So far in this course, we have been heavily focused on merger strategies from the perspective of the acquiring or bidding firms. In most cases in which the merger or acquisition is friendly, the strategy is the same for the target firms. Targets should calculate their minimum willingness to sell price and check historical transactions to see if they are being offering a fair price. However, what about the case of a hostile takeover? What can a target firm do when there is an unwelcome takeover attempt? In today’s lecture, we will talk about 1) takeover defense tactics, 2) how certain state laws can reduce the threat of hostile takeovers, 3) the economic rationale for antitakeover defenses, and lastly 4) whether the market interprets these antitakeover defenses improve shareholder welfare.
Defenses that Need Shareholder Approval
Takeover defense tactics can be categorized into those that need shareholder approval and those that do not. However, the general strategy is twofold. The first method is to entrench management and make managers and directors harder to fire or replace. The second method is making takeovers prohibitively more expensive.
Let us first talk about defenses that need shareholder approval. One way a target firm can defend itself against a takeover is by restructuring itself so that it becomes more difficult or expensive to acquire. Externally, selling oneself to another bidder you would rather be acquired by, for example, is one possible approach. This can be done through a leveraged buyout. You can find yourself a private equity firm and refinance your existing debt and take yourself off the market. You could also find yourself a “white knight” that can give you friendlier terms than from the terms offered by the hostile acquirer.
One could also respond with a tit for tat strategy: the target firm could make a bid for the acquirer. What happens is that both firms will try to acquire as many shares of the firm as quickly as possible until one firm gives up or runs out of money. A recent example of the Pac-Man defense is the case of Porsche and Volkswagen. Porsche attempted to acquire Volkswagen through debt issuance. However, their strategy coincided with the 2008 financial crisis. They eventually run out of money and sought Volkswagen as a white knight. Volkswagen eventually acquired Porsche in order to pay off its debt.
Lastly, a target firm could restructure itself internally by changing its ownership structure or corporate charter. A dual-class exchange offer is an offer to existing shareholders to trade one type of shares with voting rights to another class of shares with fewer or no voting rights but with higher dividends. With fewer voting rights shares on the market, managers and directors can worry less about shareholders tendering their shares since owning non-voting shares doesn’t change the firm’s ownership structure.
In terms of changing the corporate charter, firms can actually include antitakeover amendments or shark repellents to make it more difficult for hostile bidders to acquire the firm through tendering shares. However, it is important to note that these actions are a double-edged sword. While they prevent hostile takeovers, they also takeaway shareholder rights and the ability for shareholders to effect change.
Examples of Antitakeover Charter Amendments
I will go over four examples of antitakeover charter amendments. The first is the requirement of supermajority voting for certain transactions that can range from 2/3 to 95 percent of the votes. This means that hostile bidders need to acquire far more than 50 percent of the outstanding voting shares in order to approve its own merger. In fact, board-out clauses can be included that gives directors discretion when a supermajority is required.
To prevent the scenario in which the entire board of directors is replaced with one that is friendlier towards a hostile bidder, shareholders could vote to implement staggered or classified boards. This is so that only a fraction of the board members, and not the majority, are up for election in any year. This makes it difficult for outsiders to obtain control, for example, through a proxy fight.
To fight against the prisoner’s dilemma or coordination problem arising from a two-tier tender offer, firms can force acquirers to pay the same “fair price” for each share tendered after gaining control of the firm. The fair price can be determined by a range of formulas, such as the maximum price paid for any shares acquired during a specific period in the first tier or a multiple of earnings or book value.
Lastly, firms could also change the state of incorporation to one that has more antitakeover laws, which I will discuss a few slides later.
Defenses that do not need Shareholder Approval
What are some defense tactics that do not need shareholder approvals? The board of directors, remarkably has a lot of power to stop corporate raiders. In general, they buy and sell shares, litigate, and pay themselves in the case of a hostile takeover. In the case in which a corporate raider holds a firm hostage through the acquisition of a large block of the voting shares, the board of directors can pay the ransom or greenmail so that the raider promises not to pursue the acquisition for a few years if the firm buys the raider’s shares at a premium (i.e., above market price). Directors and managers can pay themselves through generous severance agreements. This will make the target firm less valuable since firm value is essentially transferred to the current managers and directors of the firm if the firm is acquired. These are called golden parachutes. Litigation is always an option if the target claims the bidder is in violation of antitakeover and antitrust laws.
