Chapter 8
Legal Aspects

Merger arbitrageurs must combine an investor's mindset with that of a strategy consultant and a lawyer. This makes merger arbitrage an art rather than a science. It also implies that it is very difficult for quantitative models to replicate a merger arbitrage strategy. Most references on arbitrage focus on the mechanical aspect of merger arbitrage, which we discussed in Part I. Antitrust issues are also popular among writers about the topic. However, the full richness of the arbitrage process only becomes apparent when one considers the legal aspects.

Each country has its own set of rules that apply to domestic mergers, and within some countries different jurisdictions can coexist. For cross-border mergers, it is obvious that the laws of at least two countries will apply; with the growth of globalization, however, even mergers between to domestic firms that appear to be domestic affairs at first sight can fall under the jurisdiction of the competition authorities of foreign governments. Competition regulations will be discussed in Chapter 12 more fully. This section will address other legal aspects of the merger process.

Global merger legislation falls within three parallel legal universes (Figure 8.1). The classic distinction in common law and civil law jurisdiction is only partially useful in merger arbitrage. The overall legal framework in any country certainly follows the logic of civil vs. common law. However, when dealing with mergers this distinction is not always applicable. For example, most civil law jurisdictions follow a takeover framework assimilated from the United Kingdom's Takeover Code. Commonwealth countries tend to follow the City Code rather closely, while other countries pick and choose some of its elements and incorporate them into their legal systems. Continental European civil law countries belong to this latter category. On the other extreme, the United States has developed a distinct system of corporate and M&A laws that bear little resemblance to the rest of the world. Canada follows the tradition of British corporate law but has adopted M&A laws that resemble the U.S. tradition more than the U.K. Takeover Code. Although the United States and Britain share a long history of common law traditions, they find themselves at opposites sides of the spectrum as far as the mechanics of takeover legislation is concerned. In fact, European civil law jurisdictions resemble the U.K. common law takeover regime more closely than the United States, despite the common law heritage that these two countries share.

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Figure 8.1 Legal Universes for Mergers and Acquisitions

The law of mergers and acquisitions is extremely specialized, and a comprehensive description is beyond the scope of this chapter. Most legal texts covering mergers exceed this book in length. Therefore, this section gives a limited overview of some of the key issues. Readers interested in delving deeper are strongly encouraged to consult the extensive legal literature that exists about this topic.

The legal framework is complicated by a multitude of overlapping laws and regulations that apply to mergers. It would be an exaggeration to suggest that an arbitrageur must be a lawyer. Legal training may be helpful, but a good understanding of the principles is sufficient for most arbitrage investments. Most arbitrageurs will do well using some common sense and a sharp eye for the wording of key provisions in merger agreements.

Aside from antitrust legislation, which is a world of its own, there are at least four levels of legislation that arbitrageurs must be familiar with:

  1. Supra-national regulations. Most notably, these are rules of the European Commission (EC) such as the directive on the taxation of mergers or the directive of cross-border mergers. These directives are supposed to have been incorporated into national laws by each EU member state. However, sometimes the implementation can conflict with the directives or their intent, in which case companies that are affected adversely can seek relief through the legal system. At the time of this writing, the EC was gaining a negative impact on merger arbitrage as the worldwide financial transaction tax was taking shape. It may have an impact on the ability of arbitrageurs to provide liquidity to the market after a merger announcement.
  2. National regulations. In the United States, they are promulgated by the Securities and Exchange Commission (SEC). Like all other SEC rules, the principle of full disclosure underlies these regulations. Almost anything goes as long as it is disclosed to shareholders. The SEC does not judge the fairness of a merger or the adequacy of the consideration received. Key SEC rules are discussed in Chapter 12.
  3. State or provincial laws. In the United States, the states play a crucial role as companies incorporate in a given state. There is no such thing as a national corporation. Canadian provinces play a similar role, while most other countries have national company laws and few relevant regulations below the national level. In the rest of the developed world, provincial authorities have no significant influence on mergers or the arbitrage process.
  4. Court decisions. In the United States more so than in other countries court decisions are the key to understanding the law of mergers and acquisitions. Although state corporate codes set the framework under which mergers take place, it is the precedent of case law that sets the relevant standards. Judges will look to state statutes, precedent, and SEC rules when making decisions. Readers may be surprised that SEC rules would come into play in a state court, but judges occasionally refer to a company's SEC filings and its compliance with SEC rules in their decisions.

    The most important jurisdiction is, of course, Delaware. Judges in other states will look to Delaware's decisions for guidance but will also try to maintain a certain independence.

    The venue for these decisions is almost always a state court, often the state of incorporation, and otherwise the state in which the corporation has its main place of business. Lawyers for plaintiffs sometimes suggest litigating in western states if a company has its headquarters there, under the theory that courts in those states are more shareholder-friendly than courts on the East Coast. Nevertheless, the law applied will be that of the state of incorporation. Any difference in outcome is due to a different interpretation of facts and circumstances. I will outline some key court decisions later in this chapter.

  5. Exchange regulations. Listing requirements can influence the merger process. For example, the New York Stock Exchange requires a shareholder vote from companies that seek to issue new shares amounting to more than 10 percent of the outstanding. Therefore, if a company is listed on the NYSE, its shareholders will have a say in case of a highly dilutive stock-for-stock merger, whereas shareholders of NASDAQ-listed companies do not have this privilege. Similarly, the Düsseldorf stock exchange restricted in the year 2015 the delisting of shares, making it harder for companies to coerce shareholders to tender their shares in an unfavorable acquisition. However, investors in companies listed on the Frankfurt, Munich, Stuttgart, Hamburg, or Berlin exchanges can potentially suffer such a fate.
  6. Company-specific contracts. These are mostly found in the bylaws or articles of incorporation through anti-takeover provisions, but restrictions on takeovers can also be found in less obvious places, such as bond or loan covenants or employment agreements. It is common to see so-called change of control clauses in bond covenants. If the issuer is acquired, the bond becomes due immediately.

    It should be noted that change-of-control clauses were, until recently, very uncommon in European bond covenants. As a result, highly rated companies with low debt loads could be taken over and leveraged by the new owners. The bonds continued to pay the low interest rate assigned at issuance, but rating agencies downgraded the bonds to junk level. Effectively, the cost of the buyout was borne by the widows and orphans who suffered a significant capital loss on their high-risk, low-yield bond holdings. A prominent example is the buyout of Danish cleaning firm ISS Global A/S by entity affiliated with Goldman Sachs and the Wallenberg family. Within hours of the announcement, one bond lost 25 percent of its value (see Figure 8.2). A few weeks later, the rating agencies reacted to the buyout and downgraded ISS's debt from a BBB investment grade rating to a junk level of B. The losses suffered by the bondholders effectively were a wealth transfer from widows and orphans to Goldman Sachs and the Wallenbergs.

    It is clear that anyone with advance knowledge of the merger would have profited enormously from a short position in ISS bonds or by buying protection on ISS bonds in the credit derivative markets. Indeed, it was rumored at the time that such insider trading through credit derivatives was rampant in European markets, where regulatory enforcement was completely absent and penalties are much lighter than in the United States. The earlier warning against insider trading can only be reiterated in this context.

    Change-of-control clauses can also be found in employment agreements of key executives. Typically, they provide for a lump-sum payment (golden parachute) when the firm is taken over. Similarly, stock options and restricted stock vest upon a change in control. These issues are discussed in more detail in Chapter 9.

Diagram of Legal Universes for Mergers and Acquisitions with U.S. and Canada in overlapping circles at the left; and U.K. and Continental Europe in overlapping circles at the right with Takeover Code Countries in a circle adjoining U.K.

Figure 8.2 Price of the ISS Global A/S 4.75% Bond Due 09/10

Merger law evolves discontinuously. It remains static during periods of little activity but changes rapidly in each merger boom. The key decisions both in the United States and United Kingdom emanate from the 1980s, with important changes occurring during the more recent merger boom of the new millennium.

Merger Process

Although arbitrageurs take their positions mostly after a merger has been announced, it is helpful to understand the legal requirements that companies have to follow in the adoption of the merger. A poorly conducted process is open to attack in the market or the courts. In this case, there are three possible outcomes:

  1. The deal is delayed or collapses. An outright collapse rarely happens, but delays can occur and depress the annualized return (see Chapter 5).
  2. The buyout price increases. This is the dream scenario in every deal.
  3. Another buyer gets involved. This can also lead to a higher price, but as in all contested transactions (Chapter 5), an arbitrageur may suffer a loss if a short squeeze develops on the short side of the arbitrage.

Maximizing shareholder value has become the holy grail of modern management. Unfortunately, all too often, managers cite shareholder value to justify many strategies that are more likely to destroy rather than create it. “Shareholder value” has become a somewhat empty phrase used to justify any corporate activity, from the expansion of new productive capacity to country club memberships for senior executives. Not surprisingly, mergers and acquisitions are also done in the name of shareholder value. As with country club memberships and corporate jets paid for by the firm in the name of realizing more business opportunities, it is often difficult for outsiders to discern the real motive behind a merger: Will it benefit ultimately shareholders or mainly the company's executives?

