The Corporate Takeover Market

Common Takeover Tactics,

Takeover Defenses, and Corporate
Governance
Treat a person as he is, and he will remain as he is.
Treat him as he could be,
and he will become what he should be.
—Jimmy Johnson
 Exhibit 1: Course Layout: Mergers,
Acquisitions, and Other
Restructuring Activities

Part I: M&A Part II: M&A Process Part III: M&A Part IV: Deal Part V: Alternative
Environment Valuation and Structuring and Business and
Modeling Financing Restructuring
Strategies

Ch. 1: Motivations for Ch. 4: Business and Ch. 7: Discounted Ch. 11: Payment and Ch. 15: Business
M&A Acquisition Plans Cash Flow Valuation Legal Considerations Alliances

Ch. 2: Regulatory Ch. 5: Search through Ch. 8: Relative Ch. 12: Accounting & Ch. 16: Divestitures,
Considerations Closing Activities Valuation Tax Considerations Spin-Offs, Split-Offs,
Methodologies and Equity Carve-Outs

Ch. 3: Takeover Ch. 6: M&A Ch. 9: Financial Ch. 13: Financing the Ch. 17: Bankruptcy
Tactics, Defenses, and Postclosing Integration Modeling Basics Deal and Liquidation
Corporate Governance

Ch. 10: Private Ch. 14: Applying Ch. 18: Cross-Border

Company Valuation Financial Models to Transactions
Deal Structuring
Current Lecture Learning Objectives

Providing students with an understanding of

• Corporate governance and its role in protecting
stakeholders in the firm;
• Factors external and internal to the firm affecting
corporate governance;
• Common takeover tactics employed in the
market for corporate control and when and why
they are used; and
• Common takeover defenses employed by target
firms and when and why they are used.
Alternative Models of Corporate Control
• Market model applies when: • Control model applies when:
– Capital markets are liquid – Capital markets are illiquid
– Equity ownership is widely – Ownership is heavily
dispersed concentrated
– Board members are largely – Board members are largely
independent “insiders”
– Ownership & control are – Ownership & control
separate overlap
– Financial disclosure is high – Financial disclosure limited
– Shareholder focus more on – Shareholder focus more on
short-term gains long-term gains
• Prevalent In U.S. and U.K. • Prevalent in Europe, Asia, &
Latin America
 Factors Affecting Corporate Governance:
Market Model Perspective
External to Firm

Legislation:
1933-34 Securities Acts
Dodd-Frank Act of 2010
Sherman Anti-Trust Act

External to Firm Internal to Firm External to Firm

Board of Directors
Regulators: Management Market for Corporate
SEC Internal Controls Control:
Justice Department Incentive Systems Proxy Contests
FTC Corporate Culture & Hostile Takeovers
Values
Takeover Defenses
Bond Covenants
External to Firm

Institutional Activism:
Pension Funds (Calpers)
Mutual Funds
Hedge Funds
 Internal Factors: Board of Directors
and Management

• Board responsibilities include:

--Review management proposals/advise CEO
--Hire, fire, and set CEO compensation
--Oversee management, corporate strategy, and
financial reports to shareholders
• Good governance practices include:
--Separation of CEO and Chairman of the Board
--Boards dominated by independent members
--Independent members serving on the audit and
compensation committees
 Internal Factors: Controls &
Incentive Systems
• Dodd-Frank Act (2010):
-- Gives shareholders of public firms nonbinding right to
vote on executive compensation packages
--Public firms must have mechanism for recovering
compensation 3-yrs prior to earnings restatement

• Alternative ways to align management and shareholder

objectives
– Link stock option exercise prices to firm’s stock price
performance relative to the overall market
– Key managers should own a significant portion of the
firm’s outstanding shares
 Internal Factors: Corporate Culture
& Values
• Corporate culture refers to a common set of values,
traditions, and beliefs that influence management and
employee behavior within a firm.
• The desired culture for the new organization can be
promoted through
– Clear and consistent communication to all employees of
what is appropriate and what is not
– Senior management consistently displaying the desired
behaviors
– Reward systems that foster desired behaviors while
penalizing undesirable conduct
• Trust in a new organization is undermined when there is
ambiguity about the new organization’s culture/identity.
 External Factors: Legislation

