POISON PILLS



A poison pill is a type of financial or structural maneuver that a company may make to frustrate an attempted takeover by a hostile bidder. The poison pill affords directors of a company sufficient latitude to restructure or acquire debt or sometimes sell assets, specifically to make the company a much less attractive takeover target. If the poison pill is effective, the acquiring company will abandon its takeover and allow the target company to remain independent.

For all the criticism directed at takeovers, it has been suggested that they perform a highly useful task: they motivate the directors of potential target companies to consistently maximize shareholder value and to restructure underperforming companies into profitable, competitive, and usually smaller enterprises.

HISTORY AND BACKGROUND

Poison pills have existed in various forms for many decades, but they were viewed merely as anomalies in corporate finance. Over an approximately ten-year period beginning in the late 1950s, several large conglomerates were formed out of the philosophy that any company involved in one industry would be ravaged by periodic downturns in that industry. Diversification would enable companies to maintain consistent profitability by offsetting losses in struggling operations with profits from other unrelated and more successful operations.

Conglomerates such as LTV, Textron, General Dynamics, TRW, General Electric, Teledyne, and Tenneco built enormous corporate empires that had interests in several major industries, specifically to achieve diversification. In the process, many companies lost their independence to these conglomerates, because few among them were able to mount successful defenses against unwelcome bids.

The rash of conglomerate activity and the pace of mergers and acquisitions caused concern that takeovers were causing excessive concentration in certain industries and were being allowed to proceed without sufficient notification or care. This led to congressional lobbying by business federations, labor unions, and institutional investors that culminated in passage of the Williams Act in 1968.

The Williams Act obliged parties to a takeover to fully disclose the terms of an impending acquisition and to allow a period in which competing offers for a target company could be made. The act became the basis for other federal laws regarding corporate mergers and acquisitions and established a basis for legal challenges using arguments such as bad faith, misrepresentation, and antitrust concerns.

During the period that followed, many state legislatures passed more specific and restrictive legislation on takeovers, based on the Williams Act. This, for the first time, involved legislators in corporate mergers and acquisitions and required companies to maintain strong government relations.

The Williams Act and the various state laws that were modeled after it caused many companies to alter their articles of incorporation by changing their legal domiciles to states with more favorable environments. By far, the most attractive was Delaware (and this explains why most companies today are incorporated in that state). State laws—particularly those in Delaware—provided grounds for statutory and legal defenses that could frustrate all but the least unwelcome takeovers. By the late 1970s, the pace of acquisitions nearly ground to a halt.

But in 1982 the U.S. Supreme Court passed a landmark ruling in the case of Edgar v. MITE Corp., which invalidated the basis for antitakeover laws in 37 states. Helped to some degree by a noninterventionist U.S. Department of Justice under the Reagan administration, restrictive takeover laws were severely weakened. No longer able to take shelter in statutory and legal defenses, many firms were once again vulnerable to takeover offers; hence, the need for companies to develop their own antitakeover measures in the form of poison pills.

TYPES OF POISON PILLS

Poison pills typically discourage hostile takeovers by letting companies sell large amounts of stock to existing shareholders at cheap prices. The hostile bidder is not allowed to purchase any of the new stock, and his or her total holdings are capped at an arbitrary amount, often 15 percent of the company's total shares. As a result, the hostile bidder's holdings in the takeover target become diluted and are worth less.

The most common type of poison pill—used by more than nine out of ten companies—is the shareholder rights, or "flip-over," plan. Such a plan commonly allows a company facing an unwelcome bid to declare a special stock dividend consisting of rights to purchase additional, newly created shares. The exercise price to these rights is purposely set far above market value, so that a suitor company would have to spend substantially more to acquire control. The company may redeem the rights after the bid has been abandoned, but usually at only five cents per share.

If the takeover bid is successful, the shareholder rights may be transferred, or "flipped over," to the successor firm. The rights would entitle shareholders to purchase shares in the surviving firm at a discount of as much as 50 percent, causing tremendous dilution of the surviving firm, and possibly even placing control of that firm in jeopardy.

A variation of the flip-over is the "flip-in" plan. This plan is designed to hasten the exit of a suitor with a substantial minority of shares who cannot, or will not, affect a merger—and who may be playing the shareholders for a gain through greenmail. The flip-in offers shareholders in the target company—but not the suitor—rights to buy additional discounted shares.

As these rights are exercised, the suitor's position is diluted and share value drops. The suitor is faced with mounting losses the longer he or she hesitates, and is motivated to liquidate his or her holdings as quickly as possible.