In theory, the decision to sell a company lies with shareholders, who vote in a shareholder meeting. In practice, most shareholders vote with the board, so that the de facto power to sell a company rests with its board. Proxy advisory firms also issue voting recommendations in favor of the board's recommendation except in rare cases where opposition from shareholders against a merger has reached a certain threshold. The board, in turn, itself relies to a large extent on representations made to it by management executives. Conflicts of interest exist whenever a company is up for sale. Economists refer to this as a principal/agent problem. The shareholders as principals hire an agent (manager) to act on their behalf but cannot be sure that the agent actually will act in their interest. Management and board members may be more interested in keeping their jobs than in maximizing shareholder value. Stock options may help to eliminate this conflict by aligning the interests of managers and shareholders: If managers are paid in stock, then they should act as if they were shareholders. In reality, options and share ownership can introduce new conflicts of interests. For example, options usually vest fully and are cashed out when a company is sold. A manager with sizable unvested option holdings may be more interested in selling the company at a lower price if the options vest immediately than risk waiting for several more years until the options vest. Given such complexities in modern corporations, it can be very difficult, if not impossible, for outside shareholders to understand the true motivations of management.

Two approaches to handling the principal/agent conflict in mergers are implemented throughout the world. The first relies on shareholders making the decision on whether to sell. This approach is taken in tender offers globally and mergers in the United States. The other approach relies on court supervision of the merger process. This underlies schemes of arrangement that derive from the United Kingdom legal tradition.

Corporation Codes

Many aspects of mergers and the arbitrage process are governed by the corporation codes of the jurisdiction under which the target company is incorporated. In the United States and Canada, companies incorporate under the laws of a state or province, respectively. The most prominent is the Delaware General Corporations Law. In all other countries, corporation codes are established under national laws, even in countries that otherwise have devolved powers to subnational provinces such as Switzerland or Belgium. Obvious special cases are, in the case of the United Kingdom, Crown Dependencies and Overseas Territories, as well as, in the case of China, Hong Kong, which have their own distinct laws. U.K. Company Law serves as the point of reference for these jurisdictions.

The good news is that corporation codes are fairly static and play no more role than to provide a general framework from which court decisions are derived. Corporations are governed by the law of the country or state under which they are formed, and hence their merger or dissolution is first and foremost controlled by the statues of their state of incorporation. However, state codes tend to remain relatively general in order to provide maximum flexibility to their corporate citizens. Most U.S. states model their codes after Delaware General Corporate Law; even the country of Liberia follows Delaware's example. While this might appear to be a far-fetched example, arbitrageurs had to deal with Liberian corporate law in 2004, when Stelmar Shipping, a Liberian container shipping firm founded by British/Greek entrepreneur Stelios Haji-Ioannou, was acquired by Overseas Shipholding Group. Some other shipping companies traded on Western exchanges are incorporated in Liberia, so other mergers involving Liberian companies are likely to happen in the future.

Corporation codes define the decision making and management of a firm. So it is surprising that for takeovers they play a secondary role: In the United States, SEC rules are as much a driver of a takeover process as state corporation codes. In countries that have implemented a takeover code, it is obviously these rules that are the driving force in a takeover. Company law or state corporation codes determine only the mechanics of effecting a merger. The specifics of how to get there—information rights, timing, takeover defenses—depend less on corporation laws and more on the second set of rules and regulations.

Some intricacies of different codes involve not only anti-takeover provisions but also the availability of dissenters' rights for appraisals. This topic is addressed in more detail in Chapter 13. State statutes also define many anti-takeover provisions, discussed later in this chapter.

Takeover Code and Its Derivatives

The United Kingdom's City Code on Takeovers and Mergers, or “Takeover Code” for short, is the basis for mergers and tender offers in the United Kingdom and also numerous other countries that have adopted laws that imitate it, sometimes down to minute details. Countries that follow the tradition of common law and, in particular, follow the U.K. corporation code closely, such as India, Ireland, Australia, Hong Kong, or Singapore, have adopted takeover codes that follow the U.K. precedent very closely, or have incorporated many features of the Takeover Code directly into corporate law or takeover legislation. In the following I will focus on the U.K. Takeover Code but occasionally show examples from such other countries when the similarities make them perfect substitutes.

The origins of the Takeover Code go back to the 1960s when the Panel on Takeovers and Mergers was established, originally as an advisory body, the City Working Group. Like in many other areas mission creep soon set in and what starts out as voluntary or advisory soon becomes binding. The first version of the Takeover Code was formally adopted in 1968, 15 years after Britain's first takeover, the acquisition of J. Sears & Co by Charles Clore in 1953. By the late 1950s, takeovers had become regular occurrences, and with them, many instances in which shareholders were left holding the bag. Among the more notorious instances was the 1959 takeover of Harrods, in which the priority of claims of preferred shareholders over holders of ordinary shares was violated. Throughout the 1960s, takeovers were occurring at a rate of 500 to 1,000 public companies per year. In order to preempt government regulation, the City Working Group proposed the first version of the Takeover Code in 1968. At the time, enforcement was assured through trade associations. Further improvements followed in the 1970s and 1980s. With the implementation of the EC Directive on Takeover Bids in 2004, the Panel has acquired statutory powers and both the Panel and the Code are now incorporated into the Companies Act. It should be noted that this U.K. regulation precedes the landmark Delaware rulings that govern U.S. mergers today and which I will address later.

The Takeover Code is based on six fundamental principles:

  1. Shareholders must be treated equally.
  2. There must be adequate and timely information.
  3. An orderly market must be maintained.
  4. Management cannot frustrate an offer against shareholder wishes.
  5. Offers have to be realistic.
  6. Disruption of the target company's business must be minimized.

In parallel to the implementation of the Takeover Code, a panel was established, officially named the Panel on Takeovers and Mergers (PTM), to supervise and regulate takeovers and the Code through an executive and two committees, the Hearings and Code committees. Decisions regarding pending takeovers are taken by the executive, which is the most relevant aspect from the point of view of an arbitrageur. The Code committee is charged with rule making while the Hearings committee handles appeals to executive decisions as well as hearing about breaches of the Code. The executive is composed of industry professionals from investment banking, brokerage, accounting and legal firms.

The Code applies to all companies incorporated in the United Kingdom as well as companies incorporated elsewhere but listed on the London Stock Exchange. AIM-listed companies are exempted.

Many of the principles of the Takeover Code have been incorporated into the laws of other members of the European Union. The Directive on Takeovers (2004/25/EC), which seeks to harmonize takeover procedures across the EU, borrows heavily from the principles underlying the U.K. Takeover Code. As a result, it is not surprising that there is a significant amount of similarity overall in takeover regimes across the European Union.

At first sight, a striking feature of the Takeover Code is the disproportionate space that rules around hostile takeovers take up. Hostile transactions represent only a small fraction of the overall merger universe, as outlined in Chapter 5. However, considering the potential for target shareholders to be forced into a transaction that undervalues the firm, it is absolutely justified that what appears to be a fringe issue generates a large amount of regulation. For comparison, while there are few formal rules about hostile transactions in the United States under Delaware General Corporate Law or SEC regulations, the ease with which transactions can be litigated in reliance on prior court rulings gives U.S. investors a comparable level of protection. The fact that the United Kingdom has codified rules about hostile transactions whereas Delaware has not is simply a reflection of the difference in the court system and should not be misconstrued as different level of protection for shareholders.

For arbitrageurs, mergers subject to the Takeover Code have several advantages over U.S. mergers in that they provide more certainty. First, the timeline of transactions subject to the Takeover Code is subject to very clear deadlines, shown in Figure 8.3(a) and 8.3(b) for schemes of arrangement and takeover offers, respectively. Of course, transactions can still be held up for regulatory reasons—in particular, delays due to competition investigations. But plain-vanilla mergers without competition risks benefit from this well-defined timing advantage.

Rule Day Event
2.2 −28 to 0 Announce Intent
CA S. 896 Between announcement and offer: court hearing to seek directions for convening shareholder meeting
30.1 0 Offer. Start sending Scheme circular incl. timetable
Appendix 7
paragraph 7
7 Last day for revision to Scheme (Shareholder Meeting − 14 days)
A7 p3 21 Earliest date for Shareholder Meeting
A7 p3 28 Last day to send circular (but not after shareholder meeting)
CA S. 899 40 Earliest date for Court hearing to sanction Scheme
41 Effective date (Court hearing +1) End of offer under City Code
No need to fulfill conditions
A7 p1 55 Last date for payment (Effective date + 14 days)

Figure 8.3(a) Timetable for “schemes of arrangement” under the Takeover Code with relevant rules of the Takeover Code or Section of the Companies Act

Rule Day Event
2.2 −28 to 0 Announce Intent
30.1 0 Offer. Start sending offer document
30.2 14 If contested: last date to send defense document
31.1 21 Earliest closing date (CD) for acceptances
CD+1 8 am.: Announce acceptance levels or extension. If extensions: This applies for each subsequent CD + 1 at 8 am.
31.9 39 Last date to publish new material information such as earnings, forecasts, etc.
34 42 Can withdraw acceptance if not unconditional as to acceptances (CD + 21 days)
32.1 46 Last day to send revised offer documents (Day 60 − 14 days)
31.6 60 1 p.m.: Last time for acceptances
5 p.m.: Announce acceptances
Midnight: Last time to declare unconditional
31.4 74 Earliest closing date (Unconditional + 14)
31.7 81 All conditions fulfilled (Unconditional + 21)
31.8 95 Payment (All conditions fulfilled + 14 days)

Figure 8.3(b) Timetable for takeover offers under the Takeover Code with relevant rules of the Takeover Code or Section of the Companies Act

The other area in which more certainty exists is clarity around the existence or nonexistence of a takeover proposal. Under the Takeover Code, target companies have to respond to market rumors and inform the market when they receive a proposal. In the United States, while there are clear disclosure requirements for material information, companies have some leeway in classifying takeover discussions as tentative or hiding behind a policy of not commenting on market rumors.

