Over the past decade, Maryland-incorporated real estate investment trusts ("REITs")[1] have been under increasing pressure to eliminate or reduce defenses against unsolicited takeovers. Boards have been declassified, directors are now often required to be elected by majority vote, rights plans have expired or been redeemed and stockholders have been provided the concurrent power to amend bylaws, among other examples. As a result, REITs are increasingly vulnerable to unsolicited bids for changes of control that may undervalue the company and its longer-term prospects.
Maryland law provides significant defenses against unsolicited takeovers of public REITs, many of which may be enacted by board action alone without a stockholder vote. Over the past few years, some of these provisions, such as advance notice bylaws (which our firm was the first to develop and use), have evolved to meet changes in law and new economic realities. Even if no governance changes are currently under consideration, a board should know what defenses are available, and the timing and process for implementation, if an offer were to be made that the board determines could be disadvantageous to the company. A board should also be familiar with the defenses that are currently in place, and the timing and process for removal thereof, if an offer were to be made that the board determines is in the best interests of the company to pursue, negotiate or accept.[2]
1. Stockholder Rights Plan. A stockholder rights plan, sometimes referred to as a "poison pill," generally provides for a distribution to the common stockholders of rights which (a) in the event of an acquisition of more than a certain percentage (generally 10% to 20%) of the common stock, become rights to purchase additional shares of common stock at a significant discount (the "flip-in" feature) and (b) in the event of a squeeze‑out transaction, become rights to purchase the acquiring person's equity at a significant discount (the "flip-over" feature). Importantly, these rights are not exercisable by the acquiring person, which would result in massive dilution of the acquiring person's shares. Because, in general, only the board of directors is given the power to redeem the rights or amend the plan, a potential bidder is encouraged to negotiate with the board rather than to attempt a tender offer or other stock accumulation that may trigger the distribution of the rights.
The MGCL specifically authorizes the board of directors of a Maryland corporation, "in its sole discretion", to (a) set the terms and conditions of rights, options, or warrants under a stockholder rights plan and (b) issue rights, options, or warrants under a stockholder rights plan to designated persons or classes of persons. Those options, rights or warrants "may, in the sole discretion" of the board of directors, include any limitation, restriction or condition that (i) precludes, limits, invalidates, or voids the exercise, transfer, or receipt of the rights, options, or warrants by designated persons or classes of persons in specified circumstances or (ii) limits for a period not to exceed 180 days the power of a future director, as defined in the stockholder rights plan, to vote for the redemption, modification, or termination of the rights, options, or warrants. The latter provision, known as a "slow hand" provision, prevents new directors elected in a proxy contest, which bidders often run in tandem with hostile tender offers, from voting to change or end a stockholder rights plan for 180 days after election. A board may wish to periodically review a draft rights plan and related documentation with counsel and financial advisors, in order to maintain an up-to-date rights plan "on the shelf" to facilitate implementation in the event of the emergence of a hostile bidder.
2. Classified Board of Directors; Subtitle 8 Opt-In. Classified boards are a long-time feature of corporate governance and, for many years, newly formed Maryland REITs adopted classified boards in their original charters or bylaws. Over the past 20 years or so, classified boards have been consistently scrutinized and attacked by proxy advisers, institutional shareholders and academics and are generally no longer a common feature among established Maryland-formed REITs. Nevertheless, classified boards provide several important benefits. Classified boards enhance continuity and stability in the board's development and execution of corporate strategies and contribute to board effectiveness by helping to attract and retain individuals willing to commit the time necessary to understand the company, especially prospective independent directors who may be asked to serve on the audit committee or other board committees. In addition, a classified board will slow down an unfriendly attempt to take control of the board, as an insurgent must generally win two consecutive annual elections to take control of the board. Moreover, under the MGCL, unless the charter provides otherwise, a director on a classified board may be removed only for cause. The MGCL provides different mechanisms by which a board may be classified, including (a) amendment of the bylaws (assuming no contrary provision in the charter) and (b) election by the board pursuant to Title 3, Subtitle 8 of the MGCL ("Subtitle 8"), on behalf of the corporation, to classify the board, notwithstanding any contrary provision in the charter or bylaws.
