Different Routes in Regulating Takeovers

“Only the takeover scheme provides some assurance of competitive efficiency among corporate managers and thereby affords strong protection to the interest of vast numbers of non-controlling shareholders” – Manne (1965)

A takeover of a public company is the purchase of one company whose shares are listed on a stock exchange by another. Empirical evidence on takeovers suggests that they generally create value. The question is why have the UK and U.S- two countries with ostensibly similar systems of corportate governance taking different routes when it comes to regulating takeovers. A rich analysis draws from each country’s historical development, focusing on the shareholder-oriented regulations in the UK and the defence managerial tactics employed in the U.S. This paper would critically analyse the views of the writers of the “Divergence of U.S and UK Takeover Regulation” written by Armour and Skeel JR, both well seasoned Professors of Law, a thorough analysis would be made of hostile takeovers and the reasons why takeover tactics in the UK is regarded as a better option.

An analytical framework would be used explain the diversity in the systems of takeover in the UK and the U.S. subordinate lawmakers such as Judges have had the herculean task of filling the unintended vacuum and consequences of legislation in the two countries that had other objectives at the time of enactment. An examination of the way regulations took shape in the UK and the U.S as the goal is to gain an understanding of the defensive tactics adopted and used frequently in the U.S but is frowned at and has dire consequences if adopted in the UK. Earlier case examples from each jurisdiction would be analysed to gain understanding of why different takeover regulations are used. “In the UK, defensive tactics by target managers are prohibited, whereas in the U.S, Delaware law gives managers a good deal of room to manoeuvre” [1] . The primary focus of this essay is to provide a simple yet thorough framework to understanding defence tactics, what it is; why it is so successful in the U.S and is prohibited in the UK. Clearly the two ways of takeover regulations appear to work fairly well in each jurisdiction and despite the authors of the articles view one must never forget that because the UK methods seem more share holder oriented and works very well, it does not mean there is any anything wrong with the method used in the U.S.

In a takeover bid, accounting and law firms are hired to conduct “Due Diligence”- Lawyers review contracts, agreements, leases, current and pending litigation and all other outstanding or potential liability obligations so that the buyer can have a better understanding of the target company’s binding agreements as well as overall legal related exposure. The facilities in the company and capital equipment also need to be inspected so as to avoid unreasonable expenditures in the first few months of acquisition [2] .

The first section of the essay would look at an overview of the history of business law development and corporate governance in the UK and the U.S. the takeover development and institutional responses to them. The second part looks at the US and UK takeover regulations and their differences. Also legislation that have been implemented and the fact that despite legislation, subordinate lawmakers make rules that govern the process of takeovers. Who are these subordinate lawmakers and why do they appear to have so much discretion as to what becomes a rule? They include a diverse range of characters from Judges to interest groups (Institutional investors). The identity of the subordinate lawmaker, in turn has major consequences for both the substance and the enforcement of the regulatory rules [3] . Various case examples would be used to explain the difference in takeover methodology in the UK and the U.S, objectives of takeovers, the disciplinary hypotheses of the importance of takeover regulations. Finally, proposed reforms in the US and UK and a conclusive summary on the issues of hostile takeover tactics.

History

The UK and the US are distinguished from other jurisdictions based on their high levels of takeover activities; in contrast Europe has a little or no market for corporate control (Franks and Mayer, 1996). The UK does not have the federalist structure of the U.S which does not allow room for corporate managers to exert influence. In the U.S the Delaware jurisdiction became the sole source of rules on takeovers more so, hostile takeovers. The U.S takeover regulations give target managers discretion to defend a bid whereas in the UK the shareholders make the decision. Delaware have a monopoly and is home to about 60% of the largest corporations in the country. Due to the amount of tax and other benefits that Delaware State enjoys from these corporations the State is attentive to the managers’ needs and the state lawmakers have an incentive to keep the managers content. The Legal rules have to be amenable so that unprecedented cases can be brought cheaply and quickly after has been a change in business practices so as to allow the precedent cases to be developed and updated.

The Delaware takeover doctrine was firmly established in the 1990s- that US institutional investors became a significant force in corporate governance [4] unlike their UK counterparts that embraced the importance of the concept of institutional investors.

Corporate takeovers tend to improve not only the stock prices of the companies involved but also the stock market overall. Although there is a substantial increase in the target’s company’s stock price, the outcome for the acquirer and the market over time however is considerably negative. Also some ill-fated takeovers turn into an embarrassment for the parties involved for example the merger in 1996 of San Francisco banking giant Wells Fargo and its Los Angeles rival First Interstate Bancorp in an $11.6bn hostile takeover, the merge led to many of the latter companies executives leaving, account errors appeared in the company’s account and the problems were visible to the customers.

