Proposed change to the Takeover Code could it become easier for hostile takeovers to succeed?

January 28, 2010

With the takeover bid for Cadbury plc having been in the front pages of every national paper, hostile takeovers have been receiving a great deal of attention in the UK in recent months.

Hostile bids (or those which are not recommended by the board of the target company) are actually relatively rare. Last year only one in five bids under the City Code on Takeovers and Mergers (Code) was launched in the UK without a target board recommendation; and half of these became recommended as the bid progressed (as was eventually the case with Cadbury). Hostile offers are riskier, lengthier and generally more costly.

Against this backdrop, it is interesting to see that the Panel on Takeovers and Mergers (Panel), whose main functions are to issue and administer the Code and to supervise and regulate Code takeovers, has been consulting on a proposed change to the Code which might make it easier for hostile takeovers to succeed.

Stake-building

For an offer to succeed, the "acceptance condition" must be satisfied. A bidder must obtain control (through a combination of acceptances of the offer and any market purchases) of at least 50% of the voting rights.

Typically, a higher acceptance threshold will be specified in order that the bidder can be sure of obtaining sufficient voting rights to achieve its goals. For instance, it may want to de-list the target from the stock exchange (75% of voting shares) or to use the statutory compulsory acquisition procedures to gain complete ownership (which can be implemented only if the bidder first acquires 90% of the shares to which the offer relates).

If the acceptance condition is not satisfied, the bidder can walk away and will not be obliged to acquire any shares for which acceptances have been tendered, though the bidder will usually reserve the right to reduce the acceptance condition to 50% if it so chooses.

On the other hand, where the bidder is willing to run the risk of buying shares outright (and ending up with a stake in the target even if the bid fails), it is common to make on- or off-market purchases of shares in the run-up to or during the currency of the bid. This may cut the costs of the bid (where shares can be bought in the market at less than the offer price) and increase the likelihood of success by locking out competing bidders and generally building momentum.

What is the Panel proposing?

The Code aims to prevent the bidder (together with persons acting in concert with it) from acquiring effective control of the target (30% of the voting rights) before the board of the target has had a chance to advise shareholders on the merits of the bid. In non-recommended bids, it is normally only possible to make purchases beyond the 30% threshold where:

1) the first closing date of the offer (or of any competing offer) has passed (i.e. at least 21 days after the offer document is published); and

2)  it has been announced/established that the offer (or any competing offer) will not be subject to an investigation by the UK or EU merger control authorities or does not come within the statutory provisions for possible investigation (the "competition condition").

The Panel is now proposing to delete the competition condition, so that it will be possible for a hostile bidder to make additional share purchases following the first closing date.

Historically, the competition condition was thought necessary because uncertainty about whether there will be a competition investigation could artificially depress share prices (offers normally lapse in the event of such investigation). It was thought that the bidder might be unfairly assisted by the resulting uncertainty in increasing its holding to strategically significant levels.

In practice, the Panel has taken the view that the only way to establish that no competition issue exists is to get clearance from the merger control authorities, even if on a common sense view there is no real issue.

From the bidder’s perspective the competition condition has always created a Catch 22 situation. It would need to approach regulators formally (and publicly) in advance before the publication of its offer document in order to obtain merger-control clearance by the first closing date. It is easy to see the tactical disadvantages of this approach the target would be alerted to the bidder’s intentions and could begin fighting the takeover in the regulatory arena. The timescales could be even longer for EU merger-control clearance. Pre-clearance would clearly also have cost and timing implications.

What kind of hostile takeovers will be affected?

The change is unlikely to affect bids where there is a real potential for merger control issues, as the bidder will likely already have taken steps to seek pre-clearance, or where the bidder is seeking to acquire outright ownership. However, we think that certain types of takeover would gain greater prospects of success.

We expect that the change will affect mainly cash bids where the bidder is willing to accept an outcome of any shareholding in the target above 50%. This is because exceeding the 30% threshold triggers an obligation on the bidder to make a "mandatory offer", which is a cash (or cash alternative) offer for which the only permitted condition is obtaining in excess of 50% (acceptances and shares purchased). In these circumstances, it will now be much easier for the bidder to increase its stake during the process, as it will only need to wait for the first closing date to pass before being able to do so.

This is a high-risk strategy, however, because the bidder could end up with a stake of 30-50% (having paid a price based on the assumption of obtaining a controlling stake) but still not succeed in taking formal control. Unless it is able to exit the holding at a reasonable price, it could end up being a major investor of a company with a hostile board.

Conclusion

Given that the target board will have had adequate opportunity by the first closing date to explain any potential market uncertainty which might exist in relation to competition clearance, we think that it is unnecessary and heavy-handed for the Code to prevent shareholders from deciding whether to sell their shares to the bidder. Equally, where a bidder has decided not to make a merger notification (for instance where competition concerns clearly do not, or are highly unlikely to, arise), we think that it is disproportionate to impose the costs of an unnecessary notification on the bidder purely to "settle the market". It seems to us that it is a greater distortion of the workings of the market to enable the target board to use the "competition uncertainty" to frustrate what otherwise might be a successful bid. We therefore support the Panel’s proposed change.

Because the proposed change (if implemented) will only affect a relatively narrow group of hostile takeovers, we do not expect to see any significant rise in takeover activity as a result. However, where a bidder hopes to be able to gain control of the strategic direction of the target company and is willing to run the risk of a sizeable investment without gaining overall control, bidders may be more willing to go hostile. We may therefore see more listed companies led by very powerful investors.


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