The Law of “Change in Control” Provisions in Bonds

Author: LegalEase Solutions


The development of “change of control” provisions in bonds can be traced to the much publicized bondholder losses in the RJR Nabisco leveraged acquisition in 1988. [1] A “change of control” covenant states “that if a specified takeover-related event occurs, bondholders will either have the right to ‘put’ their bonds back to the company, or to have the interest rate on their bonds increased to reflect the additional risk associated with the takeover-related event.”[2] After RJR Nabisco’s management announced its intention to carry out a leveraged buyout, there was a significant decline in the issue of investment grade bonds. This served as a catalyst to the incorporation of “change of control” provision and in November, 1988, the first “change of control” covenants appeared. In the subsequent year, over 50 bond issues contained “change of control” covenants.[3] The purpose of “change of control” covenants is purportedly to protect bondholders from takeover-related losses.[4]

As a result of the RJR Nabisco leveraged acquisition the bondholders filed an amended complaint against defendants, corporation and its chief executive officer, alleging injuries sustained in connection with the corporation’s leveraged buy-out of its shareholders.[5] The resulting decision, Metropolitan Life, 716 F. Supp. 1504, 1509 (S.D.N.Y. 1989) is the decision which triggered the incorporation of “change of control” provision in bond indentures.  The litigation began when two of RJR’s bondholders filed suit claiming a breach of the implied covenant of good faith and fair dealing.[6]  In ruling against the bondholders, the court noted that there was “no express covenant between the parties that would restrict the incurrence of new debt, and no perceived direction to that end from covenants that are express.”[7]  The court’s decision was based on four key factors.[8] First, the court noted that a bond is a contractual relationship between parties, and this contract did not set any limits on the amount of debt the corporation could incur.[9]  Second, the court stated that no fiduciary obligation runs from management to bondholders.  Third, the court found it relevant that the plaintiffs were large institutional investors who negotiated the terms of the investments they made.  In addition, it was clear from the facts of the case that the plaintiffs recognized the LBO trend and understood the ramifications on bondholders.[10] Finally, at the policy level, the court noted that a decision for bondholders in a case like this would have a destabilizing effect on the market.[11]  This shows that courts offer little protection to bondholders as it refused to find that management owes a fiduciary obligation to bondholders and failed to find a violation of the implied covenant of good faith and fair dealing under a bond contract. Thus, given the susceptibility of bondholders to the detrimental effects of a takeover, and the lack of adequate protection by the courts, the evolution of “change of contol” covenants was a natural development in the financial marketplace.[12]

Interpretation of a “change of contol” provision

In interpreting the meaning of “change in control” provisions, courts will bend the “plain meaning” rule of interpretation in order to avoid absurd results. Fischbein v. First Chicago Corp., 1998 U.S. Dist. LEXIS 2701,2726 (D. Ill. 1998).  In Fischbein, there were three employee stock plans, each of which authorized the FCC Board of Directors to issue to qualified employees certain benefits, including, among other stock-based awards, stock options and restricted shares. Id. at 2704.  The three stock award plans, included language vesting the stock rights in the employees in the event of a “change of control”.” Id. at 2704, 2705. The introductory sentence varied from plan to plan, but each introductory sentence made clear that the section was defining “change of control” to include “any” of certain events.  Id. at 2710. A merger agreement was entered into between FCC and NBD, which entered into a stock-for-stock “merger of equals,” after which FCC’s shareholders would hold over 50% of the combined entity. Id. at 2711.  Pursuant to the merger Plaintiff former employees were terminated.   Plaintiffs sought damages for breach of contract and for fraud, as Defendants refused to grant them stock benefits that would have automatically vested in the case of a “change of control.” Id. at 2718. The court granted summary judgment for defendant holding that plaintiffs’ interpretation of the three plans’ “change of control” provisions was contrary to settled rules of contract interpretation and corporate law. Id. The court reasoned:

First, it is undisputed that “change of control is defined in the three plans and that “change of control as defined does not include “actual” changes of control. Also, it is undisputed that the drafters of the three plans could choose to define a term in an idiosyncratic way — i.e., more or less broadly than the term is used in normal conversation. Thus, Plaintiffs’ attempts to broaden “change of control from the more narrowly defined terms in the plans to a “real-world” definition must fail. Second, even if this court was willing to broaden the definition of “change of control to include “actual” changes of control, Delaware case law makes clear that this merger would not be considered an actual “change of control because control remained static, i.e., in the hands of multiple shareholders with no shareholder holding sufficient amounts of stock to force its will upon others.

Id. at 2728, 2729.

The court applied Delaware contract law and stated that strict adherence should be given to the clear, literal meaning of the words if a contract is clear on its face. However, the Court further observed that when interpreting the particular provision the entire instrument, and the surrounding circumstances, along with the meaning derived from construing the Certificate in its entirety should be given. Id. at 2717.

