6 Questions About Dead Hand Proxy Puts

by: AllAboutAlpha

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Dead Hand Proxy Puts are a relatively recent innovation in corporate finance, one intended to fend off shareholder activism, whether fueled by interested hedge funds or otherwise. Here is a primer on the subject.

  1. What Is It?

A DHPP is a provision that creditors include in loan contracts with corporations, excluding certain persons from the board of the borrowing company as a condition of the loan.

In the words of a recent article by Sean J. Griffith and Natalia Reisel, scholars associated with Fordham Law School and the Gabelli School of Business, Fordham University, respectively, "We find statistically significant evidence that companies do modify their loan contracts in anticipation of experiencing hedge fund activism."

The language might for example exclude "any individual whose initial nomination for, or assumption of office as, a member of that board … occurs as a result of an actual or threatened solicitation of proxies or consents for the election or removal of one or more directors by any person or group other than a solicitation for the election of one or more directors by or on behalf of the board of directors."

  1. How much does this cost the lender?

Or, to ask that question from the other side: how much will a borrower demand in order to agree to this language, in terms of a lower interest rate on the loan? The Griffith and Reisel study, which draws on a sample of bank loans from 1994 through 2014, finds that such language significantly reduces the cost of debt, by as much as 60 basis points.

  1. Why do lenders want this provision?

Largely because certain common measures advocated by the sort of corporate gadfly they want to exclude make life riskier for such lenders. But perhaps also the motif is that the devil one knows is better than the devil one doesn't. The bank's deal is with this board, and it negotiates a provision such as that quoted above into a loan because it wants this board (or a recognizably continuous successor) to continue.

  1. How does the lender enforce this provision?

The core idea is that any violation of the clause accelerates the debt: Allow Smith onto the board in defiance thereof, and you, dear borrower, commit yourself to paying the full principal and interest at once.

  1. Does it work?

Such clauses are apparently effective in doing what they are designed to do, creating a disincentive for shareholders to vote against the incumbents, in favor of an activist's nominees.

Another natural though ancillary question is this: what, if anything, is the effect of dead hand proxy puts on bondholders? The immediate beneficiaries are bank lenders, who pay for their extra ability to oversee the borrower to the tune of the aforementioned 60 basis points. But Griffith and Reisel also suggest that bondholders benefit, getting something of a free ride on the banks' protection.

These authors approve of the mechanism: "Our research suggests that the provision may create net shareholder benefits in spite of weakening hedge fund activism."

That research will likely be challenged and the conclusions modified -- research into the full range of effects of such provisions is in its infancy.

  1. What's the catch?

On one reading, the provisions themselves may create liability for the directors who enter into them. As Vice Chancellor J. Travis Laster said in the course of the Healthways litigation:

"The conflict that's arising here is not between the interests of the lender and the interests of the borrower. The conflict is on the borrower's side and is the conflict between the interests of the entity and the personal interests of the directors in protecting their incumbency."

Companies and their creditors tempted to go this route will continue to have to face headwinds stoked by that suspicion.