In the UK, lawyers play a relatively little role in takeover bids, complaints and law suits are made to the Takeover Panel – located in the London Stock Exchange building. The Takeover Panel includes representatives from the Stock Exchange, the Bank of England, major merchant banks and institutional investors [5] . The Takeover Panel is a body that administers a set of rules known as the City Code on Takeovers and Mergers. The Panel and the rules were self-regulatory until around 2007 when the EU directives have been implemented into the UK’s regulations and have a statutory underpinning designed with the objective of maintaining the characteristic features of the Panel’s approach, which is based on self-regulation. In the U.S however, takeover regulations are moderated principally by the Securities and Exchange Commission which ensures that disclosure and process rules are adhered to. A manager’s response to a takeover bid in the U.S is regulated primarily by the Delaware’s Chancery Judges and Supreme Court- the key players here are lawyers and judges.

U.S takeover

Takeover offers are regulated under the Williams Act Amendments to the Securities and Exchange Act (SEC) 1934. The act was created to provide governance of securities exchange in the stock market, all the companies listed on the stock exchange must follow its requirements. The SEC is regarded as relatively share-holder friendly, however managers are known to sometimes adopt a hostile approach to takeovers and they adopt defence mechanisms such as ‘poison pills’ or ‘shareholder right plan’ which are designed to ward off a hostile bidder’s stake particularly if the bidder acquires more than a specified proportion of target stock, usually 10-15 percent.

“The poison pill” is a defence tactic that allows companies to thwart hostile takeover bids from other companies, examples of the poison pill include ‘Flip-over’ Rights Plan, ‘Flip-in Rights Plan’, poison debt, voting poison pill plan etc. The managers of a company that use the poison pill defence and a staggered board of directors have almost complete discretion to resist an unwanted takeover bid, the poison pill is a method that is slowly declining in the last couple of years.

The U.S tender offers are generally not share holder friendly, in the case of Atmel Corp a maker of microchips used in video game controllers, successfully defeated a challenge by investors using the poison pill tactic. Some shareholders who sued over the failed buyout by Microchip Technology Inc stated that the revisions made by Atmel were vague, a Delaware state judge rules in Atmel Corp’s favour.

State statute such as Section 203 of the Delaware General Corporation Law furthers the federal policy of investor protection. It was enacted to “protect shareholders from the coerciveness of two-tier offers by preventing the offer unless the target’s board of directors and in some instances the shareholders approves”, the legislation has been successful in stopping such coercive practices. Section 203 also gives target boards some authority in resisting unwelcome, under priced tender offers that are not beneficial to shareholders. In the BNS Inc v Koppers Co., the U.S District Court explained that Section 203 does not stop the aims of the William Act even though it may give target boards significant advantage in preventing un-solicited takeovers.

To the contrary, the statute may have “substantial deterrent effects on tender offers…so long as hostile offers which are beneficial to target shareholders have a meaningful opportunity for success.” Section 203 does not have to let bad offers succeed to be constitutional, and in fact, if it did let bad offers succeed, it would frustrate, and not further, the Williams Act’s purpose of investor protection. In BNS , the district court concluded that, “on this record, the statute appears to offer hostile bidders the necessary degree of opportunity to effect a business combination” and upheld the statute [6] .

Another example is the recent April 2011 hostile takeover battle in the U.S between Tenet a hospital chain resisting a $7billion takeover by rival Community Health Systems. Tenet filed a lawsuit stating serious allegations that Community Health Systems is an unfit acquirer because the company has been systematically defrauding Medicare, evidence to support Tenet’s claim was provided. Not only is this allegation posed to resist a takeover, it can also potentially damage the reputation of Community Health Systems. This case ranks high in the pantheon of aggressive counter punches. The health care in the U.S remains the most targeted industry since 2009 with $179.1bn; accounting for 22.9% of total U.S targeted volume [7] .

Another case example was AOL’s purchase of Time Warner for $164bn at the height of the internet mania; it remains the largest corporate merger in American history [8] . Bidders are more likely to enter into negotiations with the target’s board which results in a friendly transaction than them making a ‘hostile’ offer directly to the shareholders.

UK Takeover

In contrast to the U.S, the UK takeover regulation is shareholder oriented. Managers in the UK are not permitted to make use of any frustrating defence tactics when there is a takeover bid without the shareholders permission unlike their U.S counterparts. The Takeover Code only becomes relevant when there is a bid therefore managers can take advantage of less stringent “ex ante” regulations well before any takeover bids come to light [9] .