Note that managers and directors have the ability to buy and sell shares, corporate debt and assets without shareholder approval. Changing a firm’s capital structure is also a way to restructure the firm. That is, a firm has the ability to make themselves less valuable so that they incumbent directors and managers maintain control of the firm. Selling off desirable assets or “crown jewels” to other firms can stop a corporate raider from pursuing an acquisition. Increasing the stake of friendly investors or “white squire” also makes hostile takeovers more expensive since they have to convince large blockholders to approve the merger. Repurchasing shares using corporate resources also reduces the firm value, which makes the firm less attractive as a target. Lastly, managers could also issue more debt, increasing the creditors’ cash flow stake, which makes firm equity less valuable.
Lastly, poison pills or shareholder rights plans, is very similar to finding a white squire. Poison pills is a way to sell shares to existing shareholders in order to dilute the ownership stake of the hostile bidder. I will go through the contract design and a simple numerical example in the next few slides. A poison pill is extremely powerful in deterring takeovers, as I will demonstrate.
Poison Pills (Shareholder Rights Plan)
A poison pill is essentially a call option given to all existing shareholders except the hostile bidder. However, the contract is designed so that the call option becomes valuable only when a hostile takeover is taking place. So the contract has basically 3 features. Firstly the poison pill is given to all shareholders. This call option is far out of the money so exercising it has no value. This call option will be triggered or become in the money if a hostile bidder acquires a large percentage of the voting shares. However, this call option is not triggered for the hostile bidder. The strike price of this call option is normally 50% of the market price. However, there is an escape clause: the board can redeem or buy back the poison pills for a trivial amount. Because the incentive to exercise the call option is high (buy low, sell high), shareholders will want to buy shares from the firm. Because new shares are created, there is a dilution effect of the bidder’s value of equity holdings and its voting power. Although a very effective mechanism, it is often challenged in court.
Examples of Post-Trigger Rights
Just to be clear, the poison pill is only 1 type of post-trigger rights. Under a poison pill contract, a call option is granted to existing shareholders who are not the hostile bidder. Existing shareholders have the right, but not obligation, to buy common stock at a very low price from the firm when a hostile bidder acquires a large block of shares. Let assume that the strike price is 50% of the market price upon trigger. This event, for example, can be triggered when a bidder obtains 20% of the target firms stock. The poison pill therefore makes it more difficult to acquire the target since its ownership stake is diluted. This type of poison pill is called a “flip-in” poison pill.
A flip-over poison pill is a call option to buy the stock of the acquirer or merged firm at a very low price after the merger is completed. However, as I will explain, a flip-out poison pill fell out of fashion because the acquiring firm would only take control of the firm but not complete the merger so that the poison pill is not triggered.
Rather than use a poison pill to dilute the ownership stake of the hostile bidder, some boards have used more self-destructive post-trigger rights, such as repurchasing shares using corporate assets so much so to render the hostile bidder shares worthless. Taken the extreme, if all other shareholders cash out, the hostile bidder would own a worthless firm.
The Economics of a Poison Pill: An Example (Set Up)
Let us look at a numerical example of a poison pill. There are 3 basic features plus an escape clause. Each outstanding share has an embedded call option or the right to buy 1 additional share for, say, 100 dollars. This strike price is typically far out of the money. This option or warrant is attached or bundled to the common stock. If the poison is triggered, all stockholders, except the hostile bidder triggering the pill, can buy the additional shares at 50% of the market price. Assume that the poison pill is triggered if any bidder acquires more than 15% of the target’s stock. Lastly, for the escape clause, we assume that management can cancel or buy back all call options unilaterally for 10 cents per share.
The Economics of a Poison Pill: An Example
Discriminatory Share Repurchase: An Example
Flip-Over RIghts Plan: An Example
To give you some historical context of the poison pill, let me give you an example of why the flip-over rights plan fell out of favor. Remember that the flip-over plan is a poison pill contract that gives the target shareholders the right to purchase the post-merger firm at a steep discount. This has a dilutive effect on existing shareholders of the acquiring firm. However, this method fell out of favor because many corporate raiders only want to take control of the firm rather than complete a merger. For example, a complete merger is unnecessary if the raider only wants to sell the assets of the target. A good example of this kind of corporate raiding is the acquisition of Crown Zellerbach by Sir James Goldsmith, a British/French corporate raider in the 1980s. Crown Zellerbach was a paper and pulp conglomerate based in San Francisco. Crown Zellerbach was responsible for inventing the windowed envelope, cardboard egg carton and folded paper towels. However, their most undervalued assets was their landholdings, and Goldsmith wanted to sell them for a premium. Crown Zellerbach’s flip-over poison pill contract is a call option with an initial strike price of 100 dollars. Each shareholder had the right to purchase 4 post-merger shares. The underlying stock price at the time was 30 dollars. That strike price became 50% of the market price of the post-merger when the bidder obtains 20% of the firm’s stock or submits an offer for 30% of the outstanding shares. However, the triggering event never took place because Goldsmith was able to acquire enough shares to control Crown Zellerbach without actually merging.
