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1. - - - - - - - - Chapter 19- - - - - - - - Takeover Defenses ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 1

2. Introduction • Not all mergers are welcome • Arsenals of devices were developed to defend against unwelcome proposals during the 1980s ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 2

3. Possible motivations for takeover defenses • Target is resisting to get a better price • Management of target judges that company will perform better on its own • Management is seeking to entrench itself ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 3

4. Strategic Perspectives • Management and board of company must continuously reassess competitive environment • All forms of M&A activities may impact firm both as threats and opportunities • Main developments in industry • Opportunities for adding critical capabilities to participate in attractive growth areas ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 4

5. Opportunities for rolling-up fragmented industries into stronger firms • Likelihood of firm to be rolled-up • Improving or deteriorating sales to capacity relationships in industry • Impact of consolidating mergers on capacity and cost structure • Enhanced capabilities of competitors as a result of their merger activity • Preemptive moves • Responses to takeover bids ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 5

6. Financial Defensive Measures • Efficiency • One view: Highly efficient firms with favorable sales growth and high profitability margins provide defense against takeovers • Alternative view: Highly efficient firms become good takeover targets • Bidder firm seeks to learn from efficiencies of target • Target firm may be viewed as undervalued ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 6

7. Financial characteristics that make a firm vulnerable to takeover • Low stock price in relation to replacement cost of assets or potential earning power (low q-ratio) • Highly liquid balance sheet with large amounts of excess cash, valuable securities portfolio, and significant unused debt capacity • Good cash flows relative to current stock prices; low P/EPS ratios ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 7

8. Subsidiaries or properties that could be sold off without significantly impairing cash flows • Relatively small stockholdings under control of incumbent management • Combinations of these factors can simultaneously make firm an attractive investment and facilitate its financing • Firm's assets can be used as collateral for acquirer's borrowing • Target's cash flows from operations and divestitures can be used to repay loans ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 8

9. Financial defenses • Increase debt — use borrowed funds to • Repurchase equity • Concentrate management's percentage holdings • Increase dividends • Loan covenants structured to force acceleration of repayment in event of takeover • Liquidate securities portfolio • Decrease excess cash • Invest in positive net present value projects • Return to shareholders in dividends or share repurchases ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 9

10. Excess liquidity could be used to acquire other firms • Divest subsidiaries that can be eliminated without impairing cash flows; or spin-offs to avoid large cash inflows • Divest low-profit operations • Undervalued assets should be sold • Value increased by restructuring ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 10

11. Corporate Restructuring and Reorganization • Restructuring and reorganization policies can be used positively or defensively • Reorganization of assets • Asset acquisitions can be used to block takeovers • Dilute ownership position of bidder by using equity in acquisitions • Create antitrust problems for bidder ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 11

12. "Selling off crown jewels" — firm may dispose of business segment in which bidder is most interested • Reorganizing financial claims • Debt-for-equity exchanges — increase leverage to levels unacceptable to bidder • Dual-class recapitalizations — increase voting powers of insider groups to levels that would enable them to block tender offers • Leveraged recapitalizations — incur huge amounts of debt, using proceeds to pay large cash dividends and increase ownership position of insiders — "scorched earth" policy ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 12

13. Other strategies • Joint ventures could represent liaisons that potential bidders might prefer to avoid • ESOPs can be used to decrease voting shares available for tender • MBOs and LBOs • Widely used as defense against outside tender offer • Management can take firm private • Managers may turn to LBO specialist because their stock ownership position may increase more than in an outside tender offer ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 13

14. Target firm may look for international partner • Share repurchase can be used to defend against takeovers • Increase ownership of insiders • Low reservation price shareholders can be bought out — higher tender offer price needed for bid to succeed • Proxy contest — aim is to change control group and make performance improvements ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 14

15. Event studies • Restructuring improves firm's efficiency: favorable stock price reaction • Restructuring represents scorched-earth policy: negative stock price reaction ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 15

16. Duty of Directors • Business judgment rule: Directors must demonstrate to the courts that the best interests of shareholders have been served ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 16

17. Duty of directors to demonstrate sound business reasons to reject offer • Duty of directors to approve only a transaction that is fair to shareholders and is best transaction available • Duty of directors to fully explore independent competitive bids and obtain best offer • Fairness opinion from an investment banking firm not sufficient ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 17

18. Greenmail • Definition: Represents targeted repurchase of large block of stock from specified shareholders at premium to end hostile takeover threat ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 18

19. Two divergent views of greenmails • Greenmailers damage shareholders • Large block investors are corporate "raiders" who expropriate corporate assets • Raiders' voting power used to give themselves excessive compensation and perquisites • Raiders receive substantial premium, "looting" corporate treasury ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 19

