What Is a Poison Pill?
In corporate governance and takeover law, a poison pill is the colloquial term for a "shareholder rights plan," used by corporate boards to prevent activist investors or would-be acquirers from accumulating large stakes in companies with publicly traded shares.
Poison pills effectively block the accumulation of stakes above a set percentage of a company's outstanding shares by promising to distribute additional free or heavily discounted shares to all shareholders except those who trigger the provision.
The goal is to prevent outsiders from gaining control without negotiating with the company's board or paying a negotiated buyout price to all shareholders. Courts have upheld poison pills as a legitimate defense by corporate boards, which are not obligated to accept any offer they do not deem to be in the company's long-term interest.
- A poison pill is a defense tactic listed companies use to deter activist investors or acquirers from building large stakes or staging a takeover without the board's consent, and without paying a premium to all shareholders.
- Poison pills specify the maximum stake a shareholder may amass, and dilute the holdings of those who exceed the limit by issuing heavily discounted or free additional shares to the other shareholders.
- Because poison pills can entrench company managers and boards, companies must be able to show they are a proportional response to a credible threat.
- Investors unable to convince a company to drop its poison pill retain the option of persuading shareholders to replace the board.
Understanding Poison Pills
Takeovers transferring control of a publicly traded company to another company or a private equity firm are common in the corporate arena. Most of them take place on terms accepted by the target company's board of directors. U.S. courts have ruled company boards have broad discretion in deciding whether or not to pursue a particular deal.
One reason successful hostile takeovers are less common is that company boards have powerful tools like the poison pill to ensure their wishes are respected.
For example, a poison pill might specify that if any single entity or person acquires a company stake of 15% or more, all other shareholders will be able to acquire additional shares for half their market price, or alternatively the company could simply distribute an extra share for each one already owned, while not doing so for the party that triggered the provision. Those were the terms of the poison pill Twitter Inc. (TWTR) adopted in April 2022, shortly before agreeing to a buyout by Elon Musk.
The poison pill's practical effect is to make breaching the ownership stake limit self-defeating, because doing so would result in the dilution of the stake in breach.
The poison pill tactic has been around since the 1980s, when it was devised by New York law firm Wachtell, Lipton, Rosen, and Katz amid a wave of hostile takeover and greenmail attempts by corporate raiders, since rebranded as activist investors.
The poison pill frustrates "creeping acquisitions of control," in which the acquirer seeks to accumulate a controlling or dominant stake piecemeal, without negotiating with the board or offering the same deal to every shareholder. Courts have ruled poison pills are a legitimate defense against such attempts to circumvent a company board's prerogatives.
As in Twitter's case, a poison pill doesn't always indicate that the company is not willing to be acquired. Rather, it may be enacted to obtain a higher valuation or otherwise improve the terms of the acquisition.
Poison pills are formally known as shareholder rights plans.
Advantages of a Poison Pill
A company's board has a fiduciary duty to protect the interests of all shareholders, while an outsider seeking control may only wish or need to satisfy a minority to gain effective control through a tender offer, for example. A poison pill helps prevent takeovers based on majority control from disregarding the interests of minority shareholders.
It also discourages vulture bids seeking to take advantage of a temporary decline in a share price. Market declines at the outset of the COVID-19 pandemic led hundreds of U.S. companies to adopt shareholder rights plans for that reason.
Companies with poison pill defenses have tended to garner higher takeover premiums than those without them. Industrial gasses supplier Airgas, which deployed a poison pill to resist a hostile takeover by rival Air Products and Chemicals Inc. (APD) in a landmark legal battle, sold four years later to Air Liquide for more than twice as much as Air Products offered.
Drawbacks of Poison Pills
By discouraging a motivated buyer from buying more company stock, a poison pill is likely to leave a share price lower than it would be otherwise, at least in the short run.
Poison pills can also shield underperforming company managers from shareholder efforts to replace them. The good news on that score is that replacing a company board in a proxy contest can make a poison pill go away, if the new board so chooses.
Because poison pills discriminate against activist buyers and restrain trading in a company's stock, they typically require justification, and often have sunset provisions.
