A “poison pill” is a defensive tactic used to discourage a hostile takeover. Professor John D. Morley of Yale Law School explains (1) how they work, (2) why they are so effective at stopping hostile acquisitions, and (3) how can they be overcome.
A poison pill is a tool used by corporate boards to make an acquisition intolerably expensive. The way that a poison pill works is by setting a trigger or threshold in the terms of stock ownership which, if reached or surpassed by a particular shareholder, will result in the dilution of that shareholder's interest in the company. Morley gives the example of a company that sets its poison pill trigger at 15% of the company’s stock. If a shareholder then purchases a 17% position in the company, the company may then make significant quantities of stock available for purchase to all other shareholders at a reduced price or even at no cost at all. This can both make the potential acquisition more expensive and at the same time significantly dilute the potential acquirer's share.
Professor Morley explains that poison pills are so effective that they can make takeover bit through purchase of a majority of stock an impossibility. So how can they be overcome? Generally, the only options are either to get the approval of the board, by increasing the purchase price or to replace sufficient board members to permit the removal of the poison pill.
John D. Morley a professor of law at Yale Law School. His research focuses on the law and economics of organization, with a special emphasis on the regulation and structure of investment funds.
Interview with Yale Law Professor, John D. Morley
Joel Cohen (Host): John, let's talk about poison pills, a particularly famous or infamous tool in the arsenal of hostile takeover defense. What is a poison pill and how does it work?
The Origin of the Poison Pill
Professor John D. Morley: The poison pill is tremendously famous. The poison pill was invented in the 1980s by a man named Marty Lipton, who's one of the named partners at the law firm Wachtell, Lipton, Rosen, and Katz. Wachtell basically made itself famous and very, very rich in the 1980s and 1990s defending companies against hostile takeovers, and one of the firm's greatest inventions was the poison pill. The poison pill is so named because it's like the cyanide pill that the pilots of U-2 fighters were supposed to take if their plane went down.
Host: Oh wow, so I'll take poison before you can torture me from my secrets?
John Morley: That's right. I'm gonna take the cyanide pill and you'll never get anything out of me. Put differently, it's a kind of scorched-earth strategy.
How Does a Poison Pill Work?
John Morley: A poison pill is a little complicated, but it works very effectively. The basic idea is this – a company puts a provision in its governing documents that says that the board of directors can issue a form of preferred stock giving the existing stockholders the right to purchase stock at a discounted price upon the happening of a certain event, and the event is the acquisition of a certain number of shares by an acquirer.
Host: For example, a 15% threshold for the poison pill to come into effect.
John Morley: Yes, if I acquire 17% of the company's shares, then all of the existing stockholders other than myself will get the right to purchase new shares at some discounted price, sometimes for nothing at all. Sometimes for zero dollars.
Host: Which would make buying the company a lot more expensive.
John Morley: Yes, because let's say that a company has 100 shares outstanding, and I have just acquired 15 of them. And in so doing, I've triggered a poison pill. Let's say that the remaining shareholders all get another 100 shares for free. Well, now all of a sudden instead of owning 15 percent of the company I own 7.5%. That is to say 15 shares out of 200 total shares outstanding, and moreover because all of these existing stockholders have received their shares for nothing, the value of my shares has been effectively deflated.
Host: What if you hit the 15% again, is the poison pill triggered a second time.
John Morley: There's some dispute about this, the reason it's uncertain is that poison pills vary. Some poison pills might be re-triggered, some might not. Additionally poison pills have proven so effective that nobody's ever really triggered one twice. So we don't really know for sure what would happen, but poison pills are highly effective because they make it essentially impossible for anyone to acquire more than a certain number of shares.
How Can a Poison Pill Be Overcome?
Host: John, you mentioned Marty Lipton, the lawyer who invented the poison pill. I know there are also a lot of very fancy, high-paid lawyers out there trying to figure out how to get around these provisions. What strategies are there to attempt to overtake a poison pill?
John Morley: Yes, I spent a lot of time in my classes at Yale Law school teaching people both how to set these things up and how to get around them, and these graduates go on to get paid a lot of money to do precisely this. So, poison pills have one crucial weakness which is that if you gain control of the board of directors, you can remove it. So, if I run a proxy contest and I get my candidates on the board of directors before I trigger the poison pill, then they can vote to remove the poison pill and pave the way for me to acquire a lot of shares. Crucially, I have to get control of the board of directors before I actually trigger the pill because once the shares, once the rights to acquire shares are out there in the hands of shareholders and once they've been triggered, the board can't unilaterally take them back. And I should say that the poison pill is especially vicious because every company in the United States has one implicitly.
Host: What do you mean by that?
John Morley: A company can basically adopt a poison pill overnight or really in a matter of minutes. All that has to happen is the board of directors resolves to do the sorts of things that would involve the adoption of a poison pill so even if a company doesn't have a poison pill right now, it could have one 10 minutes from now by just getting on the phone and calling its lawyers. So, as a practical matter every single company in the United States effectively has one.