Kallick v. SandRidge Energy: Delaware Court of Chancery Finds Board Likely Breached Fiduciary Duty by Failing to Approve Dissident Nominees | Practical Law

Kallick v. SandRidge Energy: Delaware Court of Chancery Finds Board Likely Breached Fiduciary Duty by Failing to Approve Dissident Nominees | Practical Law

In a proxy-contest dispute, the Delaware Court of Chancery ruled in Kallick v. SandRidge Energy that a board's duties under Unocal required it to either approve a dissident slate of directors to avoid triggering a "proxy put" in accordance with Amylin or refrain from soliciting any further consent revocations.

Kallick v. SandRidge Energy: Delaware Court of Chancery Finds Board Likely Breached Fiduciary Duty by Failing to Approve Dissident Nominees

by PLC Corporate & Securities
Published on 14 Mar 2013 • Delaware, USA (National/Federal)
In a proxy-contest dispute, the Delaware Court of Chancery ruled in Kallick v. SandRidge Energy that a board's duties under Unocal required it to either approve a dissident slate of directors to avoid triggering a "proxy put" in accordance with Amylin or refrain from soliciting any further consent revocations.
On March 8, 2013, the Delaware Court of Chancery enjoined the board of directors of SandRidge Energy, Inc. from further soliciting or relying on any consent revocations received in its proxy contest with hedge-fund stockholder TPG-Axon until the board approves TPG-Axon's slate of board nominees. The decision in Kallick v. SandRidge Energy found that the board of SandRidge had likely committed a breach of its fiduciary duties when it refused without reasonable justification to approve the dissident slate for the narrow purpose of avoiding a trigger of the "proxy put" clause in SandRidge's note indentures. Because the Court of Chancery had ruled in 2009 in Amylin that a board can "approve" the slate for contractual purposes without "endorsing" the slate to the stockholders, the SandRidge board had to demonstrate that it had acted reasonably by refusing to approve TPG-Axon's nominees. Although the Court of Chancery did not require the board to show a "compelling justification" for its refusal under Blasius, it still considered the board's refusal to likely be a breach of its fiduciary duties under the intermediate standard of review under Unocal.

Background

The case arose out of a proxy contest, since settled (see Postscript: Case Settled), between SandRidge Energy, Inc. and stockholder TPG-Axon. TPG-Axon had launched a consent solicitation to amend SandRidge's by-laws to declassify SandRidge's staggered board, remove all the incumbent directors at once and install TPG-Axon's proposed slate. In response, the SandRidge board had campaigned to convince the stockholders to not give consents to TPG-Axon and had begun attempts to obtain consent revocations from those stockholders who had submitted consents. Several filings from this proxy contest are collected in Recent Hostile Takeovers and Proxy Contests: Recent Deals.
The incumbent board had argued that TPG-Axon's proposed nominees did not have sufficient expertise in SandRidge's oil and gas exploration industry. But it also had warned its stockholders that their election of TPG-Axon's slate of nominees would constitute a "Change of Control" under SandRidge's note indentures that would require the company to redeem its $4.3 billion in outstanding debt at 101% of par value. This was because the indentures contained change of control provisions that would not merely be triggered by a change in majority ownership of the company's stock, but even by the election of a new board majority not approved by the incumbent board. This form of change of control provision is known as a "proxy put," a type of poison put provision sometimes found in loan agreements and indentures.
The proxy-put covenant has the potential to disenfranchise the stockholders by attaching severe economic consequences to their decision to elect new directors. But in San Antonio Fire & Police Pension Fund v. Amylin Pharmaceuticals Inc., the Court of Chancery ruled that a board can "approve" the dissident slate for purposes of avoiding a trigger of the proxy put and at the same time decline to "endorse" the nominees to the stockholders (983 A.2d 304 (Del. Ch. 2009), aff'd 981 A.2d 1173 (Del. 2009)) (see Legal Updates, DE Chancery Court Interprets Poison Put Provisions in an Indenture and DE Supreme Court Affirms Chancery Court's Decision in Amylin "Proxy Put" Dispute). The SandRidge board did not dispute the Amylin decision, but argued that it was justified under Amylin to refuse to even approve the TPG-Axon slate for contractual purposes. The board's primary argument was that the proxy put held economic value for the company's lenders and that if it were to approve the dissident slate, it would acquire a reputation as a company that circumvents change of control provisions. This, the board argued, would cost the company economically when it would have to refinance its debt.
The litigation in this case was brought by plaintiff Gerald Kallick, a SandRidge stockholder supportive of TPG-Axon's consent solicitation. Kallick argued that the SandRidge board was breaching its fiduciary duties by failing to approve the TPG-Axon slate without having raised any reasonable question about the dissident nominees' fitness to serve as directors or intentions to cause the company to service its debt.

Key Litigated Issues

The dispute between Kallick and SandRidge revolved around two primary issues:
  • Whether SandRidge had, consistently with its fiduciary duties to the stockholders, justifiably refused to approve the TPG-Axon slate. This would typically require showing that the dissident nominees had posed a material threat of harm to the corporation, such as if they "lacked ethical integrity" or were "known looters." SandRidge argued that the dissident nominees did not have the right expertise to lead SandRidge and that circumventing the proxy put would cost it in the credit market.
  • The standard of review for the board's conduct. The Sandridge board argued that the correct standard was the ordinary business judgment rule, under which their decision should be upheld if it could be attributed to any rational business purpose. Kallick argued that the primary purpose of the SandRidge board's refusal to approve the TPG-Axon slate was to disenfranchise the stockholders, thus requiring a "compelling justification" under Blasius.

