The Corporate Takeover Market

Common Takeover Tactics, Takeover Defenses, and Corporate Governance

Treat a person as he is, and he will remain as he is. Treat him as he could be, and he will become what he should be.
Jimmy Johnson

Course Layout: M&A & Other Restructuring Activities

Part I: M&A Environment

Part II: M&A Process

Part III: M&A Valuation & Modeling

Part IV: Deal Structuring & Financing

Part V: Alternative Strategies

Motivations for M&A

Business & Acquisition Plans

Search through Closing Activities M&A Integration

Public Company Valuation

Payment & Legal Considerations

Accounting & Tax Considerations Financing Strategies

Business Alliances

Regulatory Considerations Takeover Tactics and Defenses

Private Company Valuation Financial Modeling Techniques

Divestitures, Spin-Offs & Carve-Outs Bankruptcy & Liquidation

Cross-Border Transactions

Current Lecture Learning Objectives

Providing students with an understanding of Corporate governance and its role in protecting stakeholders in the firm; Factors external and internal to the firm affecting corporate governance; Common takeover tactics employed in the market for corporate control and when and why they are used; and Common takeover defenses employed by target firms and when and why they are used.

Alternative Models of Corporate Control

Market model applies when: Capital markets are liquid Equity ownership is widely dispersed Board members are largely independent Ownership & control are separate Financial disclosure is high Shareholder focus more on short-term gains Prevalent In U.S. and U.K. Control model applies when: Capital markets are illiquid Ownership is heavily concentrated Board members are largely insiders Ownership & control overlap Financial disclosure limited Shareholder focus more on long-term gains Prevalent in Europe, Asia, & Latin America

Factors Affecting Corporate Governance: Market Model Perspective

External to Firm Legislation: 1933-34 Securities Acts Dodd-Frank Act of 2010 Sherman Anti-Trust Act External to Firm Regulators: SEC Justice Department FTC External to Firm Market for Corporate Control: Proxy Contests Hostile Takeovers

Internal to Firm Board of Directors Management Internal Controls Incentive Systems Takeover Defenses External to Firm Institutional Activism: Pension Funds (Calpers) Mutual Funds Hedge Funds

Internal Factors: Board of Directors and Management

Board responsibilities include: --Review management proposals/advise CEO --Hire, fire, and set CEO compensation --Oversee management, corporate strategy, and financial reports to shareholders Good governance practices include: --Separation of CEO and Chairman of the Board --Boards dominated by independent members --Independent members serving on the audit and compensation committees

Internal Factors: Controls & Incentive Systems

Dodd-Frank Act (2010): -- Gives shareholders of public firms nonbinding right to vote on executive compensation packages --Public firms must have mechanism for recovering compensation 3-yrs prior to earnings restatement

Alternative ways to align management and shareholder objectives Link stock option exercise prices to firms stock price performance relative to the overall market Key managers should own a significant portion of the firms outstanding shares

External Factors: Legislation

Federal and state securities laws Securities Acts of 1933 and 1934 Williams Act (1968) Insider trading laws Anti-trust laws Sherman Act (1890) Clayton Act (1914) Hart-Scott-Rodino Act (1976) Dodd-Frank Act (2010)

Dodd-Frank Act of 2010: Governance & Executive Compensation

Say on Pay: In a nonbinding vote, shareholders may vote on executive pay every 3 yrs. Say on Golden Parachutes (executive severance packages): Proxy statements seeking shareholder approval of M&As or sale of most of a firms assets must disclose pay agreements with target or acquirer executives Clawbacks: Public firms must disclose mechanisms for recovering incentive pay paid during 3-yrs prior to earnings restatements. Proxy Access: SEC has authority to require public firms to include nominees submitted by shareholders in proxy materials Broker Discretionary Voting: Stock exchanges must prohibit brokers from voting shares without direction from owners in election of directors and executive compensation

