Glossary of Hostile Takeover Terms with Discussion

Hi Everyone.

Since I have a background in accounting and Mergers and Acquisitions, I was asked to write a glossary of relevant terms and discuss them as they specifically apply to the Allergan-Valeant situation.

I'm posting under my own name since I have no relations with either Allergan or Valeant that would preclude me from doing so (in fact, I have no relations with either company whatsoever, nor do I own shares of either). That said, a family member (with a different last name) and many friends are Allergan employees; and it is for their benefits, primarily, that I'm writing.

I have not been paid to write this, and I'm not interested in generating any business of any kind from this writing. Please do not rely on this to make any financial decisions without first consulting with a professional, as a lot of this represent my opinion and has not been vetted for any purpose beyond generating a discussion.

Dan.

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Hostile Takeover Terms

Hostile Takeover -- Taking over a company despite the objection of the current board of directors. Since the BoD must agree to the deal to sign the necessary papers, a necessary step in any Hostile takeover is a replacement of the BoD through a shareholder meeting (or multiple meetings) and vote. In this battle, shareholder Ackman is attempting to organize a special shareholder meeting where shareholders will vote to replace 6 of the 9 board members with ones to be proposed by (and thus loyal to) Ackman. If successful, these new board members will have a majority of the board and able to negotiate a deal to Ackman liking.

Poison Pill -- Formally known as a Shareholders Right Plan, is a rule designed to prevent an aggressive party (such as Ackman) from buying so many shares that they can single-handedly gain control of the board of directors and agree to a deal that may be to the detriment of the remaining shareholders. A typical plan involves a rule that if any shareholder, or a group of colluding shareholders reach a certain threshold (typically, and in this case, 10%), all *other* shareholders receive, for free or nearly so, one new share for each one they already own. This effectively reduces the aggressor's holding down to 5% (and if they try to buy back up, it will trigger again), essentially making it impossible to single-handedly gain control of the board. While originally controversial -- since it appears to violate a cardinal rule of shareholding: that all shareholders are treated equally -- in the 1980's (the heydays of hostile takeovers), courts have ruled them legal since they give the board an opportunity to find the best possible deal for shareholders. Typical poison pill rules have an effective period of one year (considered reasonable to seek an alternative), and, in any event, if a new (pro-merger) board is elected, it will immediately remove the Plan. The term poison pill, intended to evoke the cultural image of yesteryear spies who, supposedly, carried poison pills with them to be used in case they are captured (so they'll avoid the risk of being tortured into helping the enemy), is somewhat incorrect since the company itself is never harmed, only the pro-merger shareholders. Allergan board, immediately upon hearing that Ackman has amassed nearly 10% stake, activated such a poison pill. Until the pill expires (one year), or there is a new (pro-Ackman) board of directors who will remove the pill, Ackman is effectively unable to buy more shares or enter into an agreement with other shareholders. Even his non-binding referendum concept (which he was thus forced to drop), might have triggered the pill (so none of the big shareholders wanted to participate and take that risk)

Proxy Fight -- When shareholders vote, they usually (nowadays, essentially always) do it by proxy. They assign ("proxy") their right to vote to someone who committed to cast the vote in a particular manner. When two parties compete for control of the Board, as is the case now, each party attempts to persuade holders of as many shares as possible to proxy the voting rights of their shares. Ackman's announced effort to replace 6 board member is a classic proxy fight.

Fiduciary -- The legal term that indicates the responsibility of officeholders to their constituencies regardless of their own interests or feelings. In the context of a hostile takeover, it refers to the board of directors fiduciary duties to the shareholders and (usually) no one else. (I say "usually," because in Allergan's case there is a mention in the Bylaws of other constituencies, giving the board some modest leeway -- even that much leeway is somewhat unusual).

Green Mail -- A legal, but widely despised, tactic where a hostile takeover bidder agrees to go away in exchange for cash. Even the most hard core capitalists profess hostility to the concept, since it results in self-enrichment at the expense of other shareholders (nonetheless, when offered, many took the cash). It is legal because of the view that if the company wants to pay (as determined by the board of directors in the fiduciary interest of all shareholders) and the would-be-acquirer is willing to take the cash, no other party would have a standing to object. At this time, there is no indication of any Green Mail in play; but Ackman (who would be the obvious Green Mailer, if such were to transpire) is still far from his endplay, so who knows?

White Knight -- A friendly acquisition, with another party, that is undertaken to prevent a hostile takeover (the term plays of the cultural concept of a good (white) knight coming to the rescue at the last minute). It's a defensive strategy that is almost always explored, but very rarely succeeds since the new buyer (the White Knight), who wasn't in acquisition talks beforehand (when they could have, presumably, negotiated a friendly deal) is effectively being invited into the much less attractive (from the buyer's perspective) competitive bid situation. The best prospect for a White Knight is if a major player, who would have been content to let a smaller player (who is not a head-to-head competitor) control some market segment, can't allow another major player (who is) win the acquisition and lock them out of that market. Allergan is rumored to have gone through the exercise of asking a few potential White Knights -- Johnson & Johnson and Sanofi -- if they'd be interested and they weren't. Given the overall alignment of players, there is minimal expectation that a White Knight will emerge in this case.