A buyer planning to acquire a company is required by the Takeover Code to make the proposal first to the board of directors of the target company, or the board's advisers. Only after this first step can a public announcement be made. As a result of the acquisition of Cadbury by Kraft, so-called virtual bids have been curtailed. This refers to statements made by a would-be acquirer that it might consider making an acquisition proposal. Investors have wide-ranging information rights. If rumors appear in the press about a proposal, the target must disclose any discussions. A buyer has to make a public statement even before it has approached the target company's board if the information is leaked in a rumor. An example of an announcement relating to market rumors is shown in Exhibit 8.1. In addition, even unexplained movements in a target's share price can give rise to information responsibilities. Under the Takeover Code, if shares move 5 percent in a single day the movement is considered “untoward” and a target company or the acquirer will have to publicize any planned proposals. In any announcement of a proposal, the target company must be specific and name the acquirer. The equivalent French regulations are shown in Exhibit 8.2.

Proposals must be fully financed to prevent the creation of a false market. However, other conditions may be included in an offer, in particular, material adverse change clauses. Another typical condition is a minimum acceptance threshold. Conditions deemed “subjective” are not permitted.

The offer document or scheme circular must be sent to target shareholders within 28 days of the announcement. This is also referred to as a “put up or shut up” regime. If two acquirers make a proposal for a target, then the “put up or shut up” deadline no longer applies. Instead, the acquirers must announce their firm intentions by the 53rd day of the first party's announcement. The panel distinguishes between unsolicited acquisition proposals and formal processes to sell a company. In the latter case, the panel will exempt the companies from both the requirement to name potential acquirers and from the 28-day rule. Nevertheless, once a firm intention has been declared, an offer must be made within 28 days.

Once the offer document or scheme circular has been sent, the timelines differ slightly between schemes of arrangement and takeover offers.

Within 14 days of the publication of the offer document, the target must respond with its views, including the opinions given by its advisers. In recommended offers, this information is normally included in the offer document, so that this deadline in practice only applies to hostile transactions and not to schemes of arrangement, which are friendly by design.

A takeover offer must be open for at least 21 days. The analogous rule for a scheme of arrangement demands that the shareholder meeting to approve the scheme is held no sooner than 21 days after the date of the scheme circular. Revisions to a scheme can be made no later than 14 days prior to the shareholder meeting.

For takeovers, material new information cannot be published more than 39 days after the offer document is sent. The price paid cannot be increased more than 46 days after the document is sent or 14 days before its final closing date.

Once a takeover offer becomes unconditional as to acceptances, it must remain open for at least another 14 days. “Unconditional as to acceptances” refers to a sufficient number of shares having been tendered into the offer to meet the minimum acceptance threshold. This rule allows shareholders who had been holding out to tender their shares anyway.

Extensions are possible, but not beyond the 60th day after the document has been sent. Once the condition as to the acceptance threshold has been fulfilled, all other conditions must be met within 21 days or the offer will lapse by law.

Payment of the merger consideration must be made within 14 days of the closing date for acceptances.

It should be noted that the Takeover Code has no automatic provision for regulatory delays. It is up to the Panel to decide on a case-by-case basis whether to grant an extension when Britain's competition authorities or the European Commission initiate Phase 2 proceedings.

For a scheme of arrangement, the timetable is mostly determined by the court approval of the scheme. While the shareholder meeting to approve the scheme must be held no sooner than 21 days after the circular has been published, which is similar to the 21-day minimum period during which a takeover offer must be open, there is no maximum date for a scheme. Conditions can also remain unsatisfied indefinitely. However, the circular may define a long-stop date after which the scheme will lapse.

In many other jurisdictions, a similarly well-defined timetable determines how a takeover evolves. Overall, the timing resembles that of the U.K. Takeover Code, but details vary. For example, in the case of Switzerland, the timing of a squeeze-out action after a successful takeover is well defined. Moreover, another specificity of Swiss takeover timing is that there is a three-trading-day window between electronic publication of information and its publication in traditional print media. In Figure 8.4 (a) this is indicated only for the preannouncement date, but it also applies to the other announcements that are required to be made.

Day Event
X, X+3 Pre-Announce Intent of Tender Offer elecrtonically (X), in print newspapers (X+3)
X + up to 6 weeks Publication or Prospectus
Prospectus publication (P) Start of 10 trading day (TD) cooling period
P + 10 TD Start of offer period, min 20 TD, max 40 TD
P + 15 TD Last day for board report
20 − 40 TD after start of offer period End of offer period
End of offer + 1TD Announcement of provisional interim result
End of offer + 4TD Notification whether Tender offer successful
Beginning of additional offer period
Interim results
Interim Results +10TD Publication of final result
Additional offer + 10TD End of additional offer period
Additional offer + 4TD Settlement of Tender Offer
Additional offer + 3m Start of squeeze out within 3 months of end of additional offer period. Takes 3–5 months

Figure 8.4(a) Timetable for Takeovers in Switzerland

Day Event
X Board meeting of bidder
Announcement to market, target and CONSOB
X + 20 days Offer document filed with CONSOB
X + 34 days Clearance by CONSOB
Offer document communicated to target
X + 35 days (P) Publication of offer document
A − 3 TD Target director statement filed with CONSOB
P + 1 TD (A) Start of acceptance period (A)
A + 10 TD Last day for competing offers
A + 14 TD Last day for amendments to the offer
A+ 15 TD (C) Earliest possible closing date (C)
C + 1 day Fulfillment of all conditions
C + 5 days Payment
C + 3 months Deadline to start squeeze out

Figure 8.4(b) Timetable for Takeovers in Italy

Day Event
X Announcement
X + 1 month Request for CNMV authorization
20 days CNMV authorizes prospectus within 20 days after it is completed
P Publication of offer document within 5 days of approval
P + 1 (A) Acceptance period begins, open 15 – 70 days
A + 10 Publication of director's response
E − 3 Extension of acceptance period no later than 3 days before its scheduled end
E − 5 Competing bids no later than 5 days before end of acceptance period
E − 5 Amendments no later than 5 days before end of acceptance period
A + 15 to 70 (E) End of acceptance period (E)
E + 3 Publication of results
E + 6 Settlement

Figure 8.4(c) Timetable for Takeovers in Spain

It can be noted from the timetables that courts play a less important role in the countries listed in the merger process than in the United Kingdom. In contrast, securities regulators like Italy's CONSOB (Commissione Nazionale per le Società e la Borsa) or Spain's CNMV (Comisión Nacional del Mercado de Valores) play a more important role or are even the driving force behind the process. In the United Kingdom, it is not the securities regulator but the Takeover Panel that assumes this function.

Locking out Buyers

An important feature for arbitrageurs is a provision in the Takeover Code and many of its derivatives that prevents buyers who have terminated a bid, or have made an announcement that they are not pursuing an acquisition from returning with a new proposal shortly thereafter. This can limit both the number of potential bidders and stretch the timeline until a previous bidder can return to make a new offer. No comparable provision exists in U.S. takeovers.

Under the Takeover Code, the parties cannot enter into a new transaction after the first one has lapsed. The buyer cannot propose a new transaction within 12 months of the lapse of the original transaction, unless the panel grants a waiver. Typical scenarios where waivers are granted are when an offer lapsed because competition authorities engaged in lengthy reviews, if another buyer makes a proposal, or if the target board supports the buyer's new proposal.

Similarly, when a buyer declines to make a bid after untoward market movements in the securities of a target, French regulations preclude that buyer from making a proposal for six months. The relevant regulation is shown in Exhibit 8.3.

“No Increase” and “No Extension” Statements

A special feature of takeover code regimes are rules that ban an acquirer from ruling out an increase in the merger consideration unless that really is the final word. In the United Kingdom, Rule 32.2 even requires companies to clarify false press reports that claim incorrectly that management had ruled out an increase in merger consideration.

The Takeover Code's related Rule 31.5 prevents acquirers from ruling out an extension of an offer and then reneging on that promise. The goal of these rules against no increase and no extension statements is to maintain an orderly market and prevent companies from misleading investors about their true intentions.

Exhibit 8.4 shows Guoco Group's disclosure about the analogous rules under Hong Kong's securities laws, Rules 18.3 and 31.1 of The Code on Takeovers and Mergers of Hong Kong, referred to as the Takeovers Code. Hong Leong did not achieve the needed percentage to squeeze out minority holders and hence was unable to come back with a new proposal for 12 months.

