DEFENDING ESG: A NEW STANDARD OF REVIEW FOR DEFENSIVE MEASURES THAT IMPACT ESG RATINGS.

• Author: Hovatter, Nicole R.

INTRODUCTION 204 I. A HISTORY OF DEFENSIVE MEASURES AND THEIR CONTROVERSY 208 A. The Rise of Defensive Measures 208 B. The History of Defensive Measures Through Case Law 210 C. The Modern Debate: Do Defensive Measures Diminish Value? 214 II. ESG RATINGS AND WHAT THEY TELL US 216 A. What is an ESG Rating and How is it Calculated? 216 1. How are ESG Ratings Calculated? 218 2. Limitations and Shortcomings of ESG Ratings 220 B. Increases in ESG Ratings are Correlated with Increases in Financial Performance 223 C. Defensive Measures are Correlated with Lower Ratings and Lower Value 226 III. A SUGGESTED STANDARD OF REVIEW FOR "JUST SAY NO" DEFENSIVE MEASURES 227 A. Application of a "Compelling Justification" Standard of 227 Review B. Extension of "Compelling Justification" Review to "Just Say No" Defenses 229 C. Limitations of the Compelling Justification Standard 231 CONCLUSION 233 INTRODUCTION

In June 1957, RT. Cheff met with Arnold Maremont to discuss the feasibility of a merger. (1) Cheff was the Chief Executive Officer of Holland Furnace Company, a home heating corporation that generated annual revenue of roughly thirty-two million and had monthly trading volume of approximately 10,300 shares. (2) Maremont was the President of Maremont Automotive Products, a public corporation that manufactured exhaust systems for automobiles. (3) Maremont had expressed an interest in acquiring Holland, but Cheff wasn't interested. The Holland directors thought that differences in sales practices made the merger unfeasible. (4) Maremont walked away. (5)

Over the following month, Holland's monthly trading volume tripled. (6) The mysterious spike in activity was resolved when Maremont approached Cheff stating that he had purchased 55,000 shares of Holland. (7) By August 1957, Maremont had purchased an additional 45,000 shares of Holland to accumulate a total position of approximately 100,000 shares. (8) Cheff and the other Holland directors grew uneasy--Maremont had a reputation as a corporate raider and Holland employees grew fearful that Maremont would bust up the company. (9) Before long, twenty-five "key" employees of Holland had quit out of fear of an acquisition. (10) Based on this information, the Holland board authorized a stock buyback, ostensibly for use in a stock option plan. (11) This tactic was known as greenmail, a popular defensive measure in the 1980s. (12) When Holland shareholders brought suit stating that the defensive measure violated Delaware corporate law, the Delaware Supreme Court was faced with the issue of whether the Holland directors had "reasonable grounds to believe a danger to corporate policy and effectiveness existed by the presence of the Maremont stock ownership." (13) Said differently, the Court was faced with deciding whether the board was authorized to adopt this defensive measure in the face of a hostile tender offer, or whether the board had violated their fiduciary duties in doing so.

The Delaware Supreme Court held that the adoption of the defensive measure was permissible. (14) The court's reasoning rested on the fact that the board had notice of Maremont's character and plan, and thus, the directors were using their business judgment to determine the best interests of Holland shareholders. (15) The merger was never consummated.

Notwithstanding the Holland board's concerns, years later, Maremont came to be known as an exemplary citizen: "a patron of the arts, a fighter against discrimination and for the poor, and an excellent businessman." (16) By contrast, Holland was being pursued by the Federal Trade Commission (FTC) for deceptive sales practices. Holland's salespeople would enter potential customers' homes, represent themselves as government agents, and dismantle furnaces as unsafe but fixable with Holland's help. (17) In 1965, Holland was found guilty of criminal contempt and was fined $100,000. (18) Cheff went to jail. (19) By then, Holland's sales plummeted to two million with losses exceeding three million, as compared to a company valuation of over forty million at the time of Maremont's offer. (20)

Courts have grappled with issues similar to the Cheff court since defensive measures proliferated in the mid- to late-1900s. (21) Delaware courts, scholars, and practitioners have long debated whether boards should be permitted to adopt defensive measures in the face of a hostile tender offer, or whether such defensive measures entrench management and deprive shareholders of long-term value. (22)

