Poison Pills in the Shadow of the Law

Poison pills are one of the most powerful deterrents to hostile takeovers, making a takeover so unattractive and expensive that a potential acquirer declines to pursue it. A pill typically works by triggering the issuance of new shares to “old” shareholders when a hostile takeover threat arises, thus diluting the acquirer’s stake and making the acquisition unviable.

In the four decades since its invention, however, the pill has  sparked many debates about its benefits and drawbacks and particularly its impact on the adopting firm’s value. Though the pill’s deterrence of hostile takeovers may seem beneficial at first glance, a hostile takeover may in some cases benefit shareholders by allowing the acquirer to run the firm more efficiently, thereby increasing shareholder value. Even the threat of a hostile acquisition may increase firm value by giving current management an incentive to perform better. Therefore, the impact of poison pills on firm value requires empirical study.

Past studies have produced mixed results. More recent research consistently indicates that firms that adopt a pill tend to suffer a decline in their value. However, interpreting these findings is difficult because the decision to adopt the pill is consciously made by the firm and typically happens during a special moment in its life. Firms that do well are rarely subject to hostile takeovers, and as a result, they rarely need the pill. Firms that adopt the pill are often going through tough times and facing an uncertain future. Thus, comparing firms that did and did not adopt a pill may be very misleading, as the former would likely be doing worse even absent the pill. Moreover, the situation is complicated by the fact that even firms that do not currently have a poison pill have so-called “shadow pills” – allowing them to quickly adopt a pill if necessary. Hence, adopting a “visible” pill may be inconsequential, even if shadow and visible pills combined significantly affect firm value.

Our study shifts the focus of debate from visible to shadow pills. We examined the impact of poison pill laws (PPLs) enacted by U.S. states on firms’ visible pill policy and financial value. Since their inception, there has been substantial legal uncertainty about whether poison pills are legal and whether exercising the pill is consistent with the duties of directors. PPLs make use of a visible pill more secure and less likely to be challenged in court, and so we interpret them as strengthening the shadow pill. By studying state-level changes in the legal environment, we are thus able to analyze how a weaker or stronger shadow pill affects firm value, independent of individual firms’ decision on which pill to adopt. In our analysis, we focus on so called “Second Wave Poison Pill Laws,” which a set of U.S. states enacted between 1995 and 2010. The “First Wave Poison Pill Laws” enacted in 1980s were subject to substantial uncertainty due to several rulings of Delaware courts, among others, which have both upheld and questioned the validity of the pill in various circumstances. As a result, it is hard to draw any conclusions about the impact of the shadow pill in that period.

Our study has two main findings. First, we show that PPLs influence firms’ decisions to adopt visible pills in an economically meaningful way. Firms with lower valuations, which are at a higher risk of hostile takeover, increase their use of visible poison pills after the passage of PPLs. Conversely, firms with high prior valuations reduce their use of visible pills. This pattern suggests that the PPLs reduce the variability of decision-makers’ beliefs about the validity of a poison pill, thereby aligning visible pill policies more closely with economic incentives.

Second, we find that the market-to-book value ratio (Tobin’s Q) of firms incorporated in states that adopt PPLs increases relative to similar firms incorporated elsewhere. This effect, which is approximately 4 percent in the medium-to-long run, is robust to controlling for various firm characteristics and changes in economic conditions.

To understand why there is a positive response in firm value, we investigate two possibilities: the commitment hypothesis and the bargaining power hypothesis. The commitment hypothesis suggests that the value of the firm increases because a stronger shadow pill reduces the risk of disruption and discontinuation of a firm’s operations, which in turn helps the firm achieve higher efficiency. The rationale behind that hypothesis is that much economic activity requires long-term commitment. For example, employees may hesitate to exert effort and invest in the development of their careers in  a firm if they expect that very soon its strategy may substantially change. A potential supplier may be hesitant to work with a firm that may soon not exist. Finally, managers will not take on even beneficial long-term projects if the managers are mostly concerned about the short-term and avoiding the risk of a hostile takeover. In all these cases, having a device that reduces the risk of substantial disruption to a firm’s operations may make it a better environment for various stakeholders and increase its productivity.

Our analysis of how PPLs affect the value of firms with different characteristics is consistent with the commitment hypothesis. The increase in firm value is especially pronounced for firms with many intangible assets and for which organizational capital is important. These firms are most likely to benefit from a commitment to a long-term perspective, as their operations rely more on the stable cooperation of long-term stakeholders in contrast to commodity-producing firms that create value simply by selling standardized products in arms-length transactions.

The bargaining power hypothesis suggests that the value of the firm increases because shadow pills make takeover conditions more favorable to existing shareholders. Under that mechanism, we need not observe increased stability of firm operations, but we would observe higher (friendly) acquisition prices. We do observe some evidence in favor of that hypothesis, but the effects are relatively small and not always robust to various methods of statistical analysis. While the bargaining power hypothesis may play some role, it appears secondary to the commitment hypothesis.

Overall, our study shows that PPLs can have a positive impact on the value of firms, especially for innovative firms with more intangible assets. Ensuring stability and a long-term perspective in a firm’s operations seems to be beneficial to shareholders on average, even though in some cases it may entail costs related to entrenchment of current management. Economic benefits notwithstanding, more stability in firms’ operations may also benefit workers, local communities, and other stakeholders, providing a compelling argument in favor of poison pills.

This post comes to us from professors Martijn Cremers at the University of Notre Dame, Lubomir P. Litov at the University of Oklahoma’s Michael F. Price College of Business and the University of Pennsylvania’s Wharton Financial Institutions Center, Simone M. Sepe at the University of Arizona’s James E. Rogers College of Law and the University of Toulouse, and Michał Zator at the University of Notre Dame’s Mendoza College of Business. It is based on their recent article, “Poison Pills in the Shadow of the Law,” available here.