Corporate Takeover Defense: A Shareholder's Perspective

Much has been written, often in dramatic and ominous language, about hostile takeovers and the various steps companies take to prevent them. While most articles and books view such events from the perspective of investment bankers and corporate officers, little has been written about the impact of hostile takeovers on shareholders of target companies. Yet these shareholders can experience significant financial consequences when the target company's board activates a defense or signals its intention to do so by adding defensive strategies to the corporate charter after the news of an impending takeover breaks.

To assess the ramifications of a takeover, shareholders need to identify and understand the various defensive strategies companies employ to avoid one. These shark repellent tactics can be both effective in thwarting a takeover and detrimental to shareholder value. This article will discuss the effects of some typical shark repellent and poison pill strategies.

Shareholders' Rights Plans

Martin Lipton is the American lawyer credited in 1982 for creating a warrant dividend plan, also commonly known as a shareholders' rights plan. At the time, companies facing a hostile takeover had few strategies to defend themselves against corporate raiders, investors such as Carl Icahn and T. Boone Pickens, who would purchase large stakes in companies in an attempt to gain control.

A shareholders' rights plan triggers immediately after the potential acquirer reveals their takeover scheme. These plans give existing shareholders the opportunity to buy additional company stock at a discounted price. Shareholders are tempted by the low price to buy more stock, thereby diluting the acquirer's ownership percentage. This makes the takeover more expensive for the acquirer and could potentially thwart the takeover entirely. At the very least, it gives the company's board of directors time to weigh other offers.

Example of a Shareholders' Rights Plan

A shareholders' rights plan is a type of "poison pill" strategy because it makes the target company hard to swallow for the acquirer. For shareholders, however, a poison pill can have harsh side effects.

This was the case in July 2018 when the board of directors for Papa John’s International (PZZA) voted to add a shareholders' rights plan to its charter to prevent ousted founder John Schnatter from gaining control of the company. The move made the company too expensive for Schnatter's hostile takeover plan.

While the poison pill warded off the hostile takeover of Papa John's, its beneficial effects for shareholders were temporary at best. The elevated stock price tumbled a few weeks after the takeover threat subsided, in part, due to legal struggles with Schnatter.

In addition to causing a temporary spike in stock prices, a shareholders' rights plan can have the negative side effect of preventing shareholders from reaping any profits that might occur should the takeover be successful.

Voting Rights Plans

A voting rights plan is a clause a company's board of directors adds to its charter in an attempt to regulate the voting rights of shareholders who own a predetermined percentage of the company's stock. For example, shareholders may be restricted from voting on certain issues once their ownership exceeds 20% of outstanding shares. Management might use voting rights plans as a preemptive tactic to prevent potential acquirers from voting on the acceptance or rejection of a takeover bid.

Management might also use a voting rights plan to require supermajority voting to approve a merger. Rather than a simple 51% of shareholder approval, the voting rights plan could stipulate that 80% of shareholders would need to approve a merger. With such a stringent clause in effect, many corporate raiders would find it impossible to gain control of a company.

Often companies find it difficult to persuade shareholders that such clauses are beneficial to them, particularly since they could prevent shareholders from achieving gains that a successful merger could bring. In fact, the adoption of voting rights clauses is often followed by a fall in the company's share price.

Staggered Board of Directors

This defensive tactic hinges on making it time-consuming to vote out an entire board of directors, thus making a proxy fight a challenge for the prospective raider. Instead of having the entire board come up for election at the same time, a staggered board of directors means that directors are elected at different times for multi-year terms.

Since the raider is eager to fill the company's board with directors that are friendly to the takeover plans, having a staggered board means that it will take time for the raider to control the company via a proxy fight. The target company is hoping the raider will lose interest rather than engage in a protracted fight. While employing a staggered board of directors could benefit company management, there is no direct benefit to shareholders.

Greenmail Option

Greenmail is when a targeted company agrees to buy back its shares from the prospective raider at a higher price in order to prevent a takeover. The term is derived from combining "blackmail" with "greenbacks" (dollars). In exchange for receiving the premium, the raider will agree to halt attempts at a hostile takeover.