Unfortunately, management of acquirers from countries that do not have takeover code regimes sometimes are not familiar with the strict interdictions of behavior that elsewhere might be considered a standard negotiating tactic. For example, when Danish equipment maker FLSmidth attempted to acquire its Australian competitor Ludowici in the year 2012 for A$7.20 per share, Reuters published an article with the headline “FLSmidth says A$7.20 per share Ludowici bid final” in which it reported that the CEO of FLSmidth had answered no when asked whether he would consider raising the bid. Eight days later, the newspaper The Australian cited the Reuters article, and FLSmidth promptly issues a press release stating that currently it had no intention of raising the bid but reserved the right to do so. Another 10 days later, Weir Group announced a competing A$7.92 proposal and requested that Australia's Takeovers Panel declare the Reuters article a “last and final statement” by FLSmidth, which is the Australian equivalent of a no increase statement. The Takeovers Panel permitted FLSmidth to increase its bid to A$10 subject to a final determination by the Panel. The Australian Securities and Investments Commission's Regulatory Guide 25 Takeovers: False and misleading statements defines what constitutes a last and final statement: Unless such a statement is appropriately qualified, a bidder is held to their statement. This also applies to press reports. A bidder should clarify or correct such reports immediately. In the case of FLSmidth, the failure to correct the statement for a week was deemed unacceptable. FLSmidth was ordered to pay compensation to shareholders who had sold their shares in the period between publication of the article and the clarification by FLSmidth. The compensation was capped at A$2.67 per share and A$2.9 million in the aggregate, a small fraction of the total transaction value of A$388 million. Interestingly, the Takeovers Panel did not invalidate the A$10 proposal. FLSmidth eventually won the bidding war against Weir and acquired Ludowici in July of 2012 for A$11 per share.

Limitations on increases have been incorporated into the regulations of various non–common law jurisdictions. For example, when Volkswagen tried to squeeze out the minority shareholders of Swedish truck maker Scania, it announced that it would not increase its SEK200 per share offer. After Scania's committee of independent directors and numerous shareholders rejected VW's proposal as too low, the Swedish Securities Council refused to accommodate VW's desire to increase its offer anyway. It also rejected proposals by VW for an indirect increase by paying an additional dividend to shareholders, as this would violate the spirit of VW's no-increase statement.

Key U.S. Court Decisions

The United States follows a different philosophy from the detailed prescriptions of the Takeover Code and the various rules derived from it throughout the world. State corporation codes leave considerable freedom to management in the handling of takeover offers. Over the years, court decisions have somewhat restricted and significantly professionalized takeovers, and SEC regulations further narrow the range of possibilities. Overall, however, the merger process retains much more flexibility and variability in the United States than in countries that follow a takeover code regime.

With legislators staying uncharacteristically mute about the details of the merger process, over time judges have come to fill the legislative void. Courts try to stay out of business decisions and give the benefit of the doubt to management. This principle is known as the business judgment rule. Judges do not want to second guess every decision taken by boards and expect boards to act in good faith in their decision-making process and to exercise care and loyalty to shareholders. However, the courts do recognize that mergers and acquisitions present a particular challenge to boards. Through a number of key decisions, the merger process has become a highly structured undertaking. Courts in Delaware have taken the lead; those in other states often use similar approaches when faced with merger-related litigation. Even in states where little established case law exists, legal counsel will advise boards to follow Delaware's lead as a best practice. Therefore, understanding Delaware's requirements helps following the process in other states. We will refer to these requirements as six rules.

At the center of all decisions is the question of fairness in two dimensions: fairness of price and fairness in the procedure of the merger. Courts do not like to rule on the fairness of a price—judges are lawyers, after all, not business executives. They defer to the business judgment of the board for that question by default. This gives a significant amount of protection to board members in the day-to-day management of a firm. Instead of second-guessing price, courts will focus on how it was determined. The assumption is that if the procedures were deficient and unfair, then it can be concluded that the price cannot be fair. Some relevant factors are how the merger was negotiated and structured, how information is disclosed to shareholders, and how shareholder votes were conducted. The rest of this section gives an overview of the principles underlying these procedures.

The year 1985 was one of high activity for Delaware's courts, which set the groundwork for modern merger and acquisition (M&A) court decisions. The first decision that year involved the leveraged buyout of rail car leasing firm Trans Union by its chief executive officer, Van Gorkom. The board was confronted with the buyout and was led by Van Gorkom to adopt the merger agreement only minutes after learning that a leveraged buyout was planned. Delaware's supreme court ruled:

[…] we must conclude that the Board of Directors did not reach an informed business judgment on September 20, 1980 in voting to “sell” the Company for $55 per share pursuant to the Pritzker cash-out merger proposal. Our reasons, in summary, are as follows:

The directors (1) did not adequately inform themselves as to Van Gorkom's role in forcing the “sale” of the Company and in establishing the per share purchase price; (2) were uninformed as to the intrinsic value of the Company; and (3) given these circumstances, at a minimum, were grossly negligent in approving the “sale” of the Company upon two hours consideration, without prior notice, and without the exigency of a crisis or emergency.

488 A.2d 858 (Del. 1985)

The Van Gorkom decision is Rule #1: The board must make an informed decision.

Rule #1: The Board Must Make an Informed Decision

Later that year, the Delaware supreme court ruled in a landmark decision in Unocal v. Mesa Petroleum that a board owes an “enhanced duty” of care to shareholders in its decisions. Mesa, controlled by T. Boone Pickens, had launched a tender offer for the shares of Unocal, and Unocal's board responded by launching a self-tender offer for its own shares, but excluding Mesa from this offer. The ensuing litigation gave birth to the “enhanced” scrutiny of the Unocal standard:

Because of the omnipresent specter that a board may be acting primarily in its own interests, rather than those of the corporation and its shareholders, there is an enhanced duty which calls for judicial examination at the threshold before the protections of the business judgment rule may be conferred.

Before a board may reject a takeover bid, it must analyze

…the nature of the takeover bid and its effect on the corporate enterprise. Examples of such concerns may include: adequacy and timing of the offer, questions of illegality, the impact on ‘constituencies’ other than shareholders (i.e. creditors, customers, employees, and perhaps even the community generally), the risk of non-consummation, and the quality of the securities being offered in the exchange.

493 A.2d 946 (Del. 1985)

The board's decision to thwart a takeover attempt must pass a two-pronged test:

  1. Reasonableness test. The board must have a reasonable belief that a threat to the effectiveness of corporate policy exists.
  2. Proportionality test. The defenses adopted must be reasonable relative to the threat.

Rule #2: The Board Has an Enhanced Duty of Scrutiny

If conflicts of interests are present, such as in management buyouts, then the buyout is considered so tainted that an even higher standard of board scrutiny is required. In the original case underlying this line of thought, the Signal Companies were a 50.5 percent majority shareholder of UOP, Inc. and tried to acquire the remaining 49.5 percent of shares held by public shareholders through a merger. UOP's management made no serious attempt to negotiate a price, allowed two of UOP's directors to prepared a valuation report for Signal using internal UOP data, and failed to disclose a number or relevant facts about the price and the negotiations (or absence thereof) to the public shareholders. The Delaware supreme court ruled that the damages award should be “in the form of monetary damages based upon the entire fairness standard, i.e., fair dealing and fair price” (457 A.2d (Del. 1983)).

Rule #3: “Entire Fairness” Is Required When Directors Are Not Disinterested

The typical procedure to comply with this entire fairness standard is the establishment of a special committee of independent directors, which leads the buyout negotiations. It is obvious that legal and financial advisers for this committee must also be independent.

There is one exception to the entire fairness standard: Delaware law allows for the squeeze-out of minority shareholders when the buyer holds at least 90 percent of the shares. This is referred to as a short-form merger, because it requires no shareholder approval and can be done in a very short period of time with only an information statement.

An easy way for companies to get to the 90 percent level at which they can avail themselves of close scrutiny is a voluntary tender offer. This has led to a difficult situation for shareholders in tender offers. If a buyer obtains 90 percent of the shares through a tender offer, it can then launch a freeze-out of the remaining shareholders. Neither the tender offer nor the freeze-out will be subject to judicial review if all of the following conditions are true:

  • The tender offer was noncoercive.
  • A majority of the minority shareholders tender their shares.
  • The squeeze occurs promptly after the tender offer and at the same price.
  • There are no “retributive” threats to the special committee.

The only remedy for shareholders of a squeeze-out is the exercise of appraisal rights. This topic is covered in Chapter 13.

The requirement that a tender offer be of a noncoercive nature goes beyond minority squeeze-outs and applies to all tender offers. It was first established in Solomon v. Pathe Communications Corp., where the court found that “in the absence of coercion or disclosure violations, the adequacy of price in a voluntary tender offer cannot be an issue” (672 A.2d (Del. 1996)).

Rule #4: A Merger Cannot Be Coercive

The most important rule for arbitrageurs came out of the Revlon v. MacAndrews & Forbes litigation. Corporate raider Ron Perelman had tried to buy Revlon through his company, Pantry Pride. Revlon rebutted his repeated offers and instead took a number of defensive measures that favored another buyer, private equity firm Forstmann Little & Co.:

[…]When Pantry Pride increased its offer to $50 per share, and then to $53, it became apparent to all that the break-up of the company was inevitable.[…] The duty of the board had thus changed from the preservation of Revlon as a corporate entity to the maximization of the company's value at a sale for the stockholders' benefit. This significantly altered the board's responsibility under the Unocal standards.[…] The directors' role changed from defenders of the corporate bastion to auctioneers charged with getting the best price for stockholders at a sale of the company.