J.Armour, D.A. Skeel, JR, in their article; The Divergence of the U.S. and UK Takeover Regulation state that “the UK’s ban on defensive tactics by managers clearly makes it easier for hostile bids to succeed”. It is bewildering to find that while the U.S adopts defence tactics measures, figures show that hostile takeovers are less likely to succeed there than in the UK.

Case Examples in the UK

In Jan 2010, Cadbury ended its nearly 200 years of independence after it was acquired by Kraft, a U.S food giant for 11.9bn pounds. The acquisition led to media frenzy and revived concern over the UK slowly becoming a so-called “branch office” for foreign companies, the UK Government was powerless to protect Cadbury, a heritage and one of the oldest companies in the country from foreign investment. The financial times stated in a article that “erecting barriers is not the answer, the key to solving the problem of foreign business moving their head offices to more favourable jurisdictions is to make Britain an appealing business location, with a skilled workforce and a predictable tax regime”.

Another case example is the Vodafone-Mannesmann acquisition in 2002 which is still referred to a lot by economists and critics. There have been concerns that hostile takeovers can take place provided that there is a simple majority vote from shareholders. The Government wants reforms to change this to two-thirds of shareholders and the bidders must be subject to the same rules.

Figure 1 below shows that the performance effects of takeovers differ by industry, some industries such as insurance companies have a higher number of takeover bids as opposed to banks that have a lower number.

Figure 1 Beneficial Ownership of UK shares end-2008 (Source: Office of National Statistics, Share Ownership 2008)

Difference between the US and UK takeover regulations

The most significant difference between the two countries is not the substance but the mode of regulation. The U.S depends on formal law such as the Delaware law while self-regulation is the norm in the UK.

In the Kraft-Cadbury takeover in the UK there was an outcry for change in the regulation as Cadbury was unable to defend itself to the same extent as a US company in similar circumstances, control decisions were made not by the directors but by short term investors.

Leading U.S law firms such as Wachtell, Lipson and Cravath that specialise in Mergers and Acquisition (Hereafter M&A) oriented practice generate significantly more revenue per lawyer than their UK counterparts.

Importance of Takeovers- Disciplinary Hypothesis

A takeover is sometimes used as a measure to restructure poorly performing companies. Critics and economics have long argued that the likelihood of competition in capital markets and the threat of a takeover is an incentive to discipline self-interested managers. Many writers have suggested a ban on the defence takeover tactics used in the U.S, such as the poison pills, golden parachutes and white knights- stating that these tactics more often than not are used purely for the managers/directors self interest. There have been numerous attempts by the Congress to set up legislative measures to prevent this out right abuse of power by the company managers and to protect the interests of the shareholders. There are however two hypotheses for the purpose of these defences: the shareholder hypothesis (SIH) and the management entrenchment hypothesis (MEH). The SIH is used purely to keep and satisfy the interests of shareholders whilst the MEH is used by the managers/directors of the company intended to be takeover to act in the interest of the shareholders for fear of losing their jobs if the takeover is successful, the end result of the MEH is usually that the shareholders would lose out on takeover premiums that the offeror would have paid.

This leads one to question whether the managers pursuing their self interests is a breach of their fiduciary duties to the company and its shareholders, as they have a duty to act in the best interest of the company first and foremost. The managers may use the argument that the two hypothesis work together and that the main reasons for the defence tactics is not for their self interest but to maximise the wealth of the shareholders, a valid argument I daresay, both conflicting views are obviously utmost in the strategies of the management in a takeover power tussle.

In the U.S the courts when determining whether a company management is in breach of its fiduciary duties look at the “Business Judgement Rule”- which provides that “a court should evaluate decisions by directors to employ an anti-takeover defence in the same way as they would evaluate any other business judgement” [10] . Basically anti-takeover defence tactics must be reasonable in relation to the threat posed and made in good faith. If the company’s corporate value or shareholder’s interest could be harmed due to the acquisition of its shares by a specific person or group, the company needs to take substantial measures to raise corporate value and secure shareholders’ interests to the extent permitted by laws, regulation, and the company’s Articles of Incorporation [11] .

In the UK, the takeover code states in Rule 19.1 that public criticism is one of the disciplinary measures available to the Panel. Rule 19.1 states that “each document or advertisement published or statement made, during the course of an offer must be prepared with the highest standards of care and accuracy and the information given must be adequately and fairly presented” [12] . For example in the Kraft takeover case of 2010, the company promised to keep operational some Cadbury factories, but failed to do so, this led to a public criticism from the press and the Takeover Panel.

