Global financial markets have experienced unprecedented volatility as heightened concerns about the ongoing coronavirus (COVID-19) pandemic take hold and its impact on the global macroeconomic landscape remains unknown. From its record high, the S&P 500 has plunged as much as 30%, and companies in sectors disproportionately impacted by COVID-19—particularly those that have had to reduce or suspend operations to comply with the current social distancing guidance from the US Centers for Disease Control and Prevention—have experienced stock price declines of more than 70% from their 52-week highs.
As companies continue to see their market capitalizations adversely impacted by the volatility in the financial markets—perhaps to a point where their market valuation does not reflect the company’s intrinsic value and ability to persevere through the current crisis—some may want to consider adopting a “poison pill” (more technically known as a shareholder rights plan), whether it be a traditional takeover-defense poison pill or a net operating loss (NOL) poison pill intended to protect and preserve NOLs from being limited by Section 382 of the Internal Revenue Code (IRC).
Even those companies that may not be at the point where they believe the benefits of adopting a poison pill outweigh some of the countervailing considerations, this may be the time to have a “shelf” poison pill and related documents prepared and internally vetted so a poison pill can be adopted and publicly announced on very short notice.
Takeover-defense poison pills have been in use for more than three decades. A traditional takeover-defense poison pill has a number of purposes, including to protect the company and its shareholders from the actions of third parties that the company’s board of directors determines are not in the best interests of the company and its shareholders, and to enable all shareholders to realize the long-term value of their investment in the company. Takeover-defense poison pills also encourage third parties seeking to acquire the company to negotiate with the company’s board of directors and provide the board with a longer timeframe to evaluate the adequacy of an acquisition offer, investigate alternatives, solicit competitive proposals, and/or take other steps necessary to serve the best interests of the company’s shareholders.
An NOL poison pill is intended to deter any person from acquiring beneficial ownership of 4.99% or more of a company's common stock without the approval of the company’s board of directors. By deterring such acquisitions, an NOL poison pill is intended to prevent an “ownership change” from occurring as determined pursuant to Section 382 of the IRC.
Under Section 382, an “ownership change” occurs if a shareholder or group of shareholders deemed to own at least 5% of a company’s common stock increases their ownership (individually, or collectively with other such “5% shareholders”) by more than 50 percentage points over their lowest ownership percentage within a rolling three-year period. If an ownership change occurs, Section 382 would impose an annual limit on the amount of the company’s NOLs that can be used to offset income taxes equal to the product of the total value of the company’s outstanding equity immediately prior to the ownership change (reduced by certain items specified in Section 382) and the federal long-term tax-exempt interest rate in effect for the month of the ownership change. A number of complex rules apply to calculating this annual limit. If an ownership change were to occur, the limitations imposed by Section 382 could result in a substantial delay in the timing of the usage of the company’s NOLs or in a material amount of the company’s NOLs expiring unused and, therefore, significantly impair the value of such NOLs.
While an NOL poison pill may provide significant takeover-defense protection and, at times, may be more protective than a traditional takeover defense poison pill, its primary purpose is to protect and preserve a company’s NOL carryforwards from being limited under Section 382 of the IRC.
While takeover-defense poison pills and NOL poison pills have different primary purposes, they are very similar in structure, documentation, mechanics, and dilution effects. In each case, they provide that, upon the occurrence of a triggering event—usually the acquisition of a threshold percentage of company stock by any person or group (other than certain exempted and “grandfathered” persons)—that results in a person being deemed an “acquiring person,” each shareholder other than the acquiring person would be able to exercise rights to purchase shares of the company’s common stock having a value of two times the designated exercise price, resulting in substantial dilution to the acquiring person.
Alternatively, after an acquiring person is deemed to exist, the company’s board of directors can exchange all or part of the then-exercisable rights for common shares at a ratio of one common share per right. Unless the company’s board redeems the rights or amends the poison pill to make it non-applicable to the acquiring person, the acquiring person faces severe economic and voting dilution.
The most significant difference between a takeover defense poison pill and an NOL poison pill is that the triggering ownership threshold for an NOL poison pill is driven by Section 382 of the IRC, which aggregates shareholders holding 5% or more of the company’s common stock for purposes of determining whether an ownership change has occurred that would cause a company’s NOL carryforwards to be limited. Accordingly, an NOL poison pill may have a triggering ownership threshold of 4.9% to deter the creation of any 5% shareholders. In contrast, a takeover-defense poison pill will more likely have a triggering ownership threshold set by the company’s board of directors and will typically be between 10-20%.
