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The role of the financial executive in deterring hostile takeovers.

The role of the financial executive in deterring hostile takeovers Hostile takeovers are not bad by definition, although management usually reacts as if they are. Assuming that the company's interests are served by repelling a takeover attempt, what planning must be done in advance and what can be achieved by different defensive strategies? Whether a hostile takeover attempt will be successful is greatly dependent on the defensive measures that have been implemented long before the tender offer is launched. There are a number of reasons why planning for hostile takeovers is especially important. In the first place, a tender offer typically expires in 20 business days. There is little time to start thinking about and implementing effective defensive strategies in 20 business days.

Second, the corporate law of Delaware and other states clearly favors defensive strategies that are implemented well in advance of a hostile takeover attempt. In the absence of a takeover attempt, courts generally apply the "business judgment rule," which is a presumption that in making decisions the directors of a corporation are acting on an informed basis, in good faith, and in the honest belief that the action taken is in the best interests of a corporation.

When a board of directors takes action designed to defeat or obstruct a specific takeover attempt, the question arises of whether the directors may be acting in their own self-interest, to entrench themselves in office, rather than in the best interests of the corporation and its shareholders. The courts place a higher burden of proof on the directors after a hostile takeover has been launched, requiring them to show that they had reasonable grounds for believing that a threat to corporate policy and effectiveness existed and requiring that the defensive measures be reasonable in relation to the threat posed.

The third reason why planning for hostile takeovers is important is that many effective defensive measures take substantial time and effort to put in place. For example, amendments to the articles of incorporation require a shareholders' meeting. Financing must be arranged for a corporate restructuring.

The creation of a special team to deal with possible takeover attempts is well advised. The team should include the CEO, the CFO, general counsel, and other key executives, as well as outside legal counsel, an investment banking firm, and probably a shareholder relations firm. It is also desirable to keep the board of directors familiar with the planning undertaken by the special team and its recommendations.

The CFO is in an excellent position to evaluate the vulnerability of the company as a target. Is the company's stock trading at or below book value? Does the company have a low price/earnings ratio? Is the company's debt/equity ratio low? Does the company have undervalued assets or significant assets that could be readily sold? Is the company's stock selling at a low multiple of its cash flow? Is the break-up value of the company significantly above the market price of its common stock? If enough of these questions are answered with "yes," the chances are very good that your company is popping up on the computer screens of acquisition-minded companies and corporate raiders.

As part of the analysis of the company's vulnerability, it would be a useful exercise for the CFO to go through the full process of preparing a plan for the leveraged buyout of the company: How much equity would be needed to do a leveraged buyout? How much additional debt could the company tolerate? What assets could be quickly sold to pay down the debt? This is precisely the exercise that a raider goes through in determining whether to bid for a company. When the CFO and his staff force themselves to go through the same process that a raider would, they will develop a much better idea of their vulnerability and the possible means of reducing it.

An investment banking firm will be able to provide useful assistance in this analysis. Among other things, its bankers will know what comparable companies have sold for and what divisions or significant assets of the company can be sold for a substantial profit. Their input will be valuable in determining the degree of vulnerability and the imminence of any threat.

There are a number of other areas that the CFO's planning should cover. These include an analysis of existing loan agreements, indentures, stock option plans, employment agreements, and other material agreements. There should also be a study of the feasibility of various extraordinary transactions, such as a corporate restructuring or partial or complete liquidation. The evaluation should include the capability to assemble large financing from banks and/or investment banking firms in the event that a "war chest" is needed.

Arming your company Once the CFO and the other members of the special team have a good grasp of the company's vulnerabilities, they should undertake a careful review of the defensive measures already in place and determine whether additional measures are appropriate. While a number of these defensive measures are primarily legal strategies and others may not be appropriate in the absence of a serious threat, the CFO should understand how each works and how they interrelate so that he is in a better position to make recommendations within his area of expertise. It will also facilitate his understanding of any weaknesses in the defensive armament. Charter provisions--The charter of a corporation specifies the basic principles for corporate governance and can be changed only by action of the shareholders. The articles of incorporation of most major companies now contain a variety of anti-takeover provisions, such as requiring that the terms of the board of directors be staggered or providing for a super-majority vote for major corporate transactions.

A relatively small number of corporations, including Control Data Corporation, Dow Jones & Co., Eli Lilly & Co., and McDonald's Corporation, have adopted charter amendments permitting a board of directors to consider nonmonetary factors in evaluating an acquisition proposal. The value of this type of charter provision in a broader and more comprehensive form may be underestimated. A number of court decisions recognize the right of the board of directors to consider a variety of factors in evaluating an offer, such as the inadequacy of the price offered, the nature and timing of the offer, questions of illegality, the risk of nonconsummation of the offer, the offeror's reputation as a raider, and the impact of the offer on constituencies other than shareholders (i.e., creditors, customers, employees, and the community in general). Courts have also stated that a board of directors has the right to foster the future intact existence of a company and to oppose acquisition proposals that would result in the dismemberment or liquidation of a corporation or result in the company having questionable financial viability.