Scorched Earth Defense -- Any of a number of defensive tactics that reduce the company's attractiveness to a buyer, but would also damage the company even if it were to stay independent. The term comes from a military strategy, used since ancient times, where a retreating army destroys anything of value in the territory it cedes to the enemy. Examples of Scorched Earth defenses include selling core assets, taking on debt, giving employees generous contracts, and many others. To be legal, such strategies should be in the benefit of the shareholders or else the board is failing in its fiduciary duty (this is not necessarily a contradiction: Many strategies that hurt the company can benefit the shareholders, for example, if the cash obtained by selling assets or taking on debt is given to the shareholders). After CEO Pyott used the word "battle" in a letter to employees, Ackman accused him of using "Scorched Earth." None of the actions taken by Allergan thus far can be described as Scorched Earth.

Activist Investors -- Investors who take an equity position in a company with the intention of pressuring the board of directors to change strategy, and sometimes replacing the board altogether. Pressuring the board to sell the company (often at a premium over the price the investor paid for their shares) is a common objective of activist investors. Ackman is one of the most notable activist investors. In this instance, he has taken activist investing a step further by having a buyer lined up before he even started buying the shares.

Shareholder Lawsuit -- The Board of Directors has a fiduciary responsibility to diligently act in the interest of the shareholders (see "Fiduciary"). If they fail to do so, any shareholder may sue to recover provable damages. In practice, courts tend to give Boards maximum leeway and trust that their decisions, unless strong evidence to the contrary is presented, are made with the honest intention of exercising such duties. The major exception is when financial shenanigans or fraudulent accounting has been practiced and the board failed to exercise sufficient supervision to prevent it. Shareholders who lost money may recover losses (if there is anything left of the company). Shareholder lawsuits can turn a survivable accounting fiasco into a complete bankruptcy since a company already weakened by the scandal is almost never able to cover shareholders losses. When Allergan filed with the SEC a presentation questioning the accounting practices and sustainability of Valeant, they effectively put the Valeant board on notice that they may be on a short fuse to the death spiral of accounting scandal, share price decline, shareholders lawsuit, and bankruptcy; and likewise, warn Allergan shareholders not to trade their Allergan shares for Valeant. This is somewhat of a table-turn maneuver, since often it is the hostile acquirer accusing the board of the target for failing to act in the interest of it's shareholders (and potentially facing a suit -- although it is very hard to get a court to rule against a board for declining a merger, unless the rejection was for the benefit of a clearly inferior deal).

Forensic Accounting -- A subcategory of accounting that specializes in sleuthing when financial crimes have potentially been committed or deceptive financial statements are presented. When Allergan hired two Forensic Accounting firms to study Valeant financial reports and statements, a never-been-used-before defense (to my memory), it was making a not-subtle-at-all insinuation that Valeant financial reports are at least deceptive and possibly criminal (see Shareholder Lawsuit).

Shares Buyback -- A company can buy its own shares back from investors, either on the open market or through a special offering. Companies take this action in various situations, not just hostile takeover defense, but it has multiple effects that improve takeover defenses as it increases the share price (requiring the acquirer to bid higher yet), reduces the cash and borrowing power of the target (making it harder for the acquirer to finance the acquisition), and eliminate from the voting rolls shareholders who do not believe in the share's future appreciation potential (the same shareholders who are more likely to vote for an acquisition). Shares thus purchased become "Treasury Shares." While Treasury Shares do not vote, they are available to the board of director to issue to constituencies which do vote (such as employees, management, acquired companies, friendly hedge funds, etc. -- of course, the company should get fair value for such shares, they can't just be handed over to create friendly voters). There has been no talk, thus far of a Share Buyback at Allergan, but it is a frequently speculated upon strategy by the analysts. (A question that, to my knowledge, has never been tested in court, is if a share buyback can trigger a Poisson pill: For instance, if Ackman's 9.7% were to become 10% -- the threshold for Allergan's current poison pill -- entirely through the reduction in the number of shares outstanding caused by a buyback, but through no actions of Ackman, would that trigger the poison pill?)

