We were just a little sorry to see the Sotheby’s situation end. The poison pill litigation, the competing white papers, and how a huge hedge fund went after a fine art auction house, of all things, kept our attention.

Dan Loeb at Third Point (TP) probably wasn’t sorry. He won some BoD seats, and Sotheby’s will pay him $10 million for his proxy solicitation expenses. This generous figure prompted us to read the settlement agreement, which in turn led to some fascinating findings for all investors.

In short, for all they gain, or think they gain, investors give up a lot when they settle a proxy contest. We can use this particular settlement, which in many (but not all) respects is fairly typical, to illustrate how these settlements work. In the case of Sotheby’s, it puzzles us, slightly, why TP would accept the settlement terms, when the alternative seems at least as attractive.

A Typical Settlement Agreement

Last week, one day before the scheduled annual meeting, Sotheby’s and TP settled their differences. In case you were away, TP had nominated three BoD candidates and sued Sotheby’s over a their newly-created poison pill.

Their settlement agreement has three standard components:

1. 1.What they give and get from each other
   

2. 2.TP compliance with standard Sotheby’s corporate policy
   

3. 3.Standstill terms.
   

They agreed:

1. ❖TP appoints three new directors, including Loeb and two others, to a BoD that expands by those three positions to fifteen people
   

2. ❖The BoD will return to twelve people by 2016
   

3. ❖The TP nominees receive various important BoD committee memberships
   

4. ❖TP dismisses its poison pill lawsuit and DGCL Section 220 request, and Sotheby’s terminates the poison pill
   

5. ❖TP can replace their nominees mid-term, but Sotheby’s can “reasonably” reject TP replacements (which invites further litigation)
   

6. ❖Sotheby’s pays TP $10 million for its expenses
   

7. ❖The BoD retains an integration consultant so that everyone gets along well, and forms a Business Strategy Committee to plot and scheme a future course for the company.
   

But, the TP nominees must resign if TP’s holdings fall below 5% of outstanding shares. This is standard and expected, as Sotheby’s (or any other company) does not want to give away BoD positions to small shareholders. Mechanically, the TP directors submit irrevocable resignations before serving, which the company will then enforce if TP ownership falls below 5%

And, Sotheby’s need not nominate the three TP directors after 2014. So, Sotheby’s could dismiss the three new TP directors in a year. Then, TP would need to run another proxy context, and we’d return to the same situation we presumably just resolved.

Policy Compliance

The new TP directors also need to comply with a range of corporate policies. These apply to all directors, and employees (except for the director/corp gov policies):

1. ❖Code of Business Conduct and Ethics
   

2. ❖securities trading policies
   

3. ❖anti-hedging policies
   

4. ❖Reg FD policies
   

5. ❖director confidentiality policies and corp gov guidelines.
   

All of this is routine corporate stuff. The Sotheby’s settlement does feature fairly strict confidentiality terms, and confines shareholder communication with the BoD to the CEO and (sometimes) the lead independent director.

If a director fails to comply, typically a company could demand his or her resignation, under the same irrevocable resignation for the 5% ownership requirement. Curiously, the Sotheby’s agreement does not include this.

Standstill! Don’t Move!

And, TP agrees to a set of “standstill” terms. Essentially, as long as the three TP directors remain on the BoD, TP will support management and the BoD. This, too, is standard stuff - companies don’t just give away BoD positions only to have the new director work against the executives and incumbent directors.

Just because it’s standard doesn’t mean we like it. “Support” includes a long list of customary affirmative and prohibited actions. TP will not:

1. ❖solicit proxies for any proposal or nomination
   

2. ❖join a Form 13(d) group
   

3. ❖offer shareholder proposals or BoD nominations
   

4. ❖sell stock to a third party that increases the third party ownership to over 5%
   

5. ❖designate another party as a voting proxy
   

6. ❖make DGCL Section 220 requests
   

7. ❖disparage management or the BoD
   

8. ❖sue the company for most any reason
   

9. ❖undertake a “extraordinary transaction”, like an offer to buy a material part of Sotheby’s assets
   

10. ❖request a waiver of any of the standstill terms, if the waiver would require public disclosure (say, in a Form 8(k) filing)
    

and will:

1. ❖vote its shares in support of BoD
   

2. ❖enter into a confidentiality agreement allowing the three TP directors to share BoD information within TP
   

3. ❖limit its share ownership to 15% of outstanding shares.
   

The confidentiality agreement with TP is a little novel, since most BoDs would prefer what goes on in the boardroom stays there. And, the share ownership increase (to 15%) is either a little generous, or somewhat restrictive. Standstill agreements tend to either limit a shareholders’ holdings to the shares they own at the time of the agreement, or place no limits on buying more shares.

Got to Give to Get

What did TP sacrifice in order to appoint three directors, out of fifteen (or twelve, if they last that long), and receive $10 million? Really two significant concessions:

1. ❖TP accepts strict limits on communicating with other shareholders. TP might wish to let others know what it heard in the boardroom, or even what it thinks about the company. Under this agreement, it cannot.
   

2. ❖TP agrees to not pursue any type of deal involving the company. It can’t offer financing, or to buy one or another asset of the company (although it can make a tender offer for the entire company).
   

And, TP gets only three directors, and then only for one year. (After that, they’re at the mercy of the BoD.) TP might want to fire the CEO, which does fall within the fiduciary duty of the BoD, and which seems like a goal of the whole project. But, with only three out of fifteen directors, TP doesn’t have much leverage in that (or any other) decision.

What Choice Do We Have?

Few of these limits apply if the TP nominees simply win election to the BoD outright. Then, TP and its nominees only need to obey applicable law - securities trading and Reg FD, for example. Directors also must fulfill fiduciary duties of care and loyalty. Finally, they must keep confidential only certain information, like trade secrets and employment matters.

A director that wins an election has no legal obligation to comply with corporate policy. He or she can talk directly to shareholders about any subject, without going through the BoD chair, the CEO, or IR, as long as they don’t divulge trade secrets or employee information, and stay within other applicable laws. So, company problems and BoD dysfunction becomes available to all.

Of course, an elected director may want to comply with corporate policy in the name of collegiality. A director that airs BoD dirty laundry risks exclusion from informal BoD discussions. Maybe worth the price, though, to inform investors what really goes on in the boardroom.

Note TP and Sotheby’s settled the proxy contest one day before the annual meeting. Sotheby’s most likely expected to lose the election, seeing as they counted most of the votes by then. TP in turn accepted the three BoD positions it probably would have won anyway, and also accepted the numerous other limits. We guess the $10 million helped them decide - we can’t think of any other reason.

It looks like the limits on communicating with other investors did not matter as much as that expense reimbursement. TP surely won the support of other investors this time, as Sotheby’s clearly counted beyond TP’s 10% shareholding to conclude that it should settle. TP could have preserved its ability to share internal BoD and company information with other investors, and continued to curry investor support. Seems to us TP either thinks it will have this support anyway, or won’t need it, perhaps because it may move on in a year or so.

We like communicating with other investors, which forms the basis of successful activist projects, and think it’s a core responsibility of a director. Not sure we’d give up $10 million, or about 3% of the value of TP’s 10% holding, to do that. Easy for us to say...