Understanding Act 6 of 2006 - The Latest Changes to the BCL
The following article was published in the Pennsylvania Bar Association's Spring 2006 Business Law Section Newsletter.
Removal of Directors
On February 10, 2006, Pennsylvania's Governor signed Senate Bill 595 into law as Act 6 of 2006 (the Act) became law, generating significant controversy over the broad impact of the hastily approved legislation and the appropriate role of state government in an ongoing battle for corporate control of Sovereign Bancorp Inc., a publicly traded Pennsylvania corporation.
The battle for control over Sovereign stems from an attempt by Sovereign to place a large block of its common stock with Banco Santander Central Hispano S.A., in order to generate the funds necessary to permit Sovereign to purchase another bank. The Banco Santander transaction is being objected to by Sovereign's largest shareholder, Relational Investors LLC, which has launched a proxy contest seeking to remove Sovereign's incumbent directors and install a new slate of directors. Relational alleges a host of grievances against the existing board of directors, including violations of basic corporate governance principles.
I will refrain from commenting on the merits of the ongoing battle for control of Sovereign, which led to passage of the Act as well as the question of whether the state has a legitimate role in stepping in to take action to help protect an incumbent board of directors from being removed by shareholders or to help facilitate a corporate financing transaction. However, I want to provide some commentary on what the Act actually provides and on the likely impact of the changes effected by the Act on Pennsylvania corporations.
One of the two principal changes effected by the Act was a modification of Section 1726 of the Pennsylvania Business Corporation Law of 1988 (the BCL), the section that governs removal of directors of corporations incorporated in Pennsylvania. As discussed below, the change is not ground-breaking and will likely impact at most a small number of Pennsylvania corporations, or perhaps only one - Sovereign. Many media reports discussing this change have reflected a misunderstanding of the nature of the modifications to Section 1726 as well as a misunderstanding of the basic rules governing removal of directors of Pennsylvania corporations depending on whether the board has been classified as to the directors' terms of office.
A classified or “staggered” board of directors has its members separated into several classes, typically three, with each class being as nearly equal in number as possible. In the typical configuration, the term of office of each class is three years and the term of one class expires each year, with the director seats of the expiring class being up for election at the annual meeting of shareholders.
In recent years a small number of well-known public companies have declassified their boards of directors in response to pressure from shareholder activists and corporate governance watchdogs. Because all of the members of a board of directors that is not classified are up for election annually, an unclassified board is perceived by many to be more in line with modern corporate governance principles than a classified board. Another attribute of an unclassified board is that directors may be removed by shareholders without cause.
While there is growing pressure for publicly traded companies to declassify their boards, it is still quite common for publicly traded companies to have a classified board of directors, as a means of impeding an unsolicited or hostile takeover of corporate control.
If the board of directors is classified and the classification of the board of directors is set forth in a by-law approved by shareholders or in the articles of incorporation (which are required in any event to be approved by shareholders), then unless the articles of incorporation provide otherwise, directors may only be removed by the shareholders for cause. As a technical matter, a corporation with a classified board that has been approved by shareholders in the articles or bylaws will achieve this limited removal ability even if the articles or by-laws are silent with respect to the manner in which directors may be removed. Nevertheless, the issue of removal is typically directly addressed in the articles or by-laws by clearly setting forth the “for cause” requirement for removal by shareholders.
This ability to prevent shareholders from removing directors without cause is the most powerful function of a classified board structure from the perspective of its utility as an anti-takeover measure. Through effective board classification, it would take at least two consecutive annual shareholder meetings for a shareholder seeking to acquire control of the corporation through control of the board of directors to elect directors holding a majority of the board seats. The two-year time requirement is illustrated as follows. At each of the next two annual shareholders meetings, approximately one-third of the total board seats would be up for election. Assuming that the director nominees of the shareholder seeking control were elected at two consecutive annual meetings of shareholders, the shareholder's director nominees would comprise approximately two-thirds of the total board seats and would thereby be in control of board decisions. The general perception is that a shareholder seeking control of a corporation will not have the patience to wait for two years to achieve the goal of acquiring control of the corporation's board of directors.
Without classification of the board, or even with a classified board but with a provision in the articles of incorporation permitting removal of directors by shareholders without cause, a shareholder or group of shareholders desiring to take control of a Pennsylvania corporation could seek to remove the incumbent directors at a single shareholders meeting, coupled with the nomination of an alternate slate of directors backed by the shareholder or group of shareholders. If a majority of the votes cast by shareholders at the meeting (or such higher vote as may be required under the articles or by-laws) were voted in favor of removal, all of the incumbent directors would be removed from office, leaving the board seats vacant and eligible to be filled by the alternate slate. Because directors of Pennsylvania corporations are generally elected by a plurality vote (which is an easier standard to achieve than a majority vote), the same shareholders who mustered the majority vote necessary to remove the incumbent board will be successful in electing the alternate slate of director nominees, and the entire board will have been replaced at one meeting.