There are a number of advantages to adopting a charter provision that broadly specifies the criteria to be considered in evaluating an acquisition proposal. In the first place, it strengthens the legal position of the board of directors in the event that it chooses to reject an acquisition proposal on the basis of factors specified in the charter amendment. Second, a charter amendment, since it must be approved by the shareholders, constitutes the shareholders' acceptance of such criteria as a proper basis for evaluating the offer. Third, the criteria specified in a charter amendment constitutes a useful checklist of factors to be considered in evaluating any acquisition proposal.

It is worth noting that the corporate law of Delaware and most states permits the corporate charter to contain virtually any provision for the management of a company and for creating, defining, limiting, and regulating the powers of a company, its directors, and shareholders or any class of shareholders. Accordingly, it would be possible to devise any number of other charter amendments tailored to a specific situation that would have an anti-takeover effect. While any charter amendment would have to be approved by the requisite vote of the shareholders, most amendments to charters proposed by a company's board of directors have been approved by the shareholders. Shareholder rights plans--In 1985, the Delaware Supreme Court upheld the validity of a shareholder rights plan, or "poison pill," in the case of Moran vs. Household International, Inc. The typical shareholder rights plan involves a dividend distribution to common shareholders of rights to purchase stock of the company at a price substantially above the current market price. In the event of a merger with an acquiring company that beneficially owns a specified percentage of the company's stock, the rights "flip over" and become rights to purchase the acquiring company's stock at a 50-percent discount. In the event of an acquisition of a specified percentage of the company's stock by an acquiring person and the acquiring person engages in certain self-dealing transactions, many rights plans also contain a "flip-in" feature, which permits the acquiring company's stock to be purchased under certain circumstances at a 50-percent discount. Most rights plans also contain provisions permitting the board of directors to redeem the rights upon payment of a nominal amount, such as five cents per right. The flip-over and flip-in provisions would have a significant adverse financial impact on a raider if they are triggered.

Shareholder rights plans have now been adopted in a variety of forms by over 500 companies. Such plans have frequently been effective in delaying a hostile acquirer, but, otherwise, the protection afforded by shareholder rights plans is often illusory. The Moran court pointed out that a rights plan is not absolute. The board of directors, when faced with a request to redeem the pill, is not able to arbitrarily reject an offer but will be held to the same fiduciary standards that any other board of directors would be held to in deciding to adopt a defensive mechanism.

While shareholder rights plans do have value to the extent that they encourage a bidder to negotiate with the company and they afford a company more time to consider other alternatives, they have had limited effectiveness in most situations where they have been put to the test. It is not generally known that, as of the end of 1987, 54 companies that had adopted shareholders rights plans have been acquired by unsolicited bidders or by white knights following unsolicited bids. In 1988, such companies as American Standard, Inc., Federated Department Stores, Inc., and J.P. Stevens & Co. suffered the same fate. The best advice is for a company to avoid being lulled into a false sense of security because it has adopted a shareholder rights plan. While it is beneficial to have such a plan, it would be a mistake not to put in place a variety of additional defensive measures. "Poison debt" and "poison preferred" securities--When a hostile acquisition is made, the acquiring party frequently has borrowed a substantial portion of the funds needed to make the acquisition. Consequently, the raider will need to repay those loans as rapidly as possible, generally using the assets and cash flow of the acquired company to make the repayments. A number of "poison debt" and "poison preferred" securities have emerged that are designed to discourage hostile takeovers. In the context of convertible debenture and convertible preferred issues, investors have obtained provisions that allow the holder to put back the convertible security to the company at par or at a premium in the event of a change of control not approved by the continuing board of directors. Another provision requires the lowering of the conversion price if a hostile tender offer is consummated, thereby giving the holder of the security the benefit of the tender offer price if it is lower than the conversion price.

It is becoming increasingly common for nonconvertible bond instruments and debt instruments sold in private placements to be drafted to include "put" provisions, which permit the bondholder to tender the bonds to the company in the event of a change of control or other triggering event. Companies such as Masco Industries Inc., United Air Lines Inc., and USG Corporation have issued debt with "put" provisions. Other covenants inserted in bond indentures can have a significant anti-takeover effect. For example, indentures may contain covenants that restrict the ability of the company to issue additional debt, sell assets, dispose of a major subsidiary or division, merge or consolidate, make dividend or other payments, repurchase the company's stock, engage in transactions with affiliates, incur liens and encumbrances, and engage in sale and leaseback transactions. Bond indentures also may provide for significant assets to be pledged to the bond trustee, thereby inhibiting the ability of the acquirer to sell those assets.

