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©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 1 - - - - - - - - Chapter 19 - - - - - - - - Takeover Defenses.

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Presentation on theme: "©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 1 - - - - - - - - Chapter 19 - - - - - - - - Takeover Defenses."— Presentation transcript:

1 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston Chapter Takeover Defenses

2 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 2 Introduction Not all mergers are welcome Arsenals of devices were developed to defend against unwelcome proposals during the 1980s

3 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 3 Possible motivations for takeover defenses –Target is resisting to get a better price –Management of target judges that company will perform better on its own –Management is seeking to entrench itself

4 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 4 Strategic Perspectives Management and board of company must continuously reassess competitive environment All forms of M&A activities may impact firm both as threats and opportunities –Main developments in industry –Opportunities for adding critical capabilities to participate in attractive growth areas

5 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 5 –Opportunities for rolling-up fragmented industries into stronger firms –Likelihood of firm to be rolled-up –Improving or deteriorating sales to capacity relationships in industry –Impact of consolidating mergers on capacity and cost structure –Enhanced capabilities of competitors as a result of their merger activity –Preemptive moves –Responses to takeover bids

6 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 6 Financial Defensive Measures Efficiency –One view: Highly efficient firms with favorable sales growth and high profitability margins provide defense against takeovers –Alternative view: Highly efficient firms become good takeover targets Bidder firm seeks to learn from efficiencies of target Target firm may be viewed as undervalued

7 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 7 Financial characteristics that make a firm vulnerable to takeover –Low stock price in relation to replacement cost of assets or potential earning power (low q-ratio) –Highly liquid balance sheet with large amounts of excess cash, valuable securities portfolio, and significant unused debt capacity –Good cash flows relative to current stock prices; low P/EPS ratios

8 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 8 –Subsidiaries or properties that could be sold off without significantly impairing cash flows –Relatively small stockholdings under control of incumbent management –Combinations of these factors can simultaneously make firm an attractive investment and facilitate its financing Firm's assets can be used as collateral for acquirer's borrowing Target's cash flows from operations and divestitures can be used to repay loans

9 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 9 Financial defenses –Increase debt — use borrowed funds to Repurchase equity Concentrate management's percentage holdings –Increase dividends –Loan covenants structured to force acceleration of repayment in event of takeover –Liquidate securities portfolio –Decrease excess cash Invest in positive net present value projects Return to shareholders in dividends or share repurchases

10 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 10 –Excess liquidity could be used to acquire other firms –Divest subsidiaries that can be eliminated without impairing cash flows; or spin-offs to avoid large cash inflows –Divest low-profit operations –Undervalued assets should be sold –Value increased by restructuring

11 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 11 Corporate Restructuring and Reorganization Restructuring and reorganization policies can be used positively or defensively Reorganization of assets –Asset acquisitions can be used to block takeovers Dilute ownership position of bidder by using equity in acquisitions Create antitrust problems for bidder

12 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 12 –"Selling off crown jewels" — firm may dispose of business segment in which bidder is most interested –Reorganizing financial claims Debt-for-equity exchanges — increase leverage to levels unacceptable to bidder Dual-class recapitalizations — increase voting powers of insider groups to levels that would enable them to block tender offers Leveraged recapitalizations — incur huge amounts of debt, using proceeds to pay large cash dividends and increase ownership position of insiders — "scorched earth" policy

13 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 13 Other strategies –Joint ventures could represent liaisons that potential bidders might prefer to avoid –ESOPs can be used to decrease voting shares available for tender –MBOs and LBOs Widely used as defense against outside tender offer Management can take firm private Managers may turn to LBO specialist because their stock ownership position may increase more than in an outside tender offer

14 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 14 –Target firm may look for international partner –Share repurchase can be used to defend against takeovers Increase ownership of insiders Low reservation price shareholders can be bought out — higher tender offer price needed for bid to succeed –Proxy contest — aim is to change control group and make performance improvements

15 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 15 Event studies –Restructuring improves firm's efficiency: favorable stock price reaction –Restructuring represents scorched-earth policy: negative stock price reaction

16 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 16 Duty of Directors Business judgment rule: Directors must demonstrate to the courts that the best interests of shareholders have been served