Decision

The Court of Chancery ruled in favor of Kallick in almost all respects. It found that the SandRidge board had likely violated its fiduciary duties by refusing to approve the TPG-Axon slate. Although the Court of Chancery did not invoke the Blasius standard, it found that the board had not even satisfied the reasonableness standard under Unocal. As a result, it enjoined SandRidge from further pursuing consent revocations or otherwise campaigning against TPG-Axon's slate until it approved the dissident nominees for the sake of avoiding the risk of the proxy put.

The Board Did Not Justify its Refusal to Approve the Dissident Slate

Because the underlying decision in Amylin was not in dispute, the Court of Chancery focused on the factual circumstances surrounding the incumbent board's decision to not approve the dissident slate to identify any reasonable justification for the disapproval. In so doing, it emphasized several key points:
  • The board's insistence that it had better qualifications than TPG-Axon's nominees amounted to little more than typical self-belief of incumbent directors that they can do the best job managing the company. This, however, is a decision appropriately left for the stockholders and "does not come close" to a necessary showing that the dissident nominees lacked the "integrity, character, and basic competence to serve in office."
  • The company's financial advisor's testimony indicated that lenders would not place nearly as much emphasis on the proxy put as SandRidge had argued they would. Rather, the testimony indicated that the key determinant for extending credit to SandRidge would be the prevailing market conditions, which had returned to being favorable. The SandRidge board failed to prove that the company would end up paying a penalty for avoiding a trigger of the proxy put the next time it had to refinance.
  • The record of SandRidge's negotiations of the indentures further supported the idea that the proxy put was of far greater consequence to the stockholders than the lenders. The independent director who testified on behalf of the defendants, and who had been a director in 2008 when the first indentures were entered into, could not recall whether the proxy put had been strongly negotiated with the lenders. The board generally failed to indicate what value it might have extracted from the lenders in return for agreeing to a proxy put that can have the effect of stockholder disenfranchisement.
  • The contention that the stockholders would be confused by the board's approval of the dissident nominees for the sole purpose of avoiding triggering the proxy put was inconsistent with the fundamental premise that stockholders have a right to vote on important matters like the election of directors.

Unocal Standard of Reasonableness Applied

The Court of Chancery essentially split the difference between SandRidge's argument to apply the business judgment rule and Kallick's argument to apply the Blasius standard. It instead applied the intermediate standard of review under Unocal that is applicable when boards make decisions that implicate their continued control of the corporation. The Unocal standard requires boards to justify their actions as reasonable in relationship to the threat posed.
In declining to apply Blasius, the Court of Chancery explained that Blasius is better thought of as a case that stands for the "emphatic and enduring critical role in underscoring serious scrutiny" of actions that threaten the stockholder vote than as a "useful standard of review to decide actual cases." Blasius is only applicable in the rare instance where the "sole or primary purpose" of the board's action was to impede the stockholder vote. The agreement to a proxy put and refusal to avoid its trigger could not be said to have reached that level, because those actions could have had a legitimate purpose of protecting creditors.
Nevertheless, the board's actions did not satisfy the Unocal standard for reasonableness in relationship to a posed threat. Because the board had not articulated why election of the dissident nominees would harm the corporation, its refusal to approve them could only be understood as an effort to gain an advantage in the proxy contest with TPG-Axon.

Practical Implications

Since the 2009 Amylin decision, the Delaware courts had already established that a board of directors can approve a dissident slate of director nominees to avoid triggering a proxy put, even as it continues to oppose the slate in its proxy materials. The SandRidge decision (and its aftermath; see Postscript: Case Settled) demonstrates that the board will likely be expected to provide that approval to avoid a breach of its own fiduciary duties. To demonstrate reasonableness in refusing to approve the dissident nominees, the incumbent board must show that the company will suffer severe harm if the stockholders are given the opportunity to vote for those nominees.
The SandRidge decision also emphasizes the necessity for a board to strongly push back against lenders in the first place when negotiating a proxy put. The proxy put is a restrictive covenant that can have the effect of disenfranchising the stockholders and should only be agreed to if the company will receive some tangible economic benefit in return that it needs and that it would not otherwise have received. In the SandRidge decision, Chancellor Strine does not hide his disappointment that the SandRidge board could not provide any evidence that it had seriously negotiated the proxy put. Counsel responsible for negotiating credit agreements and other documents with change of control provisions that could implicate stockholder voting rights should take heed of this implicit warning.
Less primary to the SandRidge decision but also noteworthy is the first footnote of the opinion that describes the company's implementation of a staggered board in the by-laws instead of the charter as a "rare flaw." This owes to the opportunity it gives the stockholders to unilaterally take action to declassify the board. Staggered-board provisions should be written in the charter so that their change must first be recommended by the board. For an example of a staggered-board provision for inclusion in the charter, see Standard Clause, Certificate of Incorporation: Staggered Board Provision.

Court Documents

Postscript: Case Settled

The day after the SandRidge decision, the company announced that its board had approved the dissident slate in order to satisfy the Court of Chancery's injunction. On March 13, 2013, the company announced a settlement with TPG-Axon in which, among other agreements, four of TPG-Axon's nominees would be added to SandRidge's board effective immediately.