United States: Shareholder Activists Attack Parachute Payments in M&A Transactions

It would be an understatement to say that the world of corporate governance has changed. While the first few rounds of reform were handed down to boards in the form of legislation, SEC implementation, and governance ratings criteria from independent firms, the tide has shifted to the shareholder/company relationship. The withholding of shareholder votes during Disney’s 2004 proxy process is probably the most well-known recent manifestation of shareholder dissatisfaction, but Disney was by no means alone last year. According to an article by a representative of Institutional Shareholder Services, or ISS, an independent proxy and advisory firm, shareholders withheld 30 percent or more of the votes from at least one director of AOL Time Warner, Starwood Hotels & Resorts, and others. Not to be outdone, earlier in 2004, the California Public Employees’ Retirement System, or CalPERS, was on pace to withhold votes for directors at 90 percent of its investments, and Vanguard Group, the second-largest U.S. mutual fund, approved only 29 percent of the full slates of nominated directors of companies in which it invested.

Of course, embedded in the media’s coverage of Disney was the issue of executive compensation. Shareholders have joined the media’s party and filed proposals targeted at executive compensation at a variety of companies, including HP, Alcoa, and Sprint, and it now seems clear that executive compensation has stolen the focus from the traditional antitakeover targets of governance reformists, such as classified boards and poison pills. In fact, two highly publicized transactions, AXA Financial’s acquisition of MONY and Anthem’s acquisition of WellPoint, have brought shareholder activism and executive compensation into the M&A arena. This should come as no real surprise, given that the announcement of a transaction typically rings the bell for the final round of shareholder participation for the target company.

Disgruntled shareholders have a variety of tools at their disposal to further their agenda. The arsenal includes, in escalating order, making public statements criticizing the company, making precatory shareholder proposals, soliciting support from independent proxy firms, organizing and holding investor conferences, withholding votes, engaging in proxy contests, and initiating litigation, both in the traditional sense and pursuant to the exercise of dissenters’ rights. In fact, given the emergence of new and flexible valuation models and courts’ recent willingness to find dissenters’ rights actions favorable for class certification, dissenters’ rights have become an increasingly prevalent tool for shareholder attacks on M&A transactions. The MONY and WellPoint acquisitions, in which shareholders utilized several of these tools, provide a blueprint for institutional shareholders targeting parachute payments.

In September 2003, AXA Financial and MONY announced that the financial services firms had entered into a merger agreement under which AXA Financial agreed to acquire MONY in a cash transaction valued at approximately $1.5 billion, representing an approximately 6 percent premium to MONY’s closing share price on the day before the announcement. The merger agreement permitted MONY to pay a preclosing cash dividend to its shareholders of up to $12.5 million ($0.23 to $0.25 per share, according to AXA Financial and MONY public filings) and was conditioned on holders of not more than 10 percent of the outstanding shares perfecting their appraisal rights.

According to preliminary proxy materials filed by MONY, MONY executives had the potential to receive approximately $90 million (or 6 percent of the transaction consideration) under change-in-control agreements if their employment terminated for customary reasons following the transaction. MONY also disclosed that it amended its existing change in- control agreements with 13 of its executive officers months earlier, in anticipation of the transaction, to reduce the potential payouts under the agreements. The original payouts would have netted management approximately 15 percent of the merger consideration, and the payment reduction resulted in a dollar-for-dollar increase to the public holders.

Between late September and early October 2003, 10 shareholders filed class action lawsuits in the Delaware Court of Chancery that were subsequently consolidated and followed by an amended complaint in early November. The complaint alleged inadequate merger consideration and a breach of fiduciary duties by the MONY board of directors for, among other reasons, improperly diverting merger consideration from shareholders to management under the change-incontrol agreements.

Despite these lawsuits and two similar lawsuits filed in New York State Supreme Court, MONY filed its definitive proxy statement in early January 2004 and set a shareholder meeting date of February 24, 2004. The proxy statement indicated that 11.5 percent of MONY’s shareholders had already demanded appraisal by this time.

