From the February 2008 issue of Treasury & Risk magazine

Popping Pills

A surge in the number of hostile takeovers in the first half of last year sent companies scurrying to their lawyers, looking for ways to ward off would-be raiders. "We're having a lot of conversations with companies who want to know what they can do if they get an approach from someone and don't want to be taken over," says Soren Lindstrom, a partner in the corporate practice with law firm Baker Botts LLP in Dallas. "It's very much on people's minds."

The harsh reality: It's not as easy to mount a corporate defense as it used to be. Activist shareholders have been busy tearing down formerly commonplace tools of the trade, like poison pills and staggered boards,

which investors contend only protect management and don't deliver value. At the same time, stricter governance and oversight has made some companies gun-shy to find replacements.

It's not hard to understand why executive knickers are in a twist over hostile M&A. In the first six years of this decade, hostile takeovers were a rarity, with an average annual deal volume of around $50 billion globally. In 2006, however, acquirers must have had a shot of growth hormone--the market for corporate control suddenly exploded, with hostile deals worth just over $500 billion being completed--three times higher than the previous record in 1999. Until the markets got jittery last summer, 2007 was on track to break that record again.

Admittedly, the second half of last year and January 2008 have provided a less conducive environment. But while financing is less abundant, some hedge funds and private equity are still flush with cash. "Those deals are still happening," insists Baker Botts' Lindstrom. "This is a good time for companies to re-evaluate their corporate defenses." If you don't believe Lindstrom, just ask a company like CNET Networks Inc.: To its dismay, it discovered, in the last days of 2007 that two hedge funds had bought a 20% stake in the media outlet.

So which defenses would be acceptable to shareholders and governance watchdogs, and effective against raiders? There's not a lot to choose from. "Generally speaking, the broad mass of research shows that defenses tend to diminish shareholder value," says Robert Bruner, dean of the Darden School of Business at the University of Virginia, and an expert on takeover defense. "In the case of managements that feel they have a good thing going, takeover defenses can simply lead to entrenchment."

The two that always come to mind are the poison pill and staggered board. A hangover from the 1980s, the pill is used to dilute the would-be acquirer's holdings. By coupling it with a staggered election of the board, a company can prevent an acquirer from replacing enough of the board to remove the pill.

Shareholder animosity toward the combination is clear: According to data from financial information provider FactSet Research Systems Inc., the proportion of S&P 500 companies with a poison pill has plummeted from 60% five years ago to 30% today. Over the same period, the proportion of companies with staggered boards fell from 62% to 37%.

Surprisingly, some governance experts like Stephen Deane, a member of the global policy board with Rockville, Md.-based proxy research firm Institutional Shareholders Services Inc., argue that these defenses aren't inherently anti-shareholder: Companies have simply not used tools like this in a way that provides value. "What you need is a defense that gives the company the time and flexibility it needs to deal with a hostile bid and that will lead to the highest value if there is a sale. But you need to do it in a way that doesn't entrench management. In the last couple of years, a consensus has emerged on how to balance those things."

Pharmaceutical giant Pfizer Inc. was first to identify the way forward, says Deane. In 1997, the company decided to have its poison pill reviewed by an independent committee every three years. This policy prompted the company to allow its 10-year pill to expire in 2003 ahead of schedule. More recently, a different approach--known as the "pocket pill" or "fiduciary out"--has become more common. In this defense, a company has no pill in place, but instead has a board-level policy laying out the rules under which it might adopt a pill in the future. Typically, the board calls for a shareholder vote on the issue before the pill is adopted. If adoption is an urgent matter,, the board promises to hold a vote within 12 months on whether to keep the defense or let it expire.

Shareholders are also becoming increasingly sophisticated about differentiating among defense policies and demanding best practices, suggests ISS' Deane. He points to a number of votes from this year's proxy season to illustrate his point. In total, 15 companies faced shareholder votes on restricting use of pills. The average level of support was 40.9%--down from last year's 55.6%--but the average figure conceals both some very high levels of support and some very low levels, he says. At places like Home Depot, Verizon, and Halliburton, shareholder proposals called for the companies to give shareholders a voice any time a poison pill is being contemplated. Shareholders seemed to feel the proposals were unnecessary since each had a "fiduciary out" policy in place and the idea attracted minimal support, says Deane.

In contrast, shareholders overwhelmingly voted in favor of a proposal to limit management's ability to use poison pills at packaging manufacturer MeadWestvaco and computer maker Hewlett-Packard. At MeadWestvaco, the company had a poison pill in place, but in May 79% of shareholders voted for a policy that would seriously restrict its use. In response, MeadWestvaco removed the pill. Hewlett-Packard had no requirement that shareholders vote on any future adoption of a pill, and 73% supported a proposal calling for them to get that vote. At Disney, where there was no pill or policy, 53% of shareholders told the company to create a policy that required shareholder approval on pills.

"What we learned during the last proxy season is that although average levels of support for these proposals have fallen, shareholders still hold management's feet to the fire if they think the provisions are inadequate. On the other hand, if a company has moved to adopt best practices, proposals calling on them to go further will have limited support," Deane says.


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