The Wrong Prescription? Revisiting the Justification for Poison Pills

One of the fundamental tenets of market capitalism is the freedom of willing buyers and willing sellers to transact business. Ironically, this basic rule does not apply in the world of corporate mergers and acquisitions. Because of so-called “poison pills,” corporate mergers and acquisitions effectively require the support of the target company’s board of directors. Based on massive value losses from withdrawn tender offers a result of poison pills in the last few years, we suggest that it is time to revisit the broad judicial deference that has allowed directors to use poison pills to stand between bidders and stockholders indefinitely.

Poison pills emerged in the 1980s as a solution to corporate raiders use of “two-tiered” tender offers to coerce shareholders into tendering their shares for unfair prices. In Moran v. Household Int’l Inc., the Delaware Supreme Court upheld directors’ power to use this powerful defensive device, but with conditions. The Court seemingly tied its validation of the poison pill on two points: (1) a board’s decision to keep a pill in place is always subject to fiduciary duties (and therefore open to judicial review) and (2) if shareholders do not like how a board is using the pill, the shareholders preserve their ability to remove the directors from their jobs by running a proxy fight.

The validation of the poison pill in Moran coincided (and arguably caused) the decline of the coercive hostile takeover bids that marked the 1980s. Once poison pills were held to be lawful, however, boards used these devices to prevent shareholders from accepting all-cash for all-shares tender offers. In City Capital Associates v. Interco, the Delaware Court of Chancery upheld a board’s power to employ the pill to give itself time to develop an alternative transaction or provide previously undisclosed information to stockholders, presumably to persuade against accepting the tender offer. However, the Court held that once those purposes were achieved, the stockholders should have the right to decide for themselves, whether to accept a noon-coercive offer. The Court recognized that corporate directors – even those acting in subjective good faith – could seriously harm shareholder interests by using a pill to preclude a legitimate alternative to the board’s preferred course.

The balanced rule of Interco was short lived. Soon after Wachtell Lipton publicly advised clients to reincorporate outside of Delaware if Interco remained good law, the Delaware Supreme Court issued its landmark decision in Paramount Communications, Inc. v. Time, Inc. (“Time Warner”). The Time-Warner opinion suggested (but did not expressly rule) that directors can use a poison pill to reject indefinitely any bid, so long as the directors believe their long-term strategy will eventually generate greater wealth for stockholders. Thus, boards seemingly could “just say no” to a premium bid that a majority of a company’s shareholders prefer over staking their future on the current board’s managerial skill.

Why should a board of directors have this significant power? Does a pill create shareholder benefits that justify its use to override majority rule? The conventional wisdom often presented by corporate advisors is that besides protecting against coercive offers, poison pills cause bidders to pay higher prices to gain director support than the price shareholders would otherwise demand for their shares. In other words, in the absence of any pill, bidders can pay price “X,” which is the amount needed to get a majority of shareholders to sell their shares in a takeover bid. In theory, a pill allows boards to elicit a price higher than “X.” Whatever intuitive appeal this argument may have, we have not found empirical proof that poison pills actually create this positive effect. There is little reason to conclude that shareholders would accept materially lower premiums than boards are able to elicit, suggesting that any higher premium the poison pills elicit is marginal, at best. Also, poison pills may be no more effective in eliciting higher premiums than other less aggressive defenses. Conversely, by looking at the past three years alone, we find ample empirical evidence of poison pills contributing to massive destruction of shareholder and firm value. The chart below lists recent cases where a board rejected an unsolicited takeover bid and refused to redeem the company’s poison pill, and the bidder withdrew its bid rather than wait for whatever time it would take to replace the board through a proxy fight. The chart shows the percentage loss in stock price following withdrawal of the bid:

The above data illustrates that tens if not hundreds of billions of dollars of potential shareholder gains have been lost when bidders withdrew offers in the face of boards refusing to redeem their poison pills. Whether or not the target boards acted for improper entrenchment or out of a good faith belief in their own long term strategies is irrelevant to the shareholders who were denied the chance to tender shares and saw the stock price then plummet. Notably, these examples do not even address the billions of dollars of firm value that shareholders never knew they could have enjoyed from offers that were never made public because the target CEO deters a bid by making clear that the board will leave the pill in place and actively oppose any takeover efforts. This empirical evidence is particularly salient given that numerous scholars, such as Harvard Law School’s Lucian Bebchuk and Allen Ferrell, have shown that poison pills are among the anti-takeover provisions contributing most to managerial entrenchment and the reduction of firm valuation.

Given the above data, the arguments favoring the indefinite use of poison pills may make more sense in theory than in reality. Even assuming that pills allow boards to elicit marginally higher takeover premia in the normal course, it only takes a few boards who overplay their hand to wipe out any gains attributed to poison pills, and to turn the effect of pills into massive shareholder and societal losses. While we are not advocating the invalidation of poison pills in all instances, it may be appropriate for the Delaware courts to reexamine the broad discretion the law has given to directors to prevent transactions the shareholders may want to accept. Delaware courts may well return to the standard articulated in Interco, and require that in order to maintain a poison pill in the face of a significant premium offer, a board demonstrate a legitimate need for more time to adequately inform its shareholders about the company’s standalone prospects or to pursue a realistic and imminent alternative transaction.