In late January 2004, institutional shareholders Highfields Capital and Southeastern Asset Management (in its capacity as investment advisor to Longleaf Partners Small Cap Fund) announced their intent to vote their MONY shares against AXA Financial’s offer. Southeastern Asset’s initial press release indicated that the purchase price was significantly below MONY’s book value. Southeastern Asset also noted that senior management’s interests conflicted with the overall shareholder base (stating that a 1 percent to 1.5 percent payout to management was customary) and that "[i]n view of MONY’s performance since the IPO and the inadequate price negotiated with AXA . . . senior management should be replaced, not rewarded." Similarly, Highfields Capital stated in a letter to shareholders that the sale was driven by "the desires of MONY’s current management, which [had] failed miserably to enhance MONY’s value." Both institutions indicated their intention to communicate with other shareholders through exempt proxy solicitations.

Amid additional public statements by the institutional shareholders, MONY filed a lawsuit in the U.S. District Court for the Southern District of New York seeking to enjoin the institutional shareholders from including MONY’s proxy card in its correspondence with shareholders.

Later in February 2004, the Delaware Court of Chancery held in the class action suit that the M ONY board had not breached its fiduciary duties in entering into the merger agreement. The court required MONY to amend its proxy disclosure to clarify that the change in control payments were in excess of the amount paid in comparable transactions (i.e., above the 75th percentile, which was determined to be slightly lower than 5 percent).

Shortly thereafter, MONY announced that the merger agreement had been amended to permit an additional $0.10 dividend to MONY shareholders and to modify AXA Financial’s closing condition relating to appraisal rights in MONY’s favor. Senior management voluntarily agreed to give up certain contractual rights by reducing their change-in-control payments by $7.4 million ($4.8 million after tax) to fund the additional dividend on a dollar-for-dollar basis. At the same time, the board postponed the meeting until May 18, 2004, and established a new record date of April 8, 2004.

Also at the end of February, ISS issued a recommendation that MONY shareholders vote against the proposed merger, stating that "the lack of an auction process to sell the company, rich goodbye package to management and the company’s historical underperformance to peers, creates a mosaic of management actions not serving shareholder interests." Glass, Lewis & Co., another proxy firm, issued a similar recommendation and noted that "the decision to throw in the towel was appreciated, no doubt, by the management team, which likely sees this transaction as a way to both mask its own failures and collect tens of millions in golden parachutes."

Despite the flurry of opposition and litigation, MONY shareholders voted in favor of the deal, although just barely, and the acquisition was completed in early July 2004.

In October 2003, Anthem and WellPoint Health Networks announced that Anthem would acquire WellPoint for approximately $16.4 billion. While opposition to Anthem’s acquisition has received significant press coverage, shareholders of both companies overwhelmingly approved the transaction in late June 2004.

Earlier in June 2004, CalPERS, a shareholder of both Anthem and WellPoint, announced that it would oppose the transaction as a result of executive compensation packages it estimated at more than $600 million for 293 executives. WellPoint consistently argued that the actual eligible payments were between $147 million (if all executives stayed and received retention bonuses) and $356 million (if all executives were dismissed within three years). The California State Treasurer, who is also a CalPERS board member, joined in CalPERS’ opposition and expressed his concern that California ratepayers would be indirectly funding the payments. According to the news media, other shareholder groups opposing the merger included the California State Teachers’ Retirement System, the New York State Common Retirement Fund, the New York State Teachers’ Retirement System, the Los Angeles County Employees’ Retirement System, and the Illinois State Board of Investment.

Unlike in the AXA/MONY transaction, ISS issued a recommendation in favor of the WellPoint acquisition. In recommending the deal, ISS noted that, in the context of evaluating goodbye packages, it is "primarily concerned with the potential for rich exit payments to adversely affect the negotiation of deal terms from the perspective of the non-insider shareholder." As a result, ISS focused not on the aggregate payments to all executives, but rather on the payments to the top 12 executive officers—those likely to be at the negotiating table. Given Anthem’s public representations that the vast majority of executives would stay and CalPERS’ apparent double counting of severance and retention bonuses, ISS concluded that $200 million (or 1.1 percent of the deal value) was the more likely payout. Acknowledging that the size of the payout raised a "red flag," ISS concluded that the potential negative effects were outweighed by the significant premium paid in the transaction (approximately $4.6 billion), the strategic rationale for the transaction, the expected cost and revenue synergies, and Wall Street’s response to the transaction.