17 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 17 –Duty of directors to demonstrate sound business reasons to reject offer –Duty of directors to approve only a transaction that is fair to shareholders and is best transaction available –Duty of directors to fully explore independent competitive bids and obtain best offer Fairness opinion from an investment banking firm not sufficient

18 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 18 Greenmail Definition: Represents targeted repurchase of large block of stock from specified shareholders at premium to end hostile takeover threat

19 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 19 Two divergent views of greenmails –Greenmailers damage shareholders Large block investors are corporate "raiders" who expropriate corporate assets Raiders' voting power used to give themselves excessive compensation and perquisites Raiders receive substantial premium, "looting" corporate treasury

20 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 20 –Greenmail brings about improvements Large block investors involved in greenmail force improvements in corporate personnel or in corporate strategies and policies Large block investors have stronger incentives and superior skills for evaluating potential takeover targets Managers make greenmail payments to buy time to turn around the firm

21 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 21 Greenmail sometimes accompanied by standstill agreement –Voluntary contract in which blockholder agrees not to make further investments in target company during specified period of time –If no targeted repurchase is made, large blockholder agrees not to further increase ownership percentage of the firm

22 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 22 Wealth effects of greenmail –Announcement associated with negative return to shareholders of 2-3% (significant) –Other studies find positive abnormal returns, both in initial "foothold" period and in full "purchase-to-repurchase" period

23 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 23 –Greenmail and standstill agreement Negative returns — standstill agreement viewed as reducing probability of subsequent takeover 40% of firms experience subsequent control change within three years of greenmail even with standstill agreement –Positive market reaction if greenmail viewed as giving directors more time to work out better solution

24 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 24 Antigreenmail developments –Internal Revenue Code Section 5881 of 1986 — imposes 50% excise tax on recipient of greenmail payments –Antigreenmail charter amendments Require management to obtain approval of majority or supermajority of nonparticipating shareholders prior to targeted repurchase

25 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 25 Bhagat and Jefferis (1991) –Proxy statements proposing antitakeover amendments include one or more of (other) antitakeover amendment proposals –Sample of 52 NYSE-listed firms proposing antigreenmail amendments in firms offered one or more antitakeover amendments 29 cases, shareholders had to approve or reject antitakeover provisions and antigreenmail amendments jointly

26 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 26 Eckbo (1990) –Average market reaction to charter amendments prohibiting greenmail payments weakly negative –Subsample of firms with abnormal stock price runup over three months prior to mailing of proxy: Market reaction strongly positive Particularly true if runup associated with evidence or rumors of takeover activity Prohibition against greenmail removes barrier to takeovers with positive gains to shareholders

27 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 27 Strategic Actions Pac Man defense –Definition: Target firm counteroffers for bidder firm –Rarely used; usually designed not to be used –Effective if target much larger than bidder –Implies target finds combination desirable but seeks control of surviving entity –Target gives up using antitrust issues as defense

28 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 28 –Extremely costly Could involve devastating financial effects for both firms Large amount of debt used to purchase shares could cripple firms Under state law, should both firms buy substantial stakes in each other, each could be ruled as subsidiaries of each other Severity of defense may lead bidder to disbelieve target will employ such defense

29 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 29 White knight –Definition: Target company chooses another company with which it prefers to be combined –Alternative company preferred by target because: Greater compatibility New bidder may promise not to break up target or engage in massive restructuring

30 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 30 White squire –Definition: Modified form of white knight; white squire does not acquire control of target –Target sells block of its stock to third party it considers to be friendly –White squire may be required to vote its shares with target management –Often accompanied by standstill agreement Limits amount of additional target stock white squire can purchase for specified period of time Restricts sale of its target stock, usually giving right of first refusal to target

31 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 31 –White squire often receives in return Seat on target board Generous dividend and/or Discount on target shares –Preferred stock usually used in white squire transactions because it enables board to tailor characteristics of stock as described

32 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 32 Antitakeover Amendments Antitakeover amendments to firm's corporate charter generally impose new conditions on transfer of managerial control of firm — "shark repellents" 95% of proposed antitakeover amendments are ratified –Management introduces amendments that it feels are sure of success –Failure to pass might be taken as vote of no confidence

33 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 33 –Brickley, Lease, and Smith (1988) Institutional shareholders (banks, insurance companies) more likely to vote with management on antitakeover amendments –Have continuing business relationships with management –Pension funds, mutual funds, and college endowments more likely to be independent Blockholders participate more actively in voting than non-blockholders and may oppose proposals that appear to harm shareholders

