to a stockholder upon the unsolicited request of that stockholder or by the giving of information required by Rule 14(a)(7) to stockholders by the issuer. With regard to what gets filed in a proxy contest, there is something called a Schedule 14A, which sets forth the information that is required in a proxy statement and all proxy materials are filed with the SEC in a preliminary form at least five business days before definitive copies are sent out to stockholders.
The reason that Rule 14(a)(1) uses the language “communication to a security holder under circumstances reasonably calculated to result in a procurement, withholding, or revocation of a proxy”, is so that all of the communications that are part of the continuous plan ending in solicitation are governed by the proxy rules, otherwise it would be easy for a group of stockholders that was unhappy with management to get around the law by spreading misinformation or even lies as a way of softening up the shareholders and getting them ready for a successful proxy solicitation. Why this is important to you, as either management or part of an insurgent group, is that you have to be careful regarding what discussions or other communications take place prior to the soliciting of proxies to make sure that you don’t violate the proxy rules.
What kind of communications or meetings can take place without any violation of the proxy rules? The answer obviously depends on the facts and the situation, but generally, meetings and discussions that are held by a committee of unhappy shareholders among themselves is alright and will not violate the proxy rules. Cases that involve the soliciting of funds to finance litigation that is designed to remove members of the board has been held by courts to be proxy solicitations. Also, if unfavorable newspaper advertisements are mailed to shareholders which also contain an appeal for funds to support a committee of shareholders to remove the present board, that would constitute a solicitation.
There is case law to the effect that if management communicates with shareholders wherein they report some significant corporate development soon after that development happens and far in advance of a formal proxy solicitation for an annual meeting, then such communication has been held not to be a solicitation or a violation of the proxy rules. There is little doubt that in a proxy contest, management will bring legal action against the shareholders committee that is seeking to oust them and consequently, any meetings or communications that have occurred before the time for the formal proxy solicitation will be looked at very carefully by management when they are seeking to bring this action against the insurgent group.
Participants in a Proxy Contest
Certain disclosure requirements are placed upon participants in a solicitation. These requirements are placed upon participants in connection with solicitation that are designed to elect or remove directors at any annual or special meeting. The definition of “participant” under the rules is what is important and it is very broad. The definition includes all of the people you would expect it to include and in addition, anyone who is involved in the organizing or directing of any group or committee even if they are not named as a potential director of the company and any person who finances or helps finance the solicitation of proxies with the exception that if you don’t contribute more than five hundred dollars, and you are not otherwise a participant, it wouldn’t apply to you. It also covers anyone who lends money or furnishes credit for the purpose of financing the proxy contest, except banks and other institutional lenders who are in the business of lending money in the ordinary course of their business.
The reason that you need to determine whether or not any person is a participant is because a statement on what is known as Schedule 14B must be filed on behalf of each participant in a proxy contest. This filing is also one that falls under the requirement of pre-clearance by the SEC and filing with the national securities exchanges upon which the securities of the target are listed. An example of the type of information that must be in Schedule 14B aside from the name and business address of the participant are the principle occupation of the participant, a ten year history of the participant’s material occupations and other employments, a description of prior proxy contests in which the participant has been involved in the last ten years. A description of any convictions for criminal prosecutions in the last ten years, the amount of securities that the participant owns in the target, when he bought them, if he borrowed money to buy them, who he borrowed from and how much, whether or not there are any other contracts or arrangements regarding these securities such as any voting trust agreement or things of that nature and just about anything else that would constitute a participant’s life story. So it is important that before you become a participant, even unwillingly, that you make the decision that you want to go through all of that because I can guarantee you that whatever you disclose will be looked at very closely by the other side and if, God forbid, there is something that you don’t disclose, it will certainly be found out during the course of the proxy contest and all of the related litigation.
Schedule 14A
A proxy statement that is prepared in connection with the proxy contest will have all of the same type of information that is involved in a proxy statement where a proxy contest is not involved and in addition there are other specifics that will need to be disclosed if a proxy contest is going on. Those include such things such as detailed information regarding the persons employed or retained to solicit the proxies, the total estimated costs of the solicitation, the identification of who will bear the cost of this solicitation, and whether or not reimbursement will be sought from the target company.
If reimbursement will be sought from the target, you must disclose whether or not a vote of security holders will be taken on the reimbursement. If a solicitation is terminated pursuant to a settlement with the other side, then a description of the terms of the settlement will also have to be disclosed.
One other thing that is important that would need to be disclosed is if the insurgent group has plans to sell assets or stock after they would take control of the company and plans to distribute as a dividend to stockholders any amount realized by such a sale, then they have to include in their proxy statement information regarding the basis for and the limitations on the projected realizable values.
