Ongoing Saga at Sovereign Bancorp

Posted by Bill Sjostrom

Sovereign Bancorp, the nation’s third largest savings and loan, has been under attack from its biggest shareholder, Relational Investors, since last May.  Relational is upset because it believes Sovereign’s stock is underperforming and blames this on Sovereign’s CEO, Jay Sidhu, and its conflicted board.  Last month, Relational launched a proxy fight to replace two board members.  A few days later, Sovereign announced it was acquiring Independence Community Bank, a regional thrift, for $3.6 billion.  To finance the deal, Sovereign is going to sell Sovereign shares equal to a 19.8% stake to Spanish bank Santander.  The deal will thus dilute down the ownership percentage of current Sovereign shareholders, including Relational, and will make Santander, who is presumed to view current Sovereign management favorably, Sovereign’s biggest shareholder.  Because Sovereign is buying Independence for cash and issuing less than a 20% stake to Santander, Sovereign maintains that no shareholder approval is required.  Relational asserts that Sovereign is overpaying for Independence and that Sovereign’s prime motivation for doing the deal is to thwart Relational.

Relational wants the deal submitted to Sovereign shareholders for approval.  Sovereign has refused.  In response, Relational has asked the New York Stock Exchange to require Sovereign to put the deal to a vote.  Sovereign is listed on the NYSE and is thus contractually subject to the NYSE Listed Company Manual.  Rule 312.03 of the manual provides:

. . .
(c) Shareholder approval is required prior to the issuance of common stock, or of securities convertible into or exercisable for common stock, in any transaction or series of related transactions if:

    (1) the common stock has, or will have upon issuance, voting power equal to or in excess of 20 percent of the voting power outstanding before the issuance of such stock or of securities convertible into or exercisable for common stock; or
    (2) the number of shares of common stock to be issued is, or will be upon issuance, equal to or in excess of 20 percent of the number of shares of common stock outstanding before the issuance of the common stock or of securities convertible into or exercisable for common stock.
. . .

(d) Shareholder approval is required prior to an issuance that will result in a change of control of the issuer.

Presumably, Relational has argued that the issuance to Santander falls within both (b) and (c) above.  According to this W$J article (subscription required):

To sell Santander a 19.8% postdeal stake via new shares alone, Sovereign would have to issue additional shares totaling almost 24% of its predeal outstanding-share total. That would have triggered the NYSE shareholder-vote requirement. So instead, Sovereign plans to issue 16.6% in new shares and to give Santander the rest via shares that the company has repurchased -- so-called treasury shares that aren't considered part of a company's outstanding-share count.

The effect is the same: Sovereign is selling the equivalent of almost 24% of its currently outstanding shares. The NYSE has allowed this treasury-share trick for decades, as even lawyers for the dissident shareholders concede, but rarely, if ever, for such a significant portion of a transaction.

There are media reports that say Santander has a right to buy additional shares that can increase its stake to 24.9%, which appears to open up an argument under the “series of related transactions” language in Rule 312.03(c).  These reports, however, are misleading.  I took a quick look at the underlying Investment Agreement, and it doesn’t give Santander any special rights to buy more shares. What it does is prohibits Santander from increasing its stake above 24.99% through open market purchases or otherwise.  Further, the agreement includes a standstill provision which prevents Santander from acquiring anymore Sovereign stock within five years of closing except in limited circumstances.

As for (d), the W$J article referenced above argues as follows:

A company cannot change control of itself without a shareholder vote. Sovereign and Santander say the Spanish bank wouldn't control the Pennsylvania bank once the deal is done. Right. And Spain doesn't control Catalonia either.

Under the deal, Santander would have the right to buy 5.1% more of the bank immediately. It could buy the rest of Sovereign over the next five years, with rights of first and last refusal. In years four and five, Santander could offer as little as it wants. Meantime, the deal bars Sovereign from considering other offers before it closes.

The NYSE might want to take its cue from federal banking regulators, who must decide bank control issues to determine whom to hold accountable. "The odds are very high that the Federal Reserve Board will determine this transaction constitutes a change of control," Jaret Seiberg of Stanford Washington Research Group said in a report on Monday.

The most egregious aspects of Santander power over Sovereign have to do with Mr. Sidhu, the CEO, and its board.

Santander would get only two of 10 board seats, but the deal would render the others impotent because it would allow Santander to veto any attempt to fire Mr. Sidhu. A board's most important job is overseeing a CEO, which means having the power to get rid of him.

Unless I’m missing something (and I’ll admit, I did not read the entire Investment Agreement), the 5.1% argument is erroneous because of the standstill provision.  The veto power argument is slightly misleading.  The Investment Agreement provides that the board may not remove the CEO without the approval of at least one of the two Santander directors.  These directors, of course, are subject to fiduciary duties in deciding how to vote on the matter.  Hence, I don’t see how this so-called “veto power” amounts to a change of control.

The only argument I find potentially persuasive is that if the Fed finds that the transaction constitutes a change of control so too should the NYSE.  The NYSE, obviously, would not be bound by the Fed’s ruling, but it certainly would be strong persuasive authority.  Does anyone know whether the Fed have specific guidelines as to what constitutes a change of control of a bank?

This Reuter’s article asserts that the NYSE is likely to require Sovereign to put the deal to a shareholder vote or face delisting.  Unless the experts are aware of something I’m not (which very well could be the case), I put the chance at more like 50/50.

For those unfamiliar with M&A law, it is well established that form controls over substance in this area.  Hence, there is nothing inherently wrong with purposely structuring a deal to fall just under a shareholder voting requirement trigger.  Figuring out how to best structure a deal to minimize formalities (shareholder approval, appraisal rights, third party consent, etc.), tax effects, and target liability exposure is a big part of the value an M&A attorney adds to a deal.  That’s why attorneys cook up things like horizontal double dummy structures.