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Corporate Patient: “Dr. Preparedness, I’m really worried about the hostile activity epidemic sweeping the corporate world. The old remedies � poison pills, staggered boards, just saying no � don’t seem to work anymore. What do you recommend?” Dr. Preparedness: “We’ve seen an aggressive new strain of this disease develop almost overnight, and it’s very resistant to the traditional courses of treatment. I’ve run a vulnerability exam for you, and here’s a prescription for a new kind of treatment. Remember, you need to get started on this treatment regimen as far in advance of any exposure to the disease as possible if you want to maximize your odds of avoiding catching it. “The prescription: 1. Improve operational performance. 2. Develop effective strategic plan. 3. Communicate operational accomplishments and strategic plan to shareholders and Wall Street. “If you stick with this regimen, your stock price will go up, your anti-takeover antibody count will rise and you’ll be fine.” The hostile-takeover environment has changed dramatically in just the last couple of years. As a result, the anti-takeover tactics that have been used for several decades � just saying no to an aggressor and using a rights plan, staggered board elections and other defenses to circle the wagons and hold off the aggressor � often don’t work today. Interestingly, this development has come about not as a result of any change in the law but from a confluence of nonlegal developments: A company can still refuse to engage the aggressor as a legal matter but, increasingly, it can’t do so as a practical matter. This article will first discuss how the hostile mergers and acquisitions (M&A) environment has changed in recent years and then how corporate preparedness has evolved in response to these changes. (Please note the use in this article of the more appropriate, and more “P.C.,” term “corporate preparedness” instead of “anti-takeover.”) Recent developments have made it much more difficult, and in some situations impossible, for a company to simply reject a hostile overture. This may have a lot to do with one of the legacies of the Enron era of corporate scandals: the development of an environment in which directors and officers operate under a glare of skepticism, scrutiny and criticism from all directions, including shareholders, analysts, the media, courts and Congress. While this difficult climate is not limited to the M&A area, it is being felt acutely by the management of companies trying to defend against hostile activity. These days, institutional shareholders rarely give the management of a target company the benefit of the doubt. Whether the issue involves dismantling anti-takeover � that is, preparedness � protections, changing governance practices or responding to a hostile bid or hedge fund proposal, institutional shareholders are much less inclined to sit by quietly and defer to management. They’re more likely to express their views in no uncertain terms, privately and even publicly, and to side with a hostile bidder or hedge fund. These changes have created an environment in which hedge funds and other activist investors have flourished as never before. The rise of activist investors has redefined hostile M&A activity. Until recently, banker and lawyer board presentations on hostile M&A and preparedness dealt only with hostile corporate takeovers and made no mention of the subject of activist investors. Today, these presentations always address activism, and for many of their clients there’s a greater focus on activists as a potential threat than on hostile bidders. People now use the term “hostile M&A” to refer both to hostile acquisition bids and activist-shareholder campaigns, even if the latter do not involve the acquisition of the target. Activist investors come armed with extraordinary sums of cash and a readiness to use virulently aggressive tactics, particularly of the “personal attack” kind not seen since the proxy fights of the 1960s and 1970s. Activists present a different kind of threat than hostile bidders, because they have a different investment premise. Their objective is to maximize their return on investment, generally on a short-term basis of as little as six to 12 months, by increasing the target’s stock price. Their success and compensation are based on their short-term results. Activists rarely seek to acquire the target, but instead purchase a minority stake that is large enough to earn a meaningful return and for them to be taken as a serious threat. Activists use their ownership position to encourage, and sometimes publicly demand, that the target company take actions to maximize short-term returns. These actions include increasing the company’s leverage to return cash to shareholders through a large stock buyback or dividend, selling or breaking up the company, or making changes in management. Ease of getting involved The influence of activist investors in the market has contributed to another development: the ease with which companies can now be put in play. To get something going today, one no longer needs tender-offer papers, a U.S. Securities and Exchange Commission review process and an army of litigators. All one needs is a letter to the target (still a bargain even at the new 41-cent price for a stamp) or a press release announcing the bid or activist proposal. An aggressor can then sit back and let others do all the work for it: Activist investors and their friends will accumulate a large stake overnight and, often with the participation of more traditional institutional shareholders, demand that the target give the hostile proposal a fair hearing. Given the resources available to activists, the size of the target is no longer an obstacle; witness recent investor activism over Time Warner Inc., ABN Amro Bank N.V., General Motors Corp., CSX Corp. and Motorola Inc. And activists have become a global phenomenon � in Europe (Deutsche B�rse A.G., in addition to ABN Amro), Asia (Link Real Estate Investment Trust in Hong Kong) and Latin America (Arcelor Steel in Brazil). Traditional hostile bidders seeking to buy companies have also thrived in the new environment. Activist and institutional shareholders are often powerful allies for a hostile bidder in pressuring the target to negotiate with the bidder, and today’s strong stock prices and readily available low-cost financing provide plentiful deal currency. Preparedness today When a hostile bidder or activist surfaces today, the target’s board can face, often overnight, the prospect of private and public demands from shareholders for it to engage the aggressor, along with the accumulation of a significant percentage of its shares, 15% to 20% or more, in unfriendly hands. This stock ownership provides some real teeth for the aggressor’s demands. When that much stock is held by activists, and a lot more by shareholders supporting change, just saying no may not be a practical option. These days, the battle is more likely to take place in the arena of public opinion