October 1999: Shorewood Packaging, a Delaware-based paper manufacturer, shocks rival executives at Richmond, Virginia-based Chesapeake Corporation with an unsolicited $40 per share bid (note: specifying the locations of the two companies isn’t journalistic window-dressing, they soon come into play). Chesapeake – trading at roughly $26 per share with annual revenue, at $1 bn, twice that of Shorewood’s – rejects the offer, labeling it ‘inadequate’ and not in the best interests of shareholders (another salient point to keep in mind).
Whether or not shareholders agreed with Chesapeake’s position was irrelevant. Virginia, its home state, has no laws against dead-hand poison pills (see Glossary for definition), the number one anti-takeover measure on corporate governance activists’ list of most despised. Chesapeake has a deadhand poison pill. But the company’s defenses also included a staggered board, making it difficult to remove all directors at once and dragging out a potential proxy vote. So Chesapeake’s anti-takeover defenses rendered the company nearly impregnable to a hostile takeover.
The situation at Shorewood was different. In Delaware, deadhand poison pills have been outlawed. And given this geographic disadvantage, the company soon went from hunter to hunted, as Chesapeake quickly turned the tables and launched its own hostile bid for the would-be acquirer with a $12 per share offer – a so-called Pac Man defense.
Shorewood’s outgunned board, which called Chesapeake’s offer inadequate – sound familiar? – quickly voted to amend its bylaws to require a two-thirds vote for shareholders to further change the bylaws. Given management’s stake, the move ensured shareholders couldn’t muster a majority. The maneuvering infuriated shareholders and activists and so the board backtracked, lowering the threshold to 60 percent – still above the ‘simple majority’ in the original bylaws.
Battle of the defenses
What ensued was a bruising courtroom drama, as Chesapeake went into Delaware court arguing against Shorewood’s defensive tactics. Some of the more salacious facts that emerged were certainly entertaining. As Chesapeake sought to highlight the impropriety and incompetence of Shorewood’s board, an outside director testified that she was aware the chairman and CEO, Marc Shore, had serious financial problems and significant trading losses when Shorewood extended him a $2 mn personal loan and guaranteed a portion of an additional loan.
In the end, in his 136-page decision, vice chancellor Leo Strine of Delaware Chancery Court sided with Chesapeake, rejecting the argument that Shorewood’s defensive strategies were needed to protect shareholders lacking the sophistication to understand their choices. ‘Given the fact that at that time over 80 percent of Shorewood’s shares were held by management and institutional holders…the risk of confusion was, at best, quite a weak one,’ Strine said.
Strine also pushed aside Shorewood’s contention that its own strategy, which the company refused to divulge, would ‘generate a higher realizable value than $17.25 [offered by Chesapeake] in the relatively near future.’ Opined Strine, ‘Having cloaked itself in the business strategy privilege, the Shorewood board has cut off any ability of the court to assess how inadequate the Chesapeake offer really is.’
For governance experts, the judge’s findings were extraordinary. ‘Essentially, the case sends this message: you can’t argue a stock offer isn’t enough without proof. If you’re going to argue that your market price doesn’t reflect true value, you have to explain why you haven’t convinced investors of this. What are you doing in terms of changes in management and policy, what are you doing to communicate your story and why aren’t those changes reflected? These questions the company couldn’t answer,’ says Ira Schochet, an attorney with Goodkind Labaton Rudoff & Sucharow who’s been involved in several class actions on takeovers.
Charles Elson, professor at Stetson Law School and a legal expert on director responsibilities, takes the significance of the case further. He says it will become a landmark decision. ‘The case shows the Delaware courts have lost patience with just say no and similar defenses. It’s also a real victory for shareholder suffrage. The courts are saying that when board authority begins to interfere with shareholder suffrage rights, that isn’t right. Here, the court seemed to be saying that Shorewood’s bylaw changes interfered with the fundamental voting rights of shareholders. That’s a significant ruling.’
The Delaware decision was also unique in its criticism of the Shorewood board’s decision-making process. ‘Courts rarely critique a board’s judgement. Here, the judge said its argument that shareholders needed protection was inadequate. He said if investors are smart enough to invest in you, they’re smart enough to know when to sell,’ says Elson (see Mr Popularity, below).
A second story
But there was another story hidden in the Shorewood-Chesapeake drama, which has to do with winners and losers: while Chesapeake emerged the victor in February, the postscript to the court case suggests otherwise. In late February, International Paper offered to pay $21 a share for Shorewood, roughly $100 mn more than Chesapeake was offering.
Shorewood’s shareholders ended up with a premium, while Chesapeake’s saw their stock price languishing in the low 20s (although it rebounded to the low 30s in April). Michael Beall, in charge of research at Richmond-based Davenport & Co, one of Chesapeake’s largest holders, thought a merger was best for both companies. ‘We were disappointed Chesapeake dismissed the offer out of hand,’ he says. ‘ The Chesapeake alternative, of the company reinventing itself as a packaging company, is a risky endeavor. In my view, shareholders would have been better off with the $40 offer.’
The irony is that Chesapeake argued against a defense it had used itself. ‘Chesapeake should have taken its own medicine and explained its plan for creating value. Even the judge noted this was a case of the pot calling the kettle black,’ says Leonard Chazen, partner at law firm Covington & Burling.
So the whole story really came down to the victory for shareholder voting rights, as advanced by the Delaware court’s ruling against Shorewood’s attempts to rewrite its bylaws; and to the detrimental effects of anti-takeover defenses that reduce shareholder voices.
‘This takeover battle was a particularly symmetrical case, because both companies had pernicious governance practices. Shorewood’s board is one of the most insider-dominated around. Chesapeake has a better board, but it has provisions that render it shareholder proof,’ says Kenneth Bertsch, corporate governance director at TIAA-Cref, a significant shareholder in both companies.
Chesapeake has now become a target for proponents of good governance. But according to Joel Mostrom, VP of IR at Chesapeake, the deadhand pill wasn’t relevant to the court case. He says three issues made a Chesapeake acquisition of Shorewood more appropriate than vice versa. First, the question mark about the financing needed to pull off the deal. Second, the fact that the Shorewood takeover would result in a highly leveraged company moving forward. And third, ‘We thought we had better international management experience.’
Mostrom says the deadhand provision has been in place for years; people buying shares understood the circumstances. The real issue was Shorewood’s attempt to change the rules, he says. ‘Shorewood amended its bylaws subsequent to our offer being put in place. We haven’t taken steps to change the rules we have in place.’
According to Michael Beall, however, Shorewood’s financing would have been ‘doable’. And Shorewood was a strong operator so the offer should have been considered more diligently. In fact, Beall assumed ‘money would talk’ in the end but that didn’t happen because of Chesapeake’s anti-takeover measures and its Pac Man defense. ‘I’m sure Chesapeake believes its strategy will gain more for shareholders in the end. People would have been more supportive if they’d convinced us they could execute their strategy. But given the deadhand poison pill, which in my view no company should have, my hands were tied regardless of what I thought. I could only elect a director who has no say.’