20. Greenmail brings about improvements • Large block investors involved in greenmail force improvements in corporate personnel or in corporate strategies and policies • Large block investors have stronger incentives and superior skills for evaluating potential takeover targets • Managers make greenmail payments to buy time to turn around the firm ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 20

21. Greenmail sometimes accompanied by standstill agreement • Voluntary contract in which blockholder agrees not to make further investments in target company during specified period of time • If no targeted repurchase is made, large blockholder agrees not to further increase ownership percentage of the firm ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 21

22. Wealth effects of greenmail • Announcement associated with negative return to shareholders of 2-3% (significant) • Other studies find positive abnormal returns, both in initial "foothold" period and in full "purchase-to-repurchase" period ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 22

23. Greenmail and standstill agreement • Negative returns — standstill agreement viewed as reducing probability of subsequent takeover • 40% of firms experience subsequent control change within three years of greenmail even with standstill agreement • Positive market reaction if greenmail viewed as giving directors more time to work out better solution ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 23

24. Antigreenmail developments • Internal Revenue Code Section 5881 of 1986 — imposes 50% excise tax on recipient of greenmail payments • Antigreenmail charter amendments • Require management to obtain approval of majority or supermajority of nonparticipating shareholders prior to targeted repurchase ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 24

25. Bhagat and Jefferis (1991) • Proxy statements proposing antitakeover amendments include one or more of (other) antitakeover amendment proposals • Sample of 52 NYSE-listed firms proposing antigreenmail amendments in 1984-1985 • 40 firms offered one or more antitakeover amendments • 29 cases, shareholders had to approve or reject antitakeover provisions and antigreenmail amendments jointly ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 25

26. Eckbo (1990) • Average market reaction to charter amendments prohibiting greenmail payments weakly negative • Subsample of firms with abnormal stock price runup over three months prior to mailing of proxy: Market reaction strongly positive • Particularly true if runup associated with evidence or rumors of takeover activity • Prohibition against greenmail removes barrier to takeovers with positive gains to shareholders ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 26

27. Strategic Actions • Pac Man defense • Definition: Target firm counteroffers for bidder firm • Rarely used; usually designed not to be used • Effective if target much larger than bidder • Implies target finds combination desirable but seeks control of surviving entity • Target gives up using antitrust issues as defense ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 27

28. Extremely costly • Could involve devastating financial effects for both firms • Large amount of debt used to purchase shares could cripple firms • Under state law, should both firms buy substantial stakes in each other, each could be ruled as subsidiaries of each other • Severity of defense may lead bidder to disbelieve target will employ such defense ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 28

29. White knight • Definition: Target company chooses another company with which it prefers to be combined • Alternative company preferred by target because: • Greater compatibility • New bidder may promise not to break up target or engage in massive restructuring ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 29

30. White squire • Definition: Modified form of white knight; white squire does not acquire control of target • Target sells block of its stock to third party it considers to be friendly • White squire may be required to vote its shares with target management • Often accompanied by standstill agreement • Limits amount of additional target stock white squire can purchase for specified period of time • Restricts sale of its target stock, usually giving right of first refusal to target ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 30

31. White squire often receives in return • Seat on target board • Generous dividend and/or • Discount on target shares • Preferred stock usually used in white squire transactions because it enables board to tailor characteristics of stock as described ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 31

32. Antitakeover Amendments • Antitakeover amendments to firm's corporate charter generally impose new conditions on transfer of managerial control of firm — "shark repellents" • 95% of proposed antitakeover amendments are ratified • Management introduces amendments that it feels are sure of success • Failure to pass might be taken as vote of no confidence ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 32

33. Brickley, Lease, and Smith (1988) • Institutional shareholders (banks, insurance companies) more likely to vote with management on antitakeover amendments • Have continuing business relationships with management • Pension funds, mutual funds, and college endowments more likely to be independent • Blockholders participate more actively in voting than non-blockholders and may oppose proposals that appear to harm shareholders ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 33

34. Jarrell and Poulsen (1987) • Amendments having most negative effect on stock price are adopted by firms with lowest percentage of institutional shareholders and highest percentage of insider holdings • Blockholders play monitoring role — institutional holders are well informed and vote in accordance with their economic interests ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 34

35. Supermajority amendments • Require shareholder approval by at least two-thirds vote (sometimes as much as 90%) for all transactions involving change in control • Involve "board-out" clause that gives board power to determine when and if supermajority provisions will be in effect ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 35

36. Fair-price amendments • Supermajority provisions with board-out clause and additional clause waiving supermajority requirement if fair price is paid by bidder for all purchased shares • Fair price — highest market price of target during a past specified period • Defend against two-tier tender offers • Least restrictive among class of supermajority amendments ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 36

37. Staggered or classified boards • Delay effective transfer of control following takeover • Management's rationale is to assure continuity of policy and experience • Examples: • One-third of board stands for election to three-year term each year • Reduce effectiveness of cumulative voting because greater shareholder vote is required to elect single director • Directors removable only for cause • Limit number of directors to prevent "packing" ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 37