506 A.2d 173 (Del. 1985)

Rule #5: The Board Must Seek to Maximize the Price Paid to Shareholders

Revlon duties, as this rule is referred to, can be classified easily as the most important of all rules discussed here. It is normal to see a number of shareholder lawsuits filed whenever a merger is announced. Most of these lawsuits will allege that the board breached its fiduciary duty to shareholders by failing to seek the highest possible price.

The board is only required to maximize price if it decides to sell the company. Instead of selling, it is legitimate and legal for the board to determine that the company should remain independent and not be sold—for example, if market conditions are adverse and would lead to a sale below intrinsic value, whatever that may be. In that case, the board can adopt anti-takeover provisions, as discussed in the next section.

Revlon is concerned primarily with the procedural dimension of getting the highest price, and the highest price is the one that can be achieved reasonably. If a board were faced with two competing bids, the lower of which is unconditional, whereas the higher highly uncertain, it is justified to go for the bird in the hand rather than the bird in the bush and accept the lower bid.

Note that despite the court's use of the term auctioneer, it is not necessary for the board to conduct an actual auction. It is possible for a board to sign a merger agreement and then look actively for other buyers at a higher price. This has become fashionable in the current merger boom under the term go-shop clause. It allows a company to seek a higher bidder for a limited period of time, usually 30 to 60 days, without having to pay a breakup fee. It is sometimes referred to as a fiduciary out. Here is how it works in the case of the First Data buyout by KKR:

During the period beginning on the date of this Agreement and continuing until 12:01 am (New York City time) on the 51st day following the date of this Agreement (the “No-Shop Period Start Date”), the Company and its Subsidiaries and their respective officers, directors, employees, agents, advisors and other representatives (such Persons, together with the Subsidiaries of the Company, collectively, the “Company Representatives”) shall have the right to: (i) initiate, solicit, facilitate and encourage Takeover Proposals, including by way of providing access to non-public information to any other Person or group of Persons pursuant to an Acceptable Confidentiality Agreement; provided that the Company shall promptly make available to Parent and Sub any material non-public information concerning the Company or its Subsidiaries that is made available to any Person given such access which was not previously made available to Parent and Sub; and (ii) enter into and maintain or continue discussions or negotiations with respect to Takeover Proposals or otherwise cooperate with or assist or participate in, or facilitate any inquiries, proposals, discussions or negotiations regarding a Takeover Proposal.1

Unfortunately, go-shop periods are largely pointless. The bigger and more complex a buyout is, and the shorter the go-shop period, the less likely it is that a potential buyer can be found and conduct sufficient due diligence to make a genuine counterbid. In the case of the $29 billion buyout of First Data, it took KKR four months from expressing an interest until the signing of a merger agreement. Prior to first contacting First Data, KKR must have conducted a thorough valuation study and industry research, because it gave First Data a narrow price range in which it would be interested. It is hard to see how other buyers can replicate this work in less than two months.

Two types of buyers could have topped KKR's bid: a strategic buyer or another financial buyer. Strategic buyers know their industry and competitors well and will not need to do lengthy industry research. However, they tend to move slowly and will find it difficult to react to such a short timeline. Financial buyers can act very quickly; however, they may not have researched the industry before and may not be able to complete thorough research in addition to due diligence during the short go-shop period. Therefore, go-shop clauses should not count as a market check unless they become significantly longer than at present. Three months are probably the minimum, and for large firms like First Data with different business segments, four to six months are more appropriate. In a case where a go-shop period was litigated, Delaware's chancery court considered a five-month period sufficient (in 2004 Mony Group shareholder litigation). It is unclear whether significantly shorter periods would pass legal muster.

Frequently, Revlon duties are broken in a more direct manner. It is not uncommon to see companies selling themselves without conducting a proper market test. This happens primarily with small- and micro-cap issuers, where there is less scrutiny by the press and the shareholder base is less aggressive, unaware of its rights or has simply resigned to being taken advantage of.

The Revlon decision has continued to evolve over the last 20 years. First, some states have adopted laws that require management to take the interests of constituencies other than shareholders into account. Second, the courts give the parties some leeway in protecting it against interference from third parties, such as competitors with malicious intents.

In 2003, Genesis Healthcare and NCS had signed a merger agreement that did not allow the board to terminate the merger. Omnicare made a higher bid for NCS, and NCS's board concluded that the new bid was better. In the ensuing litigation, Omnicare, Inc. v. NCS HealthCare, the Delaware supreme court ruled that the merger agreement was void because the agreement was coercive.

Hostile takeovers are a special situation where a board decides not to sell a company, or favors one particular buyer over another. The term hostile is very appropriate in many instances. One such case was the battle between mining firm Atlas Corporation and financial investor Blasius Industries. Blasius had acquired 9.1 percent of Atlas and wanted Atlas to restructure the firm and sell assets. To that end, Blasius was planning to nominate candidates to its board. However, Atlas preempted that move by expanding the board by two members, whose staggered terms made it much harder for Blasius to obtain control of Atlas. The Delaware chancery court ruled that an action taken by a board without shareholder approval, whose purpose is to disenfranchise shareholders, is not permissible:

1. […] in creating two new board positions […] the board was principally motivated to prevent or delay the shareholders from possibly placing a majority of new members on the board. […] A majority of shareholders, who were not dominated in any respect, could view the matter differently than did the board. If they do, or did, they are entitled to employ the mechanisms provided by the corporation law and the Atlas certificate of corporation to advance that view. They are also entitled, in my opinion, to restrain their agents, the board, from acting for the principal purpose of thwarting that action.

564 A.2d 651 (Del. Ch. 1988)

Rule #6: A Compelling Justification Is Needed If the Board Disenfranchises Shareholders

It is common to include deal protection clauses in merger agreements. The logic is that a deal that has been negotiated in a fair manner should be protected against spoiler bids from rivals who have no real interest in acquiring the firm. Also, the buyer, who expends significant amounts of time and money on due diligence, wants certainty with respect to its investment and do not want to be a stalking horse. For shareholders, the risk is that a merger is agreed at a low price with deal protection clauses that make it impossible to obtain fair value. Not surprisingly, this issue is a point of much litigation. In most cases, the methods described next are used in parallel.

Standard language in merger agreements is a no-shop provision. A good example is that of the buyout of Eddie Bauer Holdings (which later was voted down by shareholders):

Section 6.3. No Solicitation. (a) From and after the date of this Agreement until the earlier of the Effective Time or the termination of this Agreement in accordance with Section 8.1, the Company agrees that (i) subject to Section 6.3(b), the Company and the Company Subsidiaries shall not […] initiate or solicit […] or encourage any inquiries or the making or reaffirmation of any proposal or offer that constitutes, or is reasonably expected to lead to, an Alternative Proposal […]

(b) Notwithstanding anything in this Agreement to the contrary, the Company (directly or through its Representatives) may (i) until receipt of the Company Stockholder Approval, engage in substantive discussions or in negotiations with a Person that makes an unsolicited bona fide written Alternative Proposal […]2

Eddie Bauer was not allowed to solicit other bidders. However, the second part of this clause, in section (b), allows it to negotiate with a buyer that approaches it. This is often called a fiduciary out. If there is no fiduciary out, it is very easy to have a merger agreement voided.

If should be noted that the presence of a fiduciary out does not necessarily mean that shareholders can expect to receive fair value for their shares. First, the signing of the agreement signals to other potential buyers that management favors one particular buyer. Another buyer may have to submit a hostile bid, and not many businesses are willing to do so, if only for reputational reasons. Second, if the buyer is a financial investor, it is unlikely that it will be challenged by another financial buyer. Private equity funds rarely bid against each other. Finally, it has to be remembered that the similar time constraints apply as in the case of go-shop periods.

Breakup fees are another standard feature of merger transactions. They typically vary between 2 and 5 percent of the deal value and tend to be at the high end of that range for smaller transactions. For transactions of $50 million or more, average termination fees amounted to 3.2 percent in 2004, according to a study by investment bank Houlihan Lokey Howard and Zukin.3

Takeover Defenses

In the 1980s, the stock market witnessed a buyout wave, during which corporate raiders such as Nelson Peltz, Samuel Heyman, Carl Icahn, T. Boone Pickens, Sir James Goldsmith, and Henry Kravis acquired many established and venerable companies. In popular culture, these raiders were immortalized by Gordon Gekko in the movie Wall Street. Raiders purchased a company with different lines of business or with assets on its balance sheet that were not valued correctly by its market value. After the purchase, which involved usually a long battle with the company's existing management, the raider sold off its components separately. Raiders were an important factor in the unwinding of the conglomerate boom. One effect of this new trend in business was the emergence of the idea that investors best diversify their portfolios themselves, while companies specialize in their core business. Another effect, and an unintended consequence, was the creation of defense mechanisms by management to prevent outsiders taking control of a firm without the consent of the board.