Reaction to Goldsmith’s Ploy
So, the flip-over rights plan fell out of favor because there was a loophole. Even if you acquired 20 or 30 percent of the outstanding shares, the conversion never took place because a full merger occurred. Thus the flip-in poison pill is now used today.
Laws that Reduce the Threat of Hostile Takeovers
In most countries, including the U.S., the government has, to a certain extent, a balancing act when it comes to regulating M&A transactions. In addition to protecting consumer welfare, regulators also want to create an environment that is hospitable to corporations so that they can grow and develop. The latter generates tax revenue. So what is the right balance or shareholder rights? Not surprisingly there are both takeover and antitakeover laws in the U.S. At the federal or national level, the U.S. has lots of disclosure requirements. The Williams Act of 1968 is an example. This, of course, protects investors but at the expense of corporations, as determining optimal disclosure and its timing can be costly. However, there are also lots of local statutes or laws that vary from state to state that give managers more protection from hostile bidders, but arguably at the expense of shareholders. This is an incomplete list of statutes, but gives you an idea the kind of antitakeover laws that protect managers from unwelcome bidders.
- Control share acquisition: this kind of law strips the voting rights of the block of shares acquired by a hostile bidder if this block is large. Voting rights can be reinstated by non-management shareholders votes within a time window.
- Merger moratorium or a freeze out: this law is similar to control share acquisition, but rather than stripping the voting rights, the law prevents a second-step merger after the acquisition of a large block of shares for a few years.
- Fair Price rules: this kind of law address the prisoner’s dilemma or coordination problem of a two-tier tender offer. Basically, in order to complete the second step merger, the bidder, once acquiring a large block of shares, is required to pay a fair price to the rest of the shareholders according to a formula.
- Cash-out: This is similar to the fair price rule, but the back-end merger isn’t blocked. Rather, the bidder has to offer the “fair price” to all shareholders left after acquiring a large block.
- Mandatory staggered board: Some states require that boards be staggered so that the majority of the board is not replaced all at once.
- Endorsement of poison pill: Poison pills are often litigated, but some states have made it explicit in law that poison pills are legal.
In summary, these laws do two things: 1) make it more expensive to complete a merger or make a hostile bid and 2) reduce the cost (litigation) of changing corporate charters or using antitakeover provisions.
On the other hand, some states view antitakeover provisions as shareholder value destroying, and thus put some restrictions. For instance, some have bans on the use of golden parachutes and greenmail or paying ransom money to corporate raiders.
Control Share Acquisition
Let us talk more about control share acquisition. First of all, what is a control share? A control share is simply a large block of voting stock, which is usually between 20 to 50% of the common stock outstanding. Control share acquisition laws are triggered once a hostile bidder obtains a control share. The shares that they own are stripped of their voting rights. Without voting rights, they can’t official complete a second stage merger. In order to restore their voting rights, they have to call a shareholder meeting and allow disinterested or non-management shareholders to vote for their rights to be restored.
Merger Moratorium (Freeze-Out) Statutes
Merger Moratorium or a freeze-out is very similar to control share acquisition laws. However, the difference is that rather than stripping the bidder of their voting rights, they are banned from completing a second stage merger for a fixed period of time. Most states set the freeze-out period to be 3 years. For example, Wisconsin and Delaware’s freeze out statute is triggered when an acquirer buys more than 15% of the shares without prior board approval. Delaware has an exception: if the bidder acquires more than 85% of the non-management controlled stock, then the moratorium doesn’t apply.
Fair Price Laws
Fair price laws can actually work in combination with merger moratoriums and control share acquisitions. After regaining voting rights or waiting 3 years, if a second-step merger is to be done, fair price laws force the bidder to gain approval from a supermajority of outstanding voting stock and pay additional stock at a “fair price” set by a formula. This is usually the greater of either the market price of the stock at the time of proposed transaction announcement or the highest price per share paid by acquiring shareholder during the 2 year immediately preceding the announcement of the transaction.
