Rogue Missives Friday, August 08, 1997

Imagine that the U.S. House of Representatives has come to unanimous agreement on a startling new plan to make every American pay a 60% federal tax on his or her income. Aghast, the American people band together to throw the bums out and overturn the burdensome new tax law. But a few weeks before the election, the Speaker of the House reminds all Americans that only the current House members can alter the law. New representatives will not be able to reverse the decision, even if every current representative gets the boot. Horrified, the American people take the issue to the Supreme Court. The Court says the Speaker is correct: only the continuing members of the current House have the power to overturn the tax law.

Farfetched? Let's hope so. The Constitution imposes obvious constraints on pure democracy, but in general, our civil society delivers a relatively responsive form of representation. Even if every member of Congress is convinced that the American people will be better off paying 60% income tax, we the people don't have to lay down and accept their judgment even if we elected them. There's always another election, a new chance to make our representatives actually do our bidding.

Surprisingly, the same cannot be said of America's public companies. Near the end of the eventful seven-month attempt by Ohio-based INVACARE <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: IVCR)") else Response.Write("(Nasdaq: IVCR)") end if %> to take over Georgia-based HEALTHDYNE TECHNOLOGIES <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: HDTC)") else Response.Write("(Nasdaq: HDTC)") end if %> came the shocking revelation that shareholders sometimes can be legally prevented from exercising control over a company even when they try to do so. The problem in this case was Healthdyne's "dead hand poison pill," as Wall Street's sometimes poetic language would have it. Unless an appeals court eventually overturns U.S District Judge Clarence Cooper's decision on the matter, the Healthdyne-Invacare case could set a precedent with sweeping implications for the shareholders of hundreds of public companies. That's because dead-hand poison pills rob shareholders of their most basic right of control.

"Poison pills," also known as "shareholder rights plans," first appeared in the 1980s during the takeover frenzy, as company officials looked for ways to protect themselves from hostile suitors. The influential Delaware Supreme Court first upheld this novel defense in the 1985 case of Moran v. Household International, Inc., allowing the pills to be created by a company's board without shareholder approval. Though they come in a variety of forms, pills are generally designed to make a hostile takeover prohibitively expensive for the acquiring company.

First, a company issues shareholders rights or warrants that are worthless until a bidder acquires a sizable stake, anywhere from 5% to 20% of the target's outstanding shares. If that occurs, the pill is triggered. The warrants allow the target company's shareholders to buy shares of the acquirer at a 50% discount to the market, thereby severely diluting the value of the bidder's shares for its current shareholders. Alternately, the warrants could allow all of the target's current shareholders, except for the bidder, to purchase the target's shares at a 50% discount to market. Known, respectively, as "flip-over" and "flip-in" pills, some shareholder rights plans involve a double dose of poison that combines both options.

As shareholder activists Robert A. G. Monks and Nell Minow have written, "The pill is a 'doomsday device' with such potent wealth-destroying characteristics that no bidder has ever dared proceed to the point of causing a pill actually to become operative." It's highly debatable whether poison pills are ever justified. They do provide some protection against two-tier tender offers, where an acquirer attempts to pay one price for a controlling stake, then a lower price for the remaining minority stake. Yet protecting shareholders from such legitimate threats can be accomplished with less onerous defensive measures.

The real effect of a pill is to make it difficult for suitors to court a company without pleasing its board. If a board approves of the bidder, it can redeem the pill and allow a tender offer to proceed without causing massive indigestion. Typically, though, a board and the top management it supports will be reluctant to entertain an unexpected offer. Few people gladly accept premature retirement from their lucrative and prestigious positions. So the pill becomes a barrier between a company's board and management, and the market for corporate control. In nearly every case, an entrenched management and board protected by excessive defenses are not in any shareholder's best interests. Without the legitimate threat that outsiders may come along and decide they can do better for a firm's shareholders, neither the management nor the board will perform as well as they should. For this reason, public pension funds such as CalPERS and other institutional investors have successfully fought for some pills to be tossed out. Nonetheless, a close look at the public filings of most decent-sized public companies will reveal a reserve of poison in nearly every cabinet.

Dead-hand poison pills take a bad idea and make it far worse. Indeed, it would be nearly unfathomable for any U.S. court to uphold such a plan had Judge Cooper not done so in the Healthdyne case. After all, the classic 1985 Moran decision basically allowed Household International's pill to serve as a temporary obstacle that gave a board leverage in dealing with a hostile bidder. If negotiations between bidder and board remained sour, the suitor had the ultimate recourse of taking the issue to the target shareholders in the form of a proxy battle. Shareholders could vote for the current board, and thus force the bidder to ante up or go home. Or they could back the bidder by electing a new slate of directors who would kill the pill and allow a tender offer to proceed. What could be better than giving each side a chance to make their case and then allowing shareholders to decide the matter for themselves?