Such takeover defenses are a double-edged sword. The principal justification is that they provide a company's management team with the ability to make long-term decisions. Others argue that if a company receives an unsolicited proposal, takeover defenses give management time and leverage to negotiate a better deal. Relationships with customers and employees are also cited as justification for strong takeover defenses.4 According to this theory, they have the potential of reassuring customers: During the hostile takeover of Peoplesoft by Oracle, customer orders for Peoplesoft products declined because Oracle had announced it would discontinue Peoplesoft's product line after the merger. Strong takeover defenses might have convinced customers to continue buying Peoplesoft's software. Similarly, it is argued that employees prefer to join a company that is less likely to be taken over. Both arguments appear far-fetched. It is doubtful that takeover defenses actually enter any purchasing or employment decisions, and there is no evidence from surveys or other data.

Some academic studies have questioned the benefits of takeover defenses for shareholders. In a 2003 study, Lucian A. Bebchuk and Alma Cohen of Harvard Law School5 found that companies with staggered boards (to be described) suffer on average from a 6 percent lower valuation. Another study,6 while not addressing the question of company valuation directly, found that analysts do not adjust their earnings forecasts following the adoption of a poison pill (to be described). However, the same study found that poison pills are adopted in response to several downward revisions of earnings, which suggests that they are adopted by boards fearful of losing their jobs.

From any investor's point of view, takeover defenses are a reason for concern. Stocks trade often with a premium if they are takeover candidates, and companies with strong takeover defenses will not be able to get such a premium. Even worse, it will be more difficult for shareholders to organize a change of management in the event the company does poorly. Put simply, takeover defenses entrench management and may even signal to the market that management fears it may become ousted, which means that it is not optimistic for the company's future.

For a merger arbitrageur, takeover defenses generally are not a serious problem. Companies that get acquired will already have waived their defenses in favor of the acquirer. Nevertheless, arbitrageurs can forgo some extra return if the takeover defenses hold other potential acquirers at bay. As discussed in Chapter 2, some of the best opportunities for extra returns come from bidding wars. But in the presence of takeover defenses, another acquirer is not very likely to come forward with a hostile offer. Since inaction does not generate headlines or statistics, it is impossible to quantify how serious this issue is.

As mentioned above, the U.K. Takeover Code restricts takeover defenses severely. Most of the tools and techniques available to U.S. companies to thwart unsolicited and unwelcome acquisition proposals are not available. The Takeover Code explicitly bans the following defenses:

  • issue shares or grant options or convertible securities;
  • sell assets; and
  • enter into contracts other than is the ordinary course of business.

Other, more subtle defenses are also banned. For example, any confidential information provided to one bidder must be made available to all other bidders, too, irrespective of whether they are hostile or friendly. In addition, the Takeover Panel has opined that bringing litigation to frustrate a bid would not be allowed.

Nevertheless, some practices have been allowed, such as promising the payment of a special dividend should a takeover proposal be rejected by shareholders or simply convincing shareholders that a proposal undervalues the company.

Poison Pills

The most popular takeover defense tools are poison pills, euphemistically called shareholder rights plans or share purchase rights plans. Such a plan gives shareholders the right to acquire additional shares at a steep discount to market value when one shareholder acquires more than a certain threshold of a firm. The trick with the structure is that the acquirer itself cannot participate in the rights plan.

As an example, consider excerpts from the shareholder rights plan of OneSource Information Services:

“Acquiring Person” shall mean any Person who or which, together with all Affiliates and Associates of such Person, shall be the Beneficial Owner of 15%, or in the case of a Grandfathered Stockholder, 35%, or more of the Common Shares of the Company then outstanding […]

Whereas, the Board of Directors of the Company has authorized and declared a dividend of one preferred share purchase right (a “Right”) for each share of Common Stock, par value $0.01 per share, of the Company (a “Common Share”) outstanding on the Close of Business on October 6, 2003 (the “Record Date”), […] each Right representing the right to purchase one one-thousandth of a Preferred Share (as hereinafter defined), or such different amount and/or kind of securities as shall be hereinafter provided…

[…] in the event any Person shall become an Acquiring Person, each holder of a Right shall thereafter have a right to receive, upon exercise thereof at a price equal to the then current Purchase Price multiplied by the number of one one-thousandths of a Preferred Share for which a Right is then exercisable, in accordance with the terms of this Agreement […]

From and after the occurrence of such an event, any Rights that are or were acquired or beneficially owned by such Acquiring Person (or any Associate or Affiliate of such Acquiring Person) on or after the earlier of (x) the date of such event and (y) the Distribution Date shall be void and any holder of such Rights shall thereafter have no right to exercise such Rights under any provision of this Agreement.7

Without going into the details of this plan, it can be seen that whenever someone acquires more than 15 percent of the shares of OneSource, all shareholders receive a preferred share, but the acquirer will not receive any. The result is that the acquirer's stake is diluted and the acquirer would have to purchase the preferred shares from all shareholders. Thus, the purchase of OneSource would become much more expensive.

A remarkable aspect of this particular plan is that one shareholder was exempted. The “Grandfathered Stockholder” referred to in the first paragraph was a private equity fund that was in the process of buying OneSource at the time this poison pill was adopted. Clearly, the motivation of this plan was not to prevent a takeover but to ensure that the private equity fund would be the only possible buyer and that no hostile acquirer could emerge. This private equity fund had bid $8.40 per share.

The board eventually accepted the bid of a strategic buyer, but only after a shareholder, an investment fund managed by this author, had filed a lawsuit. Shareholders received $8.85 per share, 5.4 percent more than under the original deal. We will never know how much more other buyers may have been willing to pay if there had been no poison pill.

It should be noted that boards often adopt shareholder rights' plans when they feel threatened. This is particularly problematic if a buyer has already expressed interest or when an activist investor has called for the sale of the firm. Aggressive investors willing to take on a board may be able to get poison pills adopted under such circumstances overturned in the courts.

Poison pills have become somewhat of a rarity in recent years. Proxy advisory firms routinely recommend voting against the adoption or renewal of poison pills. The result is that while in the year 2003 poison pills could be found in 57 percent of all S&P 500 companies, this number had declined to a mere 7 percent by 2013. However, M&A lawyers have told me that many companies keep readily drafted poison pills on the shelf so that they can be adopted quickly by the board should need be. Therefore, not too many inferences can be drawn from the absence of a poison pill at a given company.

Canadian companies adopt poison pills that are much more benign than their U.S. counterparts. Their goal is not to block a hostile bid, but to provide for sufficient time to consider the bid and assure fair treatment of all shareholders. Of course, this same claim will also be made by the proponents of any U.S. poison pill. However, Canadian poison pills do have severe restrictions that make this goal realistic. For example, a Canadian poison pill will be severely restricted in duration, so that it is not possible to shield a company indefinitely from an acquirer. The duration during which Canadian regulators allow poison pills to remain in force has ranged historically from 27 to 156 days. Moreover, Canadian poison pills allow permitted bids, which are bids that are open for at least 60 days and require acceptance by more than 50 percent of shareholders. However, the permitted bids route is rarely taken by acquirers. Instead, they apply to the relevant provincial securities regulator to “cease trading” in the poison pill.

Under the U.K. Takeover Code, poison pills are banned. Companies can, however, rely on some of the other tactics described below to fend off unwanted suitors.

Staggered Boards

A buyer faced with a target board that opposes a takeover can bring a proposal to shareholders to replace the board with its own candidates. As a defense against such a scenario, many companies have adopted staggered (a.k.a. classified) boards. Under such an arrangement, a board divides its directors into several classes, and only the directors of one class are elected in a given year. For example, if a board has three classes of three directors each, a buyer needs at least two years to gain a majority on the board, and even that is possible only if it wins all slots in one of the two years. Moreover, because there are fewer positions to be elected in a given year, a larger number of votes is needed to win any board seat. Along with poison pills, staggered boards are the most powerful and frequently used defenses.

Investors who are looking for potential takeover targets should keep an eye on the proposals of activist investors to declassify a board. This is often a prelude to a future merger, but not necessarily so.

Other Defenses

A number of other defenses have been developed over time. Readers interested in details are encouraged to review the extensive specialized literature on the subject. There appears to be no limit to the creativity of corporate lawyers in developing new ones, and it is difficult for most investors to keep track.

Reincorporation in a Less Shareholder-Friendly State

California companies sometimes reincorporate in Delaware, which allows for staggered boards whereas California does not. Reincorporation can be the first step in reinforcing takeover defenses. An arbitrageur will be suspicious when a company is for sale but has recently reincorporated.

Multiple Classes of Stock

Dow Jones had two classes of stock with different voting rights. Outside shareholders held Class A shares with one vote per share, whereas the heirs of the founder, the Bancroft family, held Class B shares with 10 votes per share. When Rupert Murdoch's News Corp. made a takeover bid for Dow Jones, only after lengthy negotiations did the Bancroft family eventually agree to the transaction. Despite holding less than 25 percent of the company, the family controlled Dow Jones through the bigger voting power.

Cumulative Voting

In regular board elections, shareholders vote for each board candidate with one vote. Cumulative voting, however, allows shareholders to give all their votes to a single candidate. Therefore, small shareholders can control the board more easily.

Pac-Man

One technique that has not been used in the United States since the 1980s is the Pac-Man takeover defense. Like the vociferous character in the video game, a target company turns the tables by offering to purchase the acquirer instead. This strategy had been relegated to textbooks after it had last been used in 1982 during the takeover by Bendix of Martin Marietta, which ended up as a purchase of Bendix by Martin Marietta. This defense is useful primarily for managers who want to maintain and expand an empire, as was common up to the 1980s. With the widespread use of stock options and golden handshakes, the possibility of quick personal enrichment upon the successful completion of a merger made this defense very unattractive for a long period of time.