34 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 34 –Jarrell and Poulsen (1987) Amendments having most negative effect on stock price are adopted by firms with lowest percentage of institutional shareholders and highest percentage of insider holdings Blockholders play monitoring role — institutional holders are well informed and vote in accordance with their economic interests

35 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 35 Supermajority amendments –Require shareholder approval by at least two-thirds vote (sometimes as much as 90%) for all transactions involving change in control –Involve "board-out" clause that gives board power to determine when and if supermajority provisions will be in effect

36 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 36 Fair-price amendments –Supermajority provisions with board-out clause and additional clause waiving supermajority requirement if fair price is paid by bidder for all purchased shares –Fair price — highest market price of target during a past specified period –Defend against two-tier tender offers –Least restrictive among class of supermajority amendments

37 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 37 Staggered or classified boards –Delay effective transfer of control following takeover –Management's rationale is to assure continuity of policy and experience –Examples: One-third of board stands for election to three- year term each year Reduce effectiveness of cumulative voting because greater shareholder vote is required to elect single director Directors removable only for cause Limit number of directors to prevent "packing"

38 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 38 Authorization of preferred stock –Board authorized to create new class of securities with special voting rights –Typically preferred stock issued to friendly parties in control contest (white squire) –Historically, used to provide board with financing flexibility –Could also include poison pill security to buy shares at a discount

39 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 39 Other antitakeover actions –Abolition of cumulative voting where it is not required by state law –Reincorporation in state with more protective antitakeover laws –Provisions with respect to scheduling of shareholder meetings and introduction of agenda items –Antigreenmail amendments that restrict company's freedom to buy back raider's shares at premium

40 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 40 –Lock-in amendments to make it difficult to void previously passed antitakeover amendments –Termination of overfunded pension plans — (Iqbal, Shetty, Haley, and Jayakumar, 1999) Firms can remove a significant source of cash flows to bidder firms by liquidating excess assets Stockholders favor termination only when firm faced takeover and managerial ownership was high — view takeover as threat to their claim on excess pension assets

41 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 41 –Boyle, Carter, and Stover (1998) Studied antitakeover provisions adopted by mutual savings and loan companies converting to stock ownership (SLAs) Strength of insider ownership position after conversion substitutes for strong antitakeover provisions –Low ownership firms associated with strong antitakeover protections –High ownership firms adopted less extraordinary antitakeover protections

42 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 42 Antitakeover amendments and corporate policy –Garvey and Hanka (1999) Effects of antitakeover statutes on firm leverage Firms protected by state antitakeover statutes substantially reduced debt ratios Results not influenced by size, industry, or profitability Weak evidence that protected managers undertook fewer major restructuring programs Firms eventually covered by antitakeover legislation used greater leverage in years preceding adoption of statutes

43 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 43 –Johnson and Rao (1997) Compared financial attributes (based on income, expenses, investment, and debt) before and after antitakeover amendment adoptions For full sample, firms exhibited no significant differences from industry means except for decline in net income to total assets ratio Fair price amendments –For non-fair price subsample, no significant differences from industry mean for any of financial attributes –For fair price subsample, results similar to those of full sample

44 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 44 Antitakeover amendments and shareholder returns –General predictions Positive returns –Announcement of antitakeover measure signals increased likelihood of takeover –DeAngelo and Rice (1983) — shark repellents may help shareholders respond in unison to takeover bids Negative returns –Antitakeover amendments reflect management entrenchment –Comment and Schwert (1995) — decline of less than 1% for most types of antitakeover measures

45 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 45 –Empirical results difficult to interpret because of number of influences operating concurrently Antitakeover amendment may have been adopted to help management obtain better deal Announcement of takeover may have contagion effects on industry –Positive runup in abnormal returns because of possibility of other takeovers –Announcement of antitakeover amendments with typical 1% decline in shareholder wealth should be netted against prior positive runup –1% decline would be viewed as reflection of reduced probability of takeover being completed –If 20% is typical runup, small negative event returns from announcement of antitakeover measures would have little power to deter takeovers

