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March|April 2005

The Perfect Pill

A small innovation that transformed corporate takeovers.

By Len Costa

THE MODERN HISTORY OF MERGERS AND ACQUISITIONS divides neatly into two eras marked by a landmark ruling of the Delaware Supreme Court in 1985. Before then, financiers like T. Boone Pickens and Carl Icahn regularly struck terror in the hearts of corporate boards. If these dealmakers wanted to take over a company in a hostile maneuver, break it into pieces, and then spin those pieces off for a profit, it was difficult to stop them. But after a decision by the Delaware court, directors regained control of their companies' destinies.

The directors' trump card is a controversial innovation technically called a preferred share purchase rights plan but nicknamed the "poison pill." Its legality was affirmed unequivocally for the first time in the Delaware ruling of Moran v. Household International. By the unanimous vote of a three-judge panel, the court held that a company could threaten to flood the market with newly issued shares if a hostile suitor started buying up lots of its stock, thus diluting the suitor's existing holdings and rendering the acquisition prohibitively expensive. The poison pill quickly transformed takeover law and fortified the reputation of its creator and staunchest defender, Martin Lipton—co-founder of the New York City law firm Wachtell, Lipton, Rosen & Katz.

Today the poison pill endures, but the controversy has evolved. Critics say board control of the pill ignores the will of shareholders and protects underperforming managers. Advocates say the pill helps boards secure higher takeover prices, which puts more money in shareholders' pockets. Most recently this debate was sparked when the board of the software company PeopleSoft used a poison pill to fend off the takeover effort of Oracle until the rivals agreed to a deal in late 2004.

Still, both sides agree that the poison pill is an ingenious creation. "As a matter of lawyering, it's absolutely brilliant," said Stanford University law professor Ronald Gilson, a longstanding critic who nonetheless considers the poison pill to be the most significant piece of corporate legal artistry in the 20th century.

THE TERM "POISON PILL" COMES FROM THE DOMAIN OF ESPIONAGE and refers to the cyanide pill spies are instructed to swallow rather than face capture. When it comes to takeovers, poison pills are equally fatal. There are several variations, but most work roughly the same way. If a hostile bidder acquires more than a preset share of the target company's stock, typically 10 to 15 percent, all shareholders—except, crucially, the hostile bidder—can exercise a right to purchase additional stock at a 50 percent discount, thus massively diluting the suitor's equity stake in the takeover target. No acquirer since 1985 has "swallowed a pill" and successfully taken over a protected company.

A second, older feature of the poison pill protects target company shareholders from forced mergers like those made famous in the 1980s. This feature, which is extreme and has never been triggered, would enable besieged shareholders to buy shares of the bidding company at a discount, thus diluting the bidder's own shareholders.

THE NICKNAME "POISON PILL," WHOSE NEGATIVE CONNOTATIONS Lipton says are "unfortunate," first surfaced in 1983 during the hostile takeover of Lenox, the fine china maker, by Brown-Forman Distillers, which produces Jack Daniel's whiskey. Lipton says the naming rights for the pill go to Martin Siegel, Lenox's lead investment banker. According to Lipton, Siegel was the first banker to endorse the pill's adoption as a takeover defense, and he flippantly coined the term in an interview with The Wall Street Journal. The nickname soon landed on the paper's front page in a story illustrated with a skull and crossbones.

The pill's origins, though, date to a pair of hostile takeover battles in Texas that garnered headlines in December 1982. In the first clash, General American Oil was defending itself from a bid by Pickens. Lipton urged General American's board to fight back by employing an early form of the pill. But the tactic's legality had not been tested and General American's own bankers balked. The company was subsequently sold to a last-minute bidder, Philips Petroleum.

Undeterred, Lipton flew from General American's board meeting in Dallas to Houston, where a Wachtell, Lipton law partner was seeking defenses for The El Paso Company, a second takeover target. According to Wachtell, Lipton's written history of events, the partner told Lipton when he arrived, "There's nothing. . . . El Paso does not have any meaningful defenses in place."

But while poring over the company's financial statements, Lipton discovered that its board had blanket authority to issue preferred stock without obtaining shareholder approval. Armed with this early version of the pill, El Paso negotiated its sale to the hostile suitor, Burlington Northern, from a position of strength.

With so much money at stake, a court ruling wasn't far off. The legality of the modern poison pill was challenged in the Delaware courts, where about 60 percent of the Fortune 500 companies are incorporated, and it was confirmed in a series of four cases culminating in the Household International decision. In that case, John Moran, a financier and Household board member, filed suit to invalidate the company's pill, which he worried would stifle friendly bids (including, potentially, his own). Lipton, who defended the Household board of directors, obtained his landmark ruling: The Delaware Chancery Court definitively upheld a board's right to adopt a pill—without seeking shareholder approval—and the right of the company's independent directors to refuse a takeover bid. The state Supreme Court upheld that ruling.

WITH SO MANY PUBLIC COMPANIES INCORPORATED IN DELAWARE, the impact of the Household ruling on the legal profession was swift. Prior to the case, Wachtell, Lipton lawyers had designed roughly half of 35 poison pills in effect. Afterward, rival firms—including Skadden, Arps, Slate, Meagher & Flom, a key advisor to the era's top takeover artists and the firm that lost the Household ruling—began marketing their own versions of the pill. A year later, 300 companies had adopted poison pills and the tactic soon began to spread abroad as well.

"Poison pill" and its primary definition debuted in 1988 in the newly published Webster's New World Dictionary of American English. Today, the term isn't confined to the worlds of hostile takeovers and espionage. Washington policy makers use "poison pill" to refer to controversial legislative provisions that are added to a bill in an effort to kill it. Computer programmers have developed "poison pill" applications that are designed to frustrate spammers.

Among the 2,000 large companies tracked by the Investor Responsibility Research Center, a corporate governance research firm, last year 53 percent had some form of the poison pill written into their bylaws. The others can put pills in place quickly. Last November, News Corporation drew up a pill in a hurried effort to neutralize Liberty Media chairman John Malone, who had acquired an option to nearly double his firm's shares of News Corporation voting stock, threatening the control of chairman Rupert Murdoch.

Many observers remain troubled by the unchecked power of the pill. Nell Minow, co-founder of a corporate governance research firm called The Corporate Library, argues against board-controlled poison pills by noting that public companies belong to their shareholders. "Property is supposed to be alienable," she said. "For a board to say it isn't diminishes its value." Minow would prefer that stockholders have the final say. Stanford's Ronald Gilson contends that companies should adopt bylaws that would enable shareholders to amend or repeal an existing poison pill so that they have a way to express support for a takeover offer.

Some companies are beginning to take heed. The 53 percent figure represents a slight decline from four years earlier because of pressure from shareholder activists. Others are adopting softer versions of the pill. Southwest Airlines has created a so-called "chewable pill," which automatically dissolves if a bidder offers a fully financed or cash deal at a pre-specified, generous premium.

Not surprisingly, Lipton disagrees with critics of the pill. He pointed out that, by statute, Delaware corporations are representative democracies, with control resting firmly in the hands of the board of directors. Disgruntled stockholders can reject the pill by voting out directors who favor it. For Lipton, that's enough shareholder involvement, and the courts have continually sided with him. "I'm 100," he pointed out, "and the critics are zero.

Len Costa has written for Fortune, Worth, and The New York Times.

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