There are other notable differences between these two types of poison pills, including that NOL poison pills tie the definition of beneficial ownership to the Internal Revenue Service’s ownership rules, while takeover-defense rules tie the definition of beneficial ownership to the US Securities and Exchange Commission’s Rule 13d-3.
In addition, NOL poison pills typically provide for the board to have broad authority to exempt specific transactions from triggering the poison pill, particularly when the transaction will not adversely impact a company’s NOLs. Similar board authority does not typically exist in takeover-defense poison pills. NOL poison pills also typically have longer stated terms, but contain sunset provisions tied to the exhaustion or expiration of the NOLs.
From a corporate governance perspective, NOL poison pills adopted to protect significant NOLs are generally viewed much more favorably by institutional investors and proxy advisory firms than takeover-defense poison pills and are easier to get shareholders to support and vote to approve or ratify.
At the beginning of the millennium, there were more than 2,000 poison pills in existence. As NOL poison pills did not really come into vogue until after the 2008 financial crisis, there was only one NOL poison pill in existence in 2000. At that time, prophylactic takeover-defense poison pills with 10-year terms were very common and routinely renewed, even when the company did not face a specific threat. Fast-forward 20 years, and the corporate governance landscape has evolved to the point that multi-year, prophylactic, takeover-defense pills that are not shareholder approved or ratified are rare and viewed negatively by institutional investors and proxy advisory firms. Proxy advisory firms such as Institutional Shareholder Services Inc. have adopted voting policies providing for a withhold/against vote for all director nominees where a poison pill with a term of more than a year has been adopted without a shareholder vote.
Today, the expectation of institutional investors and proxy advisory firms is generally that takeover-defense poison pills will only be adopted for a limited duration (e.g., less than one year) in response to a specific set of circumstances. That change in corporate governance sentiment is generally responsible for there being only 171 poison pills in force at the end of 2019—including both takeover-defense and NOL poison pills. While poison pills have fallen out of favor, it is not because they became ineffective or an alternative structural defense was developed. Rather, poison pills remain the most effective tool for a public company to prevent an unwanted accumulation of its shares above a specific threshold.
A look-back at the poison pills adopted in response to the then-unprecedented market disruption and volatility that followed the 2008 financial crisis may be a helpful predictor of what to expect in the wake of the stock market’s reaction to the COVID-19 pandemic. In 2008 and 2009, there were, respectively, 61 and 57 poison pills adopted. As companies accumulated substantial NOLs during this time that they wanted to preserve and protect to offset future federal tax liabilities, there was a significant uptick in NOL poison pill adoptions. From 2007 to 2009, the number of NOL poison pills adopted increased nine-fold, from 4 to 37. In fact, 2009 remains the all-time record year for NOL poison pill adoptions. If you look at the companies that adopted NOL poison pills in 2009, you see strong representation by the industry sectors that were disproportionately impacted by the financial crisis such as financial services, automotive, and homebuilders, among others.
Extrapolating what we saw in the wake of the 2008 financial crisis, we would expect to see a significant uptick in poison pill adoptions as public companies—including those in sectors that have been disproportionately impacted by the COVID-19 pandemic—continue to grapple with market valuations that they believe do not reflect their intrinsic value and, accordingly, make them unduly vulnerable.
While some of this activity will be driven by habitual activist investors, we may see more of this activity from opportunistic investors and strategic buyers looking to buy high-quality assets at huge discounts to intrinsic value. In the 12 years that have passed since the 2008 financial crisis, many companies have eliminated most of their takeover defenses and have made themselves much more vulnerable than they were 12 years ago. For some of these companies, a poison pill may be the only takeover defense that is practically available. Further, as numerous companies accumulate significant operating losses and write-downs due to suspending operations for an extended period, many will look for ways to protect and preserve their NOLs from being limited under Section 382 of the IRC so that these NOLs remain available to offset future tax liabilities.
Notwithstanding the almost unquestionable efficacy of poison pills, there are numerous considerations to be weighed in adopting a poison pill, including that, even in the wake of the current and unprecedented volatility in the global financial markets, we have yet to see any noticeable shift in how institutional investors and proxy advisory firms look at poison pills, particularly traditional takeover-defense poison pills adopted in response to widespread macroeconomic factors as opposed to specific and direct threats that a particular company is facing.
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 Exceptions include acquisitions where the threshold was crossed inadvertently, stock buybacks, stock dividends, stock splits, stock subdivisions, stock option grants and exercises, and acquisitions by related entities such as an ESOP or other benefit plans.
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