Dodd-Frank Act of 2010: Systemic Regulation and Emergency Powers

Financial Stability Oversight Council (FSOC): Monitors U.S. financial markets to identify banks and nonbank banks exhibiting systemic risk. New Fed Bank/Nonbank Supervisory Powers: Banks/nonbanks with total assets $50 billion must Submit plans for their rapid dissolution in event of failure Limit their credit exposure in any unaffiliated firm to 25% of its capital Conduct semiannual stress tests to determine capital adequacy Provide advance notice of intent to buy voting shares in financial firms Leverage Limitations: Fed may require banks with assets $50 billion to maintain debt-to-equity ratio of no more than 15 to 1. Size Limitations: No bank or nonbank can hold deposits > 10% of deposits nationwide; does not apply to mergers involving failing banks. FDIC Guaranty Powers: May guaranty liabilities of solvent banks if FSOC and Fed determine appropriate to do so. Orderly Liquidation Authority: FDIC may seize and liquidate banks threatening U.S. financial stability New Bank Capital Requirements: At discretion of regulators.

Dodd-Frank Act of 2010: Capital Markets

Office of Credit Ratings: Sets rules for transparency, conducts audits and makes it easier to sue rating agencies. Securitization: Issuers of asset-backed securities must retain an interest of at least 5% of any security sold to third parties. Hedge and Private Equity Fund Registration: Must register with SEC as investment advisors if assets $100 million; those with < $100 million subject to state regulation. Clearing and Trading of OTC Derivatives: Must be traded on formal exchanges to provide real time data reporting to market participants (e.g., CDS-lender insurance).

Dodd-Frank Act of 2010: Financial Institutions

Volcker Rule: Prohibits insured banks from buying and selling securities with their own money (i.e., proprietary trading) or sponsoring or investing in hedge funds or private equity funds; banks may do so if they have no control over funds. Does not apply to U.S. banks with foreign operations. Consumer Financial Protection Bureau: Writes rules governing financial institutions offering consumer financial products Federal Insurance Office: Monitors insurance industry and recommends which firms should be considered systemically important.

External Factors: Regulators

Securities and Exchange Commission Justice Department Federal Trade Commission Public Company Accounting Oversight Board Financial Accounting Standards Board Financial Stability Oversight Council

External Factors: Institutional Activism

Pension funds, mutual funds, and insurance companies Ability to discipline management often limited by amount of stock can legally own in a single firm Investors with huge portfolios (e.g., TIAA-CREF, California Employee Pension Fund) can exert significant influence Recent trend has been for institutional investors to simply withhold their votes

External Factors: Market for Corporate Control

Changes in control can result from hostile takeovers or proxy contests Management may resist takeover bids to Increase the purchase price (Shareholders Interests Theory) or Ensure their longevity with the firm (Management Entrenchment Theory) Takeovers may Minimize agency costs and Transfer control to those who can more efficiently manage the acquired assets

Discussion Questions
1.Do you believe corporate governance should be narrowly defined to encompass shareholders only or more broadly to incorporate all stakeholders? Explain your answer. 2.Of the external factors impacting corporate governance, which do you believe is likely to be the most important? Be specific.

Market for Corporate Control: Alternative Takeover1 Tactics

Friendly (Target board and management supports bid) Hostile (Target board and management contests bid)

1A

corporate takeover refers to a transfer of control from one investor group to another.

Market for Corporate Control: Friendly Takeover Tactics

Potential acquirer obtains support from the targets board and management early in the takeover process before proceeding to a negotiated settlement The acquirer and target firms often enter into a standstill agreement in which the bidder agrees not to make any further investments for a stipulated period in exchange for a break-up fee from the target firm. Such takeovers are desirable as they avoid an auction environment If the bidder is rebuffed, the loss of surprise gives the target firm time to mount additional takeover defenses Rapid takeovers are less likely today due to FTC and SEC prenotification and disclosure requirements1
1The

permitted reporting delay between first exceeding the 5% ownership stake threshold and the filing of a 13D allowed Vornado Realty Trust to accumulate 27% of J. C. Pennys outstanding shares before making their holdings public.