Although it is very subjective, the SEC has taken the position that where there is a material contingency or any kind of material limitation on these values, then for the insurgents to include an amount that they are calling the realizable value, that the inclusion of that material is unreasonable and is in violation of the proxy rules. A good example of such a situation is where a public company owns a division and an insurgent group determines that if they took control of the company they would sell off that division. Taking the example one step further, the division might have something to do with say, hazardous waste, for example and because of the potential liability involved in such an operation, there is a material contingency on the value of that division. In other words, if the environmental problems are too large, they may not be able to sell the division at all, or if they can, they may not realize anything near what they think it is worth. In such a situation, the SEC would argue that to include a specific dollar value in the proxy statement that is more or less promised to be distributed to shareholders as a dividend after the insurgents take over and sell the division, that such a promise is unreasonable.
Rule 13(d)(1)
Under Rule 13(d)(1), any person or group of persons who acquires more than five percent of any security registered under Section 12 of the ’34 Act, has to file a statement containing the information specified in Schedule 13D with the SEC and copies have to be sent to the issuer of the securities and the exchange on which the securities are traded. Under present law, this has to be filed within ten days after the person or group acquires the five percent interest. As an aside, this is typically what happens when people are gathering stock in an effort to then start a tender offer. They may go up to the 4.9% amount by accumulating stock over a period of time in the market, and then exceed the five percent, file their Schedule 13D, and soon after launch a tender offer. Why this is important in a proxy contest is because of the activities of a group of stockholders who are acting together or acting in concert who in the aggregate own more than five percent of the securities of the target. If they intend to conduct a proxy contest, and are acting together, they could trigger these reporting requirements under Section 13(d)(1), because the rules provide that if securities are owned by two or more persons, they will be aggregated for purposes of computing the beneficial ownership of a group if such persons agree to act together for the purpose of acquiring, holding, voting or disposing of securities of an issuer. Because of the requirements placed upon persons deemed to be participants in a proxy contest under Schedule 14B, and because of the disclosure requirements in Schedule 14A, and because of the potential for the requirement of filing a Schedule 13D, it is important to involve counsel for an insurgent group as early as possible so that violations of the proxy rules or of 13(d)(1) don’t take place.
Insider Trading Issues
One of the original insider trading cases involved Texas Gulf Sulphur, which was based on the concept of equality of access to information. Under this case, anyone who had obtained material nonpublic information had a duty to disclose that information before trading or to abstain from trading in the securities. Later, in two different cases, Chiarella v. United States and Dirks v. SEC, the U.S. Supreme Court rejected this equal access theory. Under these cases, the law was that someone trading securities was only liable for insider trading if they owed a duty to disclose the information. In other words, they would have to breach a pre-existing fiduciary duty owed to the person with whom they traded. This theory created large gaps in the insider trading enforcement area, and consequently, the law evolved to a misappropriation theory. The Supreme Court, in United States v. O’Hagan, said that “a fiduciary’s undisclosed, self-serving use of a principal’s information to purchase or sell securities, in breach of a duty of loyalty and confidentiality, defrauds the principal of the exclusive use of that information.”
Summary
Remember that in a transaction where the acquiror is issuing stock or debt securities to a target’s shareholders, a registration statement with the SEC will be required to be filed unless an exemption from registration is available. Also remember that you need to review each Blue Sky law of each of the states that are involved in your transaction.
Tender offers involve filings with the SEC and have certain advantages and disadvantages. The advantages of a tender offer include the fact that no approval is necessary from the target’s board of directors, it is sometimes cheaper to buy stock than to acquire an assets, there is less chance that the deal will be overturned by a court in the future as being inadequate if there are no competing bids, and a tender offer can be accomplished relatively quickly. The disadvantages of a tender offer include the fees, costs, and premium over market price that can make it a very expensive proposition. There is usually an inadequate due diligence review as a result of a tender offer particularly where it’s a hostile tender offer. It is in “as is” purchase without representations or warranties that are usually contained in a document if it is a negotiated transaction and you may end up with minority stockholders that remain involved in the company’s business.
With regard to proxy contests, they are less expensive than buying a controlling interest in a target company and sometimes don’t trigger the standard poison pill defenses that many companies have put in place. The state anti-takeover provisions are generally ineffective against proxy contests. You don’t want to become a participant in a proxy contest unless you are aware fully of what it is you are getting yourself into. Be sure that you get lots of competent advice as to what actions will constitute proxy solicitation, whether you are a part of the management group or a part of an insurgent group.