Deteriorating share prices and challenging market conditions are creating opportunities for potential buyers with the financial resources to make an acquisition. The ongoing effort by Roche to acquire the minority shares of Genentech highlights the increase in hostile takeover activity in recent periods. In this environment, it is imperative for public companies to review their takeover defenses in light of recent developments, including the use of derivative equity positions, and the first triggering of a shareholder rights plan in US history.
In 2008, unsolicited transactions constituted about 20 percent of all deal volume in the United States compared to 6 percent and 8 percent in 2007 and 2006, respectively.1 In addition to share price declines, this activity may have been encouraged by the efforts of activist investors and proxy advisory firms to resist corporate takeover defenses and/or insist on transformational strategy changes.2
Not surprisingly, 2008 was the first year since 2005 in which there was a year-over-year increase in the number of companies adopting poison pills. Additionally, the rate at which companies are allowing their existing pills to expire or are proactively terminating their pills has slowed. This represents a sharp reversal from recent trends.
A poison pill is a highly effective defense against unfair takeover tactics and stock accumulations; but, it is also sufficiently flexible to permit board-approved transactions. The legality of poison pills is well established under state corporate laws. A poison pill can be adopted by a company’s board of directors under state corporate law without shareholder approval (assuming sufficient authorized shares are available). The power of the poison pill resides in its deterrent effect. A potential acquirer will not purchase shares of a target company if such purchase would cause it to exceed the pill’s triggering percentage (usually somewhere between 10 percent and 20 percent). If an acquirer were to trigger the pill, then the target company’s shareholders (other than the potential acquirer) are entitled to exercise rights to purchase a large number of target company shares at a significant discount, thereby causing massive dilution to the acquirer. Alternatively, pursuant to a common “exchange” feature, the target’s board can permit shareholders (other than the acquirer) to simply exchange their rights for additional shares, thereby avoiding the need for shareholders to make a cash payment. Either way, if the pill is triggered, the potential acquirer would suffer prohibitive dilution.
In the last ten years, proxy advisory firms and institutional shareholders called for companies to seek shareholder approval of poison pills. RiskMetrics (formerly Institutional Shareholder Services), the largest proxy advisor in the country, will recommend that shareholders not support the election of a board that has adopted or renewed a poison pill without shareholder approval (or an undertaking to seek shareholder approval within 12 months). If put to a shareholder vote, RiskMetrics will consider recommending that shareholders vote for a poison pill on a case-by-case basis provided the pill satisfies specified criteria.
There is no question that adopting or renewing a poison pill without seeking shareholder approval or without meeting the requirements of proxy advisors and institutional investors will continue to invoke the ire of those groups. The impact of a recommendation to vote against directors will be particularly acute for companies that have adopted a majority voting requirement for election to the board. But, notwithstanding the pressure to submit poison pills to a shareholder vote, the vast majority of companies that adopted or renewed poison pills in 2008 did so without a shareholder vote or any apparent intention to seek one within 12 months of adoption. In many cases, they adopted poison pills with terms that do not conform to RiskMetrics’ guidelines.
Selectica Pill Triggered
The popularity of poison pills has been premised on their unblemished record of deterring unwanted stock accumulations and takeover offers— until recently. In November 2008, Selectica, Inc. lowered the ownership trigger on its poison pill from 15 percent to 4.99 percent for the stated reason of preserving Selectica’s net operating losses. An existing shareholder challenged this change by purchasing sufficient additional shares to trigger the pill. In accordance with the exchange feature of Selectica’s pill, Selectica exchanged each right issued under the plan (except for rights held by the acquiring shareholders) for one share of common stock in the company, thereby diluting the acquiring shareholders’ equity position. Following the exchange of rights for stock, the committee reinstituted the poison pill to maintain its defense against future accumulations. Selectica’s actions are currently being litigated in Delaware.
Although surprising, the Selectica situation should not be interpreted as a repudiation of the effectiveness of poison pills. Selectica is a micro-cap company with a share price under one dollar and an aggregate market capitalization under US$20 million dollars. Although the acquiring persons were diluted as expected under the pill, on an absolute dollar basis the dilution likely was a tolerable price to pay to challenge the pill in litigation. The financial impact on an acquiring shareholder of a larger company would be much greater and should have the intended deterrent effect. The Selectica situation highlights the importance of including an exchange feature in a poison pill, particularly in today’s environment, where it may be difficult for shareholders to generate the liquidity otherwise necessary to exercise the rights.
Impact of Derivatives
Together with the resurgence of the poison pill, the most significant recent developments in takeover defenses seek to address the use of synthetic or derivative equity positions by activist shareholders as a platform from which to exert influence over the management and control of a company. To address the lack of information about derivative positions held by shareholders agitating for change, by the end of 2008, over 350 companies had amended their bylaws to require that activist shareholders disclose such derivative positions when submitting a proposal or nominating directors at a shareholders meeting. This should be an integral part of any advance notice bylaw. In addition, recent Delaware court decisions that have narrowly interpreted specific advance notice bylaws, require that companies review and revise such bylaws to ensure they remain effective in light of these court decisions.
Advance notice bylaws do not deter or arrest an accumulation of a hidden equity position. Consequently, a limited number of companies have implemented poison pill provisions that explicitly require that derivative equity positions be counted toward the beneficial ownership threshold for triggering the pill. Since January 1, 2008, 129 companies have adopted new poison pills,4 36 (approximately 28 percent) of which include language regarding derivatives (but only nine companies included in the S&P 1500).5 In this same period, 237 companies have amended or restated their pills,6 and 29 (approximately 12 percent) included language regarding derivatives (only 12 companies included in the S&P 1500).7 Most of the companies that adopted or amended their pills in this manner were small-cap companies. These statistics suggest that provisions specifically addressing derivatives have not yet become common and should be carefully considered in light of particular circumstances.
The confluence of deteriorating share prices increased hostile takeover activity and the use of undisclosed derivatives positions highlight the importance of insuring that corporate takeovers defenses are state-of-the-art. Any public corporation that has not evaluated its defensive profile should do so in the coming months.