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.
  • One of the simplest ways a target can fend off a hostile takeover is by adopting a "poison pill," which gives current shareholders the opportunity to purchase shares at a discount; effectively diluting the ownership stake of the potential acquirer.
  • In a "Pac-Man Defense," the target company responds to a hostile takeover attempt with a hostile takeover attempt of their own.
  • The main problem with scorched earth policy is that it could leave the acquiree, or target company, in such a mess that its newfound freedom is short-lived.

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.

Types of Scorched Earth Policy Strategies

Businesses can implement scorched earth policies in a wide variety of ways. They can include taking on additional debt, adopting golden parachutes for senior executives, selling off prized assets, or rescheduling debt repayment for after the proposed takeover.

In other words, each of these defense tactics aims to make the target company less attractive to a potential hostile acquirer.

Let's take a look at some specific types of scorched earth actions.

Make the Price Expensive

One of the simplest ways a target can fend off a hostile takeover is by adopting a "poison pill," which gives current shareholders the opportunity to purchase shares at a discount.

A poison pill effectively dilutes the ownership stake of a potential hostile acquirer and makes the target firm unreasonably expensive. In December of 2020, for example, athletic clothing retailer Foot Locker announced the adoption of a poison pill in order to guard against a takeover attempt by holding company Vesa Equity. Vesa Equity is controlled and run by activist investor Daniel Kretinsky, a Czech billionaire lawyer.

Foot Locker management was put on alert when Vesa Equity purchased a 12.2% stake in the company, buying up a total of 153,730 shares. Foot Locker's poison pill was implemented to keep Vesa Equity and Kretinsky at bay. The plan expires on Dec. 7 of 2021 and according to Foot Locker should reduce "the likelihood that any person would gain control of the Company through open market accumulation or other tactics."

Poison pills are formally known as shareholder rights plans.

Sell off Key Assets

A big reason why hostile takeovers occur is that a potential acquirer wants to get their hands on a specific "crown jewel" asset owned by a target company. But if the target company is able to sell off its most attractive assets to a friendly third party, it can make a potential takeover unattractive.

For example, a core or crown jewel asset can be a proprietary technology, customer database, or even a fleet of vehicles. Of course, the big difficulty with this approach is that selling off key assets can permanently damage the company. It is not an irreversible action. Because of that, selling core assets tends to be a tactic of last resort only.

Acquire the Acquirer

In this method of defense, also known as the "Pac-Man Defense," the target company looks to completely turn things around by attempting to take over the acquirer. It's an aggressive tactic but has the same purpose as any defensive strategy: make a hostile takeover extremely difficult for the acquirer and force them to give up on the attempt.

In other words, in a Pac-Man Defense, a target company responds to a hostile takeover attempt with a hostile takeover attempt of their own.

In order for a Pac-Man Defense to work, the target needs significant resources. Since the Pac-Man Defense involves buying the hostile acquirer, the target company needs enough financial resources to be considered a credible threat.

In order to raise the funds needed for a Pac-Man defense, the target can sell off its non-core assets, sell non-core business units, borrow cash, or tap its own cash balance.

One of the best examples of this tactic being used in real life comes from 1982 when engineering and manufacturing company Bendix tried to acquire building materials specialist Martin Marietta. Bendix managed to grab a 70% controlling stake in Martin Marietta shares.

In order to fend off a complete takeover, Martin Marietta sold off several non-core business segments and borrowed $1 billion to obtain a 50% stake in Bendix. The massive amounts of cash required to battle each other hurt both companies. Ultimately, Allied Corporation acquired Bendix.

Criticisms of a Scorched Earth Policy

Engaging in these practices is highly dangerous. The goal is to prevent a 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.

Scorched Earth Policy FAQs

What Is a Scorched Earth Political Policy?

A scorched earth political policy is aimed at destroying either the opposition party or the system itself so that it cannot continue.

Has a Scorched Earth Policy Been Used in Business?

Yes. Businesses have regularly implemented scorched earth policies as means to defend against or discourage hostile takeovers. For example, computer giant HP adopted a poison pill in February of 2020 in order to fend off Xerox's hostile takeover bid.