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.

The most common form of takeover defense is the shareholders' rights plans, which activates the moment a potential acquirer announces its intentions. Under such plans, shareholders can purchase additional company stock at an attractively discounted price, making it far more difficult for the corporate raider to take control.

But today, more than ever, there are steep consequences to the poison pill reaction. While it can indeed complicate matters for the acquirer, it is often enacted to protect the interests of the upper echelon of corporate executives rather than the company or its investors. It can also discourage the average, well-intentioned investor and drag down share prices. This scenario played out in July 2018, when American restaurant franchise Papa John’s International Inc.’s (PZZA) board voted to adopt a poison pill to prevent ousted founder John Schnatter from gaining control of the company. The move spiked the value of the company's common stock, making it too expensive to be attractive for a hostile takeover.

While the poison pill defense may help ward off unwanted suitors, it also makes it more difficult for shareholders to profit from the announcement of a takeover. Rights issued to existing shareholders can effectively thwart a takeover by diluting the acquirer's ownership percentage, making a takeover more expensive and preventing or delaying control of the board and the company. But shareholders are often punished when their stock drops after a company adds a poison pill clause to its charter and they are unable to reap profits from a successful takeover.

Targeted companies may also implement a voting-rights plan, which separates certain shareholders from their full voting powers at a predetermined point. For instance, shareholders who already own 20% of a company may lose their ability to vote on such issues as the acceptance or rejection of a takeover bid.

The presence of corporate predators may also trigger super-majority voting, which requires a full 80% of shareholders to approve a merger, rather than a simple 51% majority. This requirement can make it difficult, if not impossible, for a raider to gain control of a company. It is very difficult for management to convince shareholders that voter-rights clauses benefit them, and the addition of such clauses to the corporate charter is often followed by a drop in stock price.

Clauses involving shareholders are not the only escape routes available to targeted companies. A staggered board of directors, in which groups of directors are elected at different times for multiyear terms, can challenge the prospective raider. The raider now has to win multiple proxy fights over time and deal with successive shareholder meetings to successfully take over the company. It's important to note, however, that such a plan holds no direct shareholder benefit.

A company may also pursue the greenmail option by buying back its recently acquired stock from the putative raider at a higher price to avoid a takeover. This technique was popular during one of the final mergers and acquisitions trends in the 1980s, and it typically comes with the requirement that the raider not pursue another takeover attempt. Because the shares must be purchased at a premium over the takeover price, this "payout" strategy is a prime example of how shareholders can lose out even while avoiding a hostile takeover. The practice was effectively curtailed in the U.S. by an amendment to the U.S. Internal Revenue Code, which applied a punishing 50% tax on greenmail profits.

If a determined hostile bidder thwarts all defenses, a possible solution is a white knight, a strategic partner that merges with the target company to add value and increase market capitalization. Such a merger can not only deter the raider but can also benefit shareholders in the short term if the terms are favorable, as well as in the long term if the merger is a good strategic fit.

A good example of this is the acquisition of Bear Stearns by white knight JPMorgan Chase (JPM) in 2008. At the time of the acquisition, Bear Stearns' market cap had declined by 92% on concerns of its vulnerability to the global credit crisis, making it extremely vulnerable to hostile takeover and even insolvency.

Although a white knight defense is generally considered beneficial to shareholders, this is not always the case when the merger price is low or when the synergies and efficiencies of the combined entities do not materialize.

Increasing debt as a defensive strategy has been deployed in the past. By increasing debt significantly, companies hope to deter raiders concerned about repayment after the acquisition. However, adding a large debt obligation to a company's balance sheet can significantly erode stock prices.

Perhaps a better strategy for target shareholders is for the company to make an acquisition, preferably through stock swaps or a combination of stock and debt. This has the effect of diluting the raider's ownership percentage and makes the takeover significantly more expensive. Although stock prices may drop upon the acquisition of the third party, shareholders can benefit in the longer term from operational efficiencies and increased revenues. When InBev made an unsolicited bid for Anheuser-Busch (BUD) in 2008, the latter company immediately sought to purchase outright both Grupo Modelo of Mexico and Crown International of India in an attempt to make the acquisition too costly for its suitor.

Ironically, a takeover defense that has been successful in the past, albeit rarely, is to turn the tables on the acquirer and mount a bid to take over the raider. This requires resources and shareholder support, and it removes the possibility of activating the other defensive strategies. This strategy, called the Pac-Man defense, after Bendix Corporation's attempt to acquire Martin Marietta in 1982, very rarely benefits the shareholders. Martin Marietta defended itself by purchasing Bendix stock and sought a white knight in Allied Corporation.

A triggered stock option vesting strategy for large stakeholders in a company can be used as a defense, but it rarely benefits anyone involved because it often results in massive talent migration. Generally, the share price drops when the clause is added to the charter as executives sell off the stock and leave the company.

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 below 4% at the end of 2017, according to 2018 information from the ISS Governance U.S. Board Study. By contrast, 54% of companies had one in 2005. The S&P 1500 index combines the Standard & Poor’s 500 (S&P 500), the Standard & Poor’s MidCap 400 (S&P 400), and the Standard & Poor’s SmallCap 600 (S&P 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 impact of defensive strategies on shareholders boils down to the management intent. If management wishes to protect shareholders from a "dinosaur" with an outdated business model or core product, the correct stance may be to defend the company to the end. Such an acquirer, whose own growth is in decline, would bleed the acquired company and dilute shareholder value. If the intention is to hold out or negotiate a higher purchase price, defensive strategies may also be beneficial to shareholders. However, because the real motive is often to protect management's own interests, defensive strategies very rarely benefit shareholders.