OBJECTIVES OF TAKEOVER

Takeover or merger, in practice, depends upon the motives of the persons behind such move. Generally, the following types of decision limit their choice for a particular firm in which takeover or merger activity could be organised:

(1) Acquisition of shares in the target company;

(2) Acquisition of the assets of the target company’s undertaking;

(3) Acquisition for full or part ownership of the target undertaking;

(4) Acquisition for cash or for shares or other securities of the Offeror Company or combination of cash and variety of securities;

There is not one single reason for a takeover but a multiple of reasons cause which are precisely discussed below:

Synergistic operating economies:

It is assumed that existing undertakings are operating at a level below optimum. But when two undertakings combine their resources and efforts they with combined effort produce better result than two separate undertakings because of savings in operating costs, combined sale offices, staff facilities, plant management etc which lower the operating costs. Thus the resultants economies are synergistic operating economy. These gains are most likely to occur in horizontal mergers in which there more chances for eliminating duplicate facilities, vertical and multinational mergers do not offer these economies.

Diversification:

Takeover are motivated with the objective to diversify the activities so as to avoid putting all the eggs in one basket and obtain advantage of joining the resources for enhanced debt financing and better service it shareholders. Such takeovers result in conglomerate undertakings. But critics hold that diversification caused takeover of companies does not benefit the shareholders as they can get better returns by having diversified portfolios by holding individual shares of these companies.

Taxation advantage:

Takeover take place to have benefit of tax laws and company having accumulated losses may merge with profit earning company that will shield the income from taxation.

Growth advantage:

Takeovers are motivated with a view to sustain growth or to acquire growth. To develop new areas becomes costly, risky and difficult than to acquire a company in a growth sector even though the acquisition is on premium rather than investing in a new assets or new establishments.

(http://jurisonline.in/2011/03/takeover-a-critical-analysis/ Assessed 12th April 2011)

Reforms in the UK

There was an urgent need for reforms in the UK takeover regulation after acquisition of Cadbury by Kraft. The following are some of the proposed reforms.

Proposals to give target companies more protection under the Takeover Code

The Government wants the simple majority vote by shareholders to be changed to a two-thirds of shareholders in other to ensure that as many shareholders as possible are supportive of the takeover.

The prohibition of any “offer related arrangement e.g implementation agreements

Reducing the “put up or shut up” deadline from 2months to 28days- This means that a potential bidder must announce a firm intention to make an offer, declare no intention or ask for an extension of the deadline. If no bid is announced the bidder is excluded out of the market for six months. There have been criticisms that the 28day period is not enough time for bidders to undertake due diligence and arrange financing.

Detailed disclosure of advisory fees- there is no requirement at the moment under the Takeover Code for advisory fees to be disclosed. It is intended that any offer-related fees be disclosed in the offer document and target’s response. This includes legal advice, accounting and consulting advice, broking advice etc. The proposal disclosure changes are not controversial and in fact tally with the current system in the U.S.

Greater disclosure of debt facilities and other instruments to finance an offer- a bidder’s financing arrangements should be disclosed in any offer documents. This need for transparency and accountability may be prompted due to the recent financial crisis in the UK

Provision of better protection of the interests of employees of the target company

These proposals were made in March 2011 and a consultation period is open until the 17th of May 2011 after which the UK Panel will then issue a statement with the final version of the amendment, the amendments will be adopted into the UK Takeover Code later in the year [13] .

Conclusion

Even before the financial crisis there have been fundamental reassessments of the value of takeovers in the UK and the U.S. Since the financial crisis most board of directors and managers have been more concerned with running their businesses and staying afloat than with chasing expansion through takeovers. This factual point is true when the probability of a successful merger is far less certain, as in hostile takeover attempts.

A hostile takeover presents executive board leaders with unique organisation and people challenges. It is often very difficult to overcome the challenges of acquiring and integrating an organisation and people especially after a hostile takeover. Times like this need a higher level of strategic thinking, flexibility and innovative problem solving [14] .

This paper finds that the UK takeover regulation despite its numerous advantages is prone to hostile takeovers due to its compliance with upholding the interests of shareholders, while this hostile takeovers act as a form of disciplinary function by restructuring poor performing companies and improving their performance, evidence above stated shows that hostile targets in most cases experience a significant decline in profits and share returns in the first year of acquisition. Despite the criticisms of the U.S system of regulation, hostile takeovers are in decline due to the level of discretion given to the executive directors and managers by the legislation that provides antitakeover regulations that are enshrined in the corporate charters and/or state legislation.

Also in a self regulated system like the UK, institutional investors who own majority of the shares in UK quotes companies shaped the Takeover Code.

BIBLIOGRAPGHY

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http://www.complianceweek.com/s/documents/DealogicGlobalReview.pdf (assessed 18th April 2011)

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http://www.investopedia.com/articles/stocks/07/buyside_m_and_a.asp (Assessed 18th April 2011)

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http://www.cbr.cam.ac.uk