Poison Pills: Doing the vanishing act?
Poison pills form the very heart of the corporate re-structuring, mergers and acquisitions. The origin of the term can be attributed to the domain of espionage and refers to the cyanide pill spies are instructed to swallow rather than face capture. This usage of the term ‘poison pills’ eventually spilled over to the realm of hostile takeovers . In the event of an unsolicited bid for acquiring publicly held target companies, the target company’s board devised various anti-takeover strategies, commonly referred to as poison pills, which were potent enough to ward off the bidder or acquirer but in doing so caused harm to their company as well. Hence, the name ‘poison pill’. Currently, hostile takeovers account for 19 per cent of global mergers and acquisitions and are running an all-time high in almost a decade as companies with cash-rich balance sheets continue to swallow their weaker counterparts at a fraction of the latter’s true value. While the potency of these pills as anti-takeover defences stand uncontested, controversies regarding protection of shareholder interest have evolved. Consequently, there has not only been a sharp decline in the adoption of poison pills but also a number of companies have either scrapped or amended their policy on poison pills. This paper attempts to analyze the reasons behind the increasing unpopularity of poison pill and the legality of poison pills within the Indian regulatory framework.
Tracing the meaning of poison pills through its history:
Generally speaking, ‘poison pill’ is a term referring to any strategy, usually in business or politics, to increase the likelihood of negative results over positive ones for a party that attempts any kind of takeover. It is thus a strategic move by a takeover target company to make its stock less attractive to the acquirer. It was invented in 1982 by noted American lawyer Martin Lipton in the form of a warrant dividend plan or the shareholder rights plan to be used by El Paso Corporation as a successful defence against a hostile bid made by former railroad company Burlington Northern. A year later in 1983, the term ‘poison pill’ was coined during the hostile takeover of the fine china maker, Lenox by Brown-Forman Distillers, the producers of Jack Daniel’s Whiskey by Lenox’s lead investment banker, Martin Siegel .
Putting a halt to the erstwhile rampant hostile acquisition activity in America, leading to concentration of excess economic power in the hands of few corporations, the U.S. Supreme Court passed a landmark ruling in the case of Edgar v. MITE Corp. that invalidated the basis of anti-takeover laws in thirty-seven states. This was followed by a lax policy in implementing anti-takeover laws which prompted many companies to adopt their own versions of poison pill and also gave way for controversies pertaining to their illegality. Thereafter in 1985, the legality of poison pill provisions was affirmed unequivocally by the decision of the Delaware Chancery Court in the case Moran v. Household International, Inc. wherein the board’s right to adopt a pill without prior shareholder approval and the rights of the company’s independent directors to refuse a bid were upheld to be perfectly in tandem with shareholder interest and hence, legal. Thereon there was no looking back. From being the panacea that frustrates an unsolicited takeover bid, poison pills transformed gradually into a strategy primarily designed to make it difficult, time-consuming and expensive for a hostile acquirer to consummate offers that may not offer fair value to all shareholders. The idea was to arm the prospective target with an in-built defence mechanism that would not necessarily beat a takeover attempt but would nonetheless ensure a fair evaluation, if not an over-evaluation, of the target company in the hands of the acquirer. In order to consummate the bid, the acquirer would thus have to overcome the prohibitive price tag, or quite so literally, swallow the poison pill.
However, in the context of takeover defenses, Delaware courts have recognized that there is increased risk that a board may be acting primarily in its own interest rather than that of the corporation and its shareholders. Because of the potential for conflict of interest in this area, Delaware courts have imposed the additional requirement that a board show it had reasonable grounds for believing there was a threat to corporate policy and effectiveness. This burden may be satisfied by a showing of good faith and reasonable investigation on the part of a board. In addition, the defensive measure taken must be reasonable in relation to the threat posed. If these criteria are met, courts generally will defer to a board’s actions.
The Concept and its Ingredients:
Typically, takeover bids are attempts by a potential acquirer to obtain a controlling block of shares in a target company, and thereby gain control of the board and, through it, the company's management. There are several types of "poison pills" that can be planned by a company that thinks it may be the target of a takeover by a potential acquirer, but the conventional poison pill is now a shareholder rights plan.