Proxy advisory firms Glass Lewis and International Shareholder Services (ISS) have traditionally opposed poison pills because of their potential to entrench managers unresponsive to shareholders. As of 2022, ISS guidelines called for poison pills to have a term of no more than three years and a trigger no lower than 20% of shares outstanding. Glass Lewis generally opposes poison pills, with case-by-case exceptions for those limited in scope and motivated by a particular threat or objective.
From the perspective of company management concerned about a particular shareholder, one unavoidable drawback of a poison pill is that it cannot dilute a stake acquired by an activist investor or potential acquirer before the poison pill was adopted.
Poison Pill Flavors: Flip-In, Flip-Over, and Dead-Hand
Most poison pills are triggered by the accumulation of a company stake above a preset threshold. These are known as the flip-in shareholder rights plans, in contrast to the seldom used flip-over ones. A flip-over poison pill is triggered only if a company is acquired by another public company, and lets shareholders of the acquired company buy shares of the acquirer at a discount.
A dead-hand or slow-hand poison pill limits a future board's ability to remove that provision by specifying that the poison pill can only be canceled by a board majority consisting of current directors or the successors they choose. Delaware, the corporate domicile state of two-thirds of Fortune 500 companies and most recent initial public offerings, bars dead-hand poison pills, while Georgia and Pennsylvania courts have upheld them.
Poison pills often include "wolf pack" clauses applicable to the aggregate holdings of shareholders acting in concert without expressly agreeing to do so, such as hedge fund managers accumulating separate stakes in pursuit of a common activist agenda, for example.
Poison Pill Examples
In July 2018, the board of restaurant chain Papa John’s (PZZA) voted to adopt a poison pill to prevent ousted founder John Schnatter from gaining control of the company. Schnatter, who owned 30% of the company’s stock, was the largest shareholder of Papa John's.
To deter a takeover attempt by Schnatter, the board adopted a poison pill expiring after a year that would permit the company to sell its stock to shareholders for half its market price if Schnatter and his affiliates increased their stake to 31%, or if anyone else amassed a 15% stake. As with all poison pills, those triggering the provision would not be allowed to buy stock on the same discounted terms, effectively diluting their stake.
"Adoption of the Rights Plan is intended to enable all Papa John’s stockholders to realize the full potential value of their investment in the company and to protect the interests of the company and its stockholders by reducing the likelihood that any person or group gains control of Papa John’s through open market accumulation or other tactics without paying an appropriate control premium," the company said in announcing the poison pill's adoption.
Schnatter filed suit over some of the poison pill's provisions, settling it the following year along with other litigation against the company. He reduced his stake in Papa John's to less than 4% by 2020.
In 2012, Netflix (NFLX) announced a poison pill days after billionaire investor Carl Icahn and affiliates disclosed a stake of nearly 10%. The poison pill promised to dilute the stake of anyone acquiring more than 10% of the video streaming service provider, by allowing other shareholders to purchase two shares for the price of one.
In disclosing their stake, Icahn affiliates suggested "Netflix may hold significant strategic value for a variety of significantly larger companies," adding they were "considering ways for [Netflix] to maximize shareholder value."
The Icahn funds criticized the company's adoption of a poison pill in an updated securities filing. "Any poison pill without a shareholder vote is an example of poor corporate governance, and...the pill Netflix just adopted is particularly troubling due to its remarkably low and discriminatory 10% threshold," they said.
Icahn funds later reduced and eventually sold their Netflix stake for a hefty gain.
Why Are Poison Pills Used?
Poison pills prevent an activist investor or a potential acquirer from gaining control of a publicly traded company without the consent of the company's board. Deals involving the board's consent to a change of control typically provide a significant premium over the market price for all shareholders, in contrast to the share purchases in market transactions the poison pills seek to deter.
What Are the Disadvantages of Poison Pills?
Poison pills can help self-serving incumbent managers and boards frustrate shareholder efforts to oust them in order to improve the company's performance. As a result, corporate governance advisers recommend companies limit them in scope and duration, make sure such plans address a specific goal or threat, and have a high triggering threshold.
What's the Legal Precedent for Poison Pills?
In Delaware, where many large, listed companies are incorporated, the courts have held corporate boards have wide discretion in preventing the accumulation of controlling stakes, provided their response is proportional and based on a reasonable perception of a threat.