46 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 46 State Laws Background –By 1982, 37 states passed first generation antitakeover laws –First generation laws ruled to be preempted by 1968 Williams Act in Edgar v. MITE (1982) –In 1987, Supreme Court reversed in Dynamic v. CTS; ruled that state antitakeover laws were enforceable as long as they did not prevent compliance with Williams Act –Many states passed new antitakeover statutes between

47 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 47 Janjigian and Trahan (1996) –Studied factors that influenced firms to opt out of protection under Pennsylvania Senate Bill 1310 introduced on 10/20/89 –20 opt out firms: significant -9.50% return –13 no-opt out firms: insignificant 9.15% –Accounting performance of both groups deteriorated substantially from 1989 to 1992 –Firms that opted out had significantly better net profit margin, net return on assets, and operating return on assets in 1992

48 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 48 Swartz (1996) –Event date was passage of Pennsylvania Antitakeover Law (Act 36 based on Senate Bill 1310) on 4/27/90 –Event returns (CARs) Firms that opted out: –For window [-130,+60] = -5.24% (not significant) –For window [-60,+20] = 0.70% (not significant) Firms that did not opt out: –For window [-130,+60] = % (significant) –For window [-60,+20] = -4.71% (significant) –Firms that opted out outperformed firms that did not

49 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 49 Heron and Lewellen (1998) –Reincorporations to establish stronger takeover defenses had significant negative returns –Reincorporations to limit director liability to attract better qualified directors had significant positive returns

50 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 50 Poison Pills Background –Definition: Creation of securities carrying special rights exercisable by triggering event such as accumulation of specified percentage of target shares or announcement of tender offer –Make acquisition of control of target firm more costly

51 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 51 –Can be adopted by board without shareholders' approval –Poison pill adoptions often submitted to shareholders for ratification even though not required to do so –Use of poison pills requires justification to be upheld by courts — adoption of poison pills in the best interest of shareholders — "business judgment rule"

52 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 52 Types of plans –Flip-over plans Bargain purchase of bidder's shares at some trigger point Weakness: If rights are exercisable only when bidder obtains 100% of company stock, bidder may buy just over 50% to obtain control

53 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 53 –Flip-in plans Bargain purchase of target's shares at some trigger point More widely used than flip-over plans Ownership flip-in provision allows rights holder to purchase shares of target at a discount if acquirer exceeds a shareholding limit — rights of bidder who triggered pill become void Some plans waive flip-in provision if acquisition is cash tender offer for all outstanding shares (defend against two-tier offers)

54 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 54 Dead-hand provisions –Definition: Provision that grants board the ability to redeem or amend poison pill only by continuing directors — directors on the board prior to bidder's takeover attempt –Provision strengthens board's position Board's ability to redeem poison pill gives it flexibility in negotiating with bidders Hostile bidder can put considerable pressure on the board by making premium cash bid conditional on redemption of pill Provision prevents bidder from achieving control of target's board which then removes pill

55 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 55 –In some 3,000 poison pills nationwide, 200 contained dead-hand features –State laws New York court invalidated dead-hand provisions in Bank of New York v. Irving Bank 1988 case Other state courts upheld dead-hand provisions — Georgia approved dead-hand pill in Invacare v. Healthdyne Technologies 1997 case

56 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 56 –Some shareholders groups are critical of poison pills because they can be used to prevent takeovers Pension fund TIAA-CREF lobbied 35 companies to remove dead-hand pills Pressure from Counsel for Institutional Investors and International Brotherhood of Teamsters forced Phillip Morris to remove entire poison pill provisions

57 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 57 Effects of poison pills on shareholder returns –Malatesta and Walkling (1988) and Ryngaert (1988) — Early event studies found about -2% impact on wealth –Comment and Schwert (1995) Early studies covered only earlier one-fourth of adopted pills Sample of entire population of 1,577 poison pills adopted 1983 to 1991

58 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 58 Wealth effects of poison pill adoption are diverse: –May be viewed as signal for increased probability of takeover — positive influence on returns –May enable managers to obtain better price in negotiations with bidder — positive influence on returns –May deter takeovers — negative influence on returns representing expected present value of future takeover premiums lost

59 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 59 Results –Taking into account whether rumors of bid or actual bid made it likely that control premium was built into issuer's stock price at time of poison pill announcement: Wealth effect = negative 2% –Taking into account whether M&A news was announced at same time as pill: Wealth effect = positive 3 - 4% –Taking into account year of adoption In year-by-year results, only 1984 had negative wealth effects of 2.3% and 2.9% For later seven years, wealth effects positive by about 1% or less, significant only in 1988