The Shareholder Rights Plan works by threatening to substantially dilute the unfriendly acquirer’s equity interest. Upon the occurrence of certain takeover events, the target company issues rights to existing shareholders to acquire a large number of new securities, usually common stock or preferred stock . The new rights issue triggers if anyone acquires more than a predetermined amount( typically 20-30%) of the target’s stock, thereby allowing shareholders (other than a bidder) to convert the right in order to buy additional equity securities in the company or of the acquirer at a substantial discount. This dilutes the percentage of the target owned by the bidder, and makes it more expensive to acquire control of the target. This strategy has, therefore, aptly been termed as the shareholder rights plan as it provides shareholders (other than the bidder) with rights or warrants to buy more stock in the event of a control acquisition. The risk of dilution, combined with the authority of a target’s board of directors to redeem the rights prior to a triggering event, compels the potential acquirer to negotiate with the target’s board of directors, rather than proceeding unilaterally. This classic version of the poison pill is primarily of two types:
- A ‘’flip-in’’ allows existing shareholders (except the acquirer) to buy more shares in the target company at a discount, upon the mere accumulation of a specified percentage of stock by a potential acquirer. By purchasing the shares cheaply, investors get instant profits and, more importantly dilute the shares held by the competitors. As a result, the competitor’s takeover attempt is made more difficult and expensive. Internet major Yahoo! adopted this form of poison pill in 2000 allowing the board to issue upto 10 million shares on new stock in the event of an acquisition offer on the table that they did not want to endorse (like that of Microsoft) and each share cane have nearly unlimited voting power. Furthermore, they entitled every director to cash in all of their outstanding stock options which amounted to about 16 million potential new shares. This defence made it practically impossible for Microsoft to proceed with a hostile bid after Yahoo! expressed its unwillingness towards Microsoft’s offer for Yahoo! and ultimately resulted in the withdrawal of the same.
- A ‘’flip-over’’ allows stockholders to buy the acquirer’s shares at a discounted price after the merger. The holders of common stock of a company receive one right for each share held, bearing a set expiration date and no voting power. In the event of an unwelcome bid, the rights begin trading separately from the shares. If the bid is successful, all shareholders except the acquirer can exercise the right to purchase shares of the merged entity at discount. For instance, the shareholders have the right to purchase stock of the acquirer on a 2-for-1 basis in any subsequent merger. The significant dilution in the shareholdings of the acquirer makes the takeover expensive and sometimes frustrates it. If the takeover bid is abandoned, the company might redeem the rights.
Poison pills are now used more broadly to describe other types of takeover defences as well that involve the target taking some action that harms both the target and the bidder, although the broad category of takeover defences is more commonly known as ‘’shark repellants’’ and includes the traditional shareholder rights plan. The defences related to the classic version of poison pills include poison debt , put rights plan , voting poison pill plan , macaroni defence etc to name a few.
Also, several other shark repellant practices have evolved, few of them being:
• Staggered board defence wherein only a certain percent of the company’s directorial board to be replaced every year making it difficult for an acquirer to seize control
• Bankmail defence wherein the bank of a target firm refuses financing options to firms with takeover bids thereby having the triple impact of imposing financial restrictions upon the acquirer, increasing transaction costs in locating another financing option and also buying time for the target company to put more defences in place.
• White Knight defence wherein the target company joins hands with a friendly acquirer called the white knight (who may be a corporation, a private company or any person) in the event of a hostile bid and the knight might effect the acquisition by offering a higher and more enticing bid than that of the hostile acquirer or by striking a favorable deal with the management of the object of acquisition.
• People pill defence wherein the entire management tem of the target company threatens to quit in the event of a coercive takeover, leaving the company without any experienced leadership. This defence may also be strengthened by Golden Parachute Clauses included in the executives’ employment contract specifying that they will receive certain large benefits if their employment is terminated. In the event of a takeover, executives cash in their golden parachute irrespective of whether under their stewardship their companies prospered or incurred irreparable loss.
Nonetheless, there has been a lot of innovation as well as criticism with regard to these defences. Traditionally speaking, the shareholder rights plan, commonly called the poison pill, combined with the staggered board defence is deemed to be a potential defence in warding off unwelcome takeover bids.
Impact Analysis: Benefits vs. Drawbacks
That the poison pills offer inimitable aid to a company caught unaware by a hostile bid, is indeed, an axiomatic truth. Elucidating the same, Mr. James P Bouchard, CEO and Chairman of the Essar Group rightly observed:
‘’We believe the adoption of the stockholders rights agreement will level the playing field among bidders and help maximize shareholder value as we move forward with the current process to sell the company.’’
The obvious benefit of a poison pill is that it offers the target company three enviable options even in the critical situation of a coercive takeover:
a) The first option, allows the target to successfully ward off an unwelcome bid.
b) As for the second option, in case the target company is considering going ahead with the deal, it makes the raider negotiate and buys time for the target company to get a proper evaluation of the offer and thereby maximizes the takeover premium, in the best interest of the shareholders of the target company.
c) The third option furnishes the target company with a much-needed opportunity to investigate other alternatives such as locating a white knight or exploring better takeover options, in the time period between the offer being made by the hostile acquirer and acceptance of the same.
