Takeover Risks in Troubled Times

The market’s recent collapse leaves many public companies and their longterm investors highly vulnerable:

• Depressed share values create all kinds of opportunities for those with available cash or a strong equity currency. The substantial loss of market capitalization across all sectors presents buying or consolidation opportunities for financial and strategic acquirors, and creates a real risk that many companies could be approached with transactions, either for cash or stock consideration or both, that do not reflect the inherent long-term value of the company.

• Poor stock performance gives substantial credence to activists pushing Boards to complete business combinations “arranged” by the activists, to sell divisions for less than inherent long-term value, or for Board representation disproportionate to their holdings.

• Although the older-vintage hedge funds are distracted by redemption and other concerns, the newcomers are as aggressive as their predecessors and are likely to be active this year.

In this environment, directors should undertake a thorough review and assessment of their company’s charter, by-laws, compensation program, and director and officer insurance coverage. A carefully crafted survey of options and available defense tools, including poison pills, carefully reviewed and understood by the Board with the assistance of legal and financial advisors prior to receipt of any unsolicited offers, will be easier to defend and should provide the Board with greater flexibility if defensive steps are later needed in response to hostile action.

Updating structural and procedural defenses should be considered, in particular:

• Advance notice bylaws for director nominations and shareholder proposals (whether or not they are to be included in the Company’s proxy statement under Rule 14a-8 under the Securities Exchange Act of 1934), that assure transparent and timely disclosure by proponents of all equity ownership positions, including derivatives, hedged positions, loans, and synthetic and temporary holding techniques, as well as relationships amongst investors and with director nominees.

• A thorough review of all other bylaw provisions, including those addressing shareholder rights to call special meetings, board authority to fix the number of directors, and removal of directors, among other provisions, is necessary to ensure corporate bylaws are state-of-the-art and updated to reflect current case law and statutory developments.

• Directors should be familiar with the rationale for and mechanics of the use of shareholder rights plans and features tailored to company and shareholder-base specifics, that would be available for prompt Board consideration should the need arise.

• The dramatic decline in market capitalization has reduced the “early warning” benefits of the Hart-Scott-Rodino minimum reporting threshold—just increased to $65.2 million, effective February 12, 2009. For companies with $1 billion-plus market capitalization, the reporting threshold slows the accumulation of more than 6.5 percent of the outstanding shares due to the required pre-clearance waiting period, thereby affording the target Board a window within which to implement a rights plan as a reasonable step in relation to a possible threat. For companies that have been driven down to small to midsize capitalizations, however, an acquiror could accumulate 15-20 percent of a target’s shares before an HSR filing is triggered. Thus, a hostile party could quietly, without notice or warning, accumulate a substantial block in the 10 days leading up to a Schedule 13D filing obligation, leaving no meaningful opportunity to implement a pill.

• These mid to small capitalization companies may wish to consider adopting a rights plan now, with a duration of less than one year to avoid adverse consequences with Risk Metrics and other advisory firms, to provide protection against such accumulations during these severe market disruptions. During 2008, for example, the number of rights plans adopted increased by nearly 50 percent, with the vast majority being implemented by companies with market capitalizations of less than $500 million.

• Director indemnification agreements have become critical in light of recent case law denying advancement of defense expenses to former directors due to bylaw changes. While charter and bylaw provisions can be carefully drafted to protect current and former directors, the redundancy of a contractual indemnification right is prudent supplemental protection from personal monetary liability for Board actions taken in good faith. These types of agreements should be coupled with careful review, and updating where necessary, of D&O issuance coverage, including Side A coverage to mitigate enterprise bankruptcy risk.

• For companies that have, or are building in the current environment, substantial deferred tax assets such as net operating losses and built-in losses, many Boards are considering mechanisms to protect against share accumulations by greater than 5 percent shareholders, who might cause an “ownership change” under Section 382 of the Internal Revenue Code that would restrict the availability of such assets for use against future income. Such alternatives should be reviewed with care, including the possibility of a so-called “NOL pill” being triggered and itself potentially causing an “ownership change” as rights are exercised.

In addition to the more formal legal steps above, Boards will be in a much better position to consider and adopt appropriate measures against unsolicited takeover proposals by undertaking the following:

• The Board should stay fully and currently informed as to the company’s strategic planning process and goals and have management present and update regularly a longterm strategic plan that is cognizant of company externalities, including macro trends in applicable industry sectors and markets, as well as potential acquisition and divestiture opportunities.

• Financial advisors should present the Board now with valuation metrics reflective of these strategic plans and the longer-term value of the company. If a “lowball” offer is made for the company, pre-existing financial projections and associated third-party valuations will both support a strong record for a Board’s determination to reject such a proposal, as well as provide the basis for financial presentations to institutional and other investors when seeking support for the Board’s position.

• To keep the Board informed on how outsiders perceive the company’s inherent long-term value and its strategic opportunities, have financial and legal advisors keep the Board regularly and fully apprised on takeover and transactional activity affecting company peers, customers and suppliers.

• Have retained financial and legal advisors on-call and monitoring the markets for any signs of hostile activity or shareholder activism. Retain a proxy solicitation firm for regular updates on the investor base and trading activity.

• Board and management should stay abreast of recommended executive compensation practices and the latest SEC disclosure requirements. Perceived opaque compensation disclosure or philosophy could be an unwarranted and unwanted distraction in any proxy contest or battle for corporate control.

Low market prices by themselves risk disruption to building long-term value for shareholders. Activist activity, including press releases and public letters addressed to the Board or management could encourage “wolf pack” accumulations by bottom fishers and other potentially hostile parties at low cost their investors, thus putting companies in play or unduly exposed to proxy contests. In short, all public company boards should assess now what defenses they have, what they should put in place, and what best protects long-term investor interest given current market conditions.