Gary Galles is a professor of economics at Pepperdine University.
Last March Yahoo! announced that its board of directors had adopted a shareholder-rights plan, which it described as “designed to deter coercive takeover tactics, including the accumulation of shares in the open market or through private transactions, and to prevent an acquirer from gaining control of Yahoo! without offering a fair and adequate price and terms to all of Yahoo!’s stockholders.”
In other words, the directors were doing it to protect their owners. But the next day Yahoo! stock fell 11 percent (to a level more than 90 percent below its 52-week high). Why would stockholders react so adversely to something called a “shareholder-rights plan”? Why would they dislike getting extra rights for free? The more common term for such plans, “poison pills,” points us to the reason.
Similar to many other shareholder-rights plans, Yahoo!’s plan essentially gives existing shareholders the right to purchase additional shares of the company’s stock at a substantial discount below their market value if someone acquires more than 15 percent of the common stock or attempts a hostile takeover of the firm. Of course, whoever is seeking control is denied that right.
On the surface, such a plan would appear to benefit stockholders by allowing them to buy added shares for less than they are worth. But in fact they typically harm stockholders. The dilution of share value that would result from an attempted takeover by anyone not friendly with existing management means that such takeovers will not be attempted.
What’s wrong with that? When a firm’s management fails to maximize shareholder value, a takeover or merger can let the owners install new management that promises to perform better. Such takeovers pay shareholders a substantial premium over current share prices, a premium they would very much like to receive. But a takeover defense can prevent such a restructuring and protect the current management from the threat of being ousted. And poison pills are the most effective takeover defense allowed by the courts without shareholder approval. (If they were subject to shareholder approval, owners could defend themselves by voting them down.) As a result, despite the uniformly pro-shareholder rhetoric that accompanies poison-pill announcements, in fact they are often devices to benefit existing management and shortchange shareholders.
Courts have permitted poison pills in deference to the “business judgment” rule, which presumes that boards of directors act in the interests of their shareholders rather than to preserve the managers’ interests or their own positions on the board. But this is misguided in the case of unapproved poison pills. Allowing the management and board, which are delegated agents of stockholders, the right to preserve their jobs by halting takeovers that owners would approve effectively gives those bodies the right to change their employment contract unilaterally so that owners can no longer fire them in favor of another management team. Shareholders would never agree to a delegation of power to management that is so clearly contrary to their interests, which is why shareholder activists are pursuing anti-poison pill resolutions at many corporations.
This lays the blame for the abuse of poison pills squarely on the courts’ misunderstanding of shareholders’ interests. They have essentially viewed poison pills as something-for-nothing deals for current shareholders, and since (in their view) shareholders wouldn’t oppose them, they need not be asked for their permission before managements unilaterally adopt them. However, poison pills are really often nothing-for-something deals that current shareholders would reject—given the chance. As a result, the courts’ mistaken presumption that shareholders’ rights are automatically protected in such cases has led them to allow managements to implement poison pills without shareholder approval, undermining shareholders’ rights in the process.
The supposed additional shareholder rights granted by poison pills are nearly valueless, as their mere existence all but eliminates the takeovers that would trigger them. But they do take from shareholders the valuable right to the premium prices they could have received if hostile takeovers had remained possible. Taking away this valuable shareholder option without their consent is not in owners’ interests, which is reflected both by owner opposition and by negative stock price changes when most poison pills are adopted without shareholder approval.
A Better Way
If Yahoo!’s board intends to protect stockholders from abuses that may occur in a takeover, there are far less restrictive ways to do so. It could, through a variety of indirect methods, require that any share purchase offer be made to all shareholders, rather than to just enough shareholders to acquire control. It could require that any offer for shares must remain in place for a period long enough to give other bidders a chance to counter with an even higher offer that would benefit current owners more. If the board is trying to extract a higher premium through the poison pill, it could void the pill if an all-cash offer with at least, say, a 25 percent premium was tendered. But such alternatives were not mentioned.
In the words of financial economists Andre Shleifer and Robert Vishny, “hostile takeovers are probably the most effective way for shareholders to get rid of non-value-maximizing managers” (“Value Maximization and the Acquisition Process,” Journal of Economic Perspectives, Winter 1988, p. 11). Unilateral board adoption of poison pills short-circuits that mechanism. Given that there are alternative ways to protect stockholders from any abusive takeover tactics, poison pills are more likely a defense of bad management than a defense of stockholders’ rights. They undermine the market for corporate control and, as a result, the value of stockholders’ investments.
However there is hope that shareholders’ rights will be reinstated. A 1999 ruling from the Denver-based Tenth Circuit Court of Appeals has begun undermining poison pills not approved by shareholders. Affirming the first-ever federal opinion on the issue, the appellate court ruled that unless a company’s charter gives only directors control or state law explicitly gives directors the rights to create poison pills, shareholders can overrule their boards and revoke poison-pill takeover defenses.
The ruling is now binding only in the six states covered by the court, but it could be extended to others. While almost half the states give directors the right to create poison pills (which would not be changed by the ruling), California and Delaware (where most Fortune 500 companies are incorporated) do not. While threatened managements are seeking to protect themselves through changes in state law, anti-poison pill resolutions are being pressed in other states, effectively expanding the court precedent beyond the Tenth Circuit.