Weaker ‘poison pills,’ stronger shareholders?

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The big corporate law debate for the better part of 30 years has been over what legal academics opaquely call "agency costs" – the idea that the owners of a company (its shareholders) and those that control a company (its managers, directors and officers) have divergent interests that may cause those with control to make decisions that are ultimately detrimental to those with ownership.

This academic debate has informed perhaps the most important practical securities law debate in Canada over the past 25 or so years: the treatment of hostile takeovers. In short, Canadian securities regulators have sought to disallow "poison pills" – the colloquial term for legal devices implemented by boards, and (usually) approved by shareholders, that defeat hostile takeovers by threatening an acquirer with massive dilution of their shares – under the theory that poison pills represent an improper obstruction to shareholders' ability to trade their shares.

Proponents of hostile bids believe that takeovers are good for shareholders because they offer a premium over a share's market price. So, a board that is blocking a takeover is, at best, thwarting shareholder choice and, at worst, acting in violation of its duties as a board. Agency costs.

Those who dislike the current policy argue that shareholders can be shortsighted, and boards are often right to block takeovers that put short-term financial returns over a company's long-term growth. Plus, some argue pills actually protect shareholders: Without pills, shareholders are in a prisoner's dilemma, forced to choose between tendering into a bid or being left behind as a minority shareholder with a less valuable interest in the company.

Taken together, the practical debate is still centred on the academic problem of agency costs: Do you believe that directors act in the best interests of a company and its shareholders? Or do you believe that giving directors leverage to negotiate creates a better corporate landscape?

On May 9, the ultimate result of this debate goes into effect. National Policy 62-103 provides new rules for takeovers that will likely serve to eliminate poison pills.

Once the new policy goes into effect, hostile bids must be open for a period of 105 days, giving boards time to negotiate and canvass the market for other purchasers. Even more importantly, every bid now has a minimum tender condition of 50 per cent and, if 50 per cent of shareholders tender their shares into a bid, the bid must remain open for a further period of 10 days, meaning that no shareholder gets left behind (as a minority, if they don't want to be).

If you believe that individual shareholders should have an unfettered ability to decide what they do with their shares, this is a great result. As I've argued, based on U.S. academic Lucien Bebchuk, this system removes the pressure to tender into a takeover bid, by giving shareholders who oppose the bid but don't want to be stuck in the minority the chance to sell their shares once they are certain the bid will succeed.

This is all-important and well trod: The new rules balance directorial judgment with shareholder choice but ultimately come down on the side of shareholder choice.

NP 62-103 isn't just about agency costs; it's also about how capital markets should be structured. In particular, it's about the balance between settled regulatory procedures and free contracting.

My dad, in his more libertarian moments, used to say that the primary role of government is to enforce contracts. But that statement itself contains a conceit: Regulation is necessary for effective contracts. Otherwise, we live in a Hobbesian world where there is central authority to hold contracting parties to account. This is bad for business.

Thus, regulators and rule makers have to balance the freedom to structure economic relationships with regulations that ensure that contracts are fair and result in good economic outcomes.

Regulated securities markets both set rules to improve contracts and limit the freedom of parties to contract with one another. For example, disclosure requirements ensure that individuals buy securities with full information but also set out what information companies must give to shareholders.

In the United States, poison pills have become a standard term in the corporate contract. Shareholders don't get to vote on pills themselves, they can only choose to vote out board members in annual elections, leaving shareholders relatively impotent to modify aggressive and preclusive pills. This is not an efficient way to contract.

In Canada, where shareholders must approve pills (under stock exchange rules) and boards are more easily challenged, poison pills are much more directly bargained over. The result is that Canadian pills are weaker. The new takeover rules incorporate many of the protections that already made Canadian pills weaker than their U.S. counterparts, namely, minimum tender conditions and mandatory extension after that minimum tender is met. NP 62-103 takes what were once bargained-for rights and turns them into a regulatory protocol. In doing so, it substantially limits the use of the poison pill.

NP 62-103 makes our takeover regime less contractual, and therefore less flexible, but also more consistent. By prescribing regulations, regulators are running the risk, as some have argued, of getting the balance wrong by, for example, forcing bids to stay open for too long. Of course, the new rules are also empowering to shareholders.

So, is a regulatory approach better than a contractual one? Maybe there's another 30 years of debate in there.

Adrian Myers is a lawyer at Torkin Manes LLP.