3. Additional Subtitle 8 Provisions Relating to Directors. Subtitle 8 permits a Maryland corporation with a class of equity securities registered under the Securities Exchange Act of 1934, as amended, and at least three independent directors to elect, by provision in its charter or bylaws or by resolution of its board of directors and notwithstanding any contrary provision in the charter or bylaws, to be subject to the additional provisions described below.
- Fixing Number of Directors and Filling Vacancies. The power to fix the number of directors and the power to fill vacancies on the board are often – but not always – conferred on the board in the charter and the bylaws. If so, and if the board has the exclusive power to amend the bylaws (as is permitted in Maryland but not in Delaware with respect to corporations), then no further action in this regard is necessary. However, if the charter gives to stockholders the power to fix the number of directors or to fill vacancies, or if these powers are given to the board in the bylaws but the stockholders have the concurrent power to amend the bylaws, then the board may want to elect for the company to opt in to provisions of Subtitle 8 conferring on the board the exclusive powers to set the number of directors and to fill vacancies on the board. Moreover, electing to be subject to the Subtitle 8 provisions relating to filling vacancies has an added benefit for classified boards: Any director elected to fill a vacancy under Subtitle 8 will hold office for the full remainder of the term of the class of directors to which he or she was elected, instead of holding office only until the next annual meeting of stockholders.
- Removal of Directors. Under the MGCL, the stockholders may remove any director, with or without cause (unless, as noted above, the director is a member of a classified board), by the affirmative vote of a majority of all the votes entitled to be cast generally in the election of directors. However, the charter may increase this percentage. Some charters of Maryland-incorporated REITs provide for a supermajority vote to remove directors, but others do not. If there is not already a supermajority vote required in the charter, the board of directors may elect to be subject to the applicable provision of Subtitle 8 increasing the vote required to remove a director to two-thirds of all the votes entitled to be cast generally in the election of directors.
4. Director Qualification Bylaws. The MGCL provides: "Each director and each nominee for director of a corporation shall have the qualifications required by the charter or bylaws of the corporation." Carefully drafted director qualification bylaws can aid in ensuring that directors have the requisite background and expertise to act in the best interests of the company and not of any one stockholder or group of stockholders.
5. Ownership Limits. The charters of most entities taxed as REITs provide for certain restrictions on ownership and transfer of shares of stock of the company in order to avoid violation of the "five-or-fewer" requirement of the REIT provisions of the Internal Revenue Code of 1986, as amended. The MGCL specifically validates ownership restrictions "for any purpose," which could include both protection of a Maryland corporation's REIT status and defense against an unsolicited takeover attempt. The permissibility of restrictions on transferability of stock was upheld by the Court of Special Appeals of Maryland, our intermediate appellate court, in Wilcom v. Wilcom, 66 Md. App. 84, 91, 502 A.2d 1076, 1080 (1986). Additionally, in Realty Acquisition Corp. v. Property Trust of America, Fed. Sec. L. Rep. (CCH) ¶ 95,245, at 96,080 (D. Md. 1989), the United States District Court for the District of Maryland upheld, under the business judgment rule, the refusal of the board of a target REIT to exempt a bidder from share ownership limits.
6. Supermajority Board Vote Requirements; More than One Vote Per Director. The MGCL provides that the board acts by the vote of a majority of directors present at a meeting at which there is a quorum, unless "the charter or bylaws of the corporation require a greater proportion . . . ." To limit the power of a classified board of directors in which the insurgents have won two successive elections, the charter or bylaws may provide for a vote requirement in excess of two-thirds of the number of directors in order to approve various actions (e.g., election and removal of officers, appointment of committees, authorization of dividends or other distributions, recommendation of extraordinary corporate actions to the stockholders). In addition, the MGCL authorizes a charter provision granting "one or more directors or a class of directors . . . more or less than one vote per director on any matter." A would-be bidder may be deterred by one or more suspected management-friendly directors having multiple votes, especially if the provision is protected by a supermajority vote.
