Gods at War: Shotgun Takeovers, Government by Deal, and the Private Equity Implosion

by Steven M. Davidoff

  SIGNIFICANT TYPES OF TAKEOVER DEFENSES

  White Knight—A friendly buyer who purchases a target subject to a competing hostile bid.

  White Squire—Similar to a White Knight but the friendly buyer purchases a significant interest in a target instead of the entire company.

  Poison Pill—See sidebar on pages 192-193.

  Pac-Man Defense—A tactic where the target turns the table on a bidder by making a bid for the bidder itself. The most famous example occurred in the bidding war between Bendix and Martin Marietta in 1982.

  Leveraged Recapitalizations—To fight off an unsolicited bidder, the target will borrow a significant amount of funds to pay a dividend or repurchase its shares. If successful, this makes the target too leveraged for a bidder to acquire using debt financing.

  Crown Jewel Sale—A sale by the target of a key asset to make it unattractive to an unsolicited bidder.

  Golden Parachutes—Benefits provided to employees, typically senior executives, of a target upon a change of control of the target. This typically takes the form of cash payments and accelerated vesting of restricted stock and stock options.

  Greenmail—The repurchase of a block of stock at a premium from an unwanted shareholder.

  Shark Repellents—Charter and bylaw provisions that discourage takeover activity. Examples include staggered board, fair price, supermajority voting, and expansive nomination notice provisions.

  State Antitakeover Laws—Since the 1980s, most states have put in place laws that make a hostile takeover more difficult and, in some states such as Pennsylvania, almost impossible without target consent. Examples of these statutes include “control share,”“fair price,” and “business combination” statutes. Control share statutes typically mandate that a majority of disinterested target stockholders preapprove the acquisition of bidder control. Fair price statutes generally require that a business combination with a person holding 10 percent or more of the corporation’s stock be approved by a supermajority of the bidder’s disinterested stockholders unless certain exemptions were met (primarily approval of the disinterested directors or payment of a fair price). Business combination statutes usually prohibit bidders from engaging in a business combination with a target for preset period upon the bidder’s acquisition of 15 to 20 percent or more of the target’s equity unless the purchase was preapproved by the target’s board or a specified percentage of disinterested target stockholders.

  The Blasius Standard and Shareholder Voting

  The Delaware courts also review target board defensive actions under the holding of Blasius Indus., Inc. v. Atlas Corp.62 The standard in Blasius is applied when “the primary purpose of the board’s action is to interfere with or impede exercise of the shareholder franchise and the shareholders are not given a full and fair opportunity to vote.”63 There has been substantial debate about the continued existence of this standard and its fit with the Unocal standard. However, the Delaware Supreme Court reaffirmed its validity in the 2003 case of MM Companies, Inc. v. Liquid Audio, Inc.,64 when it held that a defensive action to expand a board from five members to seven in order to prevent an insurgent from taking control of the company lacked compelling justification under Unocal. The court applied a Blasius analysis within an application of the Unocal standard because “the defensive actions of the board only need to be taken for the primary purpose of interfering with or impeding the effectiveness of the stockholder vote in a contested election for directors.”65

  The advent of the poison pill and the effective requirement that a hostile bidder conduct a proxy contest are likely to mean that Blasius will continue to play a prominent role in regulating hostile takeovers for corporate control. Illustratively, in the recent case of Mercier, et al. v. Inter-Tel ,66 the Chancery Court applied Blasius outside the hostile context to a vote on a merger transaction. In that case, a special committee had postponed on the day of the meeting a shareholder vote on an acquisition proposal because it otherwise would have been defeated.Vice Chancellor Strine asserted that the Blasius standard was inappropriate. Instead, the standard should be incorporated into Unocal’s reasonableness standards. However, acknowledging that such a change could only be effected by the Delaware Supreme Court, he applied the standard in the alternative to find that the postponement had a compelling justification due to a corporate governance firm’s possible change of recommendation, among other factors, and the board’s “honesty of purpose.”67 This holding is one of only two cases so far where the Delaware courts have actually applied the Blasius standard and found the action to pass muster.68

  In reality, Blasius is not often implicated in hostile takeovers, probably because boards are now regularly advised that they have limited ability to affect the proxy machinery during a pending hostile transaction as well as the Delaware court’s preference to review target responses to hostile bids under Unocal. Blasius’s effect is thus as a regulating force that is seldom invoked but is followed by target boards fearful of the high threshold it imposes. The question remains, though, whether Vice Chancellor Strine’s attempt to rewrite the Blasius standard takes hold and, if it does, whether it applies to all takeover votes. Given the corporation’s control of the proxy machinery and the head start their positions and control provide, such a move is likely to be ill-advised, and Blasius should be generally applied to votes on all takeover transactions.69

  The Future of Hostile Takeovers

  Vice Chancellor Strine’s attempt to rewrite the Blasius standard points to a movement in Delaware law. There are many academics and even Delaware judges who want to simplify the multiple standards Delaware imposes on takeovers. They advocate instead that Delaware largely rely on independence and reasonableness tests. So long as directors act reasonably and independently in the context of a takeover, their actions should be upheld. The movement has yet to see success, but it may eventually result in a consolidation of Delaware standards.

