The Poison Pill Defense – How Board Flipping Clauses Secure Control In A Company

Board flipping clauses, or poison pills as they are often referred to, are a powerful strategy to deter hostile takeovers. If you’ve been watching this space, you’ve likely read about what hostile takeovers are and their potential impact. Founders risk losing control of their companies or getting ousted.

Although publicly traded companies utilize board flipping clauses more commonly, private companies can also use this strategy. Know that this defense approach is also called the shareholder rights plan. Its objective is to make the target company less viable for acquisition.

By deploying this strategy, you’ll effectively dilute an unwanted acquirer’s ownership stake that they intend to leverage for the takeover. Let’s dive in to understand in detail how this defense works.

Understanding Board Flipping Clauses or Poison Pills

The credit for devising the poison pill strategy goes to Martin Lipton of the law firm Wachtell, Lipton, Rosen & Katz. In 1982, Lenox faced the threat of a hostile bid from Brown-Forman after a friendly merger deal failed to materialize.

Lipton advised Lenox’s board to issue a “Special Cumulative Dividend” that entitled shareholders to purchase shares in the merged company. But with a benefit. Shareholders could buy shares in the newly formed company at steep discounts if the merger happened.

As a result, Brown-Forman had to raise its offer and renegotiate the deal. The move proved to be so successful that by 1989, around 60% of Fortune 500 companies had deployed it. Though, many countries have laws that negate the poison pill strategy.

In essence, board flipping clauses enable a target company to dilute its shares. As a result, the hostile bidder cannot acquire a controlling share without incurring massive costs. Thus, it acts as a powerful deterrent. Acquiring entities that lack the necessary resources must give up the attempt.

The shareholder rights plan has a trigger built into it, which activates when a specific shareholder acquires a pre-determined stake. This limit is set at 15% to 20% and is mentioned in the company’s bylaws. The buyer initiating the hostile bid is barred from purchasing the discounted shares.

Using this strategy, the target company’s board can maintain control over the company in case of a takeover threat. This threat can come from potential competitors, activist investors, or any other hostile entities. To make the acquisition happen, they must negotiate a buyout price with the board.

US courts recognize board flipping clauses as legitimate defenses that company boards can use. The board is not obligated to accept an offer detrimental to the company’s long-term interests.

How Poison Pills Work

Board flipping clauses are designed to avert unwanted and hostile takeover bids. Here, the acquirer attempts to use stealthy methods to gain control of the company by accumulating controlling or dominant stakes. But, without openly negotiating with the board or offering a deal to shareholders.

Purchasing a large number of shares in a company entitles the buyer to ownership and voting rights. If the buyer owns an adequate number of shares, their votes carry more weight than those of stakeholders with fewer shares. As a result, they can vote out the board or make decisions.

Voting rights will also allow the buyer to merge the company with their own or sell off the target’s assets. This is why company owners create preventive provisions in the company’s bylaws, share subscription agreements, or articles of association.

This board flipping clause enables them to establish a share ownership limit. According to the clause, as soon as a single entity or person acquires or purchases a stake of 15% or more, the company can take measures. It can issue shares or undertake any action to prevent a hostile takeover.

All the other shareholders, excluding the 15% holder, become eligible to purchase additional shares at significant discounts or for free. This action increases the number of outstanding shares, effectively lowering the hostile’s percentage and ownership stake. Thus, the takeover bid is averted.

The hostile acquirer now has no choice but to purchase a large number of shares to maintain that 15% stake. The acquisition becomes much more complex and expensive.

The right time to implement the poison pill is when you draft the articles of association and share subscription agreements. With the advice of expert legal counsel, you’ll include these provisions as a failsafe measure to protect against the risks.

Types of Poison Pills

Board flipping clauses or poison pills can be of different types, the most common being “flip-in” plans or “flip-over” plans. These provisions are legal mechanisms backed by the articles of association. Poison pills include considerations such as:

• The pre-determined percentage stake the acquirer buys, which can be 15% to 20%. Once that threshold is reached, the company can implement the shareholder rights plans.
• A conversion or discounted price at which shareholders can purchase the shares, regardless of the current market price.
• The time frame within which shareholders can exercise their rights to complete the share purchase.

Flip-In Shareholder Rights Plan

Flip-in plans allow shareholders to purchase additional shares at significant discounts. This option is available only to existing shareholders to dilute the potential acquirer’s stake. The board flipping clause comes into play before the takeover.

Flip-Over Shareholder Rights Plan

Flip-over plans allow existing shareholders of the target company to purchase shares in the newly formed company at discounted prices.

Alternatively, they can buy shares in the acquirer’s company, again at discounted prices. This strategy significantly dilutes the acquirer’s equity and is triggered as soon as the acquisition is closed.

Dead-Hand or Slow-Hand Poison Pill

Including the dead-hand or slow-hand poison pill in the company’s bylaws secures board flipping clauses from future directors. New directors cannot remove or cancel the provision without getting approval from a board majority.

The majority must comprise current board members or the successors they choose. The dead-hand poison pill also sets a timeline within which directors cannot remove or change the clause.

Not all states permit this provision, so you’ll need the advice of your legal counsel. For instance, the states of Pennsylvania and Georgia permit this strategy.

