What Is a Scorched Earth Policy?

A scorched earth policy is an aggressive defense strategy utilized by a target company to discourage attempts of a hostile takeover by an acquirer. Named after the guerrilla warfare tactic of destroying anything of potential use to an enemy when retreating from a position, this course of action generally requires the company targeted for a takeover to do everything in its power to make itself less attractive.

Key Takeaways

  • A scorched earth policy is a last-ditch attempt to deter a hostile takeover by making the target company unattractive to the potential acquirer.
  • Tactics include selling off prized assets, racking up mountains of debt, and promising management substantial payouts in the event that they are one day dismissed.
  • The price to pay for freedom could be going out of business as many scorched earth measures are hard to recover from.
  • Sometimes, hostile bidders secure injunctions to prevent the target company from implanting a scorched earth policy.

How a Scorched Earth Policy Works

A scorched earth policy is a last resort strategy. In both the military and corporate world, it can be thought of as a final, desperate attempt to fend off the advances of a hostile, unwanted predator.

The goal here is to initiate activities that damage the company, sabotaging its value and future earnings potential. Tactics used to reach this objective include selling off prized assets, racking up mountains of debt due to be repaid as soon as the hostile takeover is complete, and enacting provisions that provide senior management with substantial payouts, such as golden parachutes, if a new management team is brought on.

No company, or its shareholders, is likely to want to engage in such actions unless it is completely necessary. In fact, when seeking to thwart a hostile bid, it is more common for target companies to initiate other, less damaging anti-takeover measures. One example is a flip-in poison pill. This particular tactic enables shareholders, other than the acquirer, to buy additional stock in a company targeted for takeover at a discount.

Flooding the market with new shares dilutes the value of the shares already purchased by the acquiring company, reducing its percentage of ownership and making it harder and more costly for it to gain control. This option isn’t available to everyone, though. Poison pills can only be utilized if present in the target companies bylaw or charter, meaning that a scorched earth policy is sometimes the only viable solution left to fend off hostiles.

Criticism of a Scorched Earth Policy

Engaging in these practices is highly dangerous. The goal is to prevent the hostile takeover from happening. A scorched earth policy is so lethal that it might succeed in achieving this. The problem is that it could also leave the acquiree, or target company, in such a mess that its newfound freedom is short-lived.

A lot depends on what measures were used to scare off the suitor. If extreme steps were taken, such as important assets being sold and lots of debt being acquired, it may only be a matter of time before the target company goes under.

Important

In extreme cases, a scorched earth policy might end up being a “suicide pill.”

Killing itself is a high price to pay for freedom and one that will probably lead to a revolt from shareholders, no matter how opposed they are to being swallowed up by another company. In the event of a takeover, cash or shares in the new company will be coming their way. Bankruptcy, on the other hand, will likely leave them empty-handed.

Limitations of a Scorched Earth Policy

If all the board of directors (B of D) do somehow agree that a scorched earth policy is worth implementing, they still must overcome some potentially difficult obstacles. The hostile company may seek an injunction against the company's defensive actions and might be able to prevent the board from stopping the takeover bid.

For example, a steel company could threaten to purchase a manufacturer embroiled in lawsuits for making poor quality parts. In this case, the target company would be seeking to purchase the future liabilities associated with any lawsuit settlement in an effort to burden the new, combined company with those liabilities, making it unattractive to hostile bidders.

The option to potentially ruin itself isn’t always completely at the target company’s discretion, though. The hostile bidder in this scenario may be able to secure a court injunction to stop this acquisition, which, if successful, would effectively thwart the steel company’s scorched earth policy.