60 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 60 –Systematic evidence indicates small deterrence effects from poison pills –Only earliest pills (before 1985) associated with large declines in shareholders' wealth –Takeover premiums higher when target firms are protected by state antitakeover laws or by poison pills –Target shareholders gained even after taking into account deals that were not completed because of poison pills –Decline in takeover activity in 1991 and 1992 resulted from general economic factors, not widespread use of antitakeover measures

61 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 61 Shareholder Activism Shareholders may seek to rescind antitakeover devices Bizjak and Marquette (1998) –Sample 190 shareholder initiated proposals during Sample of firms that received shareholder proposals to rescind poison pills Matched sample of firms that adopted poison pills but did not receive shareholder proposals to rescind them

62 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 62 –Wealth effects Cumulative abnormal returns for three-day event window –Proposal sample = -0.43% –Matched sample = 1.35% Different announcement dates and event return windows –Negative market reaction to initial shareholder proposal –Positive market reaction to pill restructuring –Shareholders become active when they are concerned about managerial actions that may impede market for corporate control

63 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 63 Poison Puts Definition: Poison puts or event risk covenants give bondholders right to put, at par or better, target bonds in event of change in control –Protect against risk of takeover-related deterioration of target bonds Especially when leverage increases are substantial Began to be included in bond covenants in 1986 –Place potentially large cash demands on new owner, raising costs of acquisition

64 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 64 Economic role and empirical studies –Entrenchment hypothesis Puts made firms less attractive as takeover targets Predicted effects of poison puts –Negative effect on shareholder returns –No effect on debt-holder returns –Bondholder protection hypothesis Puts protect bondholders from wealth transfers associated with debt-financed takeovers and leveraged recapitalizations

65 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 65 Predicted effects of poison puts –Impact on stock returns would be net of two opposite effects If takeovers motivated primarily by wealth transfer from bondholders to shareholders were deterred — negative influence on shareholder returns Debt with event risk covenants could be issued at interest cost lower than unprotected debt; if interest cost savings outweighed forgone wealth transfer — nonnegative stock price reaction to sale of protected debt –If puts and related covenants did not increase protection to existing debt, hypothesis predicts no effect on price of firm's outstanding debt

66 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 66 Empirical test: –Test for difference in yield spreads at offering date for samples of protected and unprotected bonds –Inclusion of event risk protection reduced required yields on protected bonds by basis points in two studies and no effect in a third Wealth transfers from bondholders in leveraged buyouts –No evidence of bondholder losses (Marais, Schipper, and Smith, 1989) –Small losses (Warga and Welch, 1993) –Losses depend on covenant protections — protected bonds did not experience losses while unprotected debt experienced significant losses

67 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 67 –Mutual interests hypothesis Both managers and bondholders seek to prevent hostile debt-financed takeovers –Managers seek to protect their control positions –Bondholders seek to avoid losses from deterioration in credit ratings Predicted effects of poison puts –Stock price reactions would be negative –Effects on price of existing debt would be positive –Wealth effects for debt and equity would be negatively correlated

68 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 68 Cook and Easterwood (1994) –Issuance of bonds with poison puts caused negative returns to shareholders and positive returns to outstanding bondholders –Control sample of straight bond issues without poison puts had no effect on stock prices — may be related to economic environment of study period (1988 and 1989) –Cross-sectional regression: Strong negative relation between returns for stocks versus returns for outstanding bonds for put sample but not for nonput sample –Results consistent with mutual interests hypothesis

69 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 69 Golden Parachutes (GPs) Background –Definition: Separation provisions of employment contract that compensate managers for loss of their jobs under change-of-control clause –Provision usually calls for lump-sum payment or payment over specified period at full or partial rates of normal compensation

70 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 70 –Extreme cases of GPs viewed as "rewards for failure" –Cost of GPs estimated to be less than 1% of total cost of takeover — not considered to be an effective takeover defense

71 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 71 Regulation –Deficit Reduction Act of 1984 Denies corporate tax deductions for "excess parachute payments" Executive has to pay additional 20% income tax on "excess parachute payments" –GPs have to be entered into at least one year prior to date of control change to be legally binding