General Takeover Terms (Hostile or Friendly)

Friendly Takeover -- An acquisition done with the consent and co-operation of the target Board of Directors. Many times a Hostile Takeover effort turns friendly once the price offered is raised sufficiently. In a friendly takeover, both companies work together to ensure a smooth transition and to assure that the resulting merged cooperation is as valuable as possible. The vast majority of mergers and acquisitions are Friendly. The analyst community is virtually unanimous that Valeant bid for Allergan has no realistic chance of becoming friendly with the current board, since Allergan board has made it clear they do not consider Valeant shares to be a worthy consideration, and Valeant has no other means of offering sufficient considerations.

Management Buy Out -- An acquisition made by a team that primarily include the incumbent management of the company and sympathetic investors. It is usually heavily financed through debt and sometimes through asset stripping (selling parts of the company). Investors often like Management Buy Outs since the company will be run by the people who best know how to -- the current management -- and, now that they own the company and have a huge mortgage to pay, will be very diligent in finding non-destructive cost reductions and revenue gains opportunities. There has been no significant talk of MBO possibility in this instance, but it is the ultimate hostile takeover defense -- as it permanently eliminate any outsider's opportunity to gain control of the company without the consent of management.

Asset Stripping -- Selling significant assets of a company to pay part of the cost of a takeover (friendly or hostile). There has been no specific talk of asset stripping in this instance, but many analysts think that if Valeant were to acquire Allergan, everyone would be better off if DARpin were sold to another party rather than kept as a contingent values right (as proposed by Valeant).

Synergy -- The economic rationale for any merger (friendly or hostile) is that the combined company will be worth more than the sum of its parts. This could be through improved sales (the combined sales force, now empowered to sell a broader array of products, will sell more than the two sales forces separately), cost reductions (duplicative functions, such as accounting, could be reduced), or both. In Valeant presentations, they have used the word Synergy almost synonymously with laying off employees ("We achieved 95% synergy in G&A (General and Administrative) expense")

Organic Growth -- Growth in company sales net of the effects of acquisitions and divestitures (there is some heated debate if it should also be net of discontinuations). The most common way to compute it is by looking only at products that the company has been selling for over a year. If an acquisitive company is showing slow or negative organic growth, it demonstrates that it is destroying value and making deals with no economical rationale -- an ultimately unsustainable business model. Conversely, if it is generating high organic growth, it proves that the synergies (see entry) are real and genuine value is generated for the shareholders with each acquisition. This is a point of huge contention between Allergan and Valeant, and perhaps the sharpest knife in Allergan's attack on Valeant business model (and also the most responded to in Valeant's counterarguments). Backed by Forensic Accounting (see entry) consulting firms, Allergan asserts that Valeant claims of solid organic growth numbers are deceptive and that the actual numbers are nearly zero or negative. Valeant stands by their claims and asserts back that it is Allergan's analysis that is deceptive.

Good Will -- An accounting term that refers to the value paid for an acquired company in excess of it's Fair Market Value (for a publicly traded company, such as Allergan, the FMV is its trading price). The Good Will becomes an asset on the acquiring company's book, but must be re-evaluated annually (more frequently if there are relevant events) to see if it is still worth what was paid. If not, it is reduced ("Impaired" in accountant-speak) generating an instantaneous "one-time loss." (Good Will can only be Impaired downward, there are no allowed corresponding accounting processes in the opposite direction). Valeant critics have pointed out that Valeant destroys so much value in their acquisition process that these "one-time losses" due to Good Will impairments are so frequent as to dwarf the actual profits they make selling drugs. Valeant argues that Good Will Impairment losses are just accounting artifact, as they do not involve the important metric (according to Valeant) of cash flow.

Insider Trading -- A criminal activity where an individual who possess material confidential information about a company, not available to the general public, and in violation of fiduciary trust, uses such information to make profitable trades on their own behalf. Convictions often lead to prison terms, return of ill-gotten gains, hefty fines, and lifetime bans from the financial industry. A commonly investigated form of insider trading is when an individual who may have been tipped off buys shares in a target company just before an acquirer announces their intention (and the target's share price inevitably jumps). This practice is outlawed since it disadvantages the other investors, not privy to such insider information, and thus undermine trust in the overall integrity of the market. When Ackman bought nearly 10% of Allergan, knowing that Valeant is about to make an offer -- and making a huge paper gain when they did -- many questioned if his activities constitute Insider Trading. The prevailing opinion in the security laws community is that the information was given to him in the interests of Valeant (and thus not in violation any fiduciary duty) making him, effectively, a co-bidder and not an inside-trader. Nonetheless, Ackman is often dogged by reporters implying that he took advantage of a legal loophole in the Insider Trading laws to gain an advantage over the non-insider investors. (His answer is that the price increase in Allergan share price caused by his action benefited all shareholders, and even the ones who sold shares to him before the Valeant offer was public didn't lose anything relative to where they would have been without his actions altogether)

Board of Directors -- A group of individuals elected by and representative of the share holders of the company (sometimes just called "the board"). It is somewhat analogous to the legislative branch of government. The BoD does not involve itself in day-to-day activities of the company (although some members of the Board, for example CEO Pyott, may be full time managers or employees in addition to being board members), but rather issues policies and rules that are binding to the management team. Decisions of momentous or direct shareholder impact may only be made by the BoD. The Allergan Board has voted (Unanimously) to reject all Valeant acquisition offers to date. Therefore, the only realistic way for Valeant to complete the deal would be for shareholders to vote for a new BoD which will be friendly to Valeant's offer.