Classified boards are just one tool in a corporation's anti-takeover arsenal. Together with other measures such as statutory anti-takeover schemes, shareholder rights plans, authorized and unissued “blank check” preferred stock, a limitation on the ability of shareholders to call special meeting of shareholders, fill vacancies on the board of directors, or act by less than unanimous written consent, supermajority voting requirements for certain actions in the articles and by-laws, and certain other techniques, a classified board helps a board of directors prevent or delay a takeover or change in control unless the takeover or change in control is approved by the board of directors. Accordingly, while there certainly may be rare exceptions, it is hard to imagine circumstances under which a Pennsylvania corporation would implement a classified board structure and then provide in the articles of incorporation that directors may nevertheless be removed by shareholders without cause.
Which brings us to a discussion of the nature of, and reason for, the recent change in Section 1726 effected by the Act. Prior to the Act, Section 1726 provided that if a company had a classified board where the classification had been approved by shareholders in the articles or the bylaws, then unless the articles of incorporation provided otherwise, the entire board of directors, any class of directors, or any individual director could only be removed by shareholders for cause. The Act clarifies just how clear the articles of incorporation must be in order to permit shareholders to remove directors of a classified board without cause. The Act now requires that in order for shareholders of a corporation with a classified board to be able to remove directors without cause, the articles of incorporation must include “a specific and unambiguous statement that directors may be removed from office without assigning any cause.”
Why would the Pennsylvania Legislature have seen fit to add this requirement for unambiguous specificity? It seems that Sovereign, which has a classified board, has a provision in its articles of incorporation which, viewed through the lens of a long history of public disclosures by Sovereign describing the rights of shareholders to remove directors, could permit shareholders to remove any or all of its directors without cause.
In addition to a customary classification provision, Sovereign's articles include the following sentence: “No director of the Corporation shall be removed from office, as a director, by the vote of shareholders, unless the votes of shareholders cast in favor of the resolution for the removal of such director constitute at least a majority of the votes which all shareholders would be entitled to cast at an annual election of directors.” This statement effectively increases the number of shareholder votes that must be cast in favor of removal of a director from a majority of a quorum, which would ordinarily apply, to a majority of the shares outstanding. The statement does not state that directors may not be removed without cause, nor does it clearly state that directors may be removed without cause. The issue of cause is simply not directly addressed. Absent other extrinsic evidence providing some basis for interpreting this statement to upset the general rule requiring cause for the removal of directors of a classified board by shareholders, this quoted statement may well not have much significance as to the issue of cause.
However, in Sovereign's case, there is no shortage of extrinsic evidence. In a series of filings with the Securities and Exchange Commission spanning a period of over a decade, Sovereign included a statement indicating that directors may be removed by shareholders without cause. One recent example of such a statement in an SEC filing states as follows: “Sovereign directors may be removed from office without cause by the affirmative vote of a majority of outstanding voting shares.”
In a March 3, 2006 decision of the U.S. District Court for the Southern District of New York, the Court ruled that the provision in Sovereign's articles describing the majority voting requirements for shareholder removal of directors permits Sovereign's shareholders to remove directors without cause, thereby reversing the normal result for a corporation with a classified board because the articles “provided otherwise.” The Court also ruled that changes to Section 1726 effected by the Act should not be applied in the Sovereign case, because Relational should be considered to have a vested right in the standard for removal of Sovereign's directors as in effect prior to enactment of the Act. This opens the door to the ability of Relational to solicit proxies from other shareholders to vote at Sovereign's annual meeting to remove all of Sovereign's directors and replace them with nominees more to Relational's liking - directors who would presumably seek to avoid having to proceed with Sovereign's pending transaction with Banco Santander.
So, barring any countervailing developments in the ongoing litigation, it seems that the Pennsylvania Legislature's efforts to insulate Sovereign from the potential removal of its directors through Relational's proxy contest have been for naught. It is likely that the Act will similarly have little, if any, impact for the vast majority of other corporations incorporated in Pennsylvania. The media has predominantly presented the change to Section 1726 as portending a much more significant impact on shareholder rights in Pennsylvania than can reasonably be predicted through a careful review of the Act and the pre-existing law. In numerous press reports describing the ramifications of the Act, the media have reported that the Act reverses pre-existing law. Many press reports concerning this change have erroneously suggested that the Act results in a reversal of the law, reportedly prohibiting removal of directors by shareholders without cause unless the corporation's articles of incorporation provide otherwise, whereas pre-existing law reportedly would have permitted shareholders to remove directors without cause unless the articles provided otherwise. For the vast majority of Pennsylvania corporations, and perhaps all Pennsylvania corporations other than Sovereign, this reporting gives the wrong impression.
On the one hand, the Act has no impact on corporations without classified boards - shareholders of those corporations have been and will continue to be able to remove directors without cause. On the other hand, with respect to corporations with classified boards, typical custom and practice in the establishment of a classified board is either to remain silent in the articles and bylaws concerning the ability of shareholders to remove directors, or, preferably, to include a provision confirming the prohibition against removal of directors by shareholders without cause. Furthermore, one would expect that the vast majority of Pennsylvania corporations do not have provisions in their articles that give rise to ambiguity as to whether directors may or may not be removed by shareholders without cause, with which Sovereign had to contend. For this vast majority of Pennsylvania corporations not faced with the difficulties inherent in Sovereign's case, the language in Section 1726 of the BCL as in effect prior to the Act would have adequately protected directors of a properly classified board from removal by shareholders without cause, and the Act will not change anything for those corporations.
