POISON PILLS ARE BITTER MOUTHFUL FOR SHAREHOLDERS.

Byline: GARY M. GALLES Local View

WHEN a firm's top management fails to maximize shareholder value, a takeover can let owners replace them with others offering better performance.

But managers may oppose such a restructuring to protect their jobs and they sometimes respond - at shareholder expense - by creating takeover defenses against being ousted.

Poison pills, ironically termed shareholder rights plans, are the hottest takeover defense. The courts have disallowed many other takeover defenses unless shareholders approve, but they have allowed poison pill adoptions without shareholder approval. Therefore, they are sometimes adopted against shareholders' interests, reflected both by owner opposition and negative stock price impacts when most unapproved poison pills are adopted.

A poison pill's intent is to make ``swallowing'' a firm through a hostile takeover suicidal - to make the attempt so expensive no one tries, and to make sure anyone who tries anyway will fail. Typically activated by one holder's ownership share exceeding a certain level or a takeover offer, they can impose practically insurmountable costs on a bidder in various ways, including revoking their voting rights, diluting their ownership by issuing additional stock to other owners, or forcing the assumption of additional unwanted financial obligations as a condition.

Shareholder rights plans, despite appearing to give existing owners additional rights in a takeover attempt (which may explain why courts have allowed them without stockholder approval), actually harm them by preventing hostile takeovers which would have paid them substantially more for their shares than their current market value. Taking away this valuable shareholder option - the premium to be received in a takeover - without their consent is not in owners' interests.

The courts have allowed these plans from a presumption that boards of directors act not to preserve the interests of current managers or their own positions but solely in the interests of shareholders, absent clear and explicit evidence to the contrary. But following this so-called business judgment rule to allow unapproved poison pills has been a mistake if they are really concerned with protecting owners' rights.

Allowing the management and board, who are delegated agents of stockholders, the right to preserve their jobs by halting takeovers that would oust them, but that owners would approve, effectively gives them the power to rewrite their terms of employment so that owners can no longer replace them with another management team. Shareholders would never, in their self-interest, voluntarily give such power away.

However, the 10th Circuit Court of Appeal, based in Denver, may have struck the first real blow against unapproved poison pills. Grocery distributor Fleming Cos. had been sued to force a poison pill plan to a stockholder vote. The court affirmed the first federal opinion on the issue, ruling that unless state law gives directors the right to create poison pills or a company's charter gives only directors such power, shareholders can overrule their board of directors and revoke them.

While the ruling is not binding outside that court's six-state jurisdiction, the same result could apply elsewhere. Twenty-four states have laws which give directors the right to create poison pills (which would not be changed by the ruling). But Oklahoma (where Fleming is incorporated), California and Delaware (where most Fortune 500 companies are incorporated), among others, do not. Shareholder activists are in the process of filing anti-poison pill resolutions in those states to expand this precedent (while threatened managements are lobbying for protection in those state capitals).

As economist Michael Jensen wrote in a symposium on takeovers, ``The easiest solution to the problem is for the court to deny protection under the business judgment rule to managerial decisions on control issues unless those decisions have been ratified by shareholder vote.'' It appears that the 10th Circuit Court may have started much of the United States on just that path, returning to shareholders an essential control over firms they own. That would be a great advance not just for owners, but workers and customers as well, because, except for poor management teams, we all have an interest in more effectively run firms.