The cumulative effect of the strategy is thus to make it prohibitively expensive for an acquirer to buy the control of a company. The underlying assumption being that the board will always act in the best interest of the shareholders, a view that is explicitly rejected by agency theorists. They argue that the practice of allowing management to adopt poison pill strategy without shareholder approval has reduced the number of potential offers and actual takeovers. In doing so, the vested interests of the incumbent management are protected at the cost of shareholders who are faced with lower stock values.
The increasing instances of corporate scandals and an overall perception of poor corporate ethics has turned the shareholders of publicly held companies aggressively cynical about the underlying objective of the shareholder rights plan and their impact on shareholder value. Pre-supposing that a poison pill has real effect on the bargaining power of the target firm’s managers, most of the pervious empirical studies using U.S. data have investigated two theoretical hypotheses about effect of poison pills on shareholder value:
- On one hand, the shareholder interest hypothesis predicts that the adoption of poison pills should be accompanied by stock price increases because the pill is adopted primarily to protect shareholders from receiving less that full value for their holdings in controlled transactions. Also, pills increase takeover premium without decreasing the likelihood of takeover.
- On the other hand, the management entrenchment hypothesis predicts that poison pill adoptions make it less likely that shareholders will receive takeover premiums and announcements of poison pills result in stock price declines.
Both the contradictory views reflect the mixed reaction of shareholders towards the adoption of poison pill strategies but since 2000, these defences witnessed considerable decline.
Poison Pills on the decline:
Even when shareholder activism is on the rise and hostile bids are expected to grow, global poison pills that are in force show a steady decline of about 12 percent from September 2007. According to a report by Thomson Reuters Strategic Research, there have been no poison pill adoptions in the last quarter of 2007 from the Fortune 500 roster, no pills have been renewed and eight pills expired quietly during the first quarter of 2008. The trend of questioning poison pills began with a couple of large cap U.S Companies dismantling their takeover defences in the year 2000 and they continued to be increasingly unpopular thereafter. The percentage of S&P 500 companies with a poison pill in place fell below 30% by the end of 2007 as against a 60% in 2002. Most of the Fortune 100 companies have either shed their poison pills or adopted board pill policy to make poison pills shareholder-friendly, if adopted in the future. The year 2008 witnessed Japanese companies like cosmetic giant, Shiseido and internet access provider, e-Access scrapping their poison pills in 2008 following the example of their counterparts.
Also, larger U.S. Corporations continue to steer clear of the poison pill as a means to protect the company from unwelcome shareholders and are willing to take the risk that an unwelcome bidder could take a meaningful position. Summing up, pressure from shareholders, concerns of corporate governance image and a subdued M & A market have been identified as the key reasons that explain the sharp decline in poison pills.
Potent shareholder activism: Tirade against poison pills
In 2007, activist investors, mostly hedge funds, increasingly agitated for changes to maximize shareholder value and this was followed by dismantling of takeover defenses by companies of all sizes. The primary reason for the increased shareholder activism is that powerful institutional shareholder groups generally do not like rights plans. Institutional Shareholder Services (ISS), an influential provider of proxy voting and corporate governance services, recommends that institutions vote in favor of shareholder proposals requesting that the company submit its poison pill or any future pills to a shareholder vote, or redeem poison pills already in existence. In addition, a company that has a poison pill in place that has not been approved by shareholders will suffer a significant downgrading in ISS’ ratings system (Corporate Governance Quotient).
The growing apathy of shareholders towards poison pills may be attributed to a various factors, the prominent once being as follows:
a) Firstly, these defences tend to block all hostile takeovers without weighing out its merits. An unsolicited bid may sometimes cause the stock prices to shoot up and may have vast potential to increase shareholder wealth. Also, it may offer an attractive takeover premium which the shareholders might be interested in. A case in point is the Microsoft’s offer of a 62 percent premium to acquire internet giant, Yahoo! in February 2008 which was turned down by the Yahoo! Board and the Board’s decision was met with heavy criticism for having acted irresponsibly, followed by a spate of lawsuits alleging undermining of shareholder interests and a shareholder revolt led by billionaire investors like Carl Icahn.
b) Secondly, as was seen in Japan and U.S.A., poison pills tend to shield managers of dismally performing companies from the pressures of the stock market as well as from the ‘threat’ posed to its incumbent management by a better offer. Sometimes, such threat of takeovers by ‘outsiders’ is primarily in the best interest of the shareholders but is against the vested interest of the management of the target company which failed to maximize shareholder wealth. This in turn denies the shareholders the opportunity to accept a welcome offer.
c) Thirdly, with corporate governance becoming the order of the day, companies have shed their poison pills in order to enhance their corporate governance ratings. The more transparent and shareholder friendly the company practices, the better the company image and hence bigger the size of the company.
d) Fourthly, in an era of economic liberalization, economic growth is but a function of foreign investment. Thus adoption of extreme defence measures by domestic companies creates the impression of a closed marked, thereby waning foreign interest in that country. This is in itself is reason enough for companies such as e-Access thriving in developing nations to scrap their poison pills and be open to takeover offers.
