“Hostile takeover” was a feared phrase for some of America’s public company CEO’s in the 1970’s and 1980’s. Facing a hostile takeover meant facing accusations of incompetence, mismanagement and loss of shareholder value. While such takeovers have declined in recent years, they still happen, and certain economic and corporate management factors may cause them soon to rebound to previous levels. Strong business cycles or great bull stock markets do not last forever, and at the end of these cycles, corporate raiders rise.
What is a Hostile Takeover?
A corporate hostile takeover is an unwelcomed acquisition offer made by one company to another company. The vast majority of acquisitions and mergers are made under “friendly” conditions in which the proposed transaction is negotiated by corporate boards of directors of the acquiring and target companies. Often, a friendly acquisition or merger involves companies that are direct competitors and know the businesses and operations of one another, and the acquiring firm follows a highly directed planning process leading to targeting a firm for acquisition. However, even the best planned attempted acquisitions may not succeed at the negotiating table, sometimes leading the acquirer to launch a hostile takeover.
In other cases, parties involved in a hostile takeover attempt subsequently to agree to a negotiated settlement, ending in a friendly acquisition even though it did not start that way. Still, hostile takeovers can and often do result in messy fights. For example, the hostile takeover of Men’s Warehouse by Joseph A. Bank involved a proxy fight, protracted negotiation and ultimately the initial acquirer ended up being acquired by the initial target company![1] Hostile takeovers are often the result of earlier failed attempts to negotiate friendly mergers. The friendly attempt at a merger becomes a hostile takeover when the acquiring corporation refuses to accept the rejection by the target. It is these types of mergers that lead to litigation as sparring shareholders fight for control of the target company.
While many companies may walk away after receiving a rejection from the target company’s board of directors, other corporate executive teams will continue to pursue the target even if it means an expensive legal fight. One key reason is the struggle often facing the acquirer: without controlling the target’s resources, the acquirer could be forced to liquidate or sell itself to another company. The company attempting the acquisition may pursue the target for either financial gain or long-term strategic business reasons. The expense and effort of a hostile takeover is often well worth the costs of waging the fight.
The Corporate Takeover Market
Hostile takeovers are initiated by individuals or groups such as unhappy corporate shareholders, corporate takeover opportunists looking to cheaply acquire struggling target companies, competitors or even the disgruntled managers of the target company. Hostile takeovers are not always initiated by existing corporations to eliminate competition. For example, in some cases, the “company” behind the hostile takeover may be a newly formed corporation organized for the singular purpose of acquiring another company via a hostile takeover. Such newly formed entities may be partnerships of major shareholders or new investors and experienced outside managers who believe that they could better manage the target company. Another possibility is the launching of a hostile takeover attempt by former top executives of the target firm who believe that they could improve overall performance of the target company. When it comes to the actors behind hostile takeovers, one size does not fit all, as the parties involved come with different objectives, motivations and priorities in pursuing a hostile takeover.
Hostile takeover experts are often referred to as “artists” because seeing the opportunity is an art as much as a science. One must have the ability to see beyond low performance numbers to understand the reasons behind poorly managed public companies. Often, underperforming companies are products of weak governance by boards of directors. Studies show that independent directors improve corporate performance due to their objectivity and outside experience.[2] Under the corporate laws of most states, board members and officers must satisfy their fiduciary duties of care, good faith and loyalty to the corporation and its shareholders. At a minimum, directors must have a general understanding of their corporation’s business.[3] However, directors are given broad leeway in making business decisions under the judicial doctrine of the Business Judgment Rule.[4] Thus, poor management of companies does happen and no remedies short of a takeover may be easily available.
A leading outside factor is a falling stock market caused by a weak economy. Even a great management team may not be able to prevent a decline in a company’s stock price in a weak economic environment. When stock prices decrease, hostile takeover activity increases. Once strong, these companies become “cheap” targets for the takeover artists. Board of Directors’ failure to provide oversight of management is another important reason companies may face hostile takeovers, as weak supervision can cause corporate scandals robbing shareholders of their wealth. The late 1990’s and early 2000s corporate scandals, such as those of Enron and WorldCom, spurred Congress to adopt the Sarbanes Oxley Act of 2002.[5] Bad board practices included failure to remove low performing CEOs, overlooking managements’ attempts to protect their incumbency through ratification of management-protective bylaws, over compensating low-performing management and, as in the cases of Enron and WorldCom, overlooking malfeasance by top executives.
Corporate governance experts point to two models for governing corporations. The control model of corporate governance is most effective when:
- Capital (stock or equity) markets are illiquid;
- Ownership of the company is concentrated in a few major shareholders;
- The corporate board members are primarily “insiders” such as executives and investors holding large positions in the company’s stock;
- Financial disclosure is limited by laws or corporate policies;
- Owners are the key managers of the corporation; and/or
- Shareholders and managers are more focused on long-term gains.