38. Authorization of preferred stock • Board authorized to create new class of securities with special voting rights • Typically preferred stock issued to friendly parties in control contest (white squire) • Historically, used to provide board with financing flexibility • Could also include poison pill security to buy shares at a discount ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 38

39. Other antitakeover actions • Abolition of cumulative voting where it is not required by state law • Reincorporation in state with more protective antitakeover laws • Provisions with respect to scheduling of shareholder meetings and introduction of agenda items • Antigreenmail amendments that restrict company's freedom to buy back raider's shares at premium ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 39

40. Lock-in amendments to make it difficult to void previously passed antitakeover amendments • Termination of overfunded pension plans — (Iqbal, Shetty, Haley, and Jayakumar, 1999) • Firms can remove a significant source of cash flows to bidder firms by liquidating excess assets • Stockholders favor termination only when firm faced takeover and managerial ownership was high — view takeover as threat to their claim on excess pension assets ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 40

41. Boyle, Carter, and Stover (1998) • Studied antitakeover provisions adopted by mutual savings and loan companies converting to stock ownership (SLAs) • Strength of insider ownership position after conversion substitutes for strong antitakeover provisions • Low ownership firms associated with strong antitakeover protections • High ownership firms adopted less extraordinary antitakeover protections ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 41

42. Antitakeover amendments and corporate policy • Garvey and Hanka (1999) • Effects of antitakeover statutes on firm leverage • Firms protected by state antitakeover statutes substantially reduced debt ratios • Results not influenced by size, industry, or profitability • Weak evidence that protected managers undertook fewer major restructuring programs • Firms eventually covered by antitakeover legislation used greater leverage in years preceding adoption of statutes ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 42

43. Johnson and Rao (1997) • Compared financial attributes (based on income, expenses, investment, and debt) before and after antitakeover amendment adoptions • For full sample, firms exhibited no significant differences from industry means except for decline in net income to total assets ratio • Fair price amendments • For non-fair price subsample, no significant differences from industry mean for any of financial attributes • For fair price subsample, results similar to those of full sample ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 43

44. Antitakeover amendments and shareholder returns • General predictions • Positive returns • Announcement of antitakeover measure signals increased likelihood of takeover • DeAngelo and Rice (1983) — shark repellents may help shareholders respond in unison to takeover bids • Negative returns • Antitakeover amendments reflect management entrenchment • Comment and Schwert (1995) — decline of less than 1% for most types of antitakeover measures ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 44

45. Empirical results difficult to interpret because of number of influences operating concurrently • Antitakeover amendment may have been adopted to help management obtain better deal • Announcement of takeover may have contagion effects on industry • Positive runup in abnormal returns because of possibility of other takeovers • Announcement of antitakeover amendments with typical 1% decline in shareholder wealth should be netted against prior positive runup • 1% decline would be viewed as reflection of reduced probability of takeover being completed • If 20% is typical runup, small negative event returns from announcement of antitakeover measures would have little power to deter takeovers ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 45

46. State Laws • Background • By 1982, 37 states passed first generation antitakeover laws • First generation laws ruled to be preempted by 1968 Williams Act in Edgar v. MITE (1982) • In 1987, Supreme Court reversed in Dynamic v. CTS; ruled that state antitakeover laws were enforceable as long as they did not prevent compliance with Williams Act • Many states passed new antitakeover statutes between 1987-1990 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 46

47. Janjigian and Trahan (1996) • Studied factors that influenced firms to opt out of protection under Pennsylvania Senate Bill 1310 introduced on 10/20/89 • 20 opt out firms: significant -9.50% return • 13 no-opt out firms: insignificant 9.15% • Accounting performance of both groups deteriorated substantially from 1989 to 1992 • Firms that opted out had significantly better net profit margin, net return on assets, and operating return on assets in 1992 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 47

48. Swartz (1996) • Event date was passage of Pennsylvania Antitakeover Law (Act 36 based on Senate Bill 1310) on 4/27/90 • Event returns (CARs) • Firms that opted out: • For window [-130,+60] = -5.24% (not significant) • For window [-60,+20] = 0.70% (not significant) • Firms that did not opt out: • For window [-130,+60] = -23.35% (significant) • For window [-60,+20] = -4.71% (significant) • Firms that opted out outperformed firms that did not ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 48

49. Heron and Lewellen (1998) • Reincorporations to establish stronger takeover defenses had significant negative returns • Reincorporations to limit director liability to attract better qualified directors had significant positive returns ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 49

50. Poison Pills • Background • Definition: Creation of securities carrying special rights exercisable by triggering event such as accumulation of specified percentage of target shares or announcement of tender offer • Make acquisition of control of target firm more costly ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 50