Saturday, February 26, 2011

Poison Pill Lives on in Corporate America

(Mihir had earlier highlighted the importance of a recent Delaware Chancery Court decision in the Airgas case.

We now have a post by Karan Singh Tyagi, who succinctly analyzes the impact of the decision under Delaware law and goes to the nub of the issue involving the role of the board of directors of a target that is the subject matter of a hostile bid.

Karan is currently an associate at Gide Loyrette Nouel, Paris. After obtaining his law degree from the Government Law College (Mumbai) in 2009, Karan went on to do his LL.M. from Harvard Law School last year.)
On February 15, 2011, the Delaware Court of Chancery delivered the much-anticipated decision in the year long takeover battle between Air Products & Chemicals, Inc. and Airgas, Inc. Corporate attorneys in the US and shareholder activists around the world were calling it one of the most important law suits in a generation, and rightly so. Almost half of all publicly traded corporations in America, and approximately two third of the companies in the Fortune 500 are registered in the state of Delaware, and the outcome in any Delaware case significantly affects entire corporate America.

In the current case, the legality of the 'poison pill' (shareholders' rights plan), invented in the early 1980s by the preeminent Martin Lipton, was in dispute. Briefly, poison pills are instruments designed to derail hostile bids. The pill works by distributing rights to all shareholders to buy the company's stock at a discounted price. These rights get triggered when a hostile bidder acquires a certain percentage of the company's outstanding stock (15% per cent in the Airgas case). The critical part, however, is that the hostile bidder whose stock acquisition triggers the discounted buying is itself excluded from buying the discounted stock. This results in a substantial dilution of the bidder's stake, which is so great that no rational bidder would want to set off the pill, and go ahead with the bid.

For nearly a year, the Airgas board of directors had relied on its poison pill, to protect itself from the Air Products' hostile offer. Air Products moved the Delaware Court of Chancery for a judicial redemption of the poison pill contending that the pill should be pulled as a matter of shareholder choice. Their argument was that under Delaware law there was no longer any threat to shareholders or the company that justified keeping the poison pill in place, since the current offer of $70 per share was at a substantial premium than the company's prevailing share value.

Despite the fact that Air Products' tender offer had been public for more than a year, during which time Air Products won a proxy contest to place three directors on Airgas's staggered board, and that Airgas stockholders were sophisticated and well-informed, the Court concluded that the Airgas board "acted in good faith and in honest belief" that the $70 per share offer was inadequate, and thus did not breach a fiduciary duty by failing to redeem the company's poison pill.

The court based its reasoning on the threat of 'substantive coercion'- a term coined in an article by Harvard Law School Professor Reinier Kraakman (co-authored with Stanford Law School Professor Ronald Gilson). 'Substantive coercion' essentially means the risk that shareholders will mistakenly accept an underpriced offer because they disbelieve management's representations of the company's intrinsic value.

Nevertheless, the court acknowledged that the poison pill had "served its legitimate purpose" in delaying the consummation of the bid by more than a year, and it had given the shareholders sufficient time to decide whether to tender their shares or not. Chancellor Chandler, who wrote the opinion for the Court, held that he was compelled by controlling Delaware precedent to uphold the poison pill, and suggested that the Delaware Supreme Court should consider modifying the current rule.

Chancellor Chandler's personal views appear to be a nudge to the Delaware Supreme Court to strike a certain balance between the board and the shareholders, which is straying too far in favor of the board under the current Delaware precedent.

Going forward, the Delaware Courts should push for the right balance between the director-centric and the shareholder choice model, especially in cases like the current one where the offer is not structurally coercive, and is all-cash, fully financed, and the stockholders have sufficient time to be completely informed about the offer and the board's business proposal. In such cases, there are strong policy reasons to give shareholders an opportunity to decide for themselves.

More importantly, it should be remembered that the poison pill was widely adopted when the business climate in America was one of 'corporate raiders'. These 'raiders' were essentially looking to buy low through 'front-end loaded and two-tier' tender offers, and looking to sell high. Undoubtedly, these offers could lead some shareholders to sell, even if they were being offered a price less than what they believed their shares were worth. Poison pills in this economic climate served the purpose of enabling the board to act as a bargaining agent for the dispersed shareholders.

However, in the current economic scenario, and especially in the context of the current case, the poison pill has gone far beyond its original purpose. The offer price was $70 for Airgas, whose shares had been trading around $63 per share. After the Court's decision, Airgas shares fell to around $60 per share. Looking through the prism of shareholder value, this appears to be a major loss for the shareholders of Airgas.

Underlying this case was a very fundamental question pertaining to the allocation of power between directors and shareholders. In the words of the Court: "in the context of a hostile tender offer, who gets to decide when and if the corporation is for sale?" In answering this question, the Court solidified the notion that power resides with the board of directors in business-friendly Delaware, and in doing so confirmed corporate America's outlier position in the world in favoring a director-centric model of corporate governance rather than a shareholder choice model. Is this the correct approach? The fact remains, that no would-be buyer has successfully navigated both a poison pill and a staggered board. Also, there is strong empirical research supporting the proposition that vulnerability to a hostile takeover has an important disciplinary effect on corporations. Corporate America can ill-afford to lose out on this disciplinary effect.

- Karan Singh Tyagi

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