What Is a Lobster Trap?

The term lobster trap refers to a defense strategy used by small target firms to protect themselves against hostile takeovers initiated by larger corporations. Companies that use this anti-takeover strategy pass provisions in their charters that block shareholders with a stake of more than 10% from converting securities into voting shares. This prevents large shareholders from adding to their voting stock position and facilitating the takeover of the target company.

Key Takeaways

  • The lobster trap is a defense strategy used by small target firms to protect themselves against hostile takeovers initiated by larger corporations.
  • Companies that use the lobster trap strategy block shareholders with a stake of more than 10% from converting securities into voting shares.
  • Convertible securities covered by the provision include convertible bonds, convertible preferred shares, convertible debentures, and warrants.

How Lobster Traps Work

Hostile takeovers are common in the corporate world. They occur when one company tries to take over another one without getting the express approval or consent of the target firm's board of directors. In these cases, the potential acquirer may initiate several strategies such as issuing an offer or buying the target's available stock to gain control.

Target firms have a number of strategies available to defend themselves against these unsolicited offers. One of these is the lobster trap, which is commonly used by smaller companies when they want to avoid being taken over by larger ones. In order to set a lobster trap, a company must have a provision outlining details of the strategy in its charter. This anti-takeover measure is derived from the fact that these traps are aimed at catching large lobsters but not small ones. It can be used either by itself or in conjunction with other tactics such as the poison pill, white knight, or scorched earth to rebuff a hostile acquirer.

Companies must have a provision in their charter in order to enforce anti-takeover strategies like the lobster trap.

When the potential target of a hostile takeover decides to use a lobster trap as its defense, it enforces a rule in its charter that prevents certain shareholders—those who hold more than 10% of converting securities—from converting to their holdings into voting stock. The convertible securities covered by the lobster trap provision include any assets that can be converted into voting stock including convertible bonds, convertible preferred shares, convertible debentures, and warrants.

Lobster Trap vs. Other Defense Strategies

As noted above, there are several strategies potential targets can use to defend themselves against hostile takeovers. The specific strategy a company employs depends on its size and its charter. Just like the lobster trap, companies try to make themselves less attractive to an acquirer. But they work in different ways. Here are a few others that are commonly used in the corporate world.

Poison Pill

A target company that uses the poison pill defense may try a number of different tactics to dissuade an acquirer from proceeding with its hostile takeover attempt. For instance, the target company may allow existing shareholders to purchase additional shares at a discount, boosting their equity position while decreasing the acquirer's stake after it buys shares in the company. One aim of the poison pill is to force the acquirer to come to the negotiating table, rather than allow it to simply take over the target.

White Knight

This strategy essentially allows a friendly company—referred to as a white knight—to take over a target rather than an unfriendly one which is, therefore, the black knight. If a takeover is inevitable, most companies generally prefer being acquired by a friendly company rather than a hostile one. That's because the white knight normally tries to retain the integrity of the target's business rather than make sweeping changes to it. The target's investors may also benefit from a better offer for their shares in a white knight scenario.

Scorched Earth

This strategy makes the target look less attractive to the acquirer by spoiling its corporate landscape. Companies that use the scorched earth policy may take on additional debt, sell off assets, and provide their management teams with large payouts if they're replaced with new executives. The scorched earth tactic isn't always a good idea because it can often be problematic. Companies may not be able to recover if they take on too much debt or if they sell assets that are pivotal to their operations.

Example of a Lobster Trap Strategy

Let's use a hypothetical example to show how the lobster trap works. Say an enterprise named Small Pond receives a hostile takeover offer from larger rival Big Fish Inc. Small Pond’s directors and management are extremely averse to the company being swallowed up by Big Fish and try to drum up shareholder support to reject the offer. They are aware of a large hedge fund that owns 15% of Small Pond’s voting shares, plus warrants that, if converted, would give it an additional 5% stake in the company. Fortunately, Small Pond’s founders had the foresight to include a lobster trap provision in their corporate charter to prevent the company from falling into undesirable hands. The company’s board of directors, therefore, uses the provision to prevent the hedge fund from converting its warrants into voting shares and succeeds in rejecting the hostile bid.