This Comment analyzes this issue from a particular perspective: from the intersection of defensive measures and environmental, social, and governance (ESG) ratings. Specifically, this Comment hypothesizes that certain defensive measures--staggered boards and poison pills--are correlated with lower ESG ratings on average, and thus, that these defensive measures must be viewed with greater scrutiny by Delaware courts. Given the empirical evidence that higher ESG ratings increase financial performance over the long term, the fact that staggered boards and poison pills lower ESG ratings suggests that these defensive measures are detrimental to firm performance and firm value over the long term. (23) Because these defensive measures deprive shareholders of value, the combination of a poison pill and a staggered board--perhaps the most powerful defense against an unwanted takeover and the cornerstone of a "just say no" defense--should only be permissible where boards have a compelling justification to defend their use.

This Comment proceeds in three Parts. In Part I, I begin by briefly reviewing the takeover scene from 1960 to 1980 and providing an overview of the controversy surrounding poison pills and staggered boards. In discussing the controversy surrounding these defensive measures, I canvas a number of seminal cases including Moran, Paramount v. Time, eBay, and Williams, and discuss Delaware courts' treatment of defensive measures in these cases. Finally, Part I summarizes the historical debate between scholars and practitioners regarding whether these defensive measures should be permissible in the first place. In Part II, I provide an overview of ESG ratings and their implications for corporations. Using empirical studies conducted over the last decade, Part II argues that increases in ESG ratings are correlated with increases in long-term financial performance, but poison pills and staggered boards decrease ESG ratings on average. Therefore, the adoption of these defensive measures depresses firm value in the long run. Finally, in Part III, I build upon the argument from Part II to analyze its implications for Delaware corporate law. Specifically, I argue that because these defensive measures lower ESG ratings (and thus, overall financial performance) on average, the adoption of staggered boards and poison pills should be analyzed with a heightened standard of review by Delaware courts. In the absence of explicit shareholder authorization, these measures should only be permissible where boards have a compelling justification to defend their application.

1. A HISTORY OF DEFENSIVE MEASURES AND THEIR CONTROVERSY

   In this Part, I offer an overview of staggered boards and poison pills through three Sections. First, I discuss the historical rise and controversy of defensive measures. Second, I analyze Delaware courts' treatment of these defensive measures throughout history. And third, I describe the debate among scholars and practitioners regarding whether incumbent management should be permitted to adopt these defensive measures in the face of a hostile tender offer.

   1. The Rise of Defensive Measures

      The 1960s were characterized by a frenzy of merger and acquisition activity, constituting one of the largest takeover waves that the United States had ever seen. (24) Mergers during this period were typically friendly transactions by large corporations of smaller firms outside of acquirers' primary business lines. (25) These acquirers were driven by the desire to diversify operations and capitalize on market factors, such as inflated valuations of company stocks and aggressive antitrust enforcement that simply disallowed mergers of firms in the same industry. (26) Importantly, tender offers were relatively rare during this period and were regarded as "bad form" by most acquirers. (27)

      But the experiment with diversification and inflated valuations proved largely disappointing. An estimated one-third of all acquisitions made in the 1960s and 1970s were later divested. (28) When merger activity again accelerated in the 1980s, it took the form of an entirely different animal: the hostile takeover. (29) This 1980s merger wave mimicked that of the 1960s in terms of volume, but differed in that it was characterized by "radical new forms of control changes." (30) While the 1960s created many conglomerates, the 1980s destroyed them: corporate raiders sought to "bust up" underperforming companies by selling off large fractions of targets' assets. (31) Much of this activity was driven by the hands-off antitrust policy of the new Reagan Administration, which largely stopped challenging intra-industry mergers and opened the door for acquisition activity. (32)

      In response to the hostile takeover activity of this period, incumbent managers hired lawyers to develop an array of defenses. Dealmakers began experimenting with new forms of deal protection devices. The staggered board, which had long been established by the Delaware legislature, (33) now stood alongside innovative defensive measures such as greenmail, (34) "white knights," (35) leveraged recapitalization, (36) and "Pac-Man" (37) defenses. But the most advantageous weapon in the target board's new arsenal--the poison pill--attracted the majority of the buzz. The poison pill largely rendered the other defensive measures trivial. (38) The defensive measure did not entail significant transaction costs, could be adopted by a target board...