Poison pills are one of the most powerful ways of deterring hostile takeovers. Their goal is to make a hostile takeover so unattractive and expensive that the potential acquirer is deterred from pursuing the acquisition. When a hostile takeover threat arises, e.g., because a hostile acquirer’s ownership in the firm exceeded 20%, the poison pill triggers the issuance of new shares to “old” shareholders. This dilutes the acquirer’s stake, making the acquisition unviable. The pill, which has been described as “the most important innovation in corporate law since invention of the trust,” only began in 1982. Yet, in the four decades since its invention it has become immensely popular and sparked many debates about its benefits and drawbacks.
The central question in the debate surrounding poison pills, also known as shareholder rights plan, is their impact on the adopting firm’s value. The pill deters hostile takeovers, which may seem beneficial at first glance, just as it is beneficial for a country to avoid being attacked and conquered. However, in some cases, a hostile takeover may benefit shareholders by allowing the acquirer to run the firm more efficiently, thereby increasing shareholder value. Even the threat of a hostile acquisition may increase firm value by incentivizing current management to exert more effort. Therefore, the impact of poison pills on firm value is a question that requires empirical study.
Past studies have produced mixed results about the impact of adopting poison pills on the value of firms. More recent research consistently indicates that firms that adopt the pill tend to suffer a decline in their value. However, interpreting these findings is difficult because the decision to adopt the pill is consciously made by the firm and typically happens during a special moment in the firm’s life. Firms that do well are rarely subject to hostile takeovers, and as a result, they rarely need the pill. Firms that adopt the pill are often going through tough times and are facing an uncertain future. Thus, comparing firms that did and did not adopt a pill may be very misleading, as the former would likely be doing worse absent the pill. Moreover, the situation is complicated by the fact that even firms that do not currently have a poison pill in place have a so called “shadow pill” – in most cases, they can reasonably quickly adopt the pill if they need to. Hence, adopting a “visible” pill may be inconsequential, even if the entire mechanism of shadow and visible pills combined is significantly affecting firm value.
To explore the impact of poison pills on firm value more convincingly, our study shifts the focus of the debate from visible to shadow pills. We examine the impact of poison pill laws (PPLs) enacted by US states on firms’ visible pill policy and financial value. Since their inception, there has been substantial legal uncertainty about whether poison pills are legal and whether exercising the pill is consistent with the legal responsibilities of firm directors. PPLs make the right to use a visible pill more secure and less likely to be challenged in court, so we interpret them as strengthening the shadow pill. By studying state-level changes in the legal environment, we are thus able to analyze how weaker or stronger shadow pills affect firm value independent of individual firms’ decision to self-select into their pill status. In our analysis, we focus on so called “Second Wave Poison Pill Laws,” which a set of US states enacted between 1995 and 2010. The “First Wave Poison Pill Laws” enacted in 1980s were subject to substantial uncertainty due to several rulings of Delaware court, among others, which have both upheld and questioned the validity of the pill in various circumstances. As a result, it is hard to draw any conclusions about the impact of the shadow pill in that period.
Our study has two main findings. First, we show that PPLs influence firms’ decisions to adopt visible pills in an economically meaningful way. Firms with lower valuations, which are at a higher risk of hostile takeover, increase their use of visible poison pills after the passage of PPLs. Conversely, firms with high prior valuations reduce their use of visible pills. This pattern suggests that the PPLs reduce the variability of decision-makers’ beliefs about the validity of poison pills, thereby aligning visible pill policies more closely with economic incentives.
Secondl, we find that the market-to-book value ratio (Tobin’s Q) of firms incorporated in states that adopt PPLs increases relative to similar firms incorporated elsewhere. This effect, which is approximately 4% in the medium to long run, is robust controlling for various firm characteristics and changes in economic conditions over time and space.
To understand why there is a positive response in firm value, we investigate two potential mechanisms: the commitment hypothesis and the bargaining power hypothesis. The commitment hypothesis suggests that the value of the firm increases because a stronger shadow pill reduces the risk of disruption and discontinuation of a firm’s operations, which in turn helps to achieve higher efficiency. The rationale behind this hypothesis is that many parts of economic activity require long-term commitment. For example, employees may be hesitant to exert effort and invest in the development of their career in the firm if they expect that very soon its strategy may substantially change. Potential suppliers may be hesitant to work with a firm that soon may not be around. Managers may ignore long-term projects even if they are very beneficial, if they are mostly concerned about the short-term outlook and avoiding the risk of hostile takeovers. In all these cases, having a device that reduces the risk of substantial disruption to a firm’s operations may make it a better environment for various stakeholders and increase firm’s productivity.
Our analysis of how PPLs affect the value of firms with different characteristics is consistent with the importance of the commitment hypothesis. The increase in firm value is especially pronounced for firms with many intangible assets and the high importance of organizational capital. These firms are most likely to be benefitting from commitments to long-term perspective, as their operations strongly rely on stable cooperation of long-term stakeholders, compared to, e.g., a commodity-producing firms that create value simply by selling standardized products in arms-length transactions.
The bargaining power hypothesis suggests that the value of the firm increases because shadow pills make the takeover transaction conditions more favorable to existing shareholders. Under that mechanism, we do not need to observe increased stability of a firm’s operations, but we would observe higher acquisition prices. We do observe some evidence in favor of this hypothesis, but the effects are relatively small and not always robust to various methods of statistical analysis. While bargaining power hypothesis may play some role, it appears secondary to the commitment hypothesis.
Overall, our study shows that PPLs can have a positive impact on the value of firms, especially for innovative firms with more intangible assets. Ensuring more stability and long-term perspective in a firm’s operations seems to be beneficial to shareholders on average, even though in some cases may entail costs related to entrenchment of current management. Economic benefits notwithstanding, more stability in firms’ operations may also benefit workers, local communities, and other stakeholders, providing a compelling argument in favor of poison pills.
Martijn Cremers is the Bernard J. Hank Professor of Finance at the University of Notre Dame.
Lubomir P. Litov is the David M. Moffett Professor of Corporate Finance in the Price College of Business at the University of Oklahoma.
Simone M. Sepe is the Chester H. Smith Professor and Professor of Law and Finance at the James E. Rogers College of Law at the University of Arizona.
Michal Zator is an Assistant Professor of Finance at the Mendoza College of Business at the University of Notre Dame.
This post was adapted from their paper, “Poison Pills in the Shadow of the Law,” available on SSRN.