  This movement belies a more obvious fact. Even under the current standards, Delaware courts rarely rely on any of these standards to intervene in hostile takeover battles. Instead, Delaware courts increasingly regulate takeover contests through their state’s disclosure requirements. When the Delaware courts find a violation of these obligations by either the target or the bidder, they tend to then order only corrective disclosure. This allows the Delaware courts to tell a moral story: What you, the target directors or the buyer, did was bad and must not be done again. Practitioners and academics then write about these lapses and presumably clients are advised not to repeat these mistakes. But the deal itself is little affected once the corrective disclosure is made. Delaware courts will truly act to substantively intervene only when a target board takes action to completely foreclose an offer. The Delaware courts are hesitant angels rather than active umpires.70

  In recent years, at least, the process appears to have worked. Delaware courts have maintained a level playing field for wealth-maximizing bids. A board can refuse a takeover and just say no, but it cannot preclude bids and access to the proxy mechanism to force a change of control. Delaware thus allows the soft force of shareholder pressure to work to substitute the court’s judgment in these deals and overcome the deterring effects of management control and the possibility of a proxy contest. The soft force of shareholder power has purchase in effecting sales of the company and forestalling the adoption of takeover defenses. This trend is likely to be enhanced in light of the appearance of more activist hedge funds and other shareholders who will work to take advantage of these events. And this is presumably why majority substantial number of hostile bids result in a sale of the target.

  Thus, Delaware’s easy hand on takeover defenses allows many devices that impede takeovers, such as the poison pill, to exist. However, this may not be, in effect, a bad thing. It allows a board to actually fulfill the purpose of the poison pill and takeover defenses, to prevent advantaging underpriced bids, while allowing shareholder pressure to function in preventing management entrenchmen
t. Theoretically, the force should work. The InBev and Microsoft offers are illustrative and reflect the increasingly important role of shareholders and shareholder activists. Nonetheless, as in Yahoo, in the past year the just say no defense has backfired, as many bidders simply withdrew their bids before shareholder pressure could take effect. It remains to be seen, though, whether this was simply a function of market conditions or a secular trend.

  Evidence that shareholder power may be working comes from the rise in hostile activity. It is clear that hostile activity in recent years has been significantly diminished from 1980s levels. Some have connected the diminished takeover activity to Delaware’s relaxing its review of takeover defenses.The rise in activity in the last few years has correlated with the rise of activist hedge fund shareholders and good corporate governance campaigns. It may be that this soft shareholder force is indeed the tonic for the relaxed Delaware standards that otherwise seem too permissive. In such a circumstance, Delaware’s focus through Blasius on preserving access to the shareholder ballot to effect takeovers makes sense.

  None of this will do away with the staggered board. This takeover defense appears to more strongly work against shareholder interests and entrench management. As Bebchuk and his co-authors have argued, a staggered board can act as a deterrent on hostile takeovers.71 The reason is simple. A hostile takeover against a company with a staggered board can take two years to obtain majority control and complete. Many companies are unwilling to expend the time and effort for such an uncertain outcome. In this light, studies have largely found that staggered boards deter bidding and result in fewer successful bids.72 The studies are more mixed on whether a staggered board results in a higher takeover premium due to the need to overcome the target’s strong defenses.73

  Some argue that the rise of independent directors and higher management stakes will work against the staggered board.74 In particular, the ability to win the first shareholder election and elect a short slate—that is, one-third of the board—provides substantial ability to pressure a company. Here, the examples most often cited are Weyerhaeuser Co.’s acquisition of Willamette Industries Inc. and AirTran Holdings Inc.’s failed acquisition of Midwest Air Group Inc. In both cases, the bidder elected a short slate of directors, forcing the target to enter into a change of control transaction. Willamette agreed to be acquired by Weyerhaeuser, and Midwest sold itself to a white knight,TPG.

  Nonetheless, even assuming that a staggered board results in higher premiums, by reducing success rates, shareholders of companies with staggered boards probably lose out in the aggregate and on the edges. Although poison pills and other takeover defenses may deter takeovers, today only the staggered board appears to be a truly effective deterrent. The more activist shareholder agenda may indeed counteract the staggered board, but that will have to wait for further studies.The staggered board may be an appropriate tool for other value-creating reasons, such as preserving board independence and providing long-term perspective. But in the takeover realm it is for now a suspect device.

  In the first five months of 2009, the uptick in hostile activity continued. During this time period, 27.78 percent of all U.S. activity was hostile compared to 20.8 percent during the same period in 2008.75 If hostile activity continues its rise, companies may also push back, attempting to counteract this shareholder force. In the past two years, companies aware of their relative weakness began to arm themselves as quickly and best as they could. In 2008, 122 companies adopted their first poison pills to fend off takeovers. Only 71 companies adopted poison pills for the first time in all of 2007.76 The sizable increase in poison pill adoptions was most likely an attempt by companies, particularly small ones where a significant percentage of the company could be acquired in the market without a filing under antitrust laws, to signal to the market that they would resist a hostile takeover attempt. Although poison pills do not forestall an offer, these adoptions foreshadow a more aggressive response by targets in the future and perhaps a return of the more aggressive takeover defenses of the 1980s.This response may push the takeover laws further into target management’s favor, collapsing the balance that Delaware law has perhaps unwittingly arrived at. In other words, the soft power of shareholders is a fragile one at best.

