Proxy Battle Highlights Ability To Remove Directors

The intense battle between Sovereign Bancorp and one of its largest shareholders, activist hedge fund Relational Investors Corp., has shined a spotlight on a rarely used practice for ousting directors that somewhat resembles a majority-voting policy.

It also underlines a critical, overlooked reason why companies have favored staggered boards of directors and even raises questions about the effectiveness of classified boards.

Relational recently announced it is fielding its own nominees for two open director positions at Sovereign’s 2006 annual meeting. The fund plans to submit a proposal to replace all other Sovereign directors, who aren’t even up for re-election this year.

Relational’s move is the latest in its heated battle with Sovereign. The investor, which holds about 8 percent of Sovereign’s stock, has been trying to stop the bank from completing a deal that would sell a 19.8 percent stake to Spain's Banco Santander Central Hispano for $2.4 billion and use the proceeds to help acquire Brooklyn-based Independence Community Bank Corp. for $3.6 billion. Relational has been arguing that the transaction requires shareholder approval, but the New York Stock Exchange waived shareholder approval after Sovereign restructured the deal by agreeing to a number of concessions.

Last week, Sovereign announced it would delay its annual shareholder meeting until after it completed the three-way deal. Relational responded by requesting that a New York court block the delay.

While corporate lawyers concede Relational’s attempt to remove directors not up for election is very unusual, most states permit shareholders to remove directors under certain circumstances. In Pennsylvania, the law invoked by Relational, investors can seek the removal of directors “without assigning any cause” by the shareholders.

In Delaware, where an estimated 90 percent of all public companies are incorporated, the law states: “Any director or the entire board of directors may be removed, with or without cause, by the holders of a majority of the shares.”

Pierce

However, the situation changes dramatically in the case of staggered boards. “Generally, staggered boards can only be removed for cause,” says Morton Pierce, who chairs the management and executive committees at corporate law firm Dewey Ballantine.

This includes Pennsylvania as well as Delaware, which states: “… in the case of a corporation whose board is classified … shareholders may effect such removal for cause,” unless, the company’s certificate of incorporation states otherwise.

Greenberg

“That’s why a staggered board is a big deal as a takeover defense,” asserts Joel Greenberg, partner with Kaye Scholer. Not only does a classified board make it difficult for a dissident to gain control of the board in one year, but it makes it difficult to unseat directors under the removal provisions.

“It would be highly unusual if a company has a staggered board but directors can be removed freely,” adds David Brown Jr., partner of Alston & Bird.

What’s more, proving cause is no easy feat: Shareholders must be able to cite some sort of malfeasance. “You can’t say the company isn’t doing well,” Greenberg explains.

If legitimate cause exists, then activists could try to remove standing directors of classified boards who are not up for election. But, Pierce says that in all reality, it probably wouldn’t come to this. He says if between meetings shareholders try to remove directors and they have the votes, the company will most likely sit down with them and negotiate. “They won’t go to a vote if they think they will lose,” he insists.

A Rolling Process

But that doesn’t necessarily mean it’s easy to unseat an existing declassified board by majority vote between annual meetings simply because you don’t need to prove “cause” under the state laws. In order to pull it off, a shareholder must call a special meeting, or it can act by written consent.

However, many companies don’t allow shareholders to call a special meeting. “Most companies limit that,” Pierce insists. He says many of them have intentionally structured their bylaws and charters whereby there is no provision for calling a special meeting or submitting a written consent. “If you can’t call a special meeting and you can’t act by written consent, then the removal of the directors and electing your own directors at the annual meeting becomes one and the same,” he explains.

Brown

Brown, though, does note that some companies may permit special meetings if they can muster, say, 20 percent support. But, if instead of a special meeting they use a consent solicitation, new complications could arise.

Unlike proxy contests for a shareholder meeting, which end when polls close for the meeting, a consent solicitation may continue for an extended period of time without a fixed ending date, Brown explains. So theoretically, an insurgent group could accumulate enough consents early in the process and claim victory, but some consenting sharheolders could respond to the company's solicitation and revoke their earlier consent or send in a new consent going the other way. “Consent solicitations are a rolling process,” he explains. “Someone can claim victory out of the blue. They are hard to manage.”

For these reasons, it’s rare to see shareholders attempt to remove directors. “If you wait for the annual meeting and put up alternative candidates, you just need more votes,” Greenberg stresses.

With Or Without Cause

Indeed, the Sovereign-Relational dispute—which advanced to a series of suits and counter-suits in the closing week of 2005—ultimately may hinge on whether the hedge fund could move ahead with its initiative based on whether or not it needs to prove “cause.”

Relational asserts in a press release that under Pennsylvania law and Sovereign's charter, shareholders have the right to remove all directors by a majority vote of outstanding voting shares. This includes directors that may be appointed between now and the annual meeting. "Under Sovereign's articles of incorporation, Sovereign directors may be removed from office without cause by the affirmative vote of a majority of outstanding voting shares," Relational purports, saying it is quoting “numerous public filings by Sovereign.”

Specifically, the firm bases its assertions on Sovereign's articles and bylaws, and 27 instances where Sovereign made assertions and promises to its shareholders in public SEC filings—signed by senior management and the directors—that "Sovereign directors may be removed from office without cause by the affirmative vote of a majority of outstanding voting shares." Relational adds: “Sovereign has now for the first time, and only when faced with a proxy contest, reversed field and contended that the Sovereign shareholders may not remove the directors without cause.”

Through a spokesperson, Sovereign admits that Relational is correct when it says public statements suggest dissidents don’t need to prove “cause,” but refers to this language as “inadvertent statements in SEC merger filings.”

Rather, Sovereign has filed a lawsuit filed in U.S. District Court for the Southern District of New York seeking a declaratory judgment that Relational’s claim—that the firm can wage a proxy fight to remove all of Sovereign's directors without cause and replace them with Relational's designees—“has no basis in fact or law.”

The bank, among other arguments, asserts that regardless of the language in the filings, it is bound by state law and how it relates to staggered boards. It adds in its legal filing that Pennsylvania Business Corporations Law “unequivocally provides that the entire board of directors, a class of directors or any individual director of such corporation ‘may be removed from office by vote of shareholders entitled to vote thereon only for cause.’”

In an accompanying statement the company said: "We believe that Relational does not have the right under either Pennsylvania law or Sovereign's Restated Articles of Incorporation to propose a shareholder vote to remove, simultaneously and without cause, all members of the Sovereign board of directors.”

Whether the firm is successful or not, Relational’s move is a reminder that activist investors have become more creative and determined these days. Says Pierce: “To me, it’s another indication of the increased importance of institutions and hedge funds in corporate governance.”

Related coverage of hedge fund activism can be found in the box above, right.