• Federal and state securities laws

– Securities Acts of 1933 and 1934
– Williams Act (1968)
• Insider trading laws
• Anti-trust laws
– Sherman Act (1890)
– Clayton Act (1914)
– Hart-Scott-Rodino Act (1976)
• Dodd-Frank Act (2010)
 External Factors: Regulators

• Securities and Exchange Commission (SEC)

• Justice Department
• Federal Trade Commission (FTC)
• Public Company Accounting Oversight Board
(PCAOB)
• Financial Accounting Standards Board (FASB)
• Financial Stability Oversight Council (FSOC)
 External Factors:
Institutional Activism

• Pension funds, mutual funds, and insurance

companies
• Ability to discipline management often limited by
amount of stock can legally own in a single firm
• Investors with huge portfolios (e.g., TIAA-CREF,
California Employee Pension Fund) can exert
significant influence
• Recent trend has been for institutional investors
to simply withhold their votes
 External Factors: Market for
Corporate Control
• Changes in control can result from
hostile takeovers or proxy contests
• Management may resist takeover
bids to
– Increase the purchase price
(Shareholders’ Interests
Theory) or
– Ensure their longevity with the
firm (Management
Entrenchment Theory)
• Takeovers may
– Minimize “agency costs” and
– Transfer control to those who
can more efficiently manage
the acquired assets
 Discussion Questions

1.Do you believe corporate governance should be

narrowly defined to encompass shareholders
only or more broadly to incorporate all
stakeholders? Explain your answer.
2.Of the external factors impacting corporate
governance, which do you believe is likely to be
the most important? Be specific.
Market for Corporate Control: Alternative
Takeover1 Tactics
• Friendly deals (Target board
supports bid)
• Hostile deals (Target board
contests bid). Rare due to
– Target board flexibility in
setting up defenses
– Impact on bid premiums
– Impact on postclosing
integration
• The threat of hostile bids often
moves target boards toward
negotiated settlements.
1
A corporate takeover refers to a transfer of control from one investor group to another.
 Market for Corporate Control:
“Friendly” Takeover Tactics
• Potential acquirer obtains support from the target’s board and
management early in the takeover process before proceeding to a
negotiated settlement.
– The acquirer and target firms often enter into a standstill
agreement in which the bidder agrees not to make any further
investments for a stipulated period in exchange for a break-up
fee from the target firm.
• Such takeovers are desirable as they avoid an auction environment.
• If the bidder is rebuffed, the loss of surprise gives the target firm time
to mount additional takeover defenses.
• Rapid takeovers are less likely today due to FTC and SEC
pre-notification and disclosure requirements.1
1
The permitted reporting delay between first exceeding the 5% ownership stake threshold and the filing of a 13D
allowed Vornado Realty Trust to accumulate 27% of J. C. Penny’s outstanding shares before making their holdings
public.
 Market for Corporate Control:
Hostile Takeover Tactics
• Limiting the target’s
actions through a “bear
hug”
• Proxy contests in support
of a takeover
• Purchasing target stock
in the open market
• Circumventing the
target’s board through a
tender offer
• Litigation
• Using multiple tactics
concurrently
 Alcoa Aluminum Easily Overwhelms
Reynolds’ Takeover Defenses
Alcoa’s offer to Reynolds Metals consisted of $4.3 billion in cash plus the assumption of $1.5 billion
in Reynolds’ outstanding debt. Alcoa’s offer letter, which it made public, from its chief executive to
the Reynolds’ CEO indicated that it wanted to pursue a friendly deal but that it would pursue a
hostile bid if the two sides could not begin discussions within a week. Reynolds appeared to be
highly vulnerable because of its ongoing poor financial performance and because of its weak
takeover defenses.
Despite pressure from institutional shareholders, the Reynolds’ board rejected Alcoa’s bid as
inadequate. Alcoa’s response was to say that it would make a formal offer directly to the Reynolds’
shareholders and simultaneously solicit shareholder support for replacing the Reynolds’ board and
dismantling Reynolds’ takeover defenses. Reynolds capitulated within two weeks from receipt of the
initial solicitation and agreed to be acquired by Alcoa. The agreement contained a thirty-day window
during which Reynolds could entertain other bids. However, if Reynolds should choose to go with
another offer, it would have to pay Alcoa a $100 million break-up fee.