Both poison pill plans enable a company to thwart all but the most determined and deep-pocketed suitors, while allowing shareholders to benefit greatly if the suitor succeeds. Nevertheless, no poison pill or any other type of defense is ever meant to be used. Their greatest utility is in their deterrent influence; a company is unlikely to launch a takeover of a firm whose defenses are sufficiently formidable.

THE EFFECTS OF POISON PILLS ON
COMPANIES

Few companies have been able to maintain their independence indefinitely after employing a poison pill. While effective at fending off unwelcome bids, poison pills have tended to indicate to the financial community that the companies using them suffer from some financial or structural weakness and are ripe for some form of merger.

Many shareholder activists, concerned with the potential abuses that might result, have sponsored proposals that would require shareholder approval prior to including a poison pill in the corporate charter or activating an existing poison pill. Their argument is that by preserving the independence of firms, poison pills have the effect of perpetuating inefficiencies and poor management that result in declining productivity and competitiveness that is reflected in lower share value.

Another type of poison pill that has particularly angered shareholder activists is the so-called "deadhand" poison pill. Dead-hand poison pills can be redeemed only by the incumbent board of directors. Such a plan is designed to keep the existing board and current management in place, sometimes at the expense of existing shareholders or in opposition to a majority of shareholders. It eliminates shareholders' ability to act by written consent. A variation on the dead-hand poison pill is the no-hand poison pill, which cannot be altered by anyone for at least one year or some specified time.

Chief executive officers (CEOs) and boards of directors frequently argue that poison pills have exactly the opposite effect on share value. They maintain that poison pills are brutally effective bargaining tools that may be used to extract only the most favorable terms from potential suitors. Negotiating positions can only be strengthened by poison pills, they say, and this will lead to more favorable bids. CEOs also see them as a way to have some control over their companies' future, especially if the stock market were to fall sharply and opportunistic buyers began hostile takeovers of undervalued companies.

While there is merit to both arguments, it is most often the case that these effects cancel each other out and have little or no effect on share value. Shareholder activists, however, remain increasingly vigilant about possible abuses that may arise from poison pill plans, and takeover defenses in general. Meanwhile, state legislatures have spent the years since the Supreme Court ruling on Edgar v. MITE Corp. gradually reconstructing restrictive antitakeover laws.

Despite opposition from shareholder activists, poison pills appeared to be growing in popularity in the 1990s. In 1998 some 530 companies extended or adopted new shareholder rights plans. In 1999 as many as 20 percent of all poison pill plans were expected to come up for renewal. At least 40 major corporations would be affected, and shareholder activists were calling for more public debate on and repeal of poison pill plans. In many cases boards of directors were not required to consult with shareholders regarding the renewal or lapsing of existing poison pill plans.

Leading the shareholder activists was the Teachers Insurance and Annuity Association-College Retirement Equities Fund (TIAA-CREF), the world's largest pension fund with an equity portfolio of about 2,600 companies. TIAA-CREF was in the process of going through its entire portfolio looking for companies with poison pill provisions. In addition to attacking dead-hand poison pills, TIAA-CREF called for letting shareholders vote on whether or not their company's poison pill plan should be renewed. Another leading shareholder activist, Guy Wyser-Pratte of New York City, proposed a "chewable" pill that would entitle shareholders to vote on any takeover proposal before the poison pill went into effect. If shareholders approved the takeover, the board would be required to stop using the pill.

[ John Simley ,

updated by David P Bianco ]

FURTHER READING:

Crangle, Rick. "Replacing Poison Pills with Vitamins." Global Finance, July 1998, 15.

Elofson, John. "Should Dead Hand Poison Pills Be Sent to an Early Grave?" Securities Regulation Law Journal, fall 1997, 303-43.

Feinberg, Phyllis. "'Deadhand' Pills a Major Proxy Issue." Pensions and Investments, 19 October 1998, 3.

Griffin, Ricky W., and Ronald J. Ebert. Business. 2nd ed. Englewood Cliffs, NJ: Prentice-Hall, 1991.

"Hundreds of Companies Targeted by Activists: Shareholder Group Threatens Binding Proposals on Poison Pills." Investor Relations Business, 7 December 1998, 1.

Norris, Floyd. "Poison Pills Are Still Popular, but Their Purpose Has Changed." New York Times, 19 December 1996, C8/Dl0.

Norton, Leslie P. "If This Stock Market Falters, Poison Pills Could Become a Hot Topic Again." Barron's, 6July 1998,17-18.

"Poison Pills Gain in Popularity." Directorship, March 1999,12.

"Poison Pills: Let Shareholders Decide." Business Week, 17 May 1999, 104.



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