7. Advance Notice of Stockholder Proposals. The MGCL specifically authorizes the charter or bylaws of a Maryland corporation to require stockholders to provide advance notice of nominations for directors and other proposals for business. Advance notice bylaw provisions have proven to be an effective means of permitting a corporation and its stockholders sufficient time and information to evaluate stockholder nominations and proposals. Typically included in advance notice provisions are requirements for submission of various information about the proponent and the proposed nominee or other business. The bylaws of most of our Maryland-incorporated REIT clients have advance notice provisions. Companies that do not have modern advance notice bylaw provisions may want to consider adopting them and companies with existing advance notice bylaw provisions may want to consider updating and further enhancing them, particularly in light of the enactment of the Securities and Exchange Commission's universal proxy rules.
8. Conduct of Stockholders Meetings. As stockholders' meetings involving contested nominations or proposals are common, it is important for the chair of the meeting to have the necessary and appropriate powers to conduct the meeting. We have developed bylaw provisions authorizing the chair to establish procedures for the conduct of the meeting and to take various actions in his or her discretion. In particular, we suggest that boards consider giving the chair of the meeting the explicit power to recess or adjourn the meeting to a later time. It is also important that the bylaw provision on inspectors be both comprehensive in its coverage and specific in its direction to the inspector.
9. Request Requirement for Calling Special Stockholders' Meeting; Subtitle 8 Opt-In. The MGCL requires the secretary of a Maryland corporation to call a special meeting of stockholders upon the request of the holders of shares entitled to cast at least 25% of the votes entitled to be cast at the meeting. However, the MGCL permits this 25% requirement to be increased to as high as a majority in the charter or bylaws. The bylaws of most of our Maryland-incorporated REIT clients permit a special meeting of stockholders to be called by the board of directors or specified officers or upon the request of holders of shares entitled to cast at least a majority of all the votes entitled to be cast at the meeting. If the board does not have the sole control of the bylaws, the board may want to elect for the company to opt in to a provision of Subtitle 8 raising the requirement for stockholders to call a special meeting of stockholders to a majority of all the votes entitled to be cast at such meeting. This provision will allow a company to avoid the time, cost and distraction of holding a special meeting if it is not clear that the requesting stockholders will be able to attain a quorum or approve the matter in question.
10. Procedures for Stockholder-Requested Special Meetings. The MGCL expressly provides that the board of a Maryland corporation has the sole power to establish procedures for a stockholder-requested special meeting, including (a) the record date for the request, (b) the record date for the meeting and (c) the date, time and place of the meeting. We have developed a form of bylaw that establishes requirements for the stockholders' written request (e.g., record date for the request, purpose of the meeting, names and addresses of requesting stockholders) and other procedures for calling and holding a stockholder-requested special meeting (e.g., date, time, place, record date, costs of notice, inspectors of election).
11. Indemnification/Advance for Expenses. Maryland has a very broad director and officer indemnification and advance-of-expenses statute. It is common practice for the charter or bylaws of a Maryland corporation to require it to provide its directors and officers with the maximum indemnification and advance of expenses possible under Maryland law. A broad indemnification and expense advance provision aids directors in taking action in the best interests of the company in opposing hostile takeovers by reducing the possibility that a director will personally have to pay an adverse judgment and by absorbing the director's cost of defending litigation challenging board actions. We recommend reviewing a company's charter and bylaws to determine whether the provisions relating to indemnification and advance of expenses are current and, if not, what actions may be taken to obtain the broadest indemnification and advance of expenses available under Maryland law. We have also developed a Maryland-specific form of indemnification agreement that provides additional protection for directors and officers.