The second governance model, the market model of corporate governance, is more likely to be found where the:
- Capital markets are highly liquid;
- Equity ownership is widely dispersed;
- Board members are mostly independent;
- Ownership and control are separate;
- Financial disclosure is required by laws and regulators;
- Shareholders are more focused on short-term gains.
The United States is a market model country where shareholders sell shares to punish poor or inefficient management. This is especially true where institutional investors maintain large holdings, as is true in many public companies. Share prices come under the magnifying glass at the end of every quarter and falling short of investors’ expectations of profits and revenue puts pressure on managements of these companies to focus on short-term gains. Furthermore, the US capital markets are highly liquid and transparent due to the oversight of the SEC and other governmental regulators. Thus, the assumption has arisen that low stock price may be indicative of poor management, inviting potential takeover attempts.
The Strategies and Tactics of Hostile Takeovers
A friendly takeover – whether in the form of an acquisition or merger – is certainly better from the standpoint of quickly closing the proposed transaction. It’s less costly in terms of legal fees, which may include protracted litigation. But a friendly takeover may not be possible as the expected price may be substantially higher than the acquirer is willing to pay. Or, perhaps the target company’s management is unwilling to give up control. Thus, a hostile takeover may be the only option available to an aggressive acquirer. There are several strategies that acquirers may employ to effect a hostile takeover.
“Bear Hug” Strategy
In its simplest form, a hostile takeover may be a letter to the CEO and the board of the target company with a proposal to pay a substantial premium over the current stock price. This strategy, known as the “bear hug,” is a tactic aimed at undermining the board’s ability to negotiate better terms. It offers the target company’s management little time and room to negotiate, particularly when the proposed offer is set to expire within days. The board has a fiduciary duty to the shareholders to act quickly with either a recommendation to accept or reject the offer. A rejection could subject the board to liability when acceptance of an offer would be in the best interest of the shareholders.
Hostile Tender Offer
A hostile tender offer is different than a Bear Hug approach because the offer is made directly to the shareholders, circumventing the board of directors. This hostile takeover strategy is useful for several reasons. First, where the Bear Hug offer can be rejected by the board, the tender offer is a way to appeal to the shareholders directly. Second, acquiring a substantial number of shares gives the acquirer the leverage it needs to return to the table with management, pressuring them to accept the offer. Third, by acquiring a substantial number of shares via a tender offer, the acquirer preempts other potential buyers from attempting to buy the target company.
A tender offer almost always offers cash to the shareholders in order to close the transaction quickly. The acquirer typically must pay a substantial premium over the current market price to induce shareholders to sell in the numbers necessary to take over a company in this way. Tender offers are governed by the Williams Act of 1968.[6] The purpose of the Williams Act is to protect target company shareholders from fast moving hostile takeover attempts. Securities law[7] requires the following:
(1) Any party that acquires 5.0% or more of the voting stock of a public firm must file a Schedule 13 (D) with the SEC within 10 days of reaching that level of ownership;
(2) Full disclosure by the bidding party, including the identities and occupations of the bidders, sources of financing for the hostile tender offer, and the purpose of the acquisition;
(3) The tender offer must remain open for at least 20 days, and the acquiring company must accept all shares tendered during this period;
These provisions require tender offers to be more deliberate, open and subject to public scrutiny, making it easier for management to react. The Act also authorizes the target company to sue the bidding company for violation of any of the provisions of the Act.
Proxy Contest
Proxy contests may be initiated by acquirers without access to enormous amounts of capital. For example, they may be initiated by shareholders who are unsatisfied with the board for refusing to remove underperforming executives. These activist shareholders may propose special votes to remove board members or appoint new boards. To implement the hostile takeover, the acquirer needs only to control or get the vote of more than 50% of the voting stock. They may send out proxy solicitations to obtain the right to vote on behalf of a majority of the shareholders. The takeover is successful if and when the acquirer gains the votes necessary to vote in its own slate of directors, who then control the company. Because it costs only the amount necessary to run the public relations campaign to convince the shareholders, it is the most cost-effective hostile takeover method. The SEC regulates proxy solicitations under Schedule 14(A) of the Securities Act of 1934.[8] All materials used as part of the solicitation must be submitted to the SEC 10 days prior to their distribution to the shareholders.
“Toehold” Stock Position
Sometimes, a potential acquirer may begin building a toehold position in the target company’s shares prior to any public announcement by buying up larger amounts of the company stock. Once this position exceeds 5% of a publicly-held company’s outstanding common stock, it must be reported to the SEC. A toehold strategy permits the acquisition up to 5% of the public company’s shares in secret, thus keeping the stock price from increasing due to speculation of a takeover.
