November 28, 2005

NYSE Takes a Position in Sovereign Mess

Last Tuesday, it was reported that a proposed – and controversial – transaction by Sovereign Bancorp has been amended so that the NYSE would allow it to proceed without a shareholder vote. Some of Sovereign’s largest shareholders had protested the lack of a shareholder vote (and I had criticized some of Sovereign’s other governance practices in this blog). Sovereign seeks to sell a stake in itself to Banco Santander, a Spanish bank – so that Sovereign can raise the funds to acquire another bank.

In this article, the WSJ reported that the NYSE advised Sovereign how to change the deal to get it through without a shareholder vote and quoted Richard Ketchum, head of NYSE Regulation: “We called it the way we saw it, …. Not everyone will be happy [but] what’s left is a transformed transaction that complies with our standards.” The WSJ article also noted: “Shareholders and corporate-governance experts viewed the NYSE’s decision on the matter as a test of how much regulatory muscle it would flex in a time of increased shareholder activism.”

According to reports, the transaction was revised to eliminate:

(i) Santander’s veto on the termination of Sovereign’s CEO and the requirement that any new CEO be reasonably acceptable to Santander;

(ii) provisions for Sovereign directors to remain on the board for an additional 10 years if Sovereign was bought outright by Santander; and

(iii) Santander’s obligation to vote its Sovereign shares in favor of Sovereign’s board nominees.

The revised deal also includes a “fiduciary out” to the no-shop provisions that otherwise prevent Sovereign from responding to acquisition proposals from third parties and a $200 million breakup fee.

Dissecting the Shareholder Approval Issue

Unless familiar with the views of the NYSE from prior dealings, many reading the NYSE’s rules would not have thought that the NYSE could interpret them to require Sovereign to obtain shareholder approval in connection with the issuance of shares representing less than 20% of its outstanding common stock to Banco Santander.

On their face, the NYSE’s shareholder approval requirements would not seem to require shareholder approval of Sovereign’s proposed transaction with Santander:

– Sections 312.03(a) and (b) don’t apply as they relate to equity compensation and related party transactions;

– Section 312.03(c) doesn’t appear to apply because the proposed transaction doesn’t involve the issuance of shares representing 20% of Sovereign’s outstanding common stock; and

– Section 312.03(d) shouldn’t apply because, notwithstanding the board representation and veto and other rights being granted Santander, the transaction doesn’t fit the normal concept of a “change in control” (e.g., in a “Revlon” sense).

Nevertheless, Sovereign’s unhappy shareholders at least partially succeeded in making a case that the proposed transaction triggered the shareholder approval requirement of 312.03(d) because it would result in a “change in control.” According to this WSJ article, these shareholders are unhappy with the NYSE’s decision and are considering an appeal to the SEC or banking regulators.

The NYSE’s Trap for the Unwary?

This situation highlights a potential trap for the unwary under the NYSE’s shareholder approval rules for transactions resulting in a purported change of control. In the Sovereign deal, we’re not talking true control (e.g., majority ownership) or even effective control (e.g., presumably somewhere north of 35% or 40% ownership, since that will often convey control given the percentage of shares typically voted at shareholder meetings) – but something much less – even below 20% – with a couple of directors and some veto rights.

I certainly agree with the outcome here (and even think the NYSE should have required a shareholder vote) as Sovereign’s governance practices are among the worst I have seen – but, as a matter of public policy, the NYSE should file proposed amendments to its rules with the SEC, solicit comments and obtain SEC approval rather than foster controversy by unilaterally interpreting “change of control” so broadly. I’m not a big fan of stealth regulation and, at a minimum, more formal guidance would seem appropriate. This would only help the NYSE as then it would be more difficult for folks to cry “foul” when they make determinations like this.

The Use of Treasury Shares or Cash to Avoid Shareholder Approval

It’s also worth noting that no one seems to blink an eye when parties structure transactions to avoid the shareholder approval requirements of 312.03(c) by using treasury shares (which are already listed) or cash to avoid having to list shares that would constitute 20% or more of the issuer’s outstanding common stock. Sometimes the amount of cash or treasury shares used as transaction consideration is just enough to cause the newly issued and listed shares to fall below 20% of the issuer’s outstanding shares. As noted in his blog, Professor Sjostrom notes that form prevails over substance in these circumstances.

On numerous occasions, I believe the NYSE has confirmed that the use of treasury shares works under these types of circumstances, as the NYSE rule only applies if you want to newly list shares that represent 20% or more of the issuer’s outstanding shares. For example, if someone can use treasury shares equal to 2% of the outstanding combined with newly listed 19%, they don’t need to obtain shareholder approval even though the reality is that they are issuing 21% of the outstanding.

[Loyal readers of The Corporate Counsel will recall that using treasury shares doesn’t work on Nasdaq. The Nasdaq’s rules generally require shareholder approval whenever shares representing 20% of the current outstanding are to be issued, whether or not they are treasury shares. So the approach described above wouldn’t work on Nasdaq.]

With respect to cash, take a look at SBC’s recent acquisition of AT&T. By effectively paying $1 billion in cash (through an AT&T special dividend), SBC reduced the number of shares it would have had to issue in an “all stock” deal to slightly below 20%. This seems to have allowed SBC to avoid the need for an SBC shareholder vote on a fairly material transaction that seems to have diluted the rights and interests of existing shareholders.

A Final Thought on State Law vs. SRO Regulation

One final thought: The real shareholder claim here appears to be that the Sovereign board is breaching its fiduciary duties by taking extraordinary actions to entrench itself (to the potential detriment of Sovereign shareholders) rather than engaging in a transaction effecting a change in control in breach of NYSE regulations.

So it is under state law – rather than the rules of an SRO that apply to only a small percentage of companies – that seems like the more appropriate avenue to address concerns regarding the lack of shareholder suffrage for transactions of this nature. Delaware law – and the laws of many other states – generally require shareholder approval only for statutory mergers and similar business combinations and sales of all (or substantially all) of a corporation’s assets not for investments representing less than 20% of a company’s outstanding common stock.

However, it is tough to win a breach of fiduciary duty lawsuit, so the large shareholders likely decided that appealing to the NYSE had a higher likelihood of success (and was perhaps quicker than going to court) – and they can always pursue a state law claim later.

Many thanks to Kevin Miller of Alston & Bird for his contributions to this lengthy blog!