Other State Antitakeover Laws
So, those are the big antitakeover state laws, but there are also many others that address different issues. I will go over a few just to give you a taste.
- Recapture of profit laws: this law address the issue of greenmailing. Corporate raiders buy a large chunk of the common shares outstanding and sell it back at a premium. However, recapture of profit laws make such a strategy unprofitable. They either go through with the takeover or pay back all the profits that they earn.
- Cash out laws: these are very similar to fair price laws, however, it is much stronger, as it requires bidders to offer a fair price to the rest of the shareholders after acquiring a large block, whether or not they want to complete a second-step merger.
- Mandatory staggered boards: some states may require boards to have elections staggered so that board seats can’t be completely replaced in one election year.
- Poison pill endorsements: this reduces litigation costs for target firms.
The Effect of State Antitakeover Laws: An Example
Here is an historical example of state antitakeover put into effect. Sir James Goldsmith wanted to takeover Goodyear that makes car tires in 1986. Goldsmith wanted to buy 88.5% stake in Goodyear. Goodyear managers worked with Ohio officials to support controls hare acquisition laws in the same month in which the takeover announcement was made. By the end of the month, control share acquisition law was approved and took into effect. Goldsmith drops his bid as well.
Paramount Sues Time to Block Time-Warner Merger
We talked a lot earlier in the course that the purpose of M&A regulators is to protect consumer welfare. But what are the objectives of the courts with regards to business litigation? When are takeover provisions appropriate and when are they not? In general, the legal system is in place in order to make sure managers keep their promises to their stakeholders. In the case of M&A, in general, courts want to make sure corporations are looking out for the interest of all shareholders and not just the managers. Thus, corporations can invoke the “Business Judgement Rule” if they believe a particular takeover bid is not maximizing shareholder value. They can then use whatever takeover defense they need to avoid being taken over.
This was decided by the U.S. Supreme court case of Paramount v. Time in 1990. Paramount, Time, and Warner were all media companies. Time and Warner were negotiating a merger but Paramount made a lucrative tender offer. Time and Warner changed their stock swap merger into a leveraged buyout to bypass shareholder approval. Paramount brought this action to court, claiming that Time should have considered their bid and put their bid up for a shareholder vote. In other words, they believe that accepting their bid maximizes shareholder value. However, the U.S. Supreme Court decided that their claim only makes sense in the case of a “sale”. Because Time-Warner was a negotiated merger deal, it is possible that their long-term strategic alliance yields higher shareholder value than accepting Paramount’s bid.
Blocking Viacom-Paramount Merger
Conversely, Viacom’s acquisition of Paramount a few years later is a sale, and the Delaware Supreme Court decided that Paramount’s Business Judgement Rule argument is invalid. QVC made a competing bid for Paramount but was ignored. Thus, the courts invalidated Viacom’s stock purchase lock-up (or the right or option to purchase the target’s shares) and no-shop clause that made no sense in an auction process.
Revlon, Inc. v. MacAndrew and Forbes Holdings, Inc.
Both these major U.S. court cases were guided by what is called the Revlon Standard in the United States. Basically, once management concedes that the firm is up for sale, it must retract its defenses and act as an auctioneer. In other words, they have sell the firm to the highest bidder.
Investor Welfare Hypothesis
Hopefully these three court cases helped you think about the agency problems or moral hazard problems that can arise with antitakeover provisions. From the Investor Welfare Hypothesis, antitakeover provisions improves shareholder value. This is because managers can seek higher bids in the future and also addresses the coordination problem of having dispersed ownership. This also releases the time consuming stress of dealing with hostile takeovers and focus on business operations.
Management Welfare Hypothesis
On the other hand, from the management welfare hypothesis, antitakeover provisions can destroy firm value. This is because managers don’t face the threat of being replaced and therefore have less incentive to create value for shareholders and have more incentive to extract value from the firm for themselves.
Stock Price Response to Defense Measures
What does the market say about antitakeover defenses? Theoretically, you can break down the value of antitakeover provisions in the positive effects of creating an auction and the negative effects of deterrence or management entrenchment. If antitakeover provisions exacerbate agency problems, then we may observe a lower stock price. If antitakeover defenses promotes an auction, then we could see higher stock price after a antitakeover provision is added to the charter or approved by the state.