Fair Price Provisions

How Fair Price Provisions Work

Fair price provisions were originally designed to defend against the most coercive of takeover devices, the two-tiered, front-end-loaded tender offer. In this type of hostile takeover, a potential acquirer offers a price for the block of shares needed to gain control of the target company and subsequently offers a lower price for the remaining shares. In such a situation, shareholders are coerced into tendering their shares early regardless of the value of the first offer, since the second offer will be lower.

Standard Fair Price Provisions

Standard fair price provisions require that, absent board or shareholder approval of the acquisition, the bidder must pay the remaining shareholders the same price for their shares as was paid to buy the control shares (usually between five and 20 percent of outstanding shares) that triggered the provision. An acquirer may avoid such a pricing requirement by obtaining the support of holders of at least a majority of disinterested shares. Such provisions may be viewed as marginally favorable to the remaining disinterested shareholders, since achieving a simple majority vote in favor of an attractive offer may not be difficult. However, in almost every case, fair price provisions require a supermajority vote that is at least two-thirds of disinterested shares (and sometimes as high as 90 or 95 percent of voting shares) to circumvent the pricing guidelines.

Fair Price Provision Variations

Even in instances where the voting requirement is no more than a simple majority, fair price provisions may not be in shareholder's best interests. Most oblige an acquirer to pay the highest price paid in obtaining the block of stock that triggered the provision, but some apply a more complicated pricing formula. For instance, a number of provisions require that the price paid to minority shareholders include a premium to market at least as great (in percentage and/or absolute terms) as the premium paid in earlier, noncontrolling acquisitions of company stock. If the market value of the stock at the time the tender offer is announced is substantially lower than what it was when the bidder first purchased company shares (e.g., after a large market decline), this type of "double premium" pricing formula may discourage a bidder from following through on an offer because of the unreasonably high price that may be required.

State-Sponsored Fair Price Provisions

As with corporate-sponsored fair price provisions, state-sponsored fair price statutes allow the fair price requirement to be bypassed should a certain percentage of shareholders favor such a course of action. Over half of the states employing fair price provisions require that at least a majority of disinterested shares (defined as those shares not held by the potential acquirer) approve the acquisition, while roughly 40 percent require that a supermajority of all shares approve the acquisition.

Some states (Florida, Georgia, Illinois, Kentucky, Mississippi, Virginia, and Washington) allow the board to approve a transaction without shareholder approval even after the ownership threshold has been crossed. Others (Connecticut, Georgia, Louisiana, Maryland, and Michigan) grant the board total veto power over any bid not meeting fair price standards, regardless of how shareholders vote. Georgia's statute, however, is an opt-in provision, requiring a shareholder vote for it to be applicable to the company. [1] Provisions such as these shift the balance of power more toward management and away from shareholders.

Features of Statutory Provisions

Although the definition of "fair price" varies among states, the most common price requirements stipulate that the potential acquirer must pay:

• The highest market value of the stock on a certain date, such as the date the tender offer commenced or the date the tender offer was announced; or

• The highest price paid by the potential acquirer in the two years prior to becoming an interested shareholder.[2]

Some states also include a provision to capture any stock appreciation between two specified dates before the announcement of the tender offer. Maryland, for example, adds to the above criteria a formula derived by dividing the highest share price paid by the potential acquirer over a two-year period by the market value of the shares on the first day of that two-year period. Formulae such as this one attempt to award shareholders the same premium that was paid for the shares comprising the acquirer's control block. Naturally, those statutes that impose higher prices are more effective in blocking tender offers.

Fair Price Trigger Mechanisms

Fair price provisions are triggered when a potential acquirer accumulates a stipulated percentage, or "control shares," of the target's common stock (typically ten to 20 percent in most jurisdictions). Approximately 60 percent of state fair price provisions were adopted as part of freezeout statutes, meaning that a shareholder must both wait the specified length of time and meet fair price standards before effecting a business combination.

Fair Price Provisions vs. Poison Pills

While fair price provisions may be viewed as antitakeover measures, they differ from poison pills in that shareholders have some ability to discard the protection, either by electing to opt out of a state statute or amending the charter to eliminate a corporate-specific one. Granted, fair price provisions with supermajority vote requirements may be quite effective in precluding takeovers which the board does not approve, but all fair price provisions at least provide a supermajority of shareholders the right to reject unwanted protection. The fact that shareholders are given some say in the application of these takeover defenses coupled with the fact that the acquirer is allowed to complete the proposed acquisition and merger after meeting the fair price criteria makes such provisions generally less harmful than poison pills.

Shareholder Support of Fair Price Provisions

Indeed, fair price provisions, more than any other takeover defense, seem to enjoy some support among shareholders. The fact that over 40 percent of S&P 500 companies have adopted such provisions with shareholder approval gives some idea of their acceptance as a legitimate defense against abusive takeover tactics.

Available Research

The available research regarding antitakeover amendments that require shareholder approval for their adoption is less conclusive than that which examines poison pills. A 1990 paper by Victoria McWilliams does suggest that any benefit derived from antitakeover protections shrinks as management gains control over a higher percentage of a firm's shares; i.e., "the perceived reduction in the probability of a successful takeover outweighs the increase in bargaining power, leading to a negative stock price reaction."[4]

In a 1999 study, three academics showed that fair price provisions can provide some welfare benefits to shareholders. Generally, with a fair pricing requirement, potential acquirers will avoid taking significant toehold stakes in targets--which can drive up the "clean up" price--unless a rival bidder is expected. The fair pricing mechanism will ensure that a competing bidder entering the contest will win if its valuation of the target exceeds that of the first bidder. Hence, fair price provisions may be beneficial to shareholders not because of any "fairness" features but because of efficiency considerations.[5]

Evaluating Fair Price Provisions

To the extent that fair price provisions protect shareholders from abusive tender offers, they are positive. However, fair price provisions are only valuable to shareholders when shareholders may exercise some control over their application. Two areas warrant consideration when judging a fair price provision: the provision's pricing criteria and the shareholder vote requirement.

Simple vs. Supermajority Vote

While fair price provisions requiring a supermajority shareholder vote still consult shareholders, such provisions greatly reduce shareholders' ability to raise the fair price requirements, especially when the ownership position of management is high. Only those fair price provisions that may be negated by a vote of the majority of disinterested shares should be approved.

Deriving the "Fair Price"

Another concern with fair price provisions is the way in which a "fair price" is derived. Requiring an acquirer to pay minority shareholders the same price as was paid to obtain the controlling shares is reasonable. Complicated premium formulae, however, may well prevent any tender offer, rather than just protecting against coercive tender offers. Shareholders should be wary of formulae that base what is fair on events too far removed from the present. For instance, going back two years to derive the appropriate price or premium is risky, since market forces may make such a price unreasonable. Similarly, when it cannot be discovered what pricing criteria would be applied to determine a fair price, shareholders should reject fair price provisions.

Conclusion

In summary, although fair price provisions offer some modicum of protection against coercive, two-tiered offers, generally such provisions rarely protect shareholders and are often designed to discourage would-be acquirers from taking a controlling interest in the company and offering shareholders an opportunity to sell the shares at a premium in instances where the company's board does not favor an acquisition. In evaluating the acceptability of such provisions shareholders should ask the following questions:

• Is a supermajority vote required to overcome the board's opposition to the acquisition?

• Is a supermajority vote required to appeal or amend the fair pricing provision?

• What is the size of the block of shares controlled by officers, directors, and their affiliates?

• Does the company maintain numerous other takeover defenses, e.g. poison pill, classified board?

• Does the company have a history of rejecting premium acquisition offers?