Unintended Consequences: The Application of Pennsylvania's Anti-Takeover Statutes to Friendly Transactions

Pennsylvania's anti-takeover statutes were designed to protect Pennsylvania public companies from hostile takeovers which are coercive or which are otherwise not in the best interests of the corporation. However, the mechanical application of those anti-takeover statutes can actually constrain a board's desire to effect a friendly transaction which it determines is in the best interests of the corporation.

The principal anti-takeover statutes are contained in subchapters 25E through 25H of the Pennsylvania Business Corporation Law (the BCL). Because it is generally difficult to "opt out" of these statutes and because several of them do not contain board approval "outs," it is extremely important for practitioners to take these statutes into account when representing a buyer or a seller in negotiated transactions involving Pennsylvania public companies.

Subchapter 25E - Control Transactions. Subchapter 25E (BCL §§ 2541 - 2548) requires a person that acquires 20 percent or more of the voting power of a target corporation to pay in cash the "fair value" for the shares of other shareholders of the corporation who object to the acquisition transaction. In essence, this section provides a form of dissenters rights that is applicable to the acquiror rather than the issuer corporation for changes of control at the shareholder level rather than the corporate level. The primary purpose of this subchapter is to prevent creeping acquisitions, which are often followed by coercive second step transactions at an inadequate price. However, this subchapter can have important implications in several types of negotiated transactions including, most importantly, the issuance of shares to a friendly strategic investor and friendly transactions structured in two-steps.

The issuance of 20 percent or more of the corporation's voting power to a strategic investor triggers subchapter 25E as does a negotiated acquisition transaction structured as a tender offer followed by a second-step exchange offer (or even a cash out merger). Significantly, there is no Board "out", meaning that the statute is triggered even if the incumbent, disinterested directors determine that the transaction is in the best interests of the corporation and approve it.

A corporation can opt out of subchapter 25E in only two ways: one, by providing in the original articles of incorporation enacted at the time of incorporation that subchapter 25E does not apply to the corporation; and two, prior to the acquisition transaction, by amending the articles of incorporation to provide that subchapter 25E does not apply to the corporation (an amendment which generally requires the Board's approval and the shareholder vote of at least a majority of the shareholder votes cast). Accordingly, if a corporation did not originally opt out, it must do so by submitting the opt out proposal to its shareholders, which has the effect of delaying and adding an element of uncertainty to the transaction.

In 1997, Conrail, Inc. was caught in this statutory dilemma in connection with its negotiated transaction with CSX Corporation. The transaction was structured as a partial cash tender offer which would have triggered subchapter 25E, followed by a stock merger with a fixed exchange ratio. The agreement between Conrail and CSX provided that a proposal to opt out of subchapter 25E would be submitted to the Conrail shareholders for a vote. Before a Conrail shareholder meeting could be held, however, Norfolk Southern launched a hostile takeover of Conrail with an all cash proposal that was higher than CSX's ultimate bid. Conrail opposed the Norfolk Southern offer, but not enough Conrail shareholders voted to opt out of subchapter 25E, effectively scuttling the CSX transaction that Conrail's Board had determined was in the best interests of Conrail.

Practitioners representing clients involved in negotiated transactions with Pennsylvania public companies should be aware of the potential impact of subchapter 25E on those transactions and they may want to consider the following ways to minimize that impact. First, companies that anticipate a need to issue a block of shares to a strategic investor may want to opt out of the statute in advance. Second, they could also consider a "conditional opt out" articles amendment—i.e., the opt out would apply only to transactions approved by the incumbent board--in order to retain the protection of the statute for hostile transactions, although the validity of such an opt-out would not be clear under the statute. See BCL, § 2501(c)(2). Third, in connection with a strategic investment or a two-step transaction, practitioners should consider the opportunity provided by Section 2548 of the BCL to condition consummation of the transaction on less than a certain percentage of shareholders exercising their rights to demand payment of fair value for their shares. Thus, as is frequently the case in friendly mergers which are conditioned on not more than 10 percent of the target's shareholders exercising their dissenters rights, a strategic investment or a tender offer could arguably be conditioned on the holders of not more than 10 percent of the shares of the target corporation in a tender offer exercising their subchapter 25E rights. If more than the specified number of shareholders object to the transaction, the investor or acquiror would not be required to consummate the transaction. This approach eliminates the need to submit an opt out proposal to a shareholder vote and, therefore, reduces the delay and uncertainty that such a vote entails. Finally, an even more aggressive approach would be to seek a waiver of subchapter 25E directly from shareholders tendering into the first step tender offer.

Subchapter 25F: Business Combinations. Subchapter 25F (BCL, §§ 2551 - 2556) applies to business combinations, such as mergers, consolidations, share exchanges and asset sales, between the corporation and a 20 percent or more shareholder (an interested shareholder). If this subchapter is triggered, a business combination with an interested shareholder must be approved by either the corporation's board of directors or shareholders, and in some cases may not be consummated for at least five years. Unlike subchapter 25E, subchapter 25F permits the board of directors to "opt out" of the stringent requirements of its provisions on a case by case basis. Accordingly, in a friendly transaction, the potential adverse impact of this subchapter can be avoided fairly easily, although it is important for practitioners to ensure that the Board approval be obtained prior to the time that a person becomes an interested shareholder.