than that of legal defenses, involving an often relentless public campaign to win the hearts and minds of the target’s shareholders. Behind the publicity campaign lies the threat or fact of an election campaign in the form of a proxy fight to throw out or withhold votes from the incumbent directors. To prevail, the target’s board and management must be able to convince shareholders that they are better stewards of the company’s future, and have a better plan, than the hostile aggressor. What can make this challenging is that the target is often in the position of trying to sell a long-term plan in the face of an aggressor’s seductive proposal to create value in the short term. If the target does not start taking its preparedness medicine until after the aggressor has surfaced, it’s unlikely to win this campaign for shareholder support. If the target has never talked about its long-term strategic plan to build shareholder value, it will have little credibility doing so after the aggressor has appeared. Advance preparation is everything to winning the campaign for shareholder support, and indeed it is the preventive medicine for avoiding hostile aggressors altogether. So, companies need to start their preparedness treatment as far in advance of any threat as possible: First, companies should give themselves a “vulnerability test,” in which management and the board analyze their company the way a hedge fund would: Are there ways to significantly increase the company’s stock price in the short term � leveraging the balance sheet to pay cash to shareholders, selling off noncore businesses, cutting costs, selling the company, etc.? If the answer is yes, the company is vulnerable. Now, this isn’t meant to suggest that a board should take the same short-term steps that an activist would. The purpose of a vulnerability review is to enable the company to understand the threat it faces so that it can better position itself to deal with the threat. At the same time, companies sometimes decide that one or more short-term value-enhancing actions, perhaps with some moderation or variation, actually make sense. Second, once a company has taken its vulnerability test and reviewed the results, it’s ready for the next step. The company needs to develop the best possible strategic plan to increase long-term value for shareholders, based on a rigorous review of all strategic alternatives, as well as undertake a thorough analysis of its more immediate operational issues. The company’s bankers, lawyers and other outside advisers can play an important role in conducting the vulnerability review, analyzing strategic alternatives and developing a strategic plan. This part of the course of treatment can even produce surprising results. Occasionally, companies review their strategic alternatives and discover that selling the company, or parts of it, is the most attractive alternative to pursue. Third, the company needs to develop a comprehensive program to communicate proactively both its strategic plan and specific business initiatives and accomplishments to shareholders and Wall Street. This involves a top-to-bottom review of all communications being made by the company, including all of its public filings, analyst calls and communications with institutional shareholders. The second and third steps can’t just be a one-time effort. Companies sometimes go through this exercise once and, seeing how much work is involved and that there is no apparent aggressor on the horizon, find it tempting to think they’re done. The hardest part is to continue with the course of treatment: Companies must continue to review their strategic plans and talk with shareholders as an ongoing priority. If a company is not able to avoid an aggressor altogether through this course of action, let’s see how much stronger a position it will be in if it has done its advance preparation. Compare Company A and Company B. Company A hasn’t been taking its medicine. An activist surfaces with a “shareholder value” plan. Whatever Company A says in response, it will have a credibility issue and will look like it is just reacting to the aggressor. The activist, and not Company A, will get the credit for proposing value-enhancing actions. By contrast, during the last several years, Company B has developed, refined and communicated its strategic and business plans. Even if results haven’t been as strong as hoped, if an aggressor surfaces, Company B will have far more credibility in seeking the support of shareholders in its campaign against the aggressor. Ideally, it will be in the position of being able to say, in response to the aggressor, “We actually looked at what you’re proposing two years ago and rejected it in favor of the following things we’ve done: . . . .” The best way to avoid or survive an attack by an aggressor is to be a Company B, and for some other company in Company B’s industry to be the more tempting and vulnerable Company A. The right business strategy So, corporate preparedness is very different today than it used to be just a couple of years ago. Of course, the legal corporate preparedness checklist is still important: Boards and management still need to understand their fiduciary duties; review the state of their charter, by-laws and other preparedness provisions; know who their shareholders are; maintain a stock watch to monitor any telling accumulations of their shares; etc. Yes, these measures are important in treating the disease, should one catch it. But they are much less helpful today in protecting a company from catching the disease in the first place. The focus today is on a healthy lifestyle of developing a great strategic plan, running the business well, building strong relationships with shareholders and Wall Street, and improving the stock price, all well in advance of any activist or hostile bidder surfacing. Now, if these preparedness recommendations sound like they’re good for business, that’s because business colleagues say they are. While the adage that “the best defense is a high stock price” is an old one, it’s never been more true than today. The new corporate preparedness course of treatment involves a lot more work than, say, adopting a “shareholder rights” plan. Indeed, it’s hard to think of anything that requires more effort or is harder to achieve for a company. But the good news is that companies should be doing all this as a business matter anyhow, so the incremental work involved should be manageable. With these changes, lawyers are having a refreshingly different experience in boardrooms. Lawyers are much more likely today to see directors nodding their heads in support of the measures that they’re advocating, as compared to the look of polite tolerance that one used to get when discussing convoluted legal defenses that seemed to have very little to do with the job of running the business. Who says lawyers today are bad for business? Paul T. Schnell is a partner in the M&A group at New York-based Skadden, Arps, Slate, Meagher & Flom.

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