•What was the dollar value of the purchase price Alcoa offered to pay for Reynolds?
•Speculate as to why Alcoa wanted to pursue initially a friendly rather than hostile approach?
3. Describe the various takeover tactics Alcoa employed (or threatened) in its successful takeover of
Reynolds. Speculate as to why these tactics may have been employed (or threatened) by Alcoa?
4. Why did the Reynolds’ board reject the initial offer only to accept the bid two weeks later?
5. What is the purpose of the breakup fee?
 Market for Corporate Control:
Pre-Offer Takeover Defenses

• Poison pills to raise the cost of takeover1

• Shark repellants to strengthen the target board’s defenses
– Staggered or classified board elections
– Limiting conditions when directors can be removed
• Shark repellants to limit shareholder actions
– Limitations on calling special meetings
– Limiting consent solicitations
– Advance notice and super-majority provisions
• Other shark repellants
– Anti-greenmail and fair price provisions
– Super-voting stock, re-incorporation, and golden parachutes

1
Note that poison pills could also be classified as post-offer defenses as they may be issued by the board as dividends
without shareholder approval.
Poison Pill: Cash for Share Purchase
Target Price Share D S1 S2

P3
A B
P1 Target shareholder Profit/Share on
Poison Pill Conversion

P2 DD reflects relationship between

shares outstanding and price/share for
given level of expected earnings &
interest rates.

D
C D
Q1 Q2 Target Shares Outstanding
P1 = Pre-offer equilibrium price/target share
P2 = Poison pill conversion price/target share
P3 = Offer price/target share
Q1 = Pre-offer target shares outstanding
Q2 = Target shares outstanding following poison pill conversion
ABCD = Incremental acquirer cash outlay due to poison pill conversion
Poison Pills: Share for Share Exchange
Acquirer Shareholder Ownership Dilution Due to Poison Pill

New Company Shares Ownership Distribution in

Outstanding1 New Company (%)
Without Pill With Pill Without Pill With Pill
Target Firm Shareholders
Shares Outstanding 1,000,000 2,000,000 50 673
Total Shares Outstanding 1,000,000 2,000,000
Acquiring Firm Shareholders
Shares Outstanding 1,000,000 1,000,000
New Shares Issued 1,000,000 2,000,0002 50 33
Total Shares Outstanding4 2,000,000 3,000,000
1
Acquirer agrees to exchange one share of acquirer stock for each share of target stock.
2
Poison pill provisions enable each target shareholder to buy one share of target stock at a nominal
price for each share they own. Assume all target shareholders exercise their rights to do so.
3
2,000,000/3,000,000
4
Target shares are cancelled upon completion of transaction.
 Market for Corporate Control:
Post-Offer Takeover Defenses

• Greenmail
• Standstill agreement
• Pac-man defense
• White knights
• Employee stock ownership plans
• Recapitalization
• Share buy-back plans
• Corporate restructuring
• Litigation
• “Just say no”
 Discussion Questions

1. Discuss the advantages and disadvantages of

the friendly versus hostile approaches to
corporate takeovers. Be specific.
2. Do you believe that corporate takeover
defenses are more motivated by the target’s
managers attempting to entrench themselves
or to negotiate a higher price for their
shareholders? Be specific.
 Impact on Shareholder Value
• Friendly transactions realized abnormal returns to target
shareholders of about 25% during the 2000s
• Hostile transactions often result in even larger average
abnormal returns to target shareholders
• Acquirers’ shareholders earn average abnormal returns of 1%
to 1.5%; however, they may be negative for deals involving
large public firms and those using stock to pay for the deal
• Recent studies suggest
– Takeover defenses have small negative impact on abnormal
target shareholder returns
– Defenses put in place prior to an IPO may benefit target
shareholders
– Bondholders in firms with ineffective defenses (i.e., vulnerable
to takeover) may lose value
 Things to remember...
• Hostile takeover attempts and proxy contests affect
governance through the market for corporate control
• Although relatively rare, hostile takeover attempts tend to
benefit target shareholders substantially more than the
acquirer’s shareholders by putting the target into “play.”
Consequently, acquirers generally consider friendly
takeovers preferable.
• Anti-takeover measures share two things in common.
They are designed to
– Raise the overall cost of the takeover to the acquirer’s
shareholders and
– Increase the time required for the acquirer to
complete the transaction to give the target additional
time to develop an anti-takeover strategy.