Scorched Earth Defense Policy

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Blog Author :

WallStreetMojo Team

Edited by :

Ashish Kumar Srivastav

Reviewed by :

Dheeraj Vaidya, CFA, FRM

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What is the Scorched Earth Policy?

Scorched Earth Defense Policy refers to the strategy used by the target company to prevent any takeover by making itself less attractive in the eyes of the hostile bidder using tactics like borrowing high-level debts, selling off 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.

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Scorched Earth Defense-Policy

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 is 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 makes the bid unattractive and leads to dilution of holdings of the acquirer, even influencing the current market prices of the shares.

Sun Pharma (Indian Pharmaceutical MNC) v/s Taro (A research-based pharma manufacturer) can be looked into. An agreement between Sun Pharma and Israeli company Taro about a merger of Taro was reached in May 2007. However, Taro claimed violations to the agreement's specific conditions, causing unilateral termination of the agreement. Despite acquiring 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 by selling off its Irish unit and non-disclosure of financials to keep away Sun Pharma. As a result, the deal between both parties is still looming in uncertainty.

Essentially, the focus is either for the hostile bidder to purchase shares of the target firm at a premium, or the target firm shall use a friendly bidder to take over the firm. It will eliminate the element of hostility.

#2 - Lobster Trap Defense

Lobster Trap Defense arises from 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 from converting securities into voting stock. Such provision shields large stockholders from adding to their voting stock and facilitates 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.

Water Limited has received a hostile takeover from its largest rival, namely Fire Limited. The directors of 'Water' Limited are extremely opposed to the firm's takeover by Fire Ltd and take 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. In addition, they use a provision preventing the hedge funds from converting their 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%). In addition, 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 to elect a new Board of directors to redeem it. However, these shareholder rights plan provisions 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 law courts. For example, 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 to scare off the hostile takeovers. The hostile party may be caught off-guard by such a tactic and may 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 concerning 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. As a counter-strategy, the target company may buy back its shares and purchase the acquiring firm's shares.

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 when 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. However, 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.