English and US law on takeover defences

Takeover defenses: review, explain and compare English and U.S. law (federal and state levels in the U.S., as appropriate);

Takeover defenses arise when hostile takeovers are in question. Takeovers of this kind are often used as a platform to catapult managers to the forefront and question their accountability to shareholders both in the USA and the UK. While hostile bids share common structures in both jurisdictions, it should, however, be noted that there exists several significant differences between the takeover regulations of the UK and that of the USA. In the UK, defensive tactics by target managers are prohibited, whereas in the United States, particularly in Delaware, a great deal of leeway is given to managers to handle a hostile bid by themselves. This essay deals mainly with the takeover defensive devices used by the US and the UK. In this attempt to review, explain and compare those defences between both jurisdictions, I shall also analyse the background to the adoption of these tactics and their ensuing regulation both in the US and the UK through the relevant case-law. In the end, I hope to have achieved my goal of providing a clear and true representation of takeover defenses in English and US law.

A common concept to look forward in a healthy and legitimate takeover market both in the US and the UK, is that enhanced corporate governance. This, in turn, involves two different situations. Firstly, if the bidding company establishes a fruitful synergy between the two companies, better management, business operations and strategies after the merger or acquisition, this would obviously reflect a positive “cause and effect relationship between the takeover and the firm value. Secondly and more relevant to the takeover defences, if managers of the target company have reasons to believe that they will be replaced after a hostile bid, they will undoubtedly try to prevent it through various mechanism which are the subject of the whole discussion below. From the 1980s to this date, academics have debated on how best to regulate the takeover market. Frank Easterbrook and Dan Fischel [1] proposed that managers be forbidden from defending against a takeover and that it is the company’s shareholders prerequisite on the action to follow. On the other hand, other commentators argued that managers should be given at least some scope to slow down an initial takeover bid to the extent necessary to get the best possible price for the company’s shareholders. [2] 

Coming to the defensive tactics themselves, there are three of them which are most widely used by target companies to thwart any hostile bid attempt. They are; firstly, the “white squire defence" which is the issuance of new shares by the target company, secondly, the use of restructured voting rights, and finally, the famous “poison pills" which entails the creation of shareholder rights plans. I shall continue by reviewing how those tactics work, how and if, they are efficient in the US as well as the UK. I shall also make use of some relevant case law to highlight the attitudes of the courts and other relevant authorities on both sides of the Atlantic.

Issuance of shares (white squire)

Starting off with the “white squire defence", this involves the target company issuing shares to an individual or a legal entity who is regarded as the “white squire" with the arrangement being that the person will not participate in the bidding contest but will, nonetheless, hold a permanent position in the company. It is widely assumed that the “white squire" is controlled by the Board of Directors of the target company who then act as trustees or it could simply be that they both hold friendly ties. The effect of issuing those shares is that it essentially dilutes the current equity of the existing shareholders and makes it rather difficult for the bidder to acquire sufficient shares to guarantee him control of the target company. [3] This takeover defense is sometimes further strengthened by adding additional voting power to the shares issued to the squire; this further widens the company’s equity

Under US law, issuance of new shares is the prerogative of the Board of Directors but the New York Stock Exchange still requires the approval of shareholders as a prerequisite for the listing newly issued stock that exceeds 18.5 per cent of the company's already outstanding stock. [4] In UK’s jurisdiction, the law, as per the relevant statutes, is less flexible and more rigid concerning issuance of new shares. Prior to issuing new shares, the Board of Directors should either be authorised by the articles of the company or obtain shareholder approval. It would not be easy to detect the true motives of the target company, but it does not really matter as it is perfectly legal for directors to act within their powers to issue new shares, provided authorisation has been granted.

Case law

Early US case law showed that the “white squire defence" was not very successful but in the ensuing years, that trend changed. In Frantz Manufacturing [5] case, the court enjoined the management's issue of stock to its employee stock option plan, in order to dilute the voting power of the bidder who had already acquired 51 per cent of the company's voting stock. In this case, it was more than clear that the only intention of the incumbent management for employing this tactic was entrenchment. In the Nolin case [6] , the Court of Appeals rejected the excuse that the defensive measure was adopted in order to give the target more time to examine the bid and observed that the purpose of exercising such power “is to ensure a reasoned examination of the situation before action is taken, not afterwards. However, in Danaher case [7] , the court shifted the burden of proof on directors and they

managed to prove that the employee stock option plan was appropriately funded and that the

transactions were entered into in good faith for the company's benefit and with no primary

entrenchment motive.

In the UK, the same defence was used in several instances in the form of the employee stock option plan. The general practice is that employee stock option plans do not exceed 5 per cent of thecompanies' outstanding equity, so that their shareholdings will not be large enough to be used for entrenchment purposes. The creation of employee stock option plans as

defensive tactics mainly raised concerns of fair and proper corporate purpose from the directors as well as proper and ethical financing. In Hogg v. Cramphorn [8] , the court rejected the issuance of new shares to the company's employee stock option trust, financed by an interest-free loan, which was granted to the employee stock option trust by the company itself. The court held that there was no proper corporate purpose for the transaction, attributing it to entrenchment. In Bamford v. Bamford [9] , the court reserved the same judgment. In both instances, the court encouraged shareholders to oust directors who tended to get involved in such unproper acts.