Subchapter 25G: Control Share Acquisitions. Subchapter 25G (BCL, §§ 2561 - 2568) provides that a person who acquires 20 percent or more, 33 1/3 percent or more, or 50 percent or more of the voting power of the corporation for the first time loses the right to vote those "control" shares unless and until its voting rights are reinstated by the affirmative vote of at least (1) a majority of the disinterested voting shares and (2) a majority of all voting shares of the corporation.

A corporation can opt out of subchapter 25G in only two ways: one, by providing in its original articles of incorporation enacted at the time of incorporation that subchapter 25G does not apply to the corporation; or two, by amending its articles of incorporation prior to becoming a registered corporation or on or before 90 days after becoming a registered corporation to provide that subchapter 25G does not apply to the corporation. Thus, because it would be difficult and unusual to hold a shareholders meeting within 90 days after becoming a public company, subchapter 25G will virtually always be applicable to a corporation if it does not opt out of subchapter 25G prior to becoming a registered corporation.

Moreover, like subchapter 25E, the control share acquisition provision does not have a Board "out." While acquisitions of voting shares pursuant to a merger or consolidation are expressly exempt from the operation of subchapter 25G, subchapter 25G does apply to tender offers. Thus, in a friendly transaction structured as a tender offer followed by a cash-out merger or exchange offer, the acquiror will lose its voting rights upon closing the first step tender offer and will have to seek and obtain the necessary shareholder approval in order to restore its voting rights. This requirement inserts delay and uncertainty into the transaction and will almost certainly be unpalatable to the acquiror. In this situation, the practitioner can recommend two alternatives:

First, the transaction can be re-structured as merger, since mergers are exempt from the statute, although mergers generally take longer than tender offers. Second, the acquiror can condition its tender offer on the acquisition of at least 80 percent of the voting shares of the target (rather than a majority), so that it can effect the second step by means of a short-form merger without needing to vote its control shares. The BCL permits a short-form merger to be effected solely by action of the board of directors of the parent corporation if the parent corporation owns at least 80 percent of the target corporation's shares. BCL, §1924(b)(3). The short-form merger provision does not require that the parent corporation have the right to vote the shares that it owns. Accordingly, the acquiror will not have to vote its control shares (which have no voting rights) to effect the second step merger if it acquires 80 percent of the voting shares of the target corporation in the first step tender offer. This approach arguably circumvents the intent of subchapter 25G, but there appears to be nothing in the statute to prohibit it.

Subchapter 25H: Disgorgement of Profits

Subchapter 25H (BCL §§ 2571 - 2576), otherwise known as an "anti-greenmail" statute, requires a person that owns 20 percent or more of a corporation's shares, or that has publicly announced an intention to acquire control of the corporation, to disgorge any profits it realizes on the sale of its shares to the corporation within 18 months of acquiring control status. The purpose of this subchapter is to discourage corporate raiders from putting corporations "in play" with the expectation of making a profit, or obtaining "greenmail," by selling their shares back to the corporation.

The opt out provisions of subchapter 25H are very similar to that of subchapter 25G—i.e., effectively, subchapter 25H will be applicable to a corporation if it does not opt out of subchapter 25H prior to becoming a registered corporation. However, subchapter 25H does not apply to those transactions that are specifically identified and approved by the Board and ratified by shareholders and where the dispositions have been made by a controlling person or group that is in "control" of the corporation.

Accordingly, in the context of a friendly transaction, strategic investors and target corporations must be aware of the potential consequences of subchapter 25H and must take appropriate steps to avoid the risk that a friendly strategic investor could lose any profits made in the event of an early exit from the Company.

Conclusions

Pennsylvania's anti-takeover statutes provide important protections against hostile and unfair takeovers by corporate raiders. However, attorneys representing Pennsylvania public companies must also be aware of the impact that these statutes can have on negotiated transactions. Sometimes, this requires significant advance planning. Thus, for example, there are many good reasons to incorporate a candidate for an initial public offering in Pennsylvania, including the well-defined fiduciary duty provisions in the BCL, but if the corporation will have a significant (20 percent or more) shareholder after the IPO, the corporation may want to consider opting out of subchapters 25E through H prior to the IPO in order to avoid inadvertently triggering those statutes.

It may be useful in the context of negotiated transactions if certain of the statutes--in particular, subchapters 25E and 25G—gave the incumbent directors the ability to opt out of those statutes with respect to a particular transaction; however, it is probably not feasible from a legislative perspective to add such Board "outs" without jeopardizing the statutes themselves. The statutes are too important to Pennsylvania corporations to take that risk. As it is, practitioners must carefully consider the impact of the statutes on friendly transactions and suggest steps to avoid unintended consequences.