Wolf Pack Provision

The wolf pack provision is included in the poison pill strategy and applies to the aggregate holdings of shareholders. That is, if these shareholders act together to achieve a common goal without expressly indicating their intentions.

A good example is hedge fund managers who are known to acquire stakes in companies separately. Their objective is to achieve a specific activist agenda without communicating their intentions to the board.

This strategy allows them to accumulate a controlling percentage in the company with proportionate voting rights. The wolf pack provision deters them from taking control or making radical decisions.

Employee Vesting Schedule

You’ll include provisions in employee stock options that result in their vesting instantly when the merger happens. Since employees can claim shares, this right can effectively dilute the acquirer’s ownership stake.

Leveraging employee stock options is a strategic approach since they are unlikely to support any decisions against the company’s interests. Or, against the management’s wishes.

Including failsafe measures in the company’s bylaws is only one of the myriad aspects you should know about when building a business. Here’s a video outlining how to launch your company, which includes more details you’ll find helpful.

Advantages of Board Flipping Clauses

• By exercising the poison pill strategy, you and the company’s board can execute your fiduciary duty. The law expects you to secure the interests of all the shareholders. Third parties seeking control over the company could result in a small minority using tender offers to make major decisions. These decisions may not align with the company’s future growth and profitability or with the interests of smaller shareholders.
• Board flipping clauses help you secure the company from economic downturns when markets are volatile. Third parties may take advantage of temporarily low share prices to gain control of the company. A good example is the pandemic, when hundreds of American companies had to leverage shareholder rights plans to prevent takeovers.
• Demonstrating poison pill defenses in the articles of association could attract premium bids for purchasing the company. Genuine buyers are interested in paying higher prices for deals in which the company is secure from hostile takeover attempts.

Disadvantages of Board Flipping Clauses

• Exercising the poison pill invariably results in the company’s share price dropping, even if it is for a short time. You will have effectively diluted the overall equity by offering stock to current shareholders. Recovering from this setback can take time.
• Shareholder rights plans protect directors from being ousted from the board. This can be a disadvantage when shareholders seek to remove underperforming board members.
• When the poison pill clause protects directors, they may not be inclined to perform well or respond to shareholder concerns. They may also make decisions to benefit themselves rather than the company’s and shareholders’ interests. Be wary of entrenched managers and directors, particularly when they have the right to choose their successors.
• Be aware of sunset provisions according to which poison pill provisions are valid only up to a specific date. After this deadline, the provisions automatically expire. You can always extend the deadline, but it has to be with the mutual consent of all the parties involved.
• Poison pills prevent hostile takeovers but also hinder a change of management, leadership, and ownership, which are essential for the company. Sometimes, the company can benefit from a fresh perspective and strategic direction for accelerated growth.

While shareholder rights plans have their pros and cons, the decision to accept an acquisition or merger has multiple nuances. You’ll explore the different aspects of the takeover offer and make the best decisions for the company’s long-term growth and stability.

Limitations to Using the Board Flipping Clauses

Before choosing to sell the company, you’ll explore the different options available to you. Weigh your options before accepting an offer that brings the maximum price for the company. Ultimately, poison pill defenses and their success hinge on the context of the deal and its implementation.

• As mentioned earlier, the law expects the board to act in the best interests of the company and its shareholders. It’s their fiduciary duty. However, violating these duties by exercising the poison pill can attract legal charges.
• Concerned stakeholders can work around the poison pill strategy by gathering proxy votes from multiple small shareholders. Once they have an adequate number of votes, they can force directors to step down. Or, accept the acquisition offer to sell the company.
• A third party attempting a hostile takeover can initiate the proxy fight and push shareholders to replace the board. The acquirer may install directors who are in favor of the acquisition and thus accept the takeover bid.
• If investors perceive the poison pill provision as negatively impacting the company’s interests, they may hesitate to invest capital. A poorly-performing board protected by poison pill clauses is a significant red flag. This factor can also negatively influence the company’s share prices.

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Case Study of an Effective Poison Pill Defense

One of the most famous examples of board flipping clauses foiling a hostile takeover is that of Netflix. In 2012, Carl Icahn, an investor, announced that he and his affiliates owned a 10% stake in the company. They wanted to take control of Netflix (NFLX).

The board responded by implementing the shareholder rights plan that would allow them to buy newly issued shares. These shares were available at a discount to any entity interested in purchasing a 10% or higher stake. This offer would dilute the stake Icahn and his affiliates owned.

Thus, Netflix rebuffed the takeover bid with a poison pill that remained in effect until 2015. Ultimately, Icahn sold his stake for a significant profit.

The Takeaway!

Poison pill defenses or board flipping clauses are powerful strategies you can implement to retain control of your company. Including this provision in the articles of association can add a layer of protection from hostile takeover bids.

However, you should be aware of the possible limitations and potential downsides if the provision works against the company’s interests. Also, be cautious of the market perceptions you’ll create and if it can pose hurdles when securing funding.

Work with your legal team to draft the poison pill provision to deter hostile bids, but also add limitations. Your ultimate goal should be to ensure the company’s long-term stability, growth, and robust leadership.

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