Keeping Your Client Whole in a Shark-Infested Marketplace

October 5, 1998 Published Work

[Reprinted with permission from The Connecituct Law Tribune Magazine Corporate Counsel October 5, 1998]
Anti-takeover devices can keep a corporation from becoming the next flavor of the month.

The recent broad decline in the stock market, and in particular the price of smaller company stocks, may change the tone of the mergers-and-acquisitions marketplace. Although the booming stock market of the past six years has led to numerous friendly acquisitions using high-priced stock as currency, many market professional feel that the recent market pullback may encourage greater use of a takeover. The junk bond market provided much of the cash to fuel the hostile takeovers of the 80's, but many companies today are flush with cash after several years with superb financial results. The recent market correction makes many companies (in particular the smaller market capitalization companies) "less expensive," and this may provide the impetus for "bargain hunting" by corporate acquirers who have preserved cash and are ready to use it now that their stocks do not command a premium. With proxy season around the corner for calendar-year companies, practitioners who advise smaller public companies may want to revisit the menu of possible anti-takeover devices available to forestall or deter hostile takeovers in what appears to be an increasingly dangerous marketplace.

The following is a general summary of certain structural defenses that a board of directors may consider adopting to provide its company a greater likelihood of deterring or repelling a hostile takeover, or to position its company for an improved offer. This summary is not a review of Connecticut law or Connecticut's most famous recent takeover contest, the battle for Echlin. My intention is to summarize the issues in a general way. Anyone seeking to advise a client in this area must take careful account of many factors, including the law of the company's state of incorporation.

Also, keep in mind that the following steps are in almost all cases more effective if adopted well before a hostile offer is made. As most of the following steps require stockholder approval, advance planning by a board during the next few months is imperative to put matters before the stockholders next spring.

Issue "Blank Check" Preferred Stock
This allows for the issuance of stock with rights determined by the board at any time (subject to the New York Stock Exchange and Nasdaq rules that below-market issuances may not cause greater than 20 percent dilution without stockholder approval). The issuance of preferred stock to a "white knight" investor is one of the most effective defenses to a takeover bid once a company is in play.

Limit Ability of Stockholders to Call Special Meetings
The certificate of incorporation or bylaws can in most states preclude stockholders from calling special meetings of the stockholders. Thus, a hostile investor cannot itself, or in conjunction with other stockholders, force the stockholders to meet to consider a particular issue, e.g. election of directors aligned with the hostile investor.

Create a Staggered Board
The classification of the board into separate classes (typically there are three such classes), each with a three-year term, has the effect of making it more difficult for the stockholders to change the composition of the board, since (absent board resignations) at least two annual meetings will be required to effect a change in the majority of the board.

Institute a "Fair Price" Provision
This requires a greater than normal percentage (typically 75 percent, instead of 50 percent or in certain cases 66.66 percent) approval by stockholders of mergers that do not meet certain procedural and price standards, including a requirement that all stockholders receive the same consideration. Typical fair price provisions prohibit "two-tier" offers in which an acquirer obtains a majority position by tendering for less than all of the outstanding stock and later tenders for the remaining minority interest at a lower price.

Prohibit Stockholder Action by Written Consent
Generally, stockholders with more than 50 percent of the outstanding voting power can take action by written consent. If the certificate of incorporation is amended to prohibit stockholder action by written consent, the board (which can be given the sole right to call stockholder meetings) has greater control.

Spoonful of Arsenic
Although each of the foregoing measures is a popular and effective anti-takeover defense (and one that generally does not require stockholder approval, thus allowing for faster implementation) is the shareholder rights plan (a/k/a "poison pill"). The "rights plan" is a common anti-takeover device (the third most popular after blank check preferred stock and the staggered board).

To implement a rights plan, the board of directors grants to each stockholder as a dividend the right to purchase capital stock of the company under certain circumstances at (in most cases) half of the market price.

The right to purchase is triggered upon a stockholder breaking through a certain threshold percentage of ownership (typically 10 percent, 15 percent or 20 percent). Prior to implementation, the rights plan must be approved by the board and a rights agreement must be entered into with a rights agent (typically a transfer agent or bank that would administer the issuance of the rights). It is significant to note, however, that although the rights plan itself does not require stockholder approval, rights plans result in substantial potential dilution and there should be enough authorized but unissued common stock available to allow shares to be issued pursuant to the rights plan to all of the stockholders (other than the stockholder triggering the rights).

Therefore, in many cases stockholder approval of an increase must be included in authorized shares (note that a description of the reason for the increase must be included in the proxy statement-i.e., the poison pill) should be obtained. This can be accomplished at either a special meeting or at the next annual meeting of stockholders. Stockholder approval is not a condition precedent to implementation the rights plan, however, since most rights plans allow for the issuance of other equivalent consideration (e.g., preferred stock or debt) if there is insufficient common stock to satisfy the rights.

Shareholder rights plans provide a meaningful economic deterrent to a hostile takeover bid by encouraging potential acquirers to negotiate with the target's board rather than pursuing end-run strategies such as "creeping acquisitions" through the open market of structurally coercive two-tier bids that are designed to promote panic among a target's shareholders by encouraging stockholders to accept the offer lest they be left with a less attractive offer once the acquirer obtains control. Even where the only viable alternative is found to be a sale of the target at a higher price, the rights plan may well allow the board to conduct such a sale in an orderly fashion with the goal of maximizing shareholder value.

Nothing's Foolproof
A rights plan also has negative attributes, however, and is not to be viewed as a foolproof anti-takeover tool. First, many institutional shareholders view a rights plan as an attempt to entrench the established management and board of directors to the detriment of stockholders.

Thus, it is possible that some of a company's institutional holders may view the rights plan in a negative light. This must be carefully considered by a company's management, and in some circumstances it may be appropriate for a company's management to consider the question of adopting a rights plan with a significant institutional investor. Second, the adoption of a rights plan does not preclude offers for the purchase of a company, and once a target is put in play, even a target with a rights plan is likely to be the subject of a change of control of some sort, or an internally generated restructuring. Rights plans do not change a company's financial situation and do not make a company less vulnerable from a purely financial standpoint. Ultimately, the board of directors is obligated to maximize shareholder value, and this often involves accepting a legitimate offer and redeeming the outstanding poison pill.

A company that is considering a rights plan must keep in mind its various contractual obligations, in particular any covenants or "as issued" provisions in any equity or debt purchase or financing transactions to which it is a party. In addition, companies should keep in mind that although rights plans have evolved following a certain patterns as a result of considerable litigation, there is substantial continuing litigation over how a board of directors chooses to use a rights plan and when the board elects to amend such plan in the face of a hostile offer.

The foregoing is not a complete list of anti-takeover devices or of the issues raised by the use of a "poison pill," but it may help practitioners think about how to approach the needs of each individual company based upon that company's defensive profile and factual circumstances.