Finally after having explained the first tactic and reviewed its case law, it can be summarised that under US law, the issuance of new is in itself not voidable. Directors may do so without shareholder approval even in the advent of a hostile bid as long as they can prove that the primary purpose of their action was the benefit of the company and was decided in good faith. However, the U.S. courts take a very cautious approach and have devised strict tests to decipher managers' incentives. On the other hand, under UK law, the decisive and most important factor is shareholder approval.

Restructured voting rights in the USA

A major takeover defense tactic that has been widely used by companies in the US is to restructure the company's voting rights so as to delegate voting power and control of the company in friendly hands. This tactic creates classes of stock with increased voting power or classes with no voting power at all and it is usually structured in two forms: either by forming two classes of common stock with disparate voting rights or by forming a new class of preferred stock with increased or no voting rights at all. The topic of the existence of different classes of shares with disparate voting rights has caused an extended debate on whether companies should be obliged to comply with the “one share-one vote rule" that requires that, for reasons of shareholders equality, all shares of stock within a single company should have equal voting power.

For instance, the creation of a class of preferred stock with increased voting power usually grants favourable voting rights to long-term investors and the ultimate goal of it is to undermine the bidder’s ability to elect his own directors on the board of a company, in order to amend its charter or by-laws. The main reason why this defense is famous is that it does not require shareholder approval at the time of issuing the preferred class of shares. Instead, it must be obtained only before the creation of the blank cheque stock [10] . Thus, a class of preferred stock with increased voting power can be issued by the board of directors in the face of a bid, without the need for shareholder approval, as long as it preserves existing shareholder equality by providing preemptive rights to all of them and it complies with state laws on the matter of the free transfer ability of shares. [11] 

In Unilever case [12] , the court “granted a preliminary injunction against the issuance of supervoting preferred stock which would carry different voting rights if transferred; the issuance was not approved by the shareholders of the corporation and was not based on pre-existing blank cheque preferred stock. The court concluded that the plan imposed restrictions on the transfer ability of shares that were inconsistent with section 202(b) of the Delaware General Corporations Law and also violated an express term of the company's certificate of incorporation, which required that all shares have identical voting rights." [13] Additionally, in Asarco, the court judged against a plan according to which all holders of the issued preferred stock were provided with increased voting rights, except for the ones that actually exceeded the 20 per cent limit. The court ruled that this was an unacceptable violation of the equity and equality of voting power among holders of shares of the same class.

Restructured voting rights in the United Kingdom

U.K. company law allows the introduction of both common and preferred shares with specific voting rights into the equity of a company. According to U.K. common law the only condition for the justification of this practice is shareholder approval of the issuance of the new shares. Thus, in Bushell v. Faith [14] , the House of Lords upheld a provision in the articles of association that clearly violated the rule of equality among shares of the same class: this provision armed only the shares held by the directors of a company with three votes for every single share, in cases of resolutions to remove a director from office [15] . The reasoning was that as long as the majority of the company had decided so, there was no violation of the relevant provisions of the Companies Act. However, in Hogg [16] , the directors of a company attempted to attach voting power of ten votes per share, to the stock held by the trustees of the company's employees' trust. However, they did not acquire shareholder approval in a general meeting, but utilised an article, relevant to the issuance of new shares, that provided the directors with the right to “issue shares with such rights or privileges" [17] as they might determine. Disregarding the article's authorisation, the court held that the directors did not actually exercise their legal rights in attaching the votes on their share because they were using their power to prevent a takeover bid.

Comparison of restructured voting right in the USA and the United Kingdom

A significant similarity between the two jurisdiction is very apparent. Shareholder

approval is key for the issuance of dual-class common stock or preferred stock, in both legal systems. In both legal systems there is the possibility of “an a priori authorisation to the board of directors" [18] that will provide them with the power to issue stock with increased or restricted voting rights, when they wish. However, under U.K. law, the conditions of the authorisation must specify the number and the voting power of the shares to be issued, while under U.S. law the authorisation may is general. Yet, when the directors decide to exercise their power, they have to comply with the rules of shareholder equality. Additionally, U.K. law provides shareholders with pre-emptive rights, while under US law it is up to the corporations statute of each state to decide on whether to impose pre-emptive rights or not. The important difference between the two legal systems lies in the regulation of the period after a takeover bid is made. In US law, there is no difference whatsoever regarding the appropriate conduct of the board after a bid is made, while in the UK, the application of the City Code “excludes the possibility of the issuance of disparate rights stock according to an a priori authorisation and imposes an obligation to acquire specific shareholder approval in the face of a bid." [19] 

Shareholder rights plans (poison pills) in the U.S.

