Introduction to Company Law Note 6 of 7 Notes

Merger & Takeover

Universiti Kebangsaan Malaysia Faculty of Law Pursuing PHD Program in Law

Musbri Mohamed DIL; ADIL ( ITM ) MBL ( UKM ) 1

A takeover occurs when existing shareholders of a target company transfer sufficient shares to an offeror so as to confer on the offeror control of the voting power attaching to the target company's share capital. Takeover therefore involves a transfer of corporate control. Takeover offer which is opposed by the target's incumbent directors and management is known as hostile takeover . There are various factors that may drive hostile takeovers. Hostile takeovers may involve underperforming companies , under priced companies or cash rich companies. Companies with dispersed shareholding, with no party holding deciding block may also attract hostile takeover.

In Malaysia, there is cultural adversity to hostile takeovers. Moreover, the rate of institutional participation is still low as compared to the United Kingdom ('UK') (66%), the United States (over 50%) or Australia (25%). It is worth noting, however, that the current exercise of mergers, increase in size and increased institutional participation may dilute concentration of ownership and make the companies vulnerable to hostile takeovers. Thus, there is a need for putting in place some measures to protect target companies and its shareholders.

The US however has not clearly addressed the legality of most takeover defences. Some suggested that it was not until the Delaware Supreme's Court opinion in 1995 in Unitrin v American General Corporation 651A 2d 1361 Delaware Supreme Court (1995) that it became reasonably clear that corporate management has the right to maintain a takeover defence against an unwanted takeover bid without the need to obtain shareholders approval. Despite the fact that hostile takeovers were being commonly used by bidders in 1980s in the US, corporate law in US only addressed this issue long after hostile takeovers had first appeared on the scene. In the US, the use of poison pill defence in conjunction with a staggered board is claimed to be the most potent defence. It is worth noting that in the US, takeover defences are largely a matter of state corporate law. In Delaware, for example, defensive action must meet an enhanced scrutiny standard i.e the target board must show that it had reasonable grounds for believing that a danger to corporate policy and effectiveness existed as a result of the bidder's offer and that the defensive action taken was a reasonable response in relation to the threat posed.

The Malaysian takeover regime on the other hand has chose to state clearly the position of takeover defences. The Malaysian Code on Takeovers and Mergers 1998 forbids the target company from taking any action that may amount to frustration of the bid when a bid is made or is imminent. The provisions are similar to those found in the City Code. In Australia, defensive tactics are limited by Listing Requirements of the Australian Stock Exchange. Generally speaking, a transaction or conduct by the board of the target that has the effect of triggering a bid condition which is likely to lead to the defeat of a bid, must be submitted promptly to the target's shareholders for approval. The law in Australia relating to frustration action was influenced by the rules in UK. However, unlike the UK rules, the Australian Panel did not specify any precise limits to the operation of the rule.

Section 33A(5)(d) of the Malaysian Code on Takeovers and Mergers 1998 imposed a duty on Securities Commission to ensure that the directors of both the acquiring and target companies act in good faith when responding to, or making recommendations with respect to a takeover offer. It is clearly important that the directors of the target should ensure that, consistent with their fiduciary duties, the shareholders have an adequate opportunity to appraise the offer made for their shares and to consider any alternative or better one. Similarly, General Principle 3 of the City Code (UK) states that: Shareholders shall have in their possession sufficient evidence, facts and opinions, upon which an adequate judgement and decision can be reached and shall have sufficient time to make an assessment and decision. No relevant information shall be withheld from them.

Another issue that has always been raised in the context of takeover is the degree to which directors may have regard to the interests of shareholders as distinct from the interest of the company as a commercial entity. The most important issue in a takeover context which is likely to be considered by the shareholders of the target is the value placed on the company by the bidder. Directors are well aware of this fact and the practice has been that defensive tactics engaged in by many companies are specifically designed to maximise the share price for the benefit of shareholders.

In the US, it is worth noting how the business judgment rule has influenced the involvement of directors in defending the company against takeovers. Since the nineteenth century, the American courts have recognised the Business Judgment Doctrine/Rule. The rationale of the doctrine is explained by Professor John H Farrar in the following manner: First, it is a recognition of human fallibility. Secondly, it recognises the role of risk-taking in business decisions. Thirdly, it keeps the court from becoming bogged down in complex corporate decision making and second-guessing management decisions which they are ill-equiped to do.