From time to time, press reports emerge suggesting that targets of hostile merger approaches are considering a Pac-Man defense, such as when Kraft Foods was bidding for Cadbury pls in the year 2009, or two years earlier in the failed hostile bid of Rio Tinto by BHP Billiton Ltd. But actual Pac-Man defenses are rare.

A large Pac-Man defense succeeded in the attempted takeover of Volkswagen AG by Porsche SE in the year 2007. Originally, Porsche attempted to acquire Volkswagen through the purchase of call options that would have become deliverable in shares upon their expiration. By using options, Porsche was able to circumvent ownership disclosure rules then in force. However, when the options came due and Porsche was had to acquire the underlying VW shares from its counterparties, Porsche lacked sufficient liquidity to fulfill its commitments. Its position was exacerbated by the financial crisis, which was in its midst at the same time. Volkswagen came to the rescue of Porsche and ended up acquiring Porsche. Another occurrence of the Pac-Man defense was the battle between clothing retailers Men's Wearhouse and Jos. A. Banks. On October 9, 2013, clothing retailer Men's Wearhouse made a hostile takeover attempt for its competitor Joseph A. Banks for $48 cash per share. Less than two months later, on November 26, Jos. A Banks reciprocated by offering to acquire Men's Wearhouse for $55 per share, or an aggregate equity value of $1.2 billion. The final outcome in 2014 was the originally proposed transaction of Men's Wearhouse acquiring Jos. A. Banks, albeit at a higher price of $65 per share or a total value of $1.8 billion.

It remains to be seen whether these two recent occurrences of the tactic are outliers or the beginning of a new wave of Pac-Man defenses.

Buybacks (Leveraged Recapitalizations)

Buybacks can be friendly or unfriendly to shareholders. When management seeks to thwart a takeover threat, increasing leverage can serve to deter potential buyers, while the associated buyback can increase the holdings of management-friendly shareholders.

Freeze-out

Many U.S. states prevent controlling shareholders from merging with a company for a lengthy period of time, three years in Delaware, unless the board of directors approves the transaction. Note that unlike the other defenses discussed here, a freeze-out is prescribed by state statutes, not company bylaws.

Most states with these provisions give companies the option of opting out of this statute. This is normally stated in a company's bylaws. For example, in October 2007, American Community Properties Trust filed this change of its bylaws with the SEC. At the time, the controlling family was in the early planning stages of taking over the firm:

Section 16. Control Share Acquisition Act. Effective October 8, 2007, the Trust elects not to be bound by Subtitle 7 of Title of the Corporations and Associations Article of the Annotated Code of Maryland.8

The provision in Maryland's corporation act goes by the innocuous name of Maryland Control Share Acquisition Act. A shareholder who acquires more than 10 percent loses the voting rights on these shares with respect to a merger or takeover unless the board exempts these shares from the Maryland Control Share Acquisition Act. Of similar state rules, Maryland's is the strictest. When a company opts out of such a provision, it can signal that management may be seeking a sale of the firm.

Another example about the implications of freeze-out provisions was given in Chapter 4 in the discussion about the Pinnacle/Quest Resources merger. At this point, readers should go back to review the letter that Advisory Research sent to Quest's board.

Freeze-outs under State law should not be confused with lockouts after lapsing takeover proposals under the Takeover Code. The important difference is that the freeze-out provision seeks to prevent takeovers altogether.

Asset Acquisitions as Alternatives to Poison Pills

Since companies bound by the Takeover Code or its derivatives cannot use poison pills and are prohibited from using asset sales as a defensive tactic, they have to devise clever alternatives. One such creative and unusual defense strategy was employed by pharmaceutical company Elan when Royalty Pharma launched a $5.7 billion hostile bid in the year 2013. After rejecting the proposal outright, Elan entered into a $1 billion purchase agreement with drugmaker Theravance Inc. to acquire a 21 percent stake in future royalties from four drugs that Teravance was developing in cooperation with GlaxoSmithKline PLC. Since Elan was based in Ireland, it could not have sold assets as a defensive tactic. However, the rules are silent as to asset acquisitions for defensive purposes. The new assets will add to the complexity of the transaction and may be sufficient to make the target company unattractive as a target.

To the surprise of Elan's management, shareholders rejected the proposed Theravance asset purchase, and Elan was acquired a few months later by Perrigo for $8.6 billion after returning $1 billion to shareholders through a Dutch tender offer.

Creeping Takeovers and Mandatory Acquisitions

A special feature of the Takeover Code that has found its way into many countries' laws is the requirement for an investor to make an offer to acquire a company when they acquire more than 30 percent of the voting interest in a company. For any increases in holding between 30 percent and 50 percent, the same applies (Rule 9.1).

The goal of this rule is to prevent a creeping takeover by a shareholder and provide liquidity to all investors with the protection of an orderly takeover process under the rules of the game. In this spirit, an area that has come under scrutiny recently is the use of derivatives to acquire control of a company. This controversy is mostly limited to continental Europe. Aside from the well-publicized purchase of call options on Volkswagen by Porsche SE, an attempt that ultimately backfired, there are several cases in which acquirers successfully bought a majority of shares in this way.

The United Kingdom's mandatory bid rules have been copied by many other jurisdictions. Austria and Germany, for example, both have a 30 percent threshold, whereas Switzerland has a threshold of 33.33 percent. The price to be paid in such an offer is the higher of a VWAP (volume-weighted average price) and the highest price recorded in the market. The time periods vary between countries. Of the above-mentioned examples, Austria has a six-month lookback on the VWAP and a 12-month lookback for the highest price, whereas Germany considers shorter time periods, three months for the average exchange price and six months for the highest price. Switzerland has a lookback of 60 stock exchange trading days for the VWAP calculation, and 12 months for the highest price, with the additional limitation that the price paid cannot be more than 25 percent below this highest price. Table 8.1 gives an overview of key aspects of mandatory bid rules in various countries.

Table 8.1 Key Characteristics of Mandatory Takeover Rules

Country Threshold Creeping increase Minimum Price
Austria 30% Acquisition of an additional 2% over any 12-month period Higher of
  1. 6-month VWAP
  2. Maximum paid by bidder over one year
Australia Australia does not have mandatory bids. However, a holder of 20% or more cannot acquire more than an additional 3% over any 6-month period.
Belgium 30% Acquisition of additional shares beyond 30% Higher of
  1. 30-calendar-day VWAP
  2. Maximum paid by bidder over 1 year
China (People's Republic) 30% Higher of
  1. 30-calendar-day VWAP
  2. Maximum paid by bidder over 6 months
France 30%, and in addition 50% for shares traded on Alternext If holder of between 30% and 50% acquire an additional 2% over any 12-month periodMaximum paid by bidder over 1 year
Germany 30% Higher of
  1. 3-month VWAP
  2. Maximum paid by bidder over 6 months
Hong Kong 30% If holder of between 30% and 50% acquire an additional 2% over any 12-month periodMaximum paid by bidder over 6 months
Italy 30% Additional 5% over one year if own 30%. Maximum paid by bidder over one year. If no purchase: 12-month VWAP
Netherlands 30% Maximum paid by bidder over one year. If no purchase: 12-month VWAP
Spain 30% (a) Holders between 30% and 50% who acquire 5% within 12 months; (b) When exceeding 50%Maximum paid by bidder over one year. If no purchase highest of: (a) book value; (b) liquidation value; (c) 12-month VWAP; (d) consideration offered previously; (e) other commonly accepted valuation method
Switzerland 33.33% Higher of
  1. VWAP over 60 stock exchange days;
  2. not more than 25% below highest trading price in 12 months
United Kingdom 30% Any acquisition between 30% and 50% Not less than highest price paid by bidder in last 12 months

India implements an interesting variation of this rule: when an acquirer reaches a 25 percent ownership threshold it must make an offer to purchase at least an additional 26 percent of shares. Owners of 25 percent who acquire an additional 5 percent of shares during a year must also make a mandatory offer.

The United States has no provisions for mandatory acquisitions or to prevent creeping acquisitions. Disclosure requirements are the only protection available to investors. The market can observe share purchases of any 10 percent owner through Form 4 filings. In theory, the share price should rise in response to any attempt to buy shares in a creeping takeover. In practice, a point will be reached at which liquidity in the shares declines and any additional purchases by a majority owner lead to a further deterioration in liquidity, which will affect the stock price adversely. Which of the two effects dominates is difficult to tell because such cases are extremely rare and limited to firms with small capitalization. However, while investors have limited protections, company management has access to a wide array of anti-takeover measures to frustrate creeping takeovers. Overall, it is clear that shareholders in the United States are less protected than in countries that follow a variant of the Takeover Code, while management is better protected. Enhanced protections may not be necessary as management owed a fiduciary duty to shareholders and domination agreements as they are common in Europe are not possible.

Best Price Rule

As shown in Table 8.1, many jurisdictions impose minimum prices on acquisition proposals. A recurring theme across different countries is the best price rule, whereby an acquirer must pay the highest price to every investor from which it purchases shares during an acquisition. The reason for this principle is greenmailing during the 1980s, when some shareholders negotiated better prices for themselves if they committed to tendering their shares. The regulatory counteraction was to force acquirers to pay the highest price that is paid to any shareholder to all shareholders. This is the best price rule.