Changes to Anti-Takeover Law
The second of the two principal changes effected by the Act to the BCL, was also adopted to help Sovereign. Chapter 25 of Pennsylvania Business Corporation Law of 1988 (BCL) contains a number of Subchapters, of which Subchapters E through J comprise a large part of Pennsylvania's public company anti-takeover laws. Subchapter E generally provides that any person or group who or which acquires the right to vote at least 20% of a public company's voting shares (defined as a “controlling person or group”) must make an offer to purchase all of the outstanding voting shares of the company that it does not already own for “fair value,” which is no less than the highest amount the controlling person or group paid for voting shares in the past 90 days. The Act adds an exception to the definition of “controlling person or group” in Subchapter E which will permit Pennsylvania public companies to place large blocks of voting stock in corporate financing transactions without triggering Subchapter E. Before the Act was adopted, public companies that had not opted out of Subchapter E could not engage in corporate financing transactions that would result in a shareholder having more than 20% of the voting power of the company without triggering the repurchase obligations of Subchapter E.
As with the other Pennsylvania anti-takeover subchapters, corporations can opt out of the application of these protections, and because of the shareholder approval requirements associated with opting out, corporations typically decide which subchapters to opt out of while they are still private companies with relatively few shareholders. After a company's initial public offering, the nature of its shareholder base changes and it is usually no longer practical to opt out of those anti-takeover laws for which shareholder approval is required. It is not uncommon for Pennsylvania companies considering an IPO to opt out of Subchapter E as well as all of the other anti-takeover subchapters other than Subchapter F.
A typical view of companies considering an IPO is that it is beneficial to opt out of anti-takeover laws that will apply with respect to, and thereby create potential impediments in connection with the design or consummation of, a future takeover that the board of directors believes to be in the best interest of the shareholders. On the other hand, it is generally considered beneficial to remain subject to, and not to opt out of, anti-takeover laws which the board of directors retains the discretion to opt out of in the future, at a time when it is considering a specific takeover transaction. Currently, the only subchapter that offers such future discretion to Boards of Directors is Subchapter F, which, if not opted out of either altogether or with respect to a particular proposed transaction, would impose a five-year moratorium on business transactions between a Pennsylvania public company and a person or group who or which acquires at least 20% of the company's voting stock.
The Act modifies Subchapter E by causing any shares acquired by a person or group directly from the public company in a private placement (or other transaction exempt from the registration requirements of the Securities Act of 1933) not to be counted towards the 20% threshold that results in “controlling person or group” status. Sovereign, which has apparently not opted out of Subchapter E, has agreed to sell a 19.8% stake in its common stock to Banco Santander. This alone would not trigger the obligation to repurchase all outstanding shares imposed by Subchapter E. However, Relational has alleged that for purposes of the 20% test in Subchapter E, this 19.8% stake should be aggregated with shares owned by Sovereign management amounting to approximately 8% of Sovereign's outstanding voting shares, together with a contractual right given to Santander to acquire an additional 5.2% of the outstanding voting shares, resulting in Santander becoming a “controlling person or group” and triggering the consequences of Subchapter E. Because “controlling person or group” status is triggered through acquisition of the right to vote more than 20% of a Pennsylvania public company's voting shares, including through any arrangement or understanding, it is theoretically possible to achieve the type of deemed aggregation that Relational is asserting, at least with respect to outstanding voting shares such as those owned by Sovereign management. This would require evidence of the existence of such an arrangement or understanding. It remains to be seen whether a court will give effect to this change to Subchapter E in connection with the pending Sovereign litigation, and if so, whether Relational will be successful in its litigation efforts to prove the existence of such an arrangement or understanding.
The change to Subchapter E resulting from the Act will enable boards of directors of Pennsylvania public companies that have not opted out of Subchapter E to structure sales of large blocks of voting stock in private placement financing transactions without triggering the repurchase obligations imposed by that Subchapter. At the same time, these companies will retain the anti-takeover deterrent provided by Subchapter E. Although this change may be objectionable to shareholder activists and institutional shareholders, it will be welcomed by boards of directors of Pennsylvania public companies which have not opted out of Subchapter E, and which have previously been delayed or prevented in attempts to engage in transactions that involve the issuance of 20% or more of their voting stock. In addition, Pennsylvania corporations considering an IPO may well choose not to opt out of Subchapter E prior to going public, because that Subchapter would no longer present the limitations on director-approved corporate financing transactions that it has in the past.
Robert A. Friedel
Thanks to Stephanie Pindyck-Costantino, a Pepper associate, for her editorial assistance with this article.
This article is informational only, and should not be construed as legal advice or legal opinion on specific facts.