“Choose your poison,” the barman says. Could there be something new to choose? The corporate poison pill was invented almost 30 years ago as an anti-takeover defense, used by companies to prevent hostile acquisition attempts.
Although there are variations, the basic poison pill is implemented by a company adopting a rights plan (often called a “flip-in plan”) and distributing “rights” to its stockholders to acquire additional shares of common stock at a price well below market. The rights are redeemable by the company for a nominal price. Once the process is triggered, a holder can acquire shares of common stock for his rights, often on a one-to-one basis. The poison pill triggers when a third party (“Raider”) acquires, or announces a tender offer for, a significant block of company stock (typically 15% or 20%) without the consent of the company’s board.
The rights attach to the common stock, so that a shareholder who sells his stock also transfers the related rights, until a triggering event occurs. Then the rights may trade separately. In either case, however, rights can’t be exercised by a Raider and become void if a Raider acquires them. As the number of outstanding shares increases, the market price per share goes down correspondingly, similar to the effect of a stock split. Thus, the non-Raider stockholders can exercise their rights to increase their stockholdings at a reduced price, thereby diluting the Raider’s position, both as a percentage of outstanding stock and through a reduction of share price, a double loss.
Raiders will think twice before purchasing enough shares to trigger the poison pill. The pill therefore puts pressure on a potential Raider to negotiate with the target’s management concerning acquisition, rather than circumventing management and going directly to the stockholders.
In addition to flip-in rights, some poison pill plans also include an exchange feature permitting the company’s board, on its own initiative, to exchange shares of common stock for the rights. This permits management to dilute the Raider even if the stockholders like the Raider’s offer and don’t want to exercise their rights. Management simply exercises the exchange right, issuing more shares to the holders of the rights, again resulting in more outstanding shares, with an effect similar to a stock split. And the Raider suffers the double loss of reduced percentage ownership and lower price per share.
Poison pills were relatively common among public companies until a few years ago but gradually fell out of fashion. One survey showed that about 60%of public companies had pills in 2002, but the percentage was down to 28%in 2008. One reason for this was that they were perceived as tools used by management to entrench itself, to the disadvantage of stockholders. Another reason was that with larger transactions, the premerger notification requirements of the Hart-Scott-Rodino (HSR) Act prohibit the Raider from purchasing more than $63.4 million of the target’s stock unless the Raider has complied with the HSR filing and waiting period requirements (or unless the parties don’t meet HSR’s “size of the parties” test). That delay gave the target company’s management enough time to adopt a poison pill if they felt that one was needed. Many companies had a poison pill prepared and “on the shelf,” ready for adoption in such a contingency.
Events of the last 18 months, however, have given the poison pill a new life. Because of the decline in stock markets, many companies are now trading at much lower prices. Companies are concerned that their assets are undervalued, inviting unsolicited buyers at low prices. So, many companies are now adopting new poison pills to give them protection. Moreover, with lower stock prices, a Raider might have 15% or more of the stock before it reaches $63.4 million, the trigger for HSR filing. So potential targets can take less comfort that HSR will give them time to act before a Raider becomes a significant stockholder.
One new twist is that, due to the recession, many companies had losses for 2008 or 2009, or both, and now have net operating loss (NOL) carryovers, which can be offset against earnings, reducing taxes in future years. Under the tax code, however, an NOL is limited if there is a change of ownership within a three-year period looking backward from the date of any change of ownership. That would impair the value of the NOL. And one of the change-of-control tests is whether a person or group becomes a “5-percent shareholder” within the meaning of the relevant section of the code. A target with a significant NOL can lose much of its value to shelter future income if someone purchases 5% or more of the target’s stock.
As a result, companies are adopting new poison pills to try to protect their NOLs from this risk. For example, Ford Motor Company approved a “Tax Benefits Preservation Plan” in September 2009, under which it distributed one preferred share purchase right to each outstanding share of common stock and class B stock. These rights are redeemable by Ford until a Raider acquires 4.99% or more of the common stock, at which point they become exercisable. The stated purpose of the plan is to protect Ford’s ability to use its NOLs to offset future taxable income by discouraging persons from acquiring more than 4.99% of Ford common stock. The rights, when exercised, very substantially dilute the outstanding shares. Rights held by someone who becomes the beneficial owner of 4.99% of the outstanding Ford common stock are void. A Raider is thereby deterred, Ford hopes, from acquiring enough stock to adversely impact use of Ford’s NOL.
Of course, a Raider may be after a target because it believes the target is undervalued without regard to its NOL. So a poison pill aimed at protecting NOLs may not be as effective as hoped. Once the Raider gets to 5% or more in ownership and the NOLs are impaired, the target has lost much of the NOL value as an asset and its stockholders may be more inclined to sell as a result. The resulting price declinemakes the target even more attractive to the raider. Thus in many instances, there is no assurance that the NOL poison pill will achieve its purpose. In Ford’s case, however, Ford’s board can still exchange the rights for common stock on a one-for-one basis, which would dilute the Raider’s percentage of ownership and the market value of its shares. So Ford’s poison pill has some traditional anti-takeover value, in addition to helping to protect Ford’s NOL.
One other reason that poison pills are back in favor is the growth of “synthetic equity” derivative swap transactions, where a “short party” agrees to pay a “long party” the cash flows from a particular amount of a target company’s stock. In exchange, the long party agrees to pay a fee and to cover any decrease in the market value of the stock. Such a swap can be settled for cash, which has no effect on the target company. Or it may provide for an “exchange for physical” settlement in which the long party receives the stock from the short party. In effect, the long party has privately bought the stock without reporting it. Through such transactions, a long party can suddenly become a significant stockholder of a target company without warning. To protect against this kind of stealth acquisition, a target company must have a poison pill plan in place at all times or risk being blindsided.
In the final analysis, it seems that while the pill and some of the reasons for using it may be new, the poison isn’t. Some things haven’t changed.