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Poison Pills

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Overview to Poison Pills

The “poison pill” is a relatively recent invention and addition to the arsenal of the company attempting to ward off an unwanted suitor or to force upward the price paid by a buyer who wished to force a hostile takeover of the company. The poison pill is a mechanical device that is designed to operate in response to the suitor acquiring a large percentage of the target firm. In this final section of Chapter 5, we will briefly review the function, formation, and mechanism of the poison pill and its value in business.

Form of the Pill

A poison pill takes the form of what is known as a “shareholders’ rights plan.” Essentially, what a firm does in adopting a poison pill is attach a specific dividend to each outstanding share of the company, allowing the shareholders the right to acquire large amounts of stock for little or no consideration should there ever be a hostile takeover bid. The pill functions in such a manner so that, if any bidder attempts to acquire a specific percentage of ownership in the firm, the “rights plan” – i.e., the pill - is triggered. As a result of triggering the pill, additional shares may be purchased currents shareholder for very low prices. The result is that the value of the shares purchased by the incoming bidder is heavily diluted, thereby frustrating the take over bid.

EXAMPLE: Management has gotten very worried. Recently, in the industry in which their corporation operates, there has been a great deal of hostile activity. Given this situation, management has decided to adopt a "shareholders’ rights plan" under which, if any hostile bidder acquires more than 15% of the firm’s outstanding shares, the plan will be triggered. The triggering (someone purchasing more than 15% of the outstanding shares) entitles shareholders to pay $1 per share shares of the company’s stock (instead of the $58 the shares are currently trading at) and is only available to shareholders who held shares prior to the adoption of the plan. Thus, the company has created a pill that would produce massive dilution of the value of the stock in the event of a hostile takeover attempt. Let's assume the company has 1,000,000 outstanding shares. If the corporate raider buys 150,000 shares at $58 apiece, she will pay $8.7 million. But that will allow other shareholders to purchase additional shares at $1 apiece. If they do, the 150,000 will now represent much less than 15% of the company, making much of the $8.7 investment wasted. 

The commentary above represents a very basic outline of a standard poison pill. What is important to keep in mind, however, is that the nature of the pill is such that it can be adopted by a company, in virtually all cases, without shareholder consent. The board simply adopts a resolution passing the “rights plan” and shareholders are given the plan whether they want it or not. See 8 Del. C. § 157. Furthermore, the decision by the board of directors to adopt a poison pill is generally protected by the business judgment rule, and thus is insulated, to some degree, from court review. See Moran v. Household International, Inc., 500 A.2d 1346 (Del. Sup. Ct 1985)

Ultimately, it is unclear exactly how a pill would perform if triggered, as no firm has ever had a poison pill triggered. Triggering the poison pill would cause so much uncertainly and risk for the acquirer that acquirers typically would rather negotiate with the board or walk away than face the risk of triggering the provision.

Function of the Pill

Triggering a poison pill could do damage to a firm by diluting its shares' values. The question then, is why would a company intentionally hurt itself?

The answer is that the poison pill is not about hurting the company, but rather, it is designed to deter any potential buyer from acquiring too large a share in the firm without management’s consent. Ostensibly, the pill a represents a barrier in ownership that a buyer cannot cross. As such, no buyer will be able to acquire outright ownership of a firm without first coming to management (or in some cases, the court) and sitting down to negotiate any potential takeover. 

Effectively, the role of a poison pill is as a first line of defense for a company to ward off hostile bidders. If a bidder would like to purchase a company that has a poison pill provision in effect, the bidder will typically buy shares of the company up to a few shares below the pill’s trigger point. At that time, the buyer will then be forced to work with management to attempt to get the pill (i.e., the rights plan) rescinded. Once the buyer is at the negotiating table, he must ask that management sponsor a resolution whereby the pill is “redeemed” by shareholders and removed from each share. If the board agrees and the pill/rights plan is rescinded, then the buyer may go ahead and complete the transaction. However, if the board is not consulted or does not like the terms of the offer made by the buyer, then management may leave the pill in place, and simply wait for a better offer or for another solution.

EXAMPLE: Acquisitive Inc. has been quietly buying up a large percentage interest in Uknow Co. However, Acquisitive’s managers are aware that Uknow has a poison pill in place. As such, they ask Uknow’s board for a meeting. At the meeting, Acquisitive discloses their intention of taking control over the firm. The Board responds that it will not adopt a resolution for removing the pill until Acquisitive doubles the current value of its offer.

Action and Reaction

As the poison pill is such a powerful tool, it has naturally created opinions as to its legal and ethical viability. The "pill" has no shortage of supporters and detractors.

Of course, acquisitive companies hate poison pills. They view such a device as a detriment to the free market system and as creating an environment whereby management can simply tie-up the free transfer of assets indefinitely. Such a situation, say some buyers, is simply not acceptable and should be outlawed.

The market in general has distaste for poison pills as well. Much research has been conducted that indicates that when a company, already in operation, adopts a poison pill, it is not uncommon to see a decrease in the value of the firm. Such a decrease in price is attributed to the fact that investors view the adoption of the poison pill as management protecting its own interests. In other words, the market, like buyers, prefers the free   transferability of company assets to ensure that they are placed in the hands of the most capable individuals. The adoption of a poison pill suggests to the market that management is intent on resisting any such change and that management values their jobs and their careers over the shareholders’ interests.

Courts also have mixed opinions as to the legality of poison pills. Some courts have found poison pills to be per se illegal. See Amalgamated Sugar Co. v. NL Industries, 644 F. Supp. 1229 (S.D.N.Y. 1986). While most courts have traditionally allowed the pills to exist, they are sometimes skeptical of managements’ uses of the pills. Generally, when courts find that management has refused to eliminate the pill simply for the purpose of driving up the price paid to shareholders (as a negotiating tactic), courts support the use of pills. However, in situations where boards have staunchly refused to eliminate a pill even in the face of a reasonable bidder with a valuable offer, courts can get angry at the management team that is clearly placing its own interests above those of the shareholders. See Revlon, Inc. v. MacAndrews & Forbes Hodlings, Inc., 506 A.2d 173 (Del. Sup. Ct. 1986).

EXAMPLE: Recently, Going Along Inc. adopted a poison pill because of the volatility of the securities markets and the fact that management has just instituted a major overhaul of the firm. Immediately after the adoption of the pill, the value of Going Along’s securities declined in the markets by about 1%. Not long after, Going Along became the target of a hostile acquisition and the board refused to redeem the pill until the acquiring company raised its bid by 50%. The acquirer was angered by this move and filed suit in court. The judge, upon evaluating the situation, decided that a 50% increase in the offering price was not so high as to be unreasonable and it thereby allowed Going Along’s board to retain the pill.

Going too Far – The Dead Hand Poison Pill

One version of the poison pill (as there are several variations) that the legislatures and courts have shown a willingness to disallow are “dead hand poison pills.” Many states and state courts have outlawed these devices. See, e.g., Bank of New York Co. v. Irving Bank Corp, 528 N.Y.S.2d 482 (N.Y. Sup. Ct. 1988).

A dead hand poison pill is a poison pill that includes a provision that provides that those board members who adopted the pill are the only individuals who are subsequently allowed to remove it. This, if allowed, would enable a board of directors to tie up the company well beyond the time that the current members of the board have left office. Thus, even if all members of the board that adopted the pill are subsequently voted out of office, those individuals may still control the redemption or continuation of the pill.

Any such pill has the effect of tying the hands of the corporation to an extent that is untenable in a society that places such a premium on the free market. As such, it is not surprising that so many states have disallowed it.