The market for corporate control is an intense competition between acquiring firms and the target firms they pursue. Acquiring firms have developed sophisticated strategies to facilitate change of control transactions while target firms have become innovative to prevent takeovers. The high frequency of hostile takeovers, management terminations, and fiercely negotiated mergers has forced target management to take actions that improve bargaining positions. Target managers attempt to influence outcomes of control changes either to secure their employment or to obtain optimal bids for shareholders. Some devices used by target managers seem to be explicitly anti-takeover in nature, like shareholder rights plans, commonly referred to in the financial press as poison pill securities. Other methods to deter takeovers are subtle, like the use of long-term bonds by target managers.

Poison Pill Securities

Poison pills, in general, are issues of non-voting securities to current shareholders that provide them with specific rights before, during, or after changes in control. The first group of poison pill securities adopted by firms were issues of preferred stock that target shareholders could convert into common shares of acquiring firms after changes in ownership occurred. These early pills were successful in deterring takeovers because of the threat of substantial dilution of ownership structure of the surviving firm. They were extremely cumbersome anti-takeover devices, however, virtually impossible to redeem at reasonable prices, and changed the risk perceptions of the issuing firm.

The shareholder interest hypothesis suggests that target shareholder wealth increases upon the issuance of poison pills because target management can be more selective in their choice of acquiring firms. If first bids are assumed to be the lowest bids, then all shareholders will benefit if management can prevent that acquisition. When more attractive bids are received, either from the first bidder or other bidding firms, management can facilitate a merger when a firm offers an optimal bid for target shares. Thus, by having the poison pill defense tactic as a deterrent, they have increased negotiating power, and can maximize the wealth of the shareholders by accepting only the highest bid for the shares.

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