Example of Greenmail

Activist investor Carl Icahn is well-known for his use of greenmail to pressure companies to repurchase their shares from him or risk being the target of a takeover. In the 1980s, Icahn used the greenmail strategy when he tried to take control of Marshall Field, Phillips Petroleum, and Saxon Industries. In the case of Saxon Industries, a New York distributor of specialty papers, Icahn purchased 9.5% of the company's outstanding common stock. In exchange for Icahn agreeing to not undertake a proxy battle, Saxon paid $10.50 per share to buy back its stock from Icahn. This represented a 45.6% profit to Icahn, who originally paid an average price of $7.21 per share.

After the announcement that management had succumbed to this payout strategy, Saxon's stock price plummeted to $6.50 per share, providing a clear example of how shareholders can lose out even while avoiding a hostile takeover.

White Knight, Strategic Partner

A white knight strategy enables a company's management to thwart a hostile bidder by selling the company to a bidder they find more friendly. The company sees the friendly bidder as a strategic partner, one who will likely keep the current management in place and who will provide shareholders with a better price for their shares.

In general, a white knight defense is seen as beneficial to shareholders, particularly when management has exhausted all other options to avoid a takeover. However, exceptions to this are when the merger price is low or when the combined value and performance of the two companies fail to achieve the anticipated financial benefit.

Example of a White Knight

In 2008, global investment bank Bear Stearns sought a white knight after facing catastrophic losses during the global credit crisis. The company's market capitalization had declined by 92%, making it a potential target for a takeover and vulnerable to bankruptcy. White knight JPMorgan Chase & Co. (JPM) agreed to purchase Bear Stearns for $10 a share. While this was a far cry from the $170 a share the company traded for just a year earlier, the offer was up from the $2 a share JPMorgan Chase initially offered shareholders.

Increasing Debt

A company's management can deliberately increase its debt as a defensive strategy to deter corporate raiders. The goal is to create concern regarding the company's ability to make repayment after the acquisition is completed. The risk, of course, is that any large debt obligation could negatively impact the company's financial statements. If this happens, then shareholders could be left bearing the brunt of this strategy as stock prices drop. For this reason, increasing debt is generally seen as a strategy that in the short term helps the company avert a takeover, but over time could hurt shareholders.

Making an Acquisition

Compared to increasing debt, making a strategic acquisition can be beneficial for shareholders and can represent a more effective option for averting a takeover. A company's management can acquire another company through some combination of stock, debt, or stock swaps. This will make the corporate raiders' takeover efforts more expensive by diluting their ownership percentage. Another advantage to shareholders is that if the company's management has done its due diligence in selecting a suitable company to acquire, then shareholders will benefit from long-term operational synergies and increased revenues.

Acquiring the Acquirer

This defense is often referred to as the Pac-Man defense, after the popular video game. The target company staves off the unwanted advances of the acquiring company by making its own bid to take control of the acquiring company. The approach is rarely successful and runs the risk of saddling the company with a large acquisition debt. Shareholders may end up paying for this expensive strategy through a drop in share price or decreased dividend payments.

Triggered Option Vesting

A triggered stock option vesting is a clause the board of directors adds to the company's charter that activates when a specific event occurs, such as the acquisition of the company. The clause states that should there be a change of control in the company, all unvested stock options vest automatically and must be paid out to the employees by the acquiring company.

This tactic wards off hostile investors because of the large expense involved and because it could lead to talented employees selling their stock and leaving the company. Shareholders generally do not benefit when this clause is added because it often leads to a drop in share price.

The Bottom Line

The use of poison pills and shark repellent is on the decline, and the percentage of Standard & Poor's 1500 Index companies with a poison pill clause in place fell to 4% at the end of 2017. By contrast, 54% of companies had one in 2005. The S&P 1500 index combines the S&P 500, the S&P MidCap 400, and the S&P SmallCap 600.

The decline in popularity is attributable to a number of factors, including increased activism by hedge funds and other investors, shareholder desire for acquisition, moves to block boards from adding defensive plans, and the lapse of such clauses over time.

The effect that anti-takeover tactics have on shareholders often depends on the motivations of management. If management feels the takeover will lead to a decline in the company's ability to grow and generate a profit, the correct action may be to use all strategies available to fend off the takeover. If management performs its due diligence and recognizes the acquisition could benefit the company and by extension its shareholders, then management can cautiously use certain tactics as a way to increase the purchase price without jeopardizing the deal. However, if management is purely motivated to protect its own interests, then it may be tempted to use whatever defensive strategies it deems necessary, regardless of the impact on shareholders.