Some bond indentures containing anti-takeover covenants have been written in such a way that the bonds are nonredeemable for a period of years. If a company is taken over, the hostile acquirer has a limited number of options. It can comply with the restrictive covenants, attempt to purchase the bonds, or seek a waiver of the covenants by offering substantial inducements to the bondholders to obtain their consent. If the company fails to comply with the covenants, the bond trustees could take steps to enforce the covenants and accelerate the payment of the bonds. Such actions would undoubtedly trigger cross-defaults in other debt instruments and place the company in financial peril.

It should be emphasized that any bank or investment banking firm that is evaluating whether to provide financing to a hostile acquirer always reviews a target company's preferred stock provisions, bond indentures, and loan agreements to determine if there are any serious impediments to the acquisition. The objective of the institutions financing a hostile takeover is to make loans that rank senior to the existing creditors of the company and that are, following the tender offer, secured by a prior security interest in the target company's own assets. It is also customary for the acquisition lenders to insist on a rapid repayment schedule--ahead of the existing creditors of the company. The repayment schedule is often accelerated to the extent that the company has excess cash flow and by the required sale of the target company's assets.

The CFO should take a major role in analyzing and reviewing all new debt and preferred securities of the company to determine if they can be written in a manner that provides anti-takeover protection and, at the same time, preserves the flexibility of the company to conduct its business, do its own acquisitions, and adapt to changing circumstances. This is one important area of anti-takeover planning that is usually overlooked.

To the extent that the CFO can significantly disrupt or jeopardize the expectations of the acquisition lenders with respect to the repayment of their loans to the hostile acquirer, it becomes more likely that the lenders will refuse to make loans to the acquiring party in the first place. If the acquiring party cannot obtain financing at an acceptable cost, it will be unable to proceed with its tender offer and acquisition. Corporate restructuring--The purpose of a corporate restructuring is to enhance shareholder value, or to close the gap between the break-up value of the company and its current market value, which may be severely depressed.

Restructuring can take a wide variety of forms. The repurchase of the common stock of the company, through a stock repurchase program or through a tender offer by the company for its own shares, is one way to increase the value of the common shares and to leverage up the company, particularly if borrowed funds are used to pay for the stock acquisition.

Other examples of restructuring include the spin-off, sale, or disposition of nonproductive or underperforming businesses or assets, the reduction of unnecessary costs and overhead, the formation of joint ventures to improve competitiveness, and the value enhancement of the company's stock by selling a minority stock ownership interest in a subsidiary to the public.

A more drastic form of restructuring is a recapitalization, in which each share of common stock of the company is exchanged for cash, a subordinated note, and "stub" equity in the recapitalized company. The result of a typical recapitalization is that the company becomes so highly leveraged that any hostile acquirer (or his bankers) is no longer interested in pursuing the acquisition. The hostile acquirer may succeed, however, in collecting a substantial profit by driving up the market price of the stock.

The CFO is in the best position to evaluate the merits of any restructuring plan and the risks created by implementing a more leveraged financial structure. Many companies have taken the view that they would rather take steps to leverage themselves before a hostile party forces them to do so. Usually, the extent of restructuring and leveraging is dependent upon the degree of coercion exerted by an unfriendly shareholder looking for a rapid rise in market price of the company's common stock.

From the raider's viewpoint In summary, it is very important that the CFO and his staff analyze the risks of a takeover attempt and think through the possibilities of a takeover from the raider's viewpoint. The CFO should make informed judgments as to what a raider is likely to do with the company after he acquires it. Having ascertained potential vulnerabilities and a raider's probable course of action, the CFO should analyze the existing defensive mechanisms to determine if they are "state of the art" and comprehensive.

Boilerplate takeover defenses have been surmounted frequently in the past and are not likely to deter experienced hostile acquirers. The use of one or two takeover defenses is not likely to be sufficient. The CFO should not be afraid to be innovative in advocating and implementing takeover defenses that are unique and tailored to the specific factual circumstances. He is particularly well qualified to assist in the development of "poison debt" and corporate restructuring defenses, which are now emerging as more potent and effective than many of the other measures. If the CFO and his staff do their job correctly, raiders will be deterred from coming after the company and effective defenses will be in place if they do.

PHOTO : Saddle Bronc Rider, Frank Wooten, 1981, oil on canvas

PHOTO : Sky cities, John Wenger, 1980, pastel on paper

PHOTO : A small silver replica of a stagecoach's treasure chest, given to Pillsbury ""Chips"

PHOTO : Hodgkins for his 25 years as an expressman without ever losing a shipment Richard G. Clemens, Esq. Sidley & Austin
COPYRIGHT 1989 Financial Executives International
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1989, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

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Author:Clemens, Richard G.
Publication:Financial Executive
Date:Jul 1, 1989
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