What is a Defense Mechanism?
In M&A transactions, a defense mechanism (also known as a defense strategy) is any set of procedures that are employed by a target company to prevent a hostile takeover. A hostile takeover is a type of acquisition in which a bidder takes over a target company without the consent, and against the wishes, of the management or board of directors of the target. Hostile takeovers are executed through the acquisition of a controlling interest in the target company by a bidder.
In some cases, the issue of fiduciary responsibility can make using defense mechanisms controversial. For example, if the management of a target company resists a takeover, they may exploit the information asymmetry between them and the company’s shareholders and prevent the takeover even if the deal can potentially create value for the shareholders.
Generally, defense mechanisms can be divided into two broad categories: pre-offer defense mechanisms and post-offer defense mechanisms.
Types of Pre-Offer Defense Mechanisms
The pre-offer defense is a preemptive strategy. It is primarily used to either make the company’s shares less attractive for a potential bidder (e.g., increase the overall acquisition costs) or set restrictions in corporate governance to limit the benefits to the potential bidder. The pre-offer defense mechanisms include the following strategies:
1. Poison pill
The poison pill defense includes the dilution of shares of the target company in order to make it more difficult and expensive for a potential acquirer to obtain a controlling interest in the target. The flip-in poison pill is the issuance of additional shares of the target company, which existing shareholders can purchase at a substantial discount. The flip-over poison pill provides an opportunity for target company shareholders to purchase shares in the acquiring company at a significantly discounted price.
2. Poison put
The poison put defense can be considered as a variation of a poison pill, as this defense mechanism also aims to increase the total cost of acquisition. The poison put strategy involves the target company issuing bonds that can be redeemed before their maturity date in the event of a hostile takeover of the company. The potential acquirer must then take into account the extra cost of repurchasing bonds when that obligation changes from being a future obligation to a current obligation, following the takeover.
Unlike the poison pill, the poison out strategy does not affect the number of outstanding shares or their price. However, it may create significant cash flow problems for the acquirer.
3. Golden parachutes
Golden parachutes refer to benefits, bonuses, or severance pay due to the company’s top management staff in case of termination of their employment (such as might occur as part of a hostile takeover. Thus, they can be employed as yet another takeover defense mechanism that aims to increase the total acquisition cost for a bidder.
4. Supermajority provisions
A supermajority provision is an amendment in the corporate charter stating that a merger or acquisition of the company can only be approved by the board if a very large percentage of its shareholders (typically 70% to 90%) vote in favor of it. The supermajority provision supersedes the usual simple majority provision that only requires approval from more than 50% of voting shareholders.
Types of Post-Offer Defense Mechanisms
Post-offer defense mechanisms are employed when a target company receives a bid for a hostile takeover. The examples of post-offer defense mechanisms are:
1. Greenmail defense
Greenmail defense refers to the target company buying back shares of its own stock from a takeover bidder who has already acquired a substantial number of shares in pursuit of a hostile takeover. The term “greenmail” is derived from “greenbacks” (dollars) and “blackmail”. It’s a costly defense, as the target company is forced to pay a substantial premium over the current market price in order to repurchase the shares. The potential acquirer accepts the greenmail profit it makes from selling the target company’s shares back to the target at a premium, in lieu of pursuing the takeover any further. Although this strategy is legal, the acquirer is, effectively, sort of blackmailing the target company, in that the target must pay the acquirer a premium – through the share buybacks – in order to persuade it to cease its takeover attempt.
2. Crown jewel defense
The crown jewel defense strategy involves selling the most valuable assets of a target company to a third party or spinning off the assets into a separate entity. The main goal of the crown jewel defense strategy is to make the target company less attractive to the corporate raider.
3. Pac-Man defense
The Pac-Man defense occurs when a target company attempts to acquire its potential acquirer when a takeover bid has already been received. Just as the acquirer is attempting to buy up a controlling amount of shares in the target company, the target likewise begins buying up shares of the acquirer in an attempt to obtain a controlling interest in the acquirer. Of course, such a strategy is only workable if the target company has enough financial resources to purchase the required number of shares in the acquirer. The acquirer, seeing control of its own firm threatened, will often cease attempting to take over the target.
4. White knight defense
The white knight defense is a strategy that involves the acquisition of a target company by its strategic partner, called a white knight, as it is friendly to the target company. This is generally a strategy of last resort. The target company accepts the fact of being taken over, but can at least opt to be taken over or merged with a friendly company, as opposed to being the victim of a hostile takeover.
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