Toe Hold Collaborations Beyond Insider Trading

In my article, Toe Hold Collaborations beyond Insider Trading, recently made available on SSRN (forthcoming in the NYU Journal of Law & Business) I analyze the novel practice of investors co-purchasing toeholds (“TH”) and show that this practice can include profit sharing arrangements that distort the parties’ incentives and may lead to inefficient outcomes. With the proliferation of wolf-packing, the incidence of TH collaborations is likely to increase as well.

The efficiency of the traditional TH acquisition is a matter of contention. Proponents of THs argue that the profits from the acquisition of the TH may help cover searching costs and costs associated with losing the target to a higher-value use bidder, and thus encourage the search for targets and support the market for corporate control. They further show that, generally, a traditional TH will not prevent an efficient acquisition of a target by a competing bidder who is a higher-value user because of the opportunity-cost of selling the TH to the higher-value user. Opponents of the traditional TH, on the other hand, argue that shareholder activism surpassed the optimal level and that the market will benefit from increased transparency if there is prompt disclosure of acquisitions of equity stakes. Therefore, opponents appealed to shorten the notification period and to lower the threshold of Rule 13d-3 of the Securities Exchange Act of 1934, which will impair investors’ ability to acquire a TH.

Collaboration introduces interesting possibilities for bidders to enter into agreements regarding the TH. Under the new TH collaboration agreements, the bidder co-purchases the TH with a collaborator. The collaboration may help the bidder with the cost of purchasing a TH and mitigate the risk associated with it. TH collaboration agreements can include sharing provisions and provide that the collaborator will not only purchase a large part of the TH but also agree to share in its profits from the TH with the bidder. While the collaboration may enable the bidder to effectively acquire a larger TH, the TH’s size is generally restricted by the same limitations that apply to the traditional TH, such as poison-pill triggers.

However, as the article shows numerically, TH collaborations add a unique layer of complexity to the TH debate. The TH collaboration agreement may include contingent profit-sharing provisions; such provisions may require the collaborator to share in its profits from the TH with the bidder but only if certain events happen and can depend on the outcome of the attempted acquisition. Generally, each party to the collaboration agreement may undertake to transfer part of its profit from the TH to the other party; while the triggering event for the transfer between the parties can be either the bidder or a competitor acquiring the target. The cumulative effect of such provisions may balance each other out. Alternatively, the cumulative effect of the profit sharing provisions may be biased towards one direction: that is, in the aggregate the bidder’s net gain from the provisions may depend on the outcome of the planned acquisition.

For example, the TH collaboration agreement can provide that the bidder will have to transfer a significant portion of its profit from the TH to the collaborator if it sells the TH to a competitor who wins the bidding war and acquires the target. Such a provision may offsets the opportunity-cost of selling the TH to the competitor, and may incentivize the bidder to continue bidding beyond its reservation price in order to avoid paying the collaborator. Thus, unlike a traditional TH, TH collaboration may result in a lower-value user winning the bidding contest and prevent the acquisition of the target by a competing bidder who is a higher-value user. Furthermore, ex-ante, once the collaboration agreement is made public, it may have a deterrence effect on potential bidders, including higher-value bidders, who will realize that the bidder has entered into an agreement that makes losing a bidding war prohibitively expensive, thus chilling competition in the market for corporate control. With no competition, the bidder is likely to acquire the target for a lower price.

On the other hand, with the aid of a collaboration agreement, the improved prospects of successfully acquiring the target without competition (and thus for a lower price) may encourage searches for poorly managed targets and for firms with potential synergies. Increase in the search level, however, may have negative effects such as encouraging management to adopt more anti-takeover mechanisms. Thus, with competing forces influencing the outcome, the total effect of TH collaboration agreements on the market is uncertain.

The following points summarize the potential effects of the TH, which I discuss and illustrate with numerical examples in the article:

• The TH may compensate the first bidder for searching costs in case a competitor buys the Target.
• The TH opportunity-cost makes a higher-valuing bidder the optimal winner for the first bidder.
• Strategic-bidding above the reservation-price aimed at increasing the price paid by the competing bidder for the TH may result in inefficient overbidding past the competitor’s reservation-value.
• TH collaboration agreements that have the effect of penalizing the bidder for losing to a competing bidder (“forward asymmetric collaboration agreements”) may motivate the first bidder to increase the offer price above its reservation-price and the reservation-price of the competitor, in order to win.
• Forward asymmetric collaboration agreements may credibly deter a competing bidder from entering the competition for the target, thus resulting in a lower price and potentially inefficient acquisition of the target.
• Reverse asymmetric collaboration agreements, TH collaboration agreements that have the effect of rewarding the bidder for losing to a competing bidder, may motivate the first bidder to offer less than its reservation-price, possibly below the reservation-price of the competitor, in order to lose the bidding war.
• Reverse asymmetric collaboration agreements may repel free-riders who will be confused by the signals received.

The complete article is available for download here.