Toehold Strategies, Takeover Laws and Rival Bidders

Prior to the announcement of a tender offer, the bidding firm is legally allowed to acquire shares in the open market, subject to some limitations. These pre-announcement purchases are known as toeholds. This paper presents a simple model that describes the bidder's optimal toehold acquisition strategy, within an environment that closely parallels the present legal institutions. The model shows that toeholds and bids interact in a complex manner even without the presence of asymmetric information. By examining a simple environment the paper provides a useful alternative hypothesis for tests of other, presumably more complex, models. One of the main implications of our model is that if no competing bidders are expected, no toeholds should be purchased. Indeed, under a wide variety of conditions small toeholds are optimal. The paper also demonstrates that the correct specification of an empirical model can be critical. For example, under some parameter values toehold purchases may exhibit a negative cross-sectional correlation with the pre-announcement run up in the stock price. This occurs even though prices are strictly increasing the size of the toehold. Several implications concerning various aspects of merger legislation are considered. For example, we demonstrate that a rule similar to a "fair price" provision has the desirable property that a second bidder arrives and wins if and only if he places a higher value on the target than the initial bidder. A great deal of recent theoretical research has focused upon the motivations and consequences of mergers. Several papers have discussed bidding strategies and techniques notable examples include Fishman (1988) and Hirshleifer and Png (1989) who examine optimal strategies once a tender offer has been declared. However, relatively little attention has been paid to the strategies a potential bidder may use prior to announcing a tender offer. A commonly used method is the open market purchase of shares (toeholds) before the official announcement of the offer. In the present paper we provide a simple model that attempts to accurately capture the primary legal features of the takeover process. We then use the model to characterize the costs and benefits of toehold purchases. The model further explores how synergies and government regulations affect the number of shares purchased and the conditions under which second bidders contest the target. See for example Jensen (1988), Shleifer and Vishny (1988) and Scherer (1988) for reviews and Roll (1986) for a different perspective. 2 One contribution of the current analysis is to provide a set of results that are based upon the institutional setting and the basic economic trade-off facing any potential acquirer. By eliminating asymmetric information and agency issues, the model allows one to draw a clear distinction between the empirical regularities that require a richer, and thus more complex model, and those that follow directly from the legal and institutional features of mergers. Further, we show that the latter approach provides a good explanation for some of the more surprising empirical results. Bradley, Desai, and Kim (1988) find that over half the firms in their sample did not acquire any shares prior to making a tender offer. Similarly, Poulsen and Jarrell (1986) report that about 40% of the firms in their sample had no toeholds. Most of the firms in the sample collected by Jennings and Mazzeo (1993) did not purchase any toehold shares either (although Jennings and Mazzeo explicitly excluded firms that had an initial toehold of more than 50%). If bidders are acting rationally, then there must be conditions which preclude open market purchases of the target's shares as an optimal response. The model presented here shows that potential bidders should not attempt open market transactions when rival bidders are sparse. However, even when a rival is likely other elements of the problem may still induce the use of only modest open market purchases. The present analysis leads to several additional conclusions. First, we demonstrate that larger toeholds are not unambiguously more effective at discouraging rival bidders. This may explain why many toeholds are small. Secondly, we demonstrate that while toeholds allow the initial bidder to profit should a rival appear, winning is still always better than losing. In contrast, some newspaper articles and legal commentary have indicated that bidders may wish to purchase toeholds in the hope of losing and then selling out. Thirdly, because the legal institutions are part of the model, it is possible to explore the impact of changes in the prevailing laws. An explicit analysis of "fair price" provisions (which require the purchase of un-tendered shares at the highest price paid for any shares) indicates that such laws may provide some welfare benefits. This result differentiates our model from Chowdhry and Jegadeesh (1994). In their signaling equilibrium almost every type of bidder will purchase a positive toehold to signal his valuation. 3 In that sense, the analysis is similar in spirit to Bebchuk (1994), who concludes that the U.S. legal system (without the "fair price" provision) may facilitate inefficient transfers, whereas the Equal Opportunity rule (similar to Fair Price provision) does not enable inefficient transfers to go through. We also discuss the role of corporate charters and laws specifying different number of shares required to complete a merger. Simulations also demonstrate that our simple framework can lead to results consistent with Betton and Eckbo’s (1995) counter intuitive finding that empirically, larger toehold purchases are correlated with lower preannouncement stock values. While this paper examines the interaction of takeover statutes with the optimal toehold decision, there have been a number off other toehold studies that examine several other important issues. Chowdhry and Jegadeesh(1994) model the toehold selection problem as the solution to a signaling game regarding the bidder’s valuation of the target. Freund and Easton (1979) offer an informal but general discussion of the toehold problem. Burkart's (1995) model provides an analysis of strategic bidding given that bidders hold initial stake in the firm. His model predicts that overbidding will occur once a toehold is purchased. However, there is no derivation of an optimal toehold acquisition. Kyle and Vila (1991) suggest that a bidder will generally want to purchase a toehold in order to acquire shares in the open market at a lower cost than they can be obtained at in the subsequent tender offer. However, their paper does not consider multiple bidder contests nor does it explain why many firms never bother to purchase toehold shares. Most other papers, such as Shleifer and Vishny (1986) and Hirshleifer and Titman (1990) take the bidder's initial stake as given and then analyze the resulting game. Similarly, Singh (1995) discusses strategies for block-holders who have already purchased a toehold and the impact of such a situation on takeovers. Dewatripont (1993) discusses some of the trade-offs we consider within a different framework which envisions a contest between an initial raider and a potential white knight, with different private benefits. The paper is organized as follows. Section 1 describes the legal environment. Section 2 presents the model and derives the conditions under which positive and zero toeholds are optimal. Section 3 contains 4 simulations. Section 4 presents the conclusion. 