To prevent abusive avoidance action of the best price rule, many jurisdictions have extended the time frame during which the best price is calculated beyond the duration of the offer. Frequently, the clock starts ticking one year prior to the announcement of the offer.

The U.S. market takes a special place in the implementation of the best price rule. As with many merger regulations, it is not legislated but has become a de facto rule through a series of Delaware court decisions. Nothing prevents a buyer from paying different prices for shares bought from different sellers during an acquisition; however, damages actions are very likely to ensue and stand a good chance of succeeding. The plaintiff bar effectively has created a private enforcement mechanism that acts as a powerful deterrent.

The best price rule is the single most important reason why acquirers do not engage in their own merger arbitrage. Since an acquirer knows with a high degree of certainty whether its acquisition will succeed, it would make sense to purchase shares of the target at a discount were it not for the best price rule.

In rare cases, acquirers do purchase shares during an offer, as did Glencore Xstrata plc when it was trying to acquire Canadian firm Caracal Energy Inc. in the year 2014 through a plan of arrangement for GBP 5.50 per share. Glencore purchased additional shares on the London Stock Exchange for the same price, GBP 5.50, thereby avoiding problems with the best price rule.

It should be noted that while the best price rule has been implemented in most jurisdictions, some important markets lack this provision. For example, when Italy reformed its takeover regime to comply with the European Directive on Takeovers in the year 2004, it did not implement a best price rule, probably because it was not required by the directive. This is not necessarily a deliberate design for Italy's takeover laws but most likely a legislative oversight. As a result, shareholders can acquire sufficient shares to prevent an acquirer from getting to the 95 percent squeeze-out threshold and then sell these shares at a premium to the acquirer. As long as these shares are bought at a premium outside of the takeover then this would be a perfectly legal greenmailing strategy. Anyone tendering shares in the takeover would receive the lower takeover consideration.

Market Manipulation

Trading activity surrounding merger announcements lends itself to manipulation. But it is not only market participants who may try to influence stock prices through rumors. The most power to influence the market lies with the management of the target company and the buyer. The buyer's management has an incentive to keep the target company's stock price low in order to make a lowball offer appear attractive. The target company's management generally has the opposite incentive—except when they team up with a private equity buyer, in which case they have an interest in keeping the purchase price low.

The United States has no specific laws against market manipulation during takeovers. General liability against market manipulation under Section 10-b-5 applies, and takeovers are merely one instance of all conceivable cases where markets can be manipulated. Shareholders have information rights under Section 13 of the Securities Exchange Act as well as under Regulation FD, which ensures fair disclosure. These reports are filed on Form 8-K within three business days.

The Takeover Code contains a body of rules that seek to eliminate market manipulation specifically in the case of takeovers. Shareholders are awarded information rights from the target, potential acquirers and even other shareholders.

Target companies are required to disclose a material change in published information.

Acquirers who propose to issue shares to target company shareholders must disclose profit forecasts.

Other shareholders have to disclose their positions in shares of the target if they exceed a certain size. The thresholds for filing holdings reports by investors are reduced during takeovers. In the United Kingdom, investors owning 3 percent of shares must normally disclose their holdings, but during a takeover the threshold is lowered to 1 percent, a level that also applies in Ireland during a takeover.

Even employees can have substantial information rights, in particular in continental European countries with strong trade unions. In Italy, for example, consultation of worker representatives is well defined within the takeover timeline. But the Takeover Code also has employee-friendly provisions, such as a clause that employees must be informed about plans for the future of the workforce. A bidder is bound to any statements made in this context, including that of a “negative statement” if no plans regarding the workforce exist.

Shareholder Votes

As discussed earlier, in contrast to tender offers, shareholders get to vote in mergers and schemes of arrangements. The percentage of shareholders needed to approve a transaction differs between jurisdictions. In the United States, the approval threshold of 50 percent is the lowest of all countries considered here. The United Kingdom and Canadian level of two-thirds of shareholders, or 66⅔ percent, is typical for most countries. At the other extreme is Israel, which requires approval of 75 percent of shareholders for court-approved mergers as well as for mergers of companies incorporated before the current Companies Law took effect. For newer companies a lower threshold of 50 percent applies. Exhibit 8.5 shows an excerpt of the merger agreement of the acquisition of Given Imaging Ltd., which was incorporated in Israel, by Covidien. As part of a shareholder agreement approximately 44 percent of the insider votes had irrevocably committed to support the transaction. Therefore, only 55 percent of the noninsider shares had to vote in favor of the merger to reach an overall level of 75 percent.

The Given Imaging merger agreement is also notable in that it contains a provision that no more than 2 percent of shareholders may vote against the merger or the merger will not be approved. However, since 44 percent of the shares had already been locked up that means that almost 3.6 percent of the remaining shares can vote against and the merger will still go through. This is calculated as:

8.1 equation

where

  1. c08-math-0002 is the percentage of unaffiliated shares that can vote against (or abstain).
  2. c08-math-0003 is the maximum percentage of all shares that can vote against, as stated in the merger agreement.
  3. c08-math-0004 is the percentage of shares that have been locked up.

Cross-Border Transactions

U.S. regulators have a long history of extraterritorial application of their rules, and the SEC is no exception with its merger rules. Much to the chagrin of non-U.S. companies, they can find themselves subject to U.S. merger regulation under certain circumstances. For example, when a non-U.S. company wants to acquire another non-U.S. firm whose shares are traded as American Depository Receipts (ADR) in the United States, the acquirer may suddenly find itself subject to U.S. laws.

Shares of many foreign companies can be purchased in the United States over the counter. Regulators are concerned, quite rightly so, that when such a company is acquired, the absence of comparable disclosure requirements that can leave U.S. shareholders less well informed than if their investment had been acquired by a U.S. buyer. A number of exemptions make life easier for non-U.S. companies:

  1. Tier I exemptions apply when U.S. holders own fewer than 10 percent of the shares of the target. In that case, a tender offer is exempt from the disclosure requirements of Schedule TO. U.S. holders must be treated as least as favorably as any other investors, for the consideration offered as well as for the other terms of the offer. In addition, in a stock-for-stock merger, the securities issued by the acquirer do not have to be registered if fewer than 10 percent of the target's shares are held by U.S. investors. The 10 percent threshold also allows acquirers to purchase shares outside of a tender offer.
  2. Tier II exemptions are available to companies fewer than 40 percent of whose shares are owned by U.S. investors. Companies are subject to the same filing requirements as U.S. firms but get some relief in the form of timing of the payment of shares and of extensions of a tender offer, or the payment of interest when allowed under foreign law. The goal of tier II is to prevent conflicts between U.S. regulations and certain foreign merger rules.
  3. Tier III exemptions are available if more than 40 percent of the shares of a foreign company are held by U.S. investors. In this case, the company is subject to the same requirements as U.S. firms.

In all cases, the bidder must provide U.S. holders with information in English that is comparable to that received by other holders. These documents are also furnished to the SEC. However, they are not considered “filed” with the SEC. This is an important distinction because only “filed” documents are subject to the antifraud provisions of the securities laws. Therefore, these regulations allow foreign corporations to offer securities to U.S. investors without the customary regulatory protections.

It should also be noted that for going-private transactions, the disclosure requirements of 13E-3 (see Chapter 11) do not apply.

Many companies still find compliance with the exemptions too burdensome and decide to structure their acquisitions so that they exclude U.S. shareholders. The result of this avoidance strategy is extremely disadvantageous for U.S. investors: They can find themselves holding extremely illiquid shares. U.S.-based arbitrageurs must understand well whether they will be excluded. It may make sense for U.S.-based arbitrageurs to establish a non-U.S. vehicle to engage in merger arbitrage of foreign companies.

Exit Rights

A particular aspect of Italian merger law is exit rights for shareholders under certain circumstances, such as when the headquarters of a company change from Italy to a foreign country as the result of a merger. This was, for example, the case when Fiat S.p.A. merged with Chrysler into a Dutch holding company Fiat Chrysler Automobiles N.V. in 2014. Shareholders were entitled to receive a cash exit payment of €7.727 per Fiat share for surrendering their shares. This payment was based on the six-month average price of the shares after the shareholder meeting had been called. As the stock market was declining toward the end of the period, the ending price of Fiat was below the cash exit payment. This opened the opportunity for an arbitrage, because shareholders were able to purchase the shares in the open market in the low to mid €7.30s, generating a profit of around €0.40, or close to 10 percent annualized to the anticipated closing date.

Exit rights are also triggered when an Italian company is acquired by a non-Italian firm in a stock-for-stock transaction. For example, when U.S. gaming machine maker International Game Technology acquired its Italian competitor GTECH SpA for $6.4 billion in 2015, 11.4 percent of GTECH shareholders exercised their exit rights for a cash payment of €19.174 per share, which was a premium of about 1 euro over the then trading price of GTECH.

However, one risk remains with exit rights: If the amount of exit rights perfected exceeds a certain threshold, mergers can be called off. In the case of Fiat, this amount was €500 million in aggregate exit rights. The threshold was not reached and the merger closed. Of course, investors must also take care to request exit rights prior to the deadline and not vote in favor of the merger.

Notes

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