The “poison pill" which is actually a shareholder rights agreement, is generally regarded to be the most widely used and most successful takeover defensive tactic that has been used frequently by companies in the US. This takeover defense came to prominence in the 1980s when it was used for the first time in the defensive arsenal of U.S. corporations in June 1983 [20] in the case of Lenox Inc. Battle with Brown-Forman Distillers Corporation. [21] The effect of the poison pill to deliberately increase the cost of a takeover in order to discourage the bidder, by providing the existing shareholders of a company with the ability to dilute the company's equity by buying shares at a very low cost, or compelling the acquirer to purchase shares of the existing shareholders at a very high price.

The rationale behind this was conceived in the case of in Moran [22] in which the Delaware Supreme Court acknowledged the possibility of issuing rights for non-financing purposes, provided that the issued rights have realistic values and not a fake connotation to them. The court held that the “flip-in plan was the equivalent to the anti-dilution clauses of some securities" [23] , which ensure that, in the event of a merger, their holders will be able to convert them into those securities that replace the issuer's stock. [24] The court’s reasoning established that the poison pill did not actually prevent the shareholders from receiving and accepting, because a bidder can always attempt to acquire a company by “tendering on the condition that the board will redeem the poison pill, or on the condition of receiving a maximum number of tendered shares" [25] . Additionally, the court held that the plan had no effect of infringement on shareholders' ability to conduct proxy contests, as it does not limit the voting power of individual shares. It was ultimately understood the use of poison pill can be regarded as a legitimate tool business decisions or judgments.

The case-law in the US is full of cases where the poison pill was accepted by the courts as a business practice especially when there were reasonable grounds to justify its use “such as the goal of furthering the company's mid-term development and expansion plans, or the criterion of proper motives and intentions." [26] There were, however, cases in which the courts refused to uphold the pill, such as in Dynamics [27] , [28] where the court felt that such “a poison pill was designed with the sole aim of causing economic loss to the bidder instead of protecting the interests of shareholders and that it was motivated only by entrenchment".

Shareholder rights plans (poison pills) in the United Kingdom

With striking contrast to the US, the UK has seldom seen the use of the “poison pill" and this is due to “procedural impediments and marginal effectiveness of the device itself, when it operates under the provisions of the City Code."

The City Code clearly prohibits the target board of directors from granting any options over unissued shares of the company after a bid has been launched, unless they obtain the approval of the shareholders. Thus the target cannot employ the poison pill in the form of options. However, before a bid has been made, the poison bill can be used only in the advent that the criterion of “proper corporate purpose" has been satisfied. Following this rule, the only possible purpose of a board of directors attempting to employ the poison pill would be its entrenchment in office, which obviously cannot be seen as a “proper corporate purpose". Furthermore, no cases have yet agreed to the continuation of the company's independence and business strategies as a proper justification for the adoption of defensive tactics, as it has been happening with the U.S. courts. Under UK law, the prerogative of deciding the company's business strategies, as decided by the directors, is that of the shareholders. Once again, we witness that shareholder approval is crucial to adopt a poison pill in the UK. It has also been suggested that, no cases has so far tried to use the poison pill before or after a bid as its efficiency would be restricted by the City Code provisions.

CONCLUDING REMARKS

The contrast between the U.S. and UK regulatory practices has considerable relevance for emerging economies both in Europe and elsewhere in the world. Reformers have too often

assumed that top-down, mandatory regulation, together with the courts, is the only way to regulate corporate transactions in emerging economies. But the success of the UK’s Takeover Panel suggests that this assumption is seriously flawed. The U.S. approach requires an effective governmental regulator together with an efficient court system. In many emerging economies, one or both of those elements are missing. In some, the parties that are most directly affected by corporate regulation — large shareholders, banks, and exchanges — are located in close proximity to one another. And they have a

direct financial stake in the success of the regulatory framework. In this context, informal self-regulation might prove more effective than the U.S. combination of formal statutes

and courts. The UK strategy will not invariably be the best, any more than the approach in the United States. But reformers and lawmakers should keep in mind that there are at least two ways to regulate takeovers, not just one.

Nor is there any evidence that Delaware will intervene anytime soon. In summary, the U.S. approach gives target managers discretion to defend a bid, whereas the UK gives the decision to shareholders. The principal decisionmakers in the United States are Congress and the Delaware courts. In the UK, by contrast, informal regulation by the Takeover Panel takes center stage. While neither approach is clearly superior substantively, the UK process seems quicker, cheaper, and more proactive in response to market developments.

Although the margin of permitted post-bid defensive actions is significantly narrowed by the City Code, target boards of U.K. companies have developed and followed some methods, in order to deter hostile bidders, that manage to avoid the prohibition against frustrating action. In particular, U.K. companies take advantage of the terms of the mandatory offer provision in the City Code, which excludes any possibility of partial bids. Thus, when a company becomes a takeover target, its board adopts a strategy based on two strands: inflating the target's stock price and defaming the bidder's reputation. All the above-mentioned defensive strategies are, of course, permissible and are usually adopted by U.S. target boards as well. However, the importance of these measures, except for the anti-trust challenge, is considered as secondary in the USA, given the fact that in the U.S. corporate law the discretion of the target board to adopt and employ other, more effective defensive tactics, without

shareholder approval, is much wider.