72 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 72 –GPs are triggered either when manager is terminated by acquiring firm or when manager resigns voluntarily after change of control –Court can invalidate or grant preliminary injunctions against exercise of GPs especially when payment could be triggered by recipient

73 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 73 Rationale –Implicit contracts Managers' real contribution to firm cannot be evaluated exactly in current period Optimal contract between managers and shareholders will include deferred compensation Since detailing all future possibilities and contingent payments in written contract is costly, long-term deferred contract largely implicit

74 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 74 –Firm-specific investments by managers Managers not willing to invest in firm-specific skills and knowledge when likelihood of loss of job is high Managers may focus unduly on short term or even take unduly high risks if there is increased risk of losing job through takeover –Encourage managers to accept changes of control that bring shareholders gains — reduce agency problem and transaction costs from managerial resistance

75 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 75 –Berkovitch and Khanna (1991) model Tender offer –More desirable for target shareholders as more information is released in tender offers leading to competitive bidding for target –Excessive GP payment will tend to motivate managers to sell firm at too low a gain Mergers — by tying payment to synergy gains in case of mergers, firm avoids misuse of GPs –Other possible alternatives to GPs Stock options exercisable in event of change of control Increased stock ownership by management

76 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 76 Silver and tin parachutes –Silver parachutes — provide less generous severance payments to executives –Tin parachutes Extend relatively modest severance payments to wider coverage of managers including middle management, and in some cases, cover all salaried employees Number of employees to be covered –Jensen (1988) — contract should cover only those members of top-level management team involved in negotiating and implementing any transfer of control –Coffee (1988) — control-related severance contracts should be extended to middle management

77 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 77 Returns to shareholders and GPs –Hypotheses (Mogavero and Toyne, 1995) Alignment hypothesis –Prearranged severance agreements reduced conflicts of interest between managers and shareholders –GPs make executives more willing to support takeover offers beneficial to shareholders –Positive gains to shareholders Wealth transfer hypothesis –GPs reduce stock values by shifting gains from shareholders to managers –GPs reduce probability of takeover bids by increasing costs to bidders

78 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 78 –GPs reduce incentives for executives to manage firms efficiently –GPs may indicate level of influence of management over boards –Negative gains to shareholders Signaling hypothesis –Signal of likelihood of future takeover, which would be associated with positive gains to shareholders –Signal of increased management influence over boards, which would have negative implications

79 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 79 –Lambert and Larcker (LL) (1985) Period Adoption of GPs resulted in abnormal positive returns to shareholders = positive 3% Finding consistent with alignment hypothesis — cost of reducing conflicts of interest between management and shareholders low relative to potential gains from takeover premium Findings consistent with signaling hypothesis — from 1975 to 1982 relatively few firms adopted GPs, so that GPs could be taken as signals of likely takeover

80 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 80 –Born, Trahan, and Faria (1993) Period Sample firms that announced GPs while in process of being acquired –There should be no takeover signal effect –No significant abnormal stock returns Sample firms from 1979 through 1984 not in process of takeover when GPs adopted — positive stock returns Combined evidence consistent with takeover signaling hypothesis, but not with alignment hypothesis

81 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 81 –Hall and Anderson (1997) Sample of 52 firms that announced adoption of GPs during Adoptions were for new contracts and not amendments Firms did not experience pre-existing takeover bids for three years prior to GP Mean CAR –Window [-20,+20] = -1.21% (not significant) –Announcement day = 0.46% (not significant) –Window [-5,-2] = -1.19% (significant) –Other event windows were not significant –When three firms were excluded as possible outliers, for window [-5,0] = -1.29% (significant)

82 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 82 –Mogavero and Toyne (MT) (1995) Sample of 41 large firms with adoption dates from Full sample, CAR = -0.5% not significant Subsample of 18 firms from , CAR = +2.3% not significant Subsample of 23 firms from , CAR = -2.7% significant

83 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 83 Finding consistent with wealth transfer hypothesis Stock returns associated with GPs changed from positive for period of LL study to negative for in MT –Associated with initiation of legislative restraints on GPs that may have encouraged boards to adopt them to avoid further restrictions –Shareholders in later years may have perceived adoption of GPs as unfavorable signals of management's ability to control directors in their interest at expense of shareholders


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