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NEW YORK (CNN/Money) -
When Sovereign Bancorp wanted to fend off shareholders demanding a boardroom shakeup, the Philadelphia bank's bigwigs dusted off what some shareholders say was a classic 1980s corporate defense that does little but entrench current management.
And with more and more hedge funds getting more and more aggressive about forcing changes to boost the value of their investments, the so-called white squire defense may be set to make a comeback -- much to the dismay of some hedge fund managers and other "activist" investors.
Here's how the white squire defense works.
Say a block of shareholders is demanding that a company's management step down, or sell key assets, or make some other controversial move.
The company then turns around and sells a large block of stock to an entity friendly to management, but less than 20 percent, as a stake that size or larger usually requires the blessing of shareholders. With a large block of stock in friendly hands, the company can more easily fend off dissident shareholders, since their voting power is diluted.
The technique hadn't been used in a high-profile battle since 1988, when Polaroid, seeking to fend off a $2.4 billion hostile takeover bid by Roy Disney's Shamrock Holdings Inc., created an employee stock ownership plan that it used to successfully block the takeover attempt.
Fast-forward to last week. That's when Sovereign cut a deal to sell a 19.8 percent stake to Spain's Banco Santander Central Hispano for $2.4 billion, prompting an outcry from investors.
"We have never seen a response like this," said Ralph Whitworth, founder and principal of Relational Investments LLC, a $6 billion hedge fund based in San Diego that's threatened a proxy fight with Sovereign's board.
"There have been minority positions taken by banks and outsiders but not in the face of some type of insurgent or proxy effort. It's the worst one we've seen, ever."
Some shareholders are complaining Sovereign used the stock sale to beat back the demands of activist shareholders, a charge Sovereign denies. And they say that if Sovereign's maneuver works, other target companies could follow suit.
"If they get away with it, it could embolden other target companies to replicate it," said Robert Chapman Jr., who plans to re-launch his activist hedge fund firm, Chapman Capital, to investors early next year, referring to Sovereign's move.
Whitworth, whose firm is Sovereign's largest shareholder, has been a vocal critic of Sovereign's corporate governance.
"It's a seminal case in a new era," he said. "It undermines everything that we did in response to the corporate scandals. If they are successful, other companies are going to say 'You can do this in America'."
Enter the white squire
Sovereign argues that it struck the deal not to fend off Relational but to boost the company's share price and earnings and revenue growth, in part because it gave them the capital to acquire a Brooklyn-based bank, which gives Sovereign a presence in the New York region.
"We believe by partnering with Santander we have enhanced our organization not only for our customers but for our team members, and the citizens of communities for many years to come, by continuing to create above-average value for shareholders," a Sovereign spokesman said.
But that argument hasn't gone over with some on Wall Street. At least four analysts who cover Sovereign have cut their rating on the company since the announcement. Not every Sovereign shareholder is opposed to the move, though.
Anton Schutz, president and portfolio manager of Mendon Capital, whose funds own shares of Sovereign, said Sovereign was able to fend off some of Relational's demands by selling a stake to Banco Santander.
But he said that "the math behind the transaction" means the move could boost the company's share price down the road. But he said that if someone has a better idea for how to do that, he's all ears.
A throwback to the '80s
Whitworth said that after the Enron and Tyco scandals erupted, companies were more willing to listen to activist shareholders lobbying for better corporate governance. He noted that his firm played a key role in triggering Tyco to revamp its board.
"What we've seen in the post-Enron era is a lot more responsiveness from companies and a lot better communication and resolutions from activists, so this is a real outlier," he said. "It does harken back to things companies did in the 1980s to entrench managers and directors."
But the white squire defense doesn't come without risks. Companies who employ it can alienate shareholders who were undecided about where to throw their support -- behind management or dissident investors.
Plus, it sends a signal to investors that management is more interested in preserving their own jobs than maximizing shareholder value, activist shareholders say.
"I think in some ways it smells of desperation when a company puts 20 percent of its votes into friendly hands, full well knowing there is a strong contingency of shareholders" looking for changes in a company," said Chapman. "It requires rather deft calculation by the target company to ensure it nets out favorably on the vote count."
Philip Broenniman, who runs Cadence Investment Partners, a hedge fund that invests in companies undergoing restructurings, said there are other tactics emerging in response to activist investors, a trend that will only accelerate.
"There's no question in my mind that you'll start seeing a circling of the wagons as management comes under scrutiny and as they realize activist investors, hedge funds or otherwise, are not going away," he said.
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For more on the Sovereign's recent deals, click here.
Plus: Icahn's latest attack on Time Warner: More here.
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