But the distinguishing feature of a dead-hand pill is that it derails this logical process. Only those directors who put the pill in place (or their chosen successors) can get rid of it. That means a bidder could attract support from a majority of shareholders who could then elect a new slate of board members through a proxy battle. Yet this new board would still be unable to get rid of the one provision that would poison the whole deal. Perversely, directors who had been tossed out by the shareholders -- fired, if you will -- would still maintain both a fiduciary duty to those shareholders as well as practical control over the company. Such an arrangement is not only nonsensical, it's also an egregious violation of the most fundamental promise of ownership -- control, the right of shareholders, as Monks and Minow put it, "to sell their stock to whoever they please" not just to the folks approved by a company's board, who enacted the pill without shareholder approval in the first place.

The battle over Healthdyne began January 2 when Invacare sent a private letter to the company's officials offering to buy the firm for $12.50 a share, a premium over the stock's $9 price the day before. Based in Marietta, Georgia, Healthdyne makes and markets medical devices used to treat sleep and respiratory disorders, including Sudden Infant Death Syndrome (SIDS). Healthdyne Chair Parker H. Petit founded the company in 1970 after his infant son died of SIDS. Petit and other insiders own less than 10% of Healthdyne's stock. The company's sales have risen much faster than earnings over the last few years, hitting $118.3 million in FY96, and producing earnings of $5.7 million, or $0.44 per share.

Invacare, based in Elyria, Ohio, offers a similar success story. In 1979, Chair and CEO A. Malachi Mixon, III put up $10,000 of his own money plus $40,000 from friends to buy a small medical products company. Last year, Invacare reported sales of $619.5 million, earning $38.9 million or $1.28 per share. The company sells a broad line of medical products but specializes in less high-tech offerings such as wheelchairs, medical beds, and oxygen concentrators. Mixon owns just 4.3% of Invacare common, but he controls about 49% of the supervoting class B shares, giving him 19.3% of all voting rights. Insiders overall control 17.7% of the common, but nearly 75% of the supervoting class B shares for 37.6% of the total votes.

Faced with Invacare's offer, Healthdyne's board officially rejected it as woefully inadequate on January 24. That led Invacare, with a nearly 5% stake in the firm, to raise its bid to $13 a share, or about $160 million for the rest of the outstanding shares. Healthdyne's board again turned down the offer on January 31, urging shareholders to reject it as well. Four days later, Healthdyne reported first quarter earnings rose 14% from the year-ago period, excluding six cents a share in charges related to the takeover defense. During the ensuing weeks, Invacare's Mixon repeatedly said the company might raise its bid if Healthdyne's board could justify a higher price. But Petit and the Healthdyne board repeatedly refused to negotiate. Meanwhile, some Wall Street analysts were suggesting the company was worth anywhere from $17 to as much as $20 a share. Healthdyne shares repeatedly traded above Invacare's offering price, suggesting the market believed the Invacare bid was low. Nonetheless, Invacare had drawn support from about 15% of Healthdyne's shareholders by mid-March.

Frustrated with the stonewalling by the Healthdyne board, Mixon announced March 20 that Invacare would submit its own slate of directors to be voted on by shareholders at Healthdyne's annual meeting, which the company had delayed. Since all of the Georgia firm's directors are elected annually, majority support for Invacare's slate of directors would give it control. If Healthdyne could persuade investors that such a change of control, and Invacare's all-cash tender offer, were not in their best interests, then Invacare's bid would fail.

Rather than take their argument to the shareholders, though, Healthdyne opted for a different approach. Petit undertook the extraordinary action of petitioning the Georgia General Assembly to literally rewrite state law to protect it from Invacare. The ensuing proposal, which very nearly passed, would have mandated classified or staggered boards for all public companies incorporated in Georgia, unless they opted out. Under this provision, only a third of the directors would come up for election each year, making it impossible for a hostile suitor to sweep in an entirely new slate of directors in one proxy battle.

Following this setback for Petit and company, Invacare raised its bid to $15 a share, or $191 million. In late June, Healthdyne's board offered to talk with all parties interested in acquiring the company, providing non-public information as necessary. But the board insisted Invacare must drop its tender offer as a condition for such talks. Mixon rejected this proposal by declaring, "If Healthdyne's board were serious about third party transactions, it would declare the company for sale to the highest bidder and commence an auction." Mixon said the Invacare-backed slate would promptly put Healthdyne up for sale if elected. The two companies seemed prepared for a proxy battle showdown. The dead-hand provision of Healthdyne's poison pill remained the sole obstacle.

Yet that provision proved unexpectedly formidable. In a July 7 decision, federal court judge Cooper determined that "the concept of continuing directors is an integral part of a takeover defense and is not contrary to public policy in Georgia." Cooper declined to issue a preliminary injunction against the dead-hand provision, concluding, in turn, that Invacare's shareholder proposal requiring Healthdyne to remove it would not be legally binding for Healthdyne's board. Though disappointed, Mixon expressed confidence that a higher court would provide an expedited appeal and reverse this decision.