1 The Legal Environment A tender offer goes through several phases, each of which is subject to different legal strictures. The initial phase is an acquisition period during which the bidding firm can employ open market purchases to obtain a toehold in the target. Legally, a firm may acquire up to five percent of another firm before it triggers a reporting requirement. Section 13(d) of the Securities Exchange Act of 1934 stipulates that once someone obtains five percent of a firm's stock, that person has 10 days to file a disclosure form describing his intentions. Importantly, during this ten day period the potential bidder can continue to make open market purchases. Hence, toehold purchases may be considerably larger than 5% of a target firm. Once the report is filed, no additional open market activities are permitted. Much of the material in this section can be found in Gilson (1986) and Gilson and Kraakman (1987). 5 At this point the next phase of the acquisition begins, in which a tender offer is made via a 14D filing. A complete acquisition must offer compensation both for those who voluntarily relinquish their position, and for those who are forced out against their will. As such, a tender offer is necessarily divided into two parts, the second of which "cleans up" any shares not obtained in the first part. This institutional feature drives many of our results. There are very few restrictions on the form of the first tier bid. The two primary limitations are that the bid must remain open for at least 20 days and that the tenders must be taken up on a pro rata basis. In other words, the bidder cannot discriminate among the target's shareholders. While recent "second generation" takeover statutes have affected some of the details involved in an acquisition, the basic two tier structure remains. See Karpoff and Malatesta (1989) for an extensive review and empirical analysis of this legislation. One should further note that the analysis of this paper deals with cases in which the target is indeed dissolved as a corporate entity as opposed to cases in which the target is managed as a wholly owned subsidiary or is partially liquidated. Golbe and Schranz (1994) is another example of a model which makes extensive use of this institutional feature in another context. 6 The eventual goal of the bid is the dissolution of the target company. Therefore, the acquiring firm must specify a price they will pay for shares not acquired in the first half of the tender offer, if indeed a sufficient number of shares are tendered to force a merger. It is at this point that the legal framework becomes critical. Imagine that the bidder has acquired fifty percent of the target company and that there is no legal protection for the minority shareholders. Then the bidder's optimal strategy is to "sell" the target's assets to the bidder at a price of zero, and dissolve the target firm. Since the bidder has over fifty percent of the stock, approval of the agreement is guaranteed. Thus, it is clear that any remuneration the remaining target shareholders may hope to receive must be imposed via the legal system or an appropriately structured corporate charter which cannot be revoked (as is the case in some European countries). Every state has laws governing the treatment of target shares during the freezeout portion of the merger. Generally, shareholders are entitled to a minimum value which is determined via an appraisal proceeding. The Delaware statute is typical. In section 262 it states: ".... the Court shall appraise the shares, determining their fair value exclusively of any element of value arising from the accomplishment or expectation of the merger..." While the wording is clear, and appears designed to give the target owners only the pre-merger value of their stock, the courts have taken some liberties with its meaning. (For example, see Weinberger v. UOP, Inc., Supreme Court of Del., 457 A.2d 701 (1983).) In practice, the legal methods used to determine a stock's premerger value are ones that most financial academics may not consider appropriate. For example, accounting values are used in addition to the pre-merger stock price. An important feature of this process is that attributes of the bidding firm do not enter the calculations, contrary to some models which implicitly assume such dependence. Only the target's attributes determine the second tier share price. The procedures used by the courts to value shares that are not taken up in the tender offer are of course Clearly, this is an extreme case. Under most circumstances such extreme dilution is not possible according to state and corporate by laws. However, this strong statement highlights the importance of the second tier legislation. 7 a matter of public record. Thus, in the absence of competition, the bidder can in principle formulate a simple strategy. First, he calculates the price the court will allow for the second phase of the tender offer. The initial offer will exceed that amount by a few pennies in order to compensate those who agree to tender early. If necessary, one can also offer to return the submitted shares if the offer fails. It is easy to verify that given this type of bid tendering is at least a weakly dominant strategy, and so the offer should succeed. The next section analyzes a simple model which adheres closely to the institutional realities described above, and derives several empirical implications. In practice, the benefit from tendering early is often the ability to receive payment for the shares as quickly as possible. However, as long as there is a positive interest rate, tendering remains at least a weakly dominant strategy. 2 The Model