Thus, when there is an ambiguity in a “change of control provision, in interpreting the same, the Courts are free to disregard literal language of the agreement, and can engage in a process of interpretation that takes into account the parties’ intentions in determining the respective rights and duties of the parties.

Likewise, in Angelo, Gordon & Co., L.P. v. Allied Riser Communs. Corp., 805 A.2d 221 (Del. Ch. 2002) there arose a question of interpretation to determine whether a change in control provision allowed Plaintiff noteholders to “put” their shares to the company as a result of a merger. Plaintiffs’ motioned for a preliminary injunction.   However, the court scrutinized the language of the indenture and found that the Indenture excluded a merger from the definition of “change of control.” Id. at 222. The court went beyond the language and conducted a through enquiry, concluding that the merger continued to be fair to all interests concerned.  Id. at 224. Balancing the interests of the parties, the court was satisfied that the equities weighed against the entry of an injunction. Thus, the Plaintiffs’ motion for preliminary injunction was denied.

Unocal Standards

The Unocal test is the standard by which many courts determine the validity of defensive tactics,[13] and is the appropriate standard for determining the validity of “change of control” covenants in bonds. Supra n. 7 at 485.  This test was adopted for the first time by the Delaware Supreme Court for determining the validity of defensive tactics employed by incumbent management  in Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946 (Del. 1985).  The issue in this case revolved around corporate control. The dispute arose when Mesa, an owner of thirteen percent of Unocal’s stock, commenced a two-tier, front-loaded, cash tender offer for sixty-four million shares of Unocal’s outstanding stock, which was rejected by  Unocal’s board. Id. at 949-50.  In addition, the board adopted an exchange offer under which Unocal would buy stock from all outstanding shareholders except Mesa. Id. at 951. Mesa challenged this action contending that the selective exchange offer violated the fiduciary duties Unocal owed Mesa as a shareholder. Id. at 953.

The court applied the two-prong test to determine whether Unocal’s defensive tactics were valid.   The first part of the test required directors to “show that they had reasonable grounds for believing that a danger to corporate policy and effectiveness existed because of another person’s stock ownership.” Unocal, 493 A.2d at 955. In finding that Mesa’s offer constituted a danger to the corporation, the court stated, “it is now well recognized that such offers are a classic coercive measure designed to stampede shareholders into tendering at the first tier, even if the price is inadequate, out of fear of what they will receive at the back end of the transaction.”  Id. at 956. The second step of the test requires the defensive measure to be “reasonable in relation to the threat posed.”   Id. at 955.  The court determined that Unocal satisfied this part of the inquiry because Unocal’s reasons for adopting the selective exchange offer were valid and Mesa’s participation in the offer would frustrate Unocal’s defensive efforts. Id. at 956. Since both parts of the test were satisfied, the court applied the business judgment rule and determined that the actions taken by Unocal’s board were valid.   Id. at 958-59.

Thus, when there is a dispute regarding change in control, courts apply the Unocal test to determine whether the opposition or support  of a change in control is not motivated by an unjust enrichment.  For example, in Hills Stores Co. v. Bozic, 769 A.2d 88 (Del. Ch. 2000), the winning slate in a proxy contest caused the plaintiffs, the Hills Stores Company and its subsidiary, to sue the former members of the Hills board. The winning slate was proposed by Dickstein Partners, an investment fund that promised either to buy all of the shares of Hills for $ 22 in cash and $ 5 in junk bonds per share, or to sell Hills to a higher bidder in the auction its slate pledged to conduct. Dickstein assured the Hills stockholders that it had the wherewithal to finance the acquisition and to cover the costs that would accompany a change in control of the Hills board. Id. at 89. The Hills board determined that the offer was inadequate and shakily financed and that Dickstein’s proposed strategy for the company was harmful, and seriously adverse to the interests of the company and its stockholders. Id. at 89, 90, 101.

The court applied the Unocal standard and concluded that defendants were entitled to summary judgment on plaintiffs’ claims for breach of fiduciary duty and waste, as plaintiffs produced no evidence defendants’ opposition to change in control was not made in good faith. Id. Further, the court denied defendants’ motion for summary judgment against plaintiffs’ breach of contract and unjust enrichment claims based on defendants’ receipt of severance payments in excess of their contractual entitlement. The Court granted plaintiffs’ motion for partial summary judgment on their breach of contract and unjust enrichment claims against defendants based on special discretionary bonuses awarded to defendants. Id. 