But on July 11, the Eleventh U.S. Circuit Court of Appeals denied Invacare's motion, leaving Mixon and company in a battle for control of Healthdyne that they could not win, even if a majority of shareholders voted in an entirely new slate of directors. So Invacare opted to run four directors rather than a full slate of seven. A proxy win would thus install a majority Invacare-backed board while leaving three continuing Healthdyne directors who would have the power, if they chose, to redeem the poison pill and allow Invacare's tender offer or a third-party offer to proceed.

The Appeals Court's decision surprised many attorneys who follow takeover battles since it seems to set a new precedent, at least for those states, like Georgia, where the statutes appear to support dead-hand pills. "The case has a lot of relevance for companies incorporated in other states [such as Virginia, Pennsylvania, and Indiana] with pill validation statutes," according to Robert Kindler, partner at Cravath, Swaine & Moore, in comments made to The Wall Street Journal. Other attorneys have suggested the provision is especially appealing to companies, like Healthdyne, which elect all their directors each year. On the other hand, many major companies are incorporated in Delaware, and the Moran decision suggests the Delaware Supreme Court would have no patience with such a provision.

Given the contentious battle over control of Healthdyne, the July 30 shareholders meeting in Marietta proved anticlimactic. A week earlier, Invacare had announced that it might begin selling off some of its 600,000 Healthdyne shares, since the shareholder date of record had passed. Later reports showed the firm disposed of about 400,000 shares prior to the meeting on the assumption that its director slate would fail and that Petit's promise to announce soon a "value-enhancing transaction" would prove mere talk. So at the meeting, Petit made some introductory comments. Mixon spoke about his skepticism and urged shareholders to back a variety of other shareholder proposals to make Healthcare's board more responsive to shareholders. Then the proxies were collected, CEO Craig Reynolds offered an upbeat presentation on the company's prospect for substantial improvements in sales and margins, and none of the 100 or so shareholders or journalists present said a word during the scheduled question and answer period. Indeed, everything had already been said.

The only fireworks came in the last fifteen minutes of the hour-long meeting, as Petit, a dry-mouthed victor, commented on the acrimonious takeover battle. He accompanied his remarks with slides of what he considered objectionable comments made by Mixon in Invacare's press releases and supportive comments from Institutional Shareholder Services (ISS), a proxy advisory service. The week before, ISS had issued a report urging clients to back the Healthdyne board, which the ISS said had satisfactorily upheld its fiduciary duty in resisting Invacare's inadequate offer. Petit said the main issue all along had been price: Invacare has simply not made a reasonable bid. Yet he was clearly annoyed with Mixon, charging Invacare's CEO with foolishly trying to predict the Appeals Court's verdict while essentially lying when he charged Petit with temporarily altering Healthdyne's sales commissions in order to inflate first quarter results.

Indeed, though the proxies would not be officially tallied for a week or more, Petit predicted a landslide victory for Healthdyne's current board, suggesting that shareholders could tell which party in the dispute had integrity and which did not. For while Mixon had railed against Healthdyne's poison pill, Petit said, Invacare has a similar shareholder rights provision. Moreover, over a third of Mixon's own shares have special supervoting rights, worth 10 votes per share. Finally, Petit compared a chart of Healthdyne's recent quarter-over-quarter growth to the mirror image offered by the chart of Invacare's quarter-over-quarter sales decline, which has contributed to its falling share price. "I'd say that from that graph, Mr. Mixon ought to tend his own business for a while," Petit said.

It's too soon to tell how Healthdyne's shareholders will fare. Second quarter results announced July 10 saw revenues rise 33% to $38.1 million. Thanks to a concerted movement into higher margin products, earnings per share doubled to $0.20, excluding the four cents per share charge connected with the takeover defense. There's little doubt, then, that Invacare's final $15 a share offer, which expired Monday, was insufficient. Plus, Petit has promised a pending deal, telling shareholders at the meeting to "watch what rolls out next." Various press accounts have identified Siemens AG, Thermo Electron Corp., or even Johnson & Johnson as possible bidders. More recently, Petit has said a leveraged buyout by management is also a possibility. One Invacare proposal that's believed to have passed will allow shareholders with at least 10% of the stock to call a special shareholders meeting. That should keep Petit's feet to the fire.

In many ways, then, the battle over Healthdyne has hardly been a disaster for shareholders, though there's also no way of knowing exactly how much Invacare would have offered in a open auction of the company. Yet what remains troubling is that the Healthdyne board has resorted to such extraordinary devices to deny shareholders legitimate control of their company, and that the Georgia General Assembly, Georgia state law, and the federal courts have all but completely abetted the board at each step along the way.

The days of entrenched boards filled with company managers paternalistically deciding what is best for shareholders must end. Corporate control is a matter best left to a straight-up shareholder vote, and any board that attempts to stack that vote in its favor through obscure and dubious takeover defenses must itself be deemed to lack integrity. Finally, there's simply no legitimate role for dead-hand poison pills. The fact that any state's laws could permit them once again suggests the need to establish federal guidelines to protect certain basic shareholder rights. The Healthdyne case shows that the very concept of what it means to own a public company remains poorly defined.

-Louis Corrigan ([email protected])

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