12. Exclusive Board Control of Bylaws. As indicated above, Maryland law permits the board to be given the exclusive power to amend, alter and repeal the bylaws. Board control of the bylaws is critical to the adoption and maintenance of many of the measures discussed above and remains common in Maryland-incorporated REITs. If a board amends the bylaws to enable stockholders to amend the bylaws, boards may want to establish a majority of all the shares entitled to vote (i.e., not shares voted) as the vote standard for stockholders to amend the bylaws.
13. Control Share Acquisition Act. Generally, the Maryland Control Share Acquisition Act (the "Control Share Act") provides that holders of certain shares of a Maryland corporation, referred to as "control shares," have no voting rights with respect to the control shares except to the extent that such voting rights for the holder are approved by the affirmative vote of two-thirds of all the votes entitled to be cast on the matter, excluding any votes otherwise entitled to be cast by the person who has acquired or proposes to acquire the control shares (the "acquiring person") or by officers or employee-directors of the Maryland corporation. "Control shares" are voting shares which, when aggregated with all other shares owned by the acquiring person or in respect of which the acquiring person is able to exercise or direct the exercise of voting power (except solely by virtue of a revocable proxy), would entitle the acquiring person to exercise voting power in electing directors within one of the following ranges of voting power: (1) one-tenth or more but less than one-third, (2) one-third or more but less than a majority or (3) a majority or more of all voting power in the election of directors.
A Maryland corporation generally has the right to redeem control shares for fair value during certain periods, depending upon whether and when the acquiring person delivers an acquiring person statement containing the information set forth in the Control Share Act.
If voting rights are approved for an acquiring person that acquires a majority of the company's voting power, all other stockholders have the right to exercise appraisal rights and receive the fair value of their shares, which may not be less than the highest price per share paid by the acquiring person in the control share acquisition.
The Control Share Act does not apply to the voting rights of shares if the acquisition of the shares was specifically or generally approved or exempted from the statute by a provision contained in the corporation's charter or bylaws and adopted at any time before the acquisition. Accordingly, unless the charter or bylaws of a Maryland corporation prohibit its board of directors from altering or amending an exemption contained in the bylaws, the board controls the applicability of the statute to future acquisitions of the corporation's shares of stock.
Despite the foregoing, the Control Share Act has an important disadvantage: It permits an acquiring person to compel the calling of a special meeting of stockholders to consider whether to extend voting rights to shares that the acquiring person proposes to acquire before the acquiring person purchases even a single share. Thus, an acquiring person is able to compel a forum for its proposed bid without any investment in the company's shares. For many years, it has been conventional wisdom among takeover defense lawyers that the disadvantage of permitting an acquiring person an open forum to make its case to the shareholders outweighs the advantage of stripping the acquiring person of voting rights if it exceeds the statutory threshold. This is particularly true in view of the likelihood that certain proxy advisory firms would almost certainly recommend a vote in favor of voting rights for the acquiring person. As a result of the foregoing, in our experience, most REITs have opted out of the Control Share Act.
Nevertheless, the prospect of an open forum for an activist to attack management does not have the same disadvantages that it did when the statute was first enacted in 1989 as it is much easier today for an activist to publicly make its case through social media and otherwise than it was over three decades ago. Thus, the potential disadvantage of holding a special meeting compelled by the Control Share Act may be outweighed by the advantage of limiting the voting rights of the activist (unless it can obtain approval by two-thirds of all the disinterested votes entitled to be cast on the matter), especially because, as noted above, a truly hostile bidder is likely to find plenty of opportunity to make its case today, with or without a special meeting.
14. Business Combination Act. The Maryland Business Combination Act (the "MBCA") prohibits for five years any business combination between a Maryland corporation and an "interested stockholder" (defined as a holder of ten percent or more of the voting power of the corporation's outstanding voting stock or an affiliate or associate of the corporation who, at any time within the two-year period prior to the date in question, was the holder of ten percent or more of the voting power of the corporation's outstanding voting stock).