Prior to the shareholder vote, the California State Insurance Commissioner made it clear that he would not support the acquisition unless Anthem agreed to invest hundreds of millions of dollars on health care programs, arguing that without the investment, the merger offered no benefit to state residents. In late July, he ultimately denied the approval request, despite Anthem’s and WellPoint’s offer to spend nearly $500 million in state programs and to defer $100 million of the compensation packages. Anthem subsequently sued the Commissioner in early August, and the case was dropped in November after the Commissioner dropped his opposition in exchange for the companies agreeing to spend $265 million on health programs and not to raise premiums to pay for the merger. In May 2005, the Commissioner began an investigation into whether post-merger premium increases were used to cover merger transaction costs.

Motivated by what they deemed to be "lavish rewards" as a result of mergers engineered by executives, several CalPERS board members, including the California State Treasurer, late last year requested that CalPERS take the lead in enlisting other institutional investors and setting tough new executive severance policies with the goal of mounting a national campaign against executive compensation and merger plans that do not comply with their guidelines. The suggested model policy would prohibit accelerated vesting of options for top executives in mergers, place limits on the size of severance payments, and preclude 280G gross-ups.

The MONY and WellPoint acquisitions have resulted in more than interesting reading. While it can be said that CalPERS picked the wrong battle in that it misunderstood the potential payments and that much of the opposition to the Anthem/ WellPoint merger had at least as much to do with protecting California residents as Anthem shareholders, the transaction nonetheless instigated the CalPERS board members’ announcement of their intention to reform a system that in their view unfairly compensates management at investors’ expense. AXA Financial’s acquisition of MONY, on the other hand, was the perfect storm for shareholder revolt—a seemingly excessive goodbye kiss for management in a deal priced at 75 percent of book value. The transaction also resulted in federal case law that restricts the use of a company’s proxy card in communications by dissident shareholders and Delaware case law that requires increased disclosure regarding executive compensation in certain circumstances. More important, though, both transactions illustrate yet another avenue for chipping away at a board’s decisionmaking ability.

It is no secret why golden parachutes exist. Although it was largely ignored in the media coverage of these transactions, the governance community believes that golden parachutes serve as antitakeover protection and are therefore viewed

with suspicion as mechanisms to entrench management. This view, however, ignores the real purpose of change-in-control payouts, which is ironically the same reason that the governance community initially embraced parachutes. Golden parachutes are designed to attract and retain executives and make them neutral to mergers, thereby removing one impediment to a company sale. In other words, boards want management to act in the best interests of the shareholders, and sometimes that means deciding to sell the company in the face of a probable termination of employment. A golden parachute softens the landing.

But the opposition to the MONY and WellPoint acquisitions turned that logic on its head. The shareholders’ complaints were based on the premise that management will in fact push for a transaction that is bad for the company and its investors in order to trigger their own compensation payments. Aside from the fact that this directly contradicts the governance community’s view that golden parachutes inherently entrench management, this argument presupposes, as does most of the reformists’ logic in the post-Enron world, that executives are motivated solely by greed. And it also presupposes that a board is unable to make determinations about executives’ conflicts, their ability to act in the best interests of their shareholders, and other relevant factors when approving change-in-control contracts. Whereas judicial deference to the board’s decision-making process, of course, can help boards in lawsuits, the use of the media and other tools to oppose payments to management bypasses the judicial process and therefore can render a board’s rationale irrelevant in the forum of public opinion. Circumstances can be conveniently ignored because the bottom-line size of payments to executives evokes the most visceral public reactions.

Although the ’80s and ’90s helped prepare companies for attacks by corporate raiders, shareholder activism is a different kind of attack, and defending against it in the context of an M&A transaction arguably is as—or more—complicated than defending against a takeover. Boards, companies, and practitioners can, of course, hope that shareholder challenges to executive compensation in M&A transactions will be limited to outlying situations such as the MONY acquisition; however, given the fact that CalPERS’ crusade was instigated by a transaction involving customary parachute payments and the overwhelming support of shareholders generally, it is probably naïve to count on it. As a result, companies can and should take preemptive measures to defend against these attacks, such as reviewing parachutes to ensure that executives are adequately protected and considering funding change-in-control payments upfront or in anticipation of a change in control. In addition, provisions can be added to parachute contracts to ensure that the payments will be triggered if the contract is terminated at the request of an acquirer prior to a change in control, in order to avoid manipulation of payments at executives’ expense.

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