What is the dead-hand provision?

A dead-hand provision is a strategy for blocking takeovers by giving new shares to everyone except the hostile bidder who wants to buy the company

In this article, we’re going to explore some ways in which a hostile takeover is initiated – where a company moves to acquire a majority share in another company without the target management’s consent.

A dead-hand provision is a way to prevent this hostile takeover and acts as a target defence. Let’s understand this blocking provision in more detail.

What is a hostile takeover?

A hostile takeover is an attempt by one company (the acquirer) to gain control of another company (the target) against the wishes of the target’s management team and board of directors. Unlike a friendly takeover, where both companies agree to the terms of the acquisition, a hostile takeover involves a more aggressive strategy by the acquirer.

Here’s how a typical hostile takeover goes down:

Unwanted bid:  The target company does not welcome the acquisition offer and actively resists it.

Then comes the acquisition method. Here are some types:

• Tender offer: This constitutes a public offering to purchase shares of the target company directly from shareholders, often at a premium price above the current market value. This entices passive investors who hold shares simply for the capital gain and have no interest in long-term corporate decisions. They are usually easy targets for takeover bids.
  
• Proxy fight: The acquirer attempts to replace the target company’s board of directors with individuals who are more likely to approve the takeover.
  
• Accumulating shares: The acquirer quietly buys shares of the target company on the open market over time, gradually increasing their ownership stake. This is usually a hard way to take over the company since disclosures have to be made with regulators when a certain ownership threshold has been passed through the acquisition of floating shares.

Defending the takeover: The dead-hand provision

A dead hand provision is an anti-takeover defence specifically designed to make a hostile takeover more difficult, if not impossible, to complete.

Unlike traditional poison pills that can be redeemed by the target company’s board, a dead hand provision is different. It is automatically triggered once a predetermined ownership percentage is breached by the acquirer. This threshold is typically between 15% and 20% of the target company’s shares.

This means that once the acquirer obtains around 15% to 20% of the company through the purchase of free shares or through tender offers, the dead hand automatically comes into play. In this instance, let’s say that Company X is the hostile bidder and Company Y is the target.

The dilution: Immediately after X crosses the 15% or 20% threshold, a significant number of new shares are issued at a discount directly to existing shareholders, excluding the acquirer. This dilution drastically reduces the percentage ownership of all existing shareholders, but the acquirer suffers the most.

Company X, which had painstakingly bought 15% or 20% of Company Y’s shares, might suddenly find its ownership diluted to a much smaller percentage (say, 5%) due to the issuance of new shares.

The aftermath: Company Y’s existing shareholders, while experiencing some dilution, benefit from acquiring shares at a discount. The sudden increase in the total number of shares outstanding also makes it much more expensive for Company X to buy enough shares to gain control. This discourages them from continuing their hostile takeover attempt.

The key point: The dead hand provision’s power lies in its automatic execution upon reaching the ownership threshold.  Unlike traditional poison pills that require board approval for activation, the dead hand cannot be deactivated, even by a newly elected board installed by the acquirer through a proxy fight.

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