What is the Scorched Earth Policy?
Scorched Earth Defense Policy refers to the strategy used by the target company with the motive of preventing itself from any takeover by making itself less attractive in the eyes of the hostile bidder using the tactics like borrowing high-level debts, sale of the crown assets, etc.
Scorched Earth Policy is a strategy for preventing a hostile takeover through which the target company makes itself less attractive to the hostile bidders. Some of the common modes of Scorched Earth Policy include:
- Taking additional debt to impact the financial statements
- Schedules debt repayment schedules immediately following the takeover.
- Golden parachutes with senior management
- Selling off core assets of the firm;
However, Scorched Earth Defense Policy tactics may not be advisable as the hostile firm can seek an injunction against defensive actions. For instance, a paint manufacturing firm may threaten to indulge in a contract with a manufacturer/producer that has been entangled in lawsuits for making poor quality inputs.
In this case, the target company will be taking on risk since future liabilities will be associated with a manufacturer battling legal issues. Such aspects can make the deal unattractive, but hostile bidders can secure an injunction to such practices.
Top Types of Scorched Earth Defense Policy Strategies
Let us look into some of the various types of scorched earth defense policy strategies:
#1 – Crown Jewel Defense
Crown Jewel Defense a scorched earth policy whereby the target firm sells its core/attractive assets to a friendly third party. They may also spin-off the valuable assets into a separate entity. It not only makes the bid unattractive but also leads to dilution of holdings of the acquirer, even influencing the current market prices of the shares.
The instance of Sun Pharma (Indian Pharmaceutical MNC) v/s Taro (Research based pharma manufacturer) can be looked into, whereby an agreement between Sun Pharma and Israeli company Taro pertaining to a merger of Taro was reached in May 2007. Taro claimed violations to specific conditions of the agreement causing unilateral termination of the agreement. Despite the acquisition of a 36% stake for INR 470 crore, Sun Pharma is facing an injunction by the Supreme Court of Israel for not closing the deal. Taro has implemented various strategies through selling off its Irish unit along with non-disclosure of financials to keep away Sun Pharma. The deal between both parties is still looming in uncertainty.
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Essentially, the focus is either for the hostile bidder to purchase shares of the target firm at a premium or the target firm shall make use of a friendly bidder to take-over the firm. It will eliminate the element of hostility.
#2 – Lobster Trap Defense
Lobster Trap Defense arises from the fact of such traps aimed at catching big targets and avoiding the small ones. It is an anti-takeover strategy involving the target firm, including a provision preventing shareholders with ownership of more than 10% stock to convert securities into voting stock. Such provision shields large stockholders from adding to their voting stock and facilitating the takeover of target firms. The convertible securities included in this trap are:
- Convertible Preferred shares
- Convertible Warrants
- Convertible Bonds
- Convertible Debentures
Example of a Lobster Trap
Let us consider the below example for a better understanding.
An enterprise named Water Limited has received a hostile takeover from its largest rival, namely Fire Limited. The directors of ‘Water’ Limited are extremely averse to the firm’s takeover by Fire Ltd and are taking steps to accumulate shareholder support to prevent the acquisition. Simultaneously, they also get knowledge of a large hedge fund owning 15% of Water Limited’s voting shares plus warrants, which, once converted, provides an additional 5% stake in the company.
The Board of directors includes a ‘Lobster Trap’ provision in the Charter, which prevents the firm from falling into hostility. They use a provision preventing the hedge funds from converting its warrants into voting shares, thereby successfully rejecting the hostile bid.
#3 – Dead Hand Clause
This scorched earth defense policy makes the hostile takeover unreasonably expensive, whereby the bidder acquires a designated amount of the target firm (normally in the range of 10-20%). It involves a rights issue allowing stockholders other than the bidder to purchase newly issued shares at a discounted price, triggering a massive dilution in the value of the bidder’s holdings.
Hostile bidders can overcome this poison pill by launching a proxy contest for electing a new Board of Directors for redeeming it. However, these provisions in shareholder’s rights plans prevent anyone except the directors who adopted them from revoking it. Thus, existing directors can protect the acceptance of an unsolicited offer irrespective of the shareholder’s wishes or the viewpoint of the new Board of Directors.
Dead hand poison pills have proven to be controversial and challenged in various court of laws. In 1998, the Delaware Supreme Court ruled that dead-hand redemption provisions in stockholder rights plans are invalid defensive measures as a matter of Delaware statutory law.
#4 – Pac Man Defense
This Pac Man Defense scorched earth policy involves the targeted firm attempting to acquire the targeted firm in an effort to scare off the hostile takeovers. The hostile party may be caught off-guard by such a tactic and may decide to reverse its decision. The target firm may use extension methods like taking extensive loans, dipping into its profits, and reserves for cash to buy a majority stake in the company.
The name has been derived with reference to the Pac Man game. In the game, the player has multiple ghosts attempting to eliminate it, but if they eat a power pellet, the player may turn around the tables and turn out to destroy the ghosts.
During the acquisition, the takeover firm may commence a large-scale purchase of the target company’s stocks to gain control of the target company. As a counter-strategy, the target company may buy back its shares and purchase shares of the acquiring firm.
One of the drawbacks of this strategy is that it can be very expensive and damage the financial position for many years.
One of the known instances was in 1982 by Bendix Corp (American Engineering & Manufacturing Company) attempted to acquire Martin Marietta (a leading supplier of aggregates and heavy building materials) by purchasing a controlling amount of stocks. On paper, Bendix became the owner of the company. In retaliation, Martin Marietta’s management sold its Cement, Chemical, and aluminum divisions and borrowed over $1 billion. It resulted in Allied Corporation acquiring Bendix.
This article has been a guide to Scorched Earth Defense Policy to prevent a hostile takeover. Here we also discuss the types of Scorched Earth Anti-takeover Defense strategies, including Crown Jewel, PacMan, Lobster Trap, and Dead Hand. You can learn more about from the following articles –