  Ultimately, takeovers have come a long way from the first true blue-chip hostile, International Nickel Company of Canada’s 1974 unsolicited offer for ESB, Inc., then the country’s largest battery maker.77 The wild times of the 1980s corporate raiders are not likely to return. The days when Goldman Sachs and other investment banks and law firms refused to participate in hostiles because of their aggressive nature are also long gone. The hostile probably achieved full legitimacy in 1995, when IBM launched its landmark and textbook hostile against Lotus Corporation.78 Since that time, hostiles have become an accepted part of the marketplace, another facet of the deal machine.They are no longer the coercive bids of the 1980s launched by raiders to take over and carve up companies. Now, the hostile is the domain of strategic buyers using terms like synergies and growth. It is a trend that is part of the mainstreaming of the strategic transaction, the subject of the next chapter.

  Chapter 9

  Mars, Pfizer, and the Changing Face of Strategic Deals

  The fervent activity and wallets of private equity overshadowed strategic buyers in the sixth wave. During the period from 2004 through 2007, strategic transactions—transactions where the buyer is an operating company rather than a financial buyer such as a private equity firm—were 71 percent of announced U.S. takeover transactions.1 Strategic transactions still comprised the majority of dealmaking, but their profile and role was limited by private equity’s aggressive tactics and willingness to bid for almost any company.

  In this environment, sellers could attract a large number of private equity bidders to compete with a strategic one. Company auctions became a more frequent means to sell companies, as sellers favored competitive bidding contests. Private equity came to these auctions in full strength. The free availability of easy credit meant that private equity could finally compete with strategic buyers. In prior times, strategic buyers could almost always trump a private equity bid. Strategic buyers could do this by paying higher amounts due to the cost savings and synergies that they could obtain by combining their operations with a target.

  Private equity lacked these advantages because private equity purchased companies on a one-off basis. But the determining factor in auctions and acquisitions changed. Now, it became which buyer could tolerate the highest possible debt load. As private equity grew, these firms even began to create their own strategic buyers, leveraging the advantages of being a private equity bidder with the ability to obtain the cost savings and synergies of a strategic buyer. The most notable example was certainly Apollo’s Hexion Specialty Chemicals. Hexion outbid the strategic buyer Basell Holdings BV for Huntsman in a $10 billion deal with near-fatal results for both Huntsman and Hexion.2

  The deal machine accommodated this financing trend, and investment banks began to successfully lobby targets to offer stapled financing in these auctions. Stapled financing is prepackaged financing offered by a target’s investment banker in an auction. The financing is encouraged for use by any bidder. Stapled financing allowed targets to level the playing field among buyers by homogenizing bid financing. It also allowed investment banks to doubly profit by representing both the target and the buyer. Shareholders complained that this was a conflict of interest, but the practice continued, with some targets hiring a second investment bank to paper over the conflict claims, producing yet more fees for the investment banks.3

  The availability of cheap credit and the presence of private equity also changed the nature of the consideration buyers offered in the sixth wave. Cash came to dominate as an acquisition currency. This marked a strong turn from stock, the preferred currency of the fifth wave, the technology bubble. The increased use of cash by strategic buyers also heralded a more conservative approach to dealmaking. In the techno
logy bubble, many buyers had made dilutive takeovers with their company’s stock, takeovers that then proceeded to fail miserably. The ultimate example was the 2001 merger of AOL and Time Warner, which resulted in Time Warner shareholders losing up to $220 billion in value.The use of cash was viewed as a disciplining force in acquisitions. Stock could be freely issued, but managers would have to work diligently to ensure that the cash borrowed to finance an acquisition would be paid back.

  This sentiment was a reflection of an intermittent focus during the sixth wave on disciplined acquisitions in light of the illfated deals of the prior years.

  Disciplined takeovers became a cherished goal advocated by shareholders and market observers to some success, but the social aspect of dealmaking became a less important factor during this time period. In strategic transactions, one of the primary concerns is social integration. The buyer must not only complete the deal but also then effectively merge the target’s business, management, and employees into the buyer’s own corporate culture. In the fifth wave, this had been a significant issue as large merger-of-equals transactions predominated. In these transactions, there was no designated buyer. Instead, the companies claimed that they were equals and peers combining for purely strategic reasons. Unfortunately, in a number of these transactions, such as Morgan Stanley’s $10 billion merger of equals with Dean Witter & Co. and Citicorp Inc.’s $37.4 billion merger of equals with Travelers Group Inc., trench warfare subsequently broke out, as the executives of each company fought for control and the cultures failed to effectively integrate.4 Companies in the sixth wave had learned from these difficulties. Merger-of-equals transactions became less commonplace, and buyers self-selected for more appropriate targets that would fit within the buyer’s own culture.