Market for Corporate Control: Hostile Takeover Tactics

Limiting the targets actions through a bear hug Proxy contests in support of a takeover Purchasing target stock in the open market Circumventing the targets board through a tender offer Litigation Using multiple tactics concurrently

Market for Corporate Control: Pre-Offer Takeover Defenses

Poison pills to raise the cost of takeover1 Shark repellants to strengthen the target boards defenses Staggered or classified board elections Limiting when can remove directors Shark repellants to limit shareholder actions Limitations on calling special meetings Limiting consent solicitations Advance notice and super-majority provisions Other shark repellants Anti-greenmail and fair price provisions Super-voting stock, re-incorporation, and golden parachutes
1Note

that poison pills could also be classified as post-bid defenses as they may be issued by the board as dividends without shareholder approval.

Poison Pill: Cash for Share Purchase

Target Price Share P3 A P1 P2 B
Target shareholder Profit/Share on Poison Pill Conversion

S1

S2

DD reflects relationship between shares outstanding and price/share for given level of expected earnings & interest rates.

D C Q1 D Q2 Target Shares Outstanding

P1 = Pre-offer equilibrium price/target share P2 = Poison pill conversion price/target share P3 = Offer price/target share Q1 = Pre-offer target shares outstanding Q2 = Target shares outstanding following poison pill conversion ABCD = Incremental acquirer cash outlay due to poison pill conversion

Poison Pills: Share for Share Exchange

Acquirer Shareholder Ownership Dilution Due to Poison Pill

New Company Shares Outstanding1

Without Pill Target Firm Shareholders Shares Outstanding Total Shares Outstanding Acquiring Firm Shareholders Shares Outstanding New Shares Issued Total Shares Outstanding4
1Acquirer

Ownership Distribution in New Company (%)

Without Pill 50 With Pill 673

With Pill 2,000,000 2,000,000 1,000,000 2,000,0002 3,000,000

1,000,000 1,000,000 1,000,000 1,000,000 2,000,000

50

33

agrees to exchange one share of acquirer for each share of target stock. 2Poison pill provisions enable each target shareholder to buy one share of target stock at a nominal price for each share they own. Assume all target shareholders exercise their rights to do so. 32,000,000/3,000,000 4Target shares are cancelled upon completion of transaction.

Market for Corporate Control: Post-Offer Takeover Defenses

Greenmail Standstill agreement Pac-man defense White knights Employee stock ownership plans Recapitalization Share buy-back plans Corporate restructuring Litigation Just say no

Discussion Questions
1. Discuss the advantages and disadvantages of the friendly versus hostile approaches to corporate takeovers. Be specific. 2. Do you believe that corporate takeover defenses are more motivated by the targets managers attempting to entrench themselves or to negotiate a higher price for their shareholders? Be specific.

Impact on Shareholder Value

Friendly transactions result in average abnormal returns to target shareholders of 20% Hostile transactions result in average abnormal returns to target shareholders of 30-35% Bidders shareholders earn average abnormal returns that are zero or slightly negative; however, often positive in certain situations Recent studies suggest Takeover defenses have small negative impact on abnormal target shareholder returns Defenses put in place prior to an IPO may benefit target shareholders Bondholders in firms with ineffective defenses (i.e., vulnerable to takeover) may lose value

Things to remember...
Hostile takeover attempts and proxy contests affect governance through the market for corporate control Hostile takeover attempts tend to benefit target shareholders substantially more than the acquirers shareholders by putting the target into play. Consequently, acquirers generally consider friendly takeovers preferable. Anti-takeover measures share two things in common. They are designed to Raise the overall cost of the takeover to the acquirers shareholders and Increase the time required for the acquirer to complete the transaction to give the target additional time to develop an anti-takeover strategy.