In Brittain v. Stroh Brewery Co., 1993 U.S. App. LEXIS 9898 (4th Cir. 1993), appellants shareholders contended that a provision of the agreement was ambiguous because it was unclear whether the objective reasonableness or subjective good faith standard governed the brewing company’s decision to approve a control change. Id. The shareholders argued that a decision taken in good faith nevertheless could be unreasonable. Id. According to the shareholders, material questions of fact existed concerning the meaning of the provision that precluded entry of summary judgment. Id. Accordingly, the central inquiry on appeal was whether there were genuine issues of material fact regarding the reasonableness or good faith of the brewing company’s refusal to consent to the questioned distributing transaction. Id. The appellate court found that the brewing company had reasonable grounds to fear sales dilution and to withhold its consent to transfer, and the action was neither unreasonable nor taken in bad faith. Id.

Distinction between the terms “take over” and “change in control” 

 Though apparently of the same meaning, courts have distinguished between the terms “take over” and “change in control.”  For example, in Am. Cas. Co. v. Etowah Bank, 288 F.3d 1282 (11th Cir. 2002), the insured acquired the predecessor by purchasing 100 percent of its outstanding stock, thereby making the predecessor a wholly-owned subsidiary of the insured.  According to the court, this was a situation of “takeover” and not a “change of control.” The court reasoned that a change in control occurs when ten percent of the insured’s stock is acquired, while a taking over usually occurs when more than fifty percent of the stock is acquired.  Id. at 1287.  Therefore, while every “taking over” will involve a change in control, not every change in control will involve a takeover.  Id. at 1288.

Distinction between the terms “transfer” and “change of control”

H-B-S P’ship v. Aircoa Hospitality Servs., 137 N.M. 626 (N.M. Ct. App. 2005) involved the interpretation of a right of first refusal (ROFR) provision in a limited partnership agreement. Intervenor plaintiff partnership was formed for the purpose of acquiring an interest in a hotel and one of its partners was defendant. Plaintiffs’ complaint arose when defendant’s corporate great-great-grandparent was sold. Id.  The Appellate Court affirmed the district court’s decision in favor of the plaintiff that the ROFR was triggered when the corporate great-great-grandparent of one of the general partners was sold in a stock transfer transaction. Id.  The issues in this case revolve around the ROFR language of the Partnership Agreement. The court held that the sale of the defendant company’s corporate great-great-grandparent was an “indirect transfer” of equity interest in the company within the meaning of the contract triggering the ROFR. Id. at 92. the court observed that “it would be ‘illogical’ not to consider a transfer of the parent as an indirect transfer of the wholly-owned subsidiary’s controlling capital stock interest,” where the object of the agreement was as much affected by an indirect sale of a parent’s stock in its subsidiary as a direct sale of stock by the subsidiary. Id. at 79.

The court held that Contracts are interpreted to “give force and effect to the intent of the parties.” And the language of the partnership agreement is  broad enough to conclude that the ROFR was to be triggered by all changes in ownership of the defendant.

The purchase option is triggered under Article 9.1 if “a Partner proposes to sell, assign, or otherwise dispose of all or any part of his interest in the Partnership.” As explained in Article 9.5, the ROFR is triggered by “any direct or indirect transfer including, without limitation: . . . . the transfer of any equity interest in a Partner which is a corporation, . . . if the transfer . . . results in a change in control of such corporation.” Use of the phrases “any direct or indirect transfer” and “without limitation” clearly evinces a desire by the parties to maximize the reach of the ROFR. Similarly, reference to “the transfer of any equity interest in a Partner” indicates intent to include changes in stock ownership in partners by sale. This intent is made all the more clear given that transfers by “merger, consolidation or similar action” are separately covered in Article 9.5(b). We agree with the district court that the language and structure of Article 9.5 evince intent that the ROFR was to be triggered by all changes in ownership of AHS and AHS’s corporate body.

 Id. at 71-72.

The court held that the contract terms control its decision. In light of the broad language of Article 9.5, expressly restricting both indirect and direct transfers of equity interests, and the clear intent to restrict corporate sales to outsiders, the court concluded that the parties bargained for a broader ROFR than parties to whom the general rule has been applied. Id. at 80.

The court held that though it agreed with the defendant  that Article 9.5 required the plaintiff  to show both a transfer and a “change of control”, it disagreed that a “transfer” within the meaning of this ROFR does not include a stock sale  by a remote parent corporation. Quoting Black’s Law Dictionary on the meaning of transfer, the court held that “Transfer” is itself broadly defined by Article 9.5 to encompass “any direct or indirect transfer” of an equity interest by or in a partner “without limitation.” “Transfer” must be interpreted within the context of the ROFR.  The court further held that since the defendant is a wholly-owned subsidiary, a transfer of its stock by its parent would constitute a direct transfer of an “equity interest in a Partner” within the meaning of the ROFR. Transfer of the stock of the defendant’s corporate parents necessarily constitutes an indirect transfer of an “equity interest in a Partner.” Since the restriction is “without limitation,” the ROFR is triggered regardless of whether the transaction is two or even five tiers removed, so long as it results in a change of that control of defendant. Id. at 73.