Many hostile bidders attempt to acquire majority control in a tender offer (first step) and then attempt to eliminate the remaining stockholders in a freeze-out merger or similar transaction (second step) designed to give the bidder 100% ownership. The MBCA prohibits for five years a second-step "business combination" (as defined in the MBCA) between the corporation and an interested stockholder. After the five-year moratorium, the statute requires that, in addition to any other vote required by law or the corporation's charter, a business combination with the interested stockholder must be recommended by the board of directors and approved by the affirmative vote of at least (a) 80% of all votes entitled to be cast by holders of outstanding voting stock, voting together as a single group, and (b) two-thirds of the votes entitled to be cast by holders of voting stock other than the interested stockholder that is a party to the combination or by its affiliate or associate, voting together as a group.
We know of no situation since this statute was first enacted more than 35 years ago in which a hostile bidder for control of a Maryland corporation has successfully penetrated the protection of the MBCA. In addition, the MGCL appraisal statute provides for "super-appraisal rights," requiring that any dissenting stockholder be paid in accordance with the "fair price" formula, discussed in the next sentence, rather than at fair market value. As an alternative to obtaining the two super-majority votes, a bidder may pay the stockholders in the second-step business combination the so-called "fair price," calculated using a formula designed to ensure that the bidder pays the remaining stockholders in a freeze-out transaction a price not less (and generally significantly greater) than the highest price paid to any stockholder prior to the second step. The combination of the difficulty in achieving the super-majority votes for the second step and the economic unattractiveness of paying the fair price to avoid the super-majority votes is generally believed to discourage prospective bidders from taking the first step.
The MBCA authorizes a Maryland corporation, by resolution of its board of directors, to opt out of the five-year moratorium and supermajority vote requirements before the stockholder becomes an "interested stockholder." The MBCA also provides that a person will not be considered an interested stockholder if, prior to the time the person would have otherwise become an interested stockholder, the board of directors approves the transaction that would have made that person an interested stockholder. In approving such a transaction, the board may provide that its approval is subject to compliance, at or after the time of approval, with any terms and conditions set by the board, e.g., undertakings by the holder not to acquire more than 15% of the voting power or not to engage in a hostile proxy contest for some period of time.
By giving the board of directors the power to control the applicability of the MBCA to a corporation or a particular bidder or present or future transaction, the MBCA encourages a bidder to negotiate with the board as the elected representatives of the stockholders with more information about the company than any non-management stockholder.
15. General Considerations. In taking action with respect to takeover defenses, consideration should, of course, always be given not just to the legality of the proposed action but also to other relevant considerations, including the reaction of a company's institutional stockholders and of proxy advisers. However, in making these decisions, directors should remember their overarching responsibilities for continuing oversight and informed decision-making and that the duties of a director of a Maryland corporation are to the corporation, and not to the corporation's stockholders or any particular group of stockholders, or, absent insolvency, to creditors, employees, customers or any other group. Accordingly, we advise directors to consider and be familiar with among other matters:
- their legal duties,
- their business strategy for the REIT,
- the presence and prior history of any activists,
- the views of the REIT's stockholders, especially long-term stockholders,
- the views of management, and
- any other factors or information that the directors consider relevant.
In weighing these and other considerations, directors should gather as much material information as possible, seek the views of experts, deliberate carefully, meet as often as seems appropriate, avoid undue haste, express their views, listen to the views of others and take whatever time they feel they need to reach a decision that each director reasonably believes is in the REIT's best interests.
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As always, our colleagues and we are available at any time to discuss these or other matters.
Jim Hanks
Michael Leber
Jeff Keehn
Hirsh Ament
[1] By our latest count, approximately 70% of the current stock exchange-listed REITs (and many private REITs) are formed in Maryland.
[2] Because the same takeover defenses generally apply to both REITs formed as corporations under the Maryland General Corporation Law (the "MGCL") and to REITs formed as real estate investment trusts under the Maryland REIT Law (the "MRL"), we refer hereafter, unless otherwise noted, only to corporations (or sometimes companies).