Defensive tactics White knight When a company is the target of unwanted bid or threat of a bid from a potential acquirer, it may seek the aid of a white knight. Ie the company can issue a significant number of shares to a person who or a company which was perceived as friendly. White knight may best suit a company which has a share register without any major shareholding blocks. n28 The effect is to provide a blocking state before another person could acquire sufficient shares to acquire control of the company. The issue of shares also has the effect of diluting existing shareholdings, including those of any potential bidders. White knight is a tactic frequently adopted in the United States. It has also been applied in Australia, the UK, and Malaysia. It is worth noting that any company considering the use of such a tactic should be extremely careful in proceeding with such step. Rodd Levy stated that there have been many instances in Australian corporate history where a white knight subsequently became hostile and either sold the shares to bidder or made a takeover bid itself. n29 This defence however has its own disadvantage. One disadvantage to this tactic is that White knight shareholders may suffer deterioration in shareholder value.

Another similar tactic is White Squire defence. In the white squire defence, however, the target company seeks to implement a strategy that will preserve the target company's independence. A white squire is a firm that consents to purchase a large block of the target company's stock. The stock selected often is convertible preferred stock. The white squire is typically not interested in acquiring control of the target. A deal may be structured so that the shares given to the white squire may not be tendered to the hostile bidder.
It is worth noting that in Malaysia, unless the shareholders give consent, tactical share allotment will constitute frustration of the offer under section 35 of the Code on Take-overs and Mergers 1998.

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Differential voting rights A company may adopt a voting structure which could enable the directors and other insiders to own a small number of shares but have a disproportionately a large number of votes. This will have the effect of making it more difficult for an outsider to acquire sufficient shares to achieve control. The steps necessary to implement a differential voting structure will depend on the constitution of the company.

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Interlocking or circular shareholdings It is possible for two or more companies to acquire and to hold blocks of shares in one another. Interlocking shareholdings may be established to rationalise a market or to facilitate a greater degree of integration between the companies concerned. Shark repellants "Shark repellant" is the expression used to describe a wide range of devices designed to deter opposed takeovers. It is common in the United States but less common in Australia. It is a provision in a company's constitution designed to make it more difficult for the acquirer of a significant number of shares to take control of the company. Shark repellants generally involve amendments to the articles of association of company.

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Defensive strategies
Companies may adopt defensive strategies in an attempt to avoid takeover or at least to make takeover difficult. Here the company may adopt certain measures in advance of a bid so as to make the target less vulnerable. One of the first steps in developing defensive strategies is to analyse the distribution of share ownership of the company. A number of the more common strategies include: Golden parachutes One long term defence to be considered by a company to buffer itself against takeover attempts is to enter into service or employment agreements with officers of the company. This contract between a company and an executive which provides for a significant termination payment on the event of losing their position to a successful offeror is usually referred to as golden parachute. The word golden is used because of the lucrative compensation that executives covered by these agreements receive. A typical golden parachute agreement provides for lump sum payments to certain senior management upon termination of their employment. The amount of compensation is usually determined by the employee's annual compensation and years of service.

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Employee stock ownership plans ('ESOPs') Another defence where potential target may consider to thwart a takeover is through employee stock ownership plans which is commonly referred to as ESOPs (in Malaysia this is commonly known as ESOS). This tactics normally involves placing large blocks of shares in the hands of employees through an employees' trust fund. The use of ESOPs affords a target company a strong defence in avoiding the loss of control of the company. A target company may try to use the ESOPs as a white squire by placing stock in the plan. It then hopes that ESOPs shares will vote with management on major decisions such as approving takeovers.