Liability of former stockholders for the purchaser stock holder’s misconduct

The law does not require one to act on the assumption that a person with whom a business transaction, even of large amount, is had, will commit a fraudulent or criminal act if given the opportunity to do so. Levy v. American Beverage Corp., 265 A.D. 208, 219 (N.Y. App. Div. 1942).  In Levy, Defendants, a corporation and its former majority stockholders, appealed from a judgment entered by the Supreme Court of New York County on a decision directing an accounting in plaintiff minority stockholders’ action to recover corporate losses sustained after the majority’s ownership connection to the corporation had ended. Id. The appellate court found that the inferences drawn from the evidence were unwarranted, as sufficient circumstances did not exist to place the majority on notice that their purchasers intended to loot the corporation.  The court observed:

[A] majority stockholder may not knowingly use his position to wrongfully injure one who holds a minority interest, and will incur liability when he does so.  The test of common honesty would seem to be a sufficient one to apply in order to determine when a wrong is being done.  To apply the rigid rules limiting a fiduciary, and to say further that the failure to investigate the moral character, or financial ability of the purchaser of one’s stock is an actionable wrong, is to place an unwarranted burden upon the ownership of stock. Knowledge that  the purchasers were about to loot the corporate treasury, or were persons who had previously engaged in such practices would be one thing.

Id. at 218 and 219, (emaphasis added)

The Appellate court reversed the judgment entered against the corporation and its former majority stockholders, and dismissed the minority stockholders’ complaint on merits. Id.

Thus, the courts consider it as an unwarranted burden upon the stock owners to be held responsible for the fraudulent act of the purchaser of one’s stock as Stockholders are not ipso facto trustees for each other, id. at 216, provided the stock owner did not have knowledge.

Pleading requirements

In order to prove “change in control”, the plaintiff need not allege facts that would prove that the control person actually exercised the power to influence or control. In Acacia Nat’l Life Ins. Co. v. Kay Jewelers, 203 A.D.2d 40 (N.Y. App. Div. 1994),

the court held that for the purpose of pleading, the plaintiff “need not allege facts that would prove that the control person actually exercised the power to influence or control. Rather [it] only needs to allege ‘the power or potential to influence and control’ . . . . Consequently, ‘the determination of who is a controlling person . . . is an intensely factual question'” Id. at 46.  In this case, the Plaintiff sought to recover the difference between the principal amount of the notes and what was paid by defendants after defendants had changed a “change of control” provision anticipating a merger. The lower court denied defendants’ motion to dismiss the complaint as to certain of the causes and the parties appealed. The court found that the cause of action for breach of contract had to be dismissed because at the time defendants refused to repurchase the notes no “change of control” had occurred.  However, the order which denied defendants’ motion to dismiss the first, third, fourth and sixth causes of action, was modified to grant the motion to dismiss the first and third causes of action, and otherwise it was affirmed.


The “change in control” provision in a bond indenture is a safety valve to the note holders in the event of transfer of interest, merger and take over of companies and other corporate entities. Courts have devised various safeguards and corporate norms to minimize the risks associated with the takeover-related event.  The Unocal Test devised by the Delaware Supreme Court is used by many courts to determine the validity of defensive tactics.

[1] In a leveraged buy-out (LBO) a group of investors, often including members of a company’s management team, seek to take the company private by buying out the existing shareholders. The debt financing usually includes significant amounts of high risk, high yield “junk” bonds. On October 20, 1988, F. Ross Johnson,   the chief executive officer of RJR Nabisco,   proposed a seventeen billion dollar leveraged buy-out of the company’s shareholders at seventy five dollars per share. Metropolitan Life Ins. Co. v. RJR Nabisco, Inc., 716 F. Supp. 1504, 1509 (S.D.N.Y. 1989)

[2] Marcel Kahan & Michael Klausner, Antitakeover Provisions in Bonds: Bondholder Protection or Management Entrenchment?  40 UCLA L. Rev. 931, 934 (1993).

[3] Id. at 971-72.

[4] Id. at 934.

[5] Id.

[6]  Metropolitan Life Ins. Co. v. RJR Nabisco, Inc., 716 F. Supp. 1504, 1509 (S.D.N.Y. 1989)

at 1507

[7] Id. at 1508

[8] Thomas P. Marko, An Argument For Invalidating “change of contol” Covenants, 20 Iowa J. Corp. L. 475,480.

[9] Supra n.5at 1509

[10] Id. at 1511-14

[11] Id. at 1520

[12] Supra n. 7 at 481

[13] Randall S. Thomas, Judicial Review of Defensive Tactics in Proxy Contests: When is Using a Rights Plan Right? 46 Vand. L. Rev. 503, 516 (1993)