Convert into “Friendly, Negotiated Merger”
Finally, a target’s management might waive the white flag and give in to accepting the proposed hostile tender offer by recommending acceptance to the shareholders involved in the proxy fight. However, the board’s fiduciary duty requires them to evaluate the offering price to determine if it is fair.
Defending Against Corporate Hostile Takeover
For a company under attack by an unwanted acquirer, management may adopt pre-offer and post-offer defenses to prevent the takeover or to make it costlier for the acquiring firm. First, let’s examine the pre-offer defenses.
The “Poison Pill” Defense
A popular defense to hostile takeovers is the use of poison pills that raise the costs of the acquisition. This is a pre-offer defense because, while the board may expect an unwanted offer to acquire the company, it can be enacted before there is an offer on the table. A poison pill is a shareholder rights provision that gives shareholders rights that would render the stock worthless or almost worthless if triggered. For example, the provision might allow shareholders to purchase unlimited additional shares in the company for $1 per share. If triggered, this would dilute the value of the shares dramatically.
The board first issues the rights to current shareholders, excluding the new purchases of the hostile acquirer. Second, the board presets a target minimum of number of shares by the hostile acquirer that will trigger the poison pill. For example, it might provide that if any person reaches a 10% ownership in the target company, shareholders will be able to buy additional shares below market price. While the poison pill is extremely effective, it also shows weakness and fear on the part of the directors. It also might annoy shareholders who may think the board is using underhanded tactics to prevent a merger that might be in the best interest of the shareholders. As a practical matter, a poison pill may be used as negotiating leverage. The board may agree to revoke the rights provision in exchange for more favorable terms in merger negotiations.
Staggered Boards or Limits on Removal of Directors
Another pre-offer defense involves amending corporate articles of by-laws to create staggered elections of the boards of directors. Instead, part of the board is elected each year. For example, each seat of the board might be up for election once every three years so that only 1/3 of the board is elected each year (like the US Senate). By creating staggered board members’ terms, the removal of directors to gain control will be more challenging and require a longer sustained effort for the hostile takeover group looking to get its slate of directors elected.
Changes to the Corporate By-Laws or Articles of Incorporation
A corporate board may also make amendments to repel attempted hostile takeovers, such as those that:
(1) Limit the ability of shareholders to call for special meetings to remove board members or to add new seats to the board;
(2) Require a supermajority vote, such as 60%, for shareholder votes involving certain events such as hostile takeover offer voting;
(3) Limit the ability of dissatisfied shareholders to expedite a proxy contest process for removing directors.
Reincorporation
Another pre-offer defense involves the reincorporation of the company in a state jurisdiction where the antitakeover laws are stronger.
Golden Parachutes
The board may adopt another pre-offer defense that will reward select managers and executives with significant payout compensation in the event of a hostile takeover. This raises the cost of the hostile acquisition.
“White Knight” Strategy
A final defense to an attempted hostile takeover involves finding a more favorable, alternative acquirer, popularly known as a white knight. It is a very complex defense that may require more time to complete than is available to the target company, which is why the white knight defense is rarely successful. A successful white knight defense requires identifying a potential, more attractive acquirer and then immediately conduct due diligence and acquisition terms negotiations simultaneously.
Conclusion
Today, hostile takeovers are rare due to stronger antitakeover laws adopted by many states. New federal laws also require more notice and fuller disclosures in proxy solicitations. However, hostile takeovers are not gone. The same management hubris that we saw in the past may launch future takeovers. Investors looking for extraordinary returns will continue to fund hostile takeovers. Finally, the global economy will witness cycles of growth and decline that will create new opportunities for hostile takeovers domestically and abroad. The global economy will create corporate losers and winners, opening doors to opportunists.
In our next module, we’ll look at “friendly” mergers and the problems- practical and regulatory- that can go along with even those mergers and acquisitions.
[1] Donald M. DePamphilis, Mergers, Acquisitions and Other Restructuring Activities, 88 (8th ed. 2015).
[2] Byrd, J. & Hickman, K. Do outside directors monitor managers? Evidence from tender offers, 32 J. Fin. Econ. 195 (1992).
[3] See Francis v. United Jersey Bank, 87 N.J.15 (1981); In re Caremark Int’l. Inc.Derivative Litigation, 698 A.2d 959 (Del. Ch. 1996)
[4] See UnocalCorp. v. Mesa Petroleum Co., 493 A.2946 (Del. 1985)
[5] 15 USCS §§7201 et seq.
[6] 15 U.S.C. sections 78a et seq.
[7] 17 CFR 240.13d-101 (Schedule 13D Information to be included in statements filed).
[8] 17 CFR240.14a-101 (Information required in proxy statements).