There are nevertheless a host of companies which instead of scrapping the poison pills in toto have adopted favorable policies that preclude their flip side. These include several practices such as the one followed in Canada of making the shareholder rights ‘’chewable’’ by incorporating a permitted bid concept such that the bidder who is willing to conform to the requirements of a permitted bid can acquire the company by takeover bid without triggering a flip-in event. Also, the periodic review of poison pills by an independent board and adopting a board pill policy, in the lines of Fortune 100 companies like Exxon Mobil, Hewlett Packard, General Electric amongst several others, whereby the board cannot adopt poison pills without prior shareholder approval (and if done without such approval, the plan needed to be ratified or terminated within a certain period) seem to have gained popularity.
Indian legal framework vis-a-vis Poison Pills:
In India, the law pertaining to takeovers is embodied in the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 1997, commonly called the Takeover Code and the SEBI (Disclosure & Investor Protection Guidelines), 2000. Apart from these, various provisions of the Companies Act, 1956 need to be referred to as and when required. At the outset, the regulatory framework governing Indian capital market does not pose any insuperable impediment to a determined hostile acquirer. It simply mandates the acquirer to make public disclosure of his shareholding or voting rights to the target company as well as the stock exchange on which its shares as listed, if he acquires shares or voting rights beyond pre-determined threshold limits . Also, in case he wishes to acquire control over a target company, the acquirer has to make a public announcement of the same, stating lucidly various details of the bid including his intention of acquisition, his identity, details of offer price and number of shares to be acquired from public, future plans (if any), change in control over the target company, amongst others. This paves way for an informed decision as well as planned course of action.
The Takeover Code also restricts the corporate actions of target companies during the offer period, such as transferring assets or entering into material contracts and prohibiting issue of any authorized but unissued securities during the offer period . Furthermore, the shareholder rights plan sanctions the target companies to issue shares at a discount and warrants which convert to shares at a discount, even without shareholder approval, which is illegal in the Indian context unlike the U.S. where companies are permitted to do so. The DIP Guidelines require the minimum issue price to be determined with reference to the market price of the shares on the date of issue or upon the date of exercise of the option against the warrants. Such issue must also be approved by shareholders. Without the ability to allow its shareholders to purchase discounted shares/options against warrants, an Indian company would not be in a position to dilute the stake of the hostile acquirer and also seeking shareholder approval in the event of a takeover attempt is a very time-consuming process, thereby making impossible poison pills to operate within the existing Indian legal framework. Apart from this, in the event of a takeover bid, all the directors of the target company may be removed in a single shareholders meeting, as permitted under the Companies Act, 1956, thus making futile the Staggered Board defence available to foreign companies.
Thus, Indian market can be safely concluded to be a pro-acquire market. Several regulatory changes would be required to give effect to these takeover defences in India. In the meanwhile, other defences such as ‘’brand pills’’ are home to Indian Companies like Tata who have in place an arrangement whereby anyone who acquires any of its entities, may not be allowed to use its name or brand. By depriving the right to use the brand name, the acquirer loses out on a considerable portion of the target company’s valuation and this serves as an acquisition deterrent.
India is yet to foray into the realm of poison pills and shark repellants.
Poison pills can thus be termed as a necessary evil in an age of rising mergers and acquisitions. However, their sharp decline also reflects a change in the attitude of the investors and their increasing participation in management decisions. Gone are the days when investors had blind faith in the board’s decision. Shareholder activism and corporate governance measures have practically changed the traditional perception of hostile takeovers and their defences. With the shareholders determined to get the best value for their investment at any cost, the negative image of ‘hostile acquirer’ or say an ‘acquirer’ amongst the shareholders of the target company seems to be a thing of the past. There is absolutely no melodrama revolving a takeover attempt, which is now evaluated strictly on merits and from a purely business perspective. The recent sale of Indian pharmaceutical giant Ranbaxy to a Japanese drug discoverer, Daiichi Sankyo bears testimony to this. Against the background of increasing hostile acquisitions, it is therefore too early to conclude whether poison pills do the vanishing act or make a surprise comeback.
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