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Share buy-backs
Another way to prevent a takeover is for the target to buy back its own shares. Such share repurchases have several advantages for a target corporations. Share repurchases can divert shares away from a hostile bidder. Once the target has acquired certain shares, these shares are no longer available for the bidder to purchase. The acquisition of the target's own shares can allow the company to use up its own resources. Further, periodic purchases by a company of its own shares may be desirable as a long term defensive measure. This may reduce the existence of loose shares which could otherwise be sold into a bid, return surplus cash to shareholders and add depth to the market for the company's shares. If the share price is depressed, a buy back program shall also improve the company's earnings per share and asset backing per share figures.. Buy-back activity will also assist to ensure the company's shares are properly valued in the market and diminish the attractiveness of the company as a takeover target.

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Crown jewel A crown jewel defence is essentially an arrangement concerning the most attractive assets or the key assets of the company, which in the event of a takeover bid, may lead to the assets being sold. One way of doing it is where the company's asset would become subject to an arrangement which would require the consent of a third party before the asset could be dealt with. The same technique may be applied in Malaysia as long as there is shareholders approval. Otherwise this would amount to frustration of takeover bid.

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Poison pill
Poison pill which is a preventive anti-takeover measures has only been adopted in the US. Poison pills were invented by Martin Lipton who used them in 1982 to defend El Paso Electric against General American Oil. This type of poison pill is referred to as preferred stock plan. However, due to certain disadvantages, secondgeneration poison pill was developed. The new pills did not involve the issuance of preferred stock. The pill came in the form of rights offerings that allowed the holders to buy stock in the firm at a low price. It is commonly known as the flipover poison pill. This type of pill, however, has its own drawback. They are only effective if the bidder acquires 100% interest in the target. The third generation poison pill is called flip-in poison pills which were an innovation designed to deal with the problem of a bidder who was not trying to purchase 100% of the target. The flip-in provisions allow holders of rights to acquire stocks in the target. The flip-in rights were designed to dilute the target company regardless of whether the bidder merge the target into his company. They can be effective in dealing with bidders who seek to acquire a controlling influence in a target while not even acquiring majority control. It is worth noting that in the UK poison pills have not been prevalent, in part due to the fact that the investment community has generally not looked favourably upon such practices.

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Staggered Board Another preventive measure that applies only to US is "staggered board". It refers to a technique where companies adopt provisions in the article providing for a staggered board of directors. A staggered board provision comes in the form of an amendment of the corporate charter. The ability to amend the corporate charter is dictated by the prevailing state laws. A typical staggered board provision provides for one-third of the board to be elected each year for a three year term. Here, the terms of the board of directors is varied so that only a few directors can be elected in any given year. This technique slows down the offeror company in placing its own appointees on the board even though it may have acquired legal control pursuant to the takeover bid. n44 When the bidder has already bought majority control, the staggered board may prevent him from electing managers who will pursue the bidder's goals for the corporation. However, the effectiveness of this right is dependent upon there being no weighted voting rights in connection with the appointment and removal of directors. This technique may not be applicable in Malaysia as entire boards can be replaced through shareholder action.

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Companies have the ability to implement a wide variety of defensive tactics if they becomes the target of a takeover bid, especially a hostile one. The tactics and strategies discussed above are just a few examples of defences adopted by companies in defending against takeovers. Other defensive measures include criticism of the bidding company, appeals to the shareholders to reject the offer on the basis of loyalty and also lobbying or appealing to the regulators in the responsible jurisdiction. Companies may also resort to other long term defensive tactics. For instance, the company may bring out the valuation of share price through improving profits. The company may also build and improve communications and relations with shareholders, investors and analyst. Another way of buffering takeover offer is through response to the offer and by showing independent adviser true worth of the company.

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It is worth noting, however, that takeover activities in the United States outperform the exercise of takeover elsewhere. In the UK, Australia and Malaysia the legal position on takeover defences are clearly stated. The law requires that once a bona fide offer has been made or is imminent, the board of the target is barred from taking action which would frustrate the bid without first receiving shareholders approval. This to some extent has limit the ability of the target management to block unwelcomed bids. However, it is important to note that the law is not designed to prevent takeover exercise, whether friendly or hostile, as long as the takeover activity creates significant wealth.

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Much of what is called investment is actually nothing more than mergers and acquisitions, and of course mergers and acquisitions are generally accompanied by downsizing. Thanks you. Musbri Mohamed May 2012
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