Hedge Funds  |  Deal Professor

In Trying to Save Darden, a Board Sealed Its Own Demise

By Steven Davidoff Solomon   September 30, 2014 6:45 pm

Gestures of futile nobility seem mostly confined to the movies these days. And yet the directors of Darden Restaurants, the owner of Olive Garden and other quintessentially American restaurant chains, may have decided that they would rather commit corporate suicide than give in to the demands of two activist shareholders, Starboard Value and the Barington Capital Group. It would be touching if it didn’t appear to be so inexplicably foolish.

For almost a year, Darden has paid a steep price for refusing to meet Starboard and Barington’s sometimes shifting demands. Clarence Otis Jr., Darden’s chief executive and chairman, announced in July he was resigning, eight of Darden’s directors have agreed to step down, and the four remaining board members are engaged in an uphill contest to keep their seats. Against this onslaught, the Darden directors, who once refused to speak to the shareholder activists, have been reduced to pleading with Starboard to negotiate a face-saving resolution.

One has to wonder how the Darden board allowed the situation to get to this point.

In December, Starboard announced that it had taken a 5.6 percent position in Darden a few months after Barington announced its 2.8 percent stake. Starboard proposed spinning off Olive Garden, Red Lobster and LongHorn Steakhouse into a company separate from Darden’s higher-growth chains like Capital Grille. It also suggested the usual dash of corporate reorganization because of the company’s poor results.

There was nothing unusual about this; shareholder activists love to propose spinoffs as a way to earn a quick buck. But Darden and Mr. Otis had performed well until the financial crisis. The company had only recently begun to underperform while being accused of overpaying its executives.

In short, there was room for compromise, familiar terrain for companies dealing with the increasing prevalence of shareholder activists.

But Darden also has a history of not appreciating criticism, to put it politely. Mr. Otis, for example, has been accused of barring analysts who were overly negative in their views from participating in future Darden events.

The result was that Darden’s board initially tried to ignore the activists, refusing to speak to them. The company also adopted a host of unfriendly measures to fight off the activists, including bylaws intended to inhibit shareholder nominations of new directors.

But perhaps the Darden board’s most controversial move was to propose spinning off Red Lobster, but not Olive Garden, as a stand-alone company.

Shareholders led by Starboard protested this maneuver, arguing that it would sacrifice value by leaving Red Lobster too small to survive while failing to capitalize on its real estate. Fifty-seven percent of Darden’s shareholders called a special meeting to vote on the Red Lobster spinoff. It would not take a rocket scientist to figure out that if those shareholders made the effort to call for such a meeting, they most likely did not favor the idea.

It was at this point that the Darden directors may have drunk their metaphorical hemlock.

Before the shareholder meeting on the spinoff, Darden’s board agreed abruptly in May to sell Red Lobster for $2.1 billion to Golden Gate Capital.

This was a stick in the eye for shareholders. In a situation that seemed ripe for compromise, the sale of Red Lobster only infuriated the protesting Darden shareholders led by Starboard. Starboard complained that the deal was at a fire sale price because $1.5 billion of the value was for Red Lobster’s real estate, thus valuing the nation’s pre-eminent fast seafood chain at only $600 million with a tax bill that was $500 million. Starboard has asserted that after payments related to debt, the proceeds from the actual Red Lobster business were only $21 million, a fact that Darden heatedly disputes.

This prompted Starboard to try to replace all of Darden’s directors.

Darden’s board has been on the appeasement trail ever since, overhauling corporate governance, appearing to push out Mr. Otis and then desperately pleading with Starboard to negotiate while offering it four seats and proposing to add four new independent directors for a fresh perspective. The company’s argument has essentially devolved into one that says, “We don’t want too much change at Darden, so please keep at least four of us.” It’s not the best defense, frankly, to say that the reason you should stay is because you oppose change.

The question is why the Darden board would sell Red Lobster so rashly, knowing there was a strong possibility it would end up in the mess it finds itself in right now. After all, the board was aware that a majority of Darden’s shareholders most likely opposed the sale.

Over the last few months, I have spoken to several people close to Darden. They tell a uniform tale: The board felt that Red Lobster was a melting ice cube and that if it didn’t sell quickly, it would not get a good price. Moreover, the directors felt that the board’s fiduciary duties required them to sell Red Lobster at the time. Darden also tried to make the sale contingent on shareholder approval, but Golden Gate, as might be expected, refused, so nothing more could be done.

Darden has spent a lot of money on advisers with stellar reputations, including Goldman Sachs for financial advice and the law firm Wachtell Lipton Rosen & Katz for legal advice. But the directors’ justification is still puzzling to me.

The idea that a board is forced to sell something because of fiduciary duties may be warranted, but that would mean no alternatives existed, like in the sale of Bear Stearns to JPMorgan Chase. That was the only option for Bear Stearns to avoid bankruptcy.

Under corporate law, the sale of an asset like Red Lobster is the board’s decision, and it has wide latitude to sell or not. I certainly know of no case that would support the Darden board’s contention that it had no choice. In fact, one of the seminal cases in corporate law involves the sale of the TransUnion Corporation in the 1980s to the Pritzkers. In that case, the lawyer for TransUnion told the directors that if they refused to agree to the sale, they could be held personally liable for passing up on the bid. A court found the directors personally liable for following that lawyer’s advice. Since then, lawyers have been careful to avoid this type of all-or-nothing advice.

We don’t know what was discussed in the Darden boardroom, but one hopes it wasn’t phrased the way the directors seem to say it was. We will most likely never know what caused the board to take this inexplicable path, particularly because anyone who has watched the shareholder movement over the last few years could have predicted an all-consuming shareholder backlash.

When asked for a comment, a representative of Darden pointed me to a previous statement that the decision to sell was about maximizing value. “After careful evaluation,” the statement said, “the board was certain that halting a robust Red Lobster sale process midcourse would have negative consequences for the value” received for Red Lobster.

In any event, it doesn’t appear from the evidence that Red Lobster needed to be sold immediately. Institutional Shareholder Services, the big proxy advisory firm, called the Red Lobster sale “very close to a giveaway.” The Darden board has also not benefited from the fact that Red Lobster’s management said in a document prepared by Red Lobster’s buyer related to the financing of the acquisition that it believed that the chain’s problems “are temporary in nature.”

In its battle with Darden, Starboard, whose stake is now at 8.8 percent, seems to have momentum. I.S.S. and the other main proxy adviser, Glass Lewis, have taken the unusual step of recommending that all of the directors be thrown out at the shareholder meeting, which is scheduled for Monday.

Absent a last-minute, face-saving compromise, the likelihood of a full-scale ouster raises the glaring question: Why would the board pointlessly and perhaps foolishly invite its own demise?

Steven Davidoff Solomon, a professor of law at the University of California, Berkeley, is the author of “Gods at War: Shotgun Takeovers, Government by Deal and the Private Equity Implosion.” E-mail: dealprof@nytimes.com | Twitter: @StevenDavidoff

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