Leverage -- Any of various ratios measuring the debt of a company relative to its assets or ability to pay. Without doing anything different, companies with higher leverage can achieve a higher rate of return for their shareholders, but also carry higher risk; since even a minor fluctuation in ability to pay debt holders carries the risk of default and consequent wiping out of shareholders altogether. This is somewhat analogous to the Loan-to-Value (LTV) in a home mortgage, where a higher LTV allows a home buyer to buy a pricier house for the same down payment, and, if home prices were to appreciate, have a higher percentage gain on the investment; but a higher LTV also carries a greater risk of going upside-down in a downturn and losing the entire investment. In this instance, the leverage ratio of relevance is debt/EBITDA (see entry). Valeant has a debt/EBITDA ratio a bit above 4.0, meaning they owe over 4 years worth of cash flow; considered unhealthy and generally precludes additional borrowing on sensible terms. The original Valeant offer for Allergan, even with additional borrowing of the $48 per share for the cash portion of the offer, would have created a combined company with a much improved debt ratio of 3.5 (since Allergan would add a lot of cash flow and minimal debt). The current offer, which includes $72 cash only slightly improves the leverage; and thus largely taps Valeant ability to borrow, which means that $72 is very close to the maximum cash it is able to offer for Allergan (unless they find cash somewhere other than the debt market -- for instance through asset sales or equity offerings).

Credit Rating -- An evaluation, performed by an independent agency, of the creditworthiness of a corporate borrower. This is very analogous to the FICO score of individual borrowers. Moody's, one of the major credit rating agencies, maintains a rating of Valeant debt. Moody's has a system where "A" bonds are considered to have minimal risk, "B" have notable risk, and "C" are already in trouble. They further divide each category with additional letters and numbers. (Other rating agencies use similar systems and are usually largely in synch with each other). The credit rating is a principal driver of the interest rate a company is able to obtain in the credit markets. Valeant debt is rated Ba3, which is in the middle of "junk bond territory" (see entry), primarily because the debt Leverage (see entry) is above an unhealthy 4.0. Prior to the announced Allergan bid, Moody's outlook for Valeant was "negative." -- meaning that Moody's expected the next change to at least twice as likely be downward as upward. Once the bid was announced, Moody's changed the outlook to "Developing" (meaning -- wait and see), and stated that if the Leverage were to decline to below 3.5 (as would have been under the original $48 offer), Valeant credit rating would improve; whereas if it will go well above 4.0, rating would decline (the $72 offer leaves it around 4.0). Allergan rating is A3 (solid investment grade), with a leverage just above 1.0. Before the announced bid, the outlook was "stable," but was changed to "negative" with the bid to account for the possibility that the takeover will succeed and then all Allergan debt would become Valeant debt with junk status.


Junk Bonds -- A term popularized, and often vilified, during the 1980's boom in takeovers (including many hostile ones). It refers to a debt that is considered to have significant risk of default. To entice lenders to accept Junk Bonds, they offer interest rates significantly above market rates for less risky debt (bond traders prefer to use the term "High Yield" to "Junk" to emphasize the attractive aspect of such debt). A very hard rule in corporate law is that all debt, including "Junk Bonds," must be fully paid with interest, before any shareholder may receive a penny. So, no matter how "junky" the bonds might be, the shares are always "junkier." Valeant debt is rated as "Junk Bond." None of Allergan debt is "Junk." This fact supports Allergan's assertion that Valeant shares are junk.

SEC (Securities and Exchange Commission) -- An agency of the US Federal government responsible for enforcing security laws and the orderly formation of capital. It investigates potential insider trading and accounting fraud. Publicly traded companies, such as Allergan and Valeant, must follow strict rules, overseen by the SEC, with regard to transacting, and disclosing information. The rules require companies to file reports for public availability disclosing, in significant details, their financial statements on quarterly and annual basis (the latter in even greater details). In addition, special events, material new information, legal stock transactions by insiders, and others must be publicly filed (see section on SEC forms). Valeant was able to generate a bid for Allergan, without even talking to Allergan (much like offering to buy someone's house without ever been allowed to see it inside), based entirely on what they were able to read from Allergan's SEC filings. Likewise, much of Allergan's attack on Valeant's business model is based on information available in Valeant's SEC filings. By filing it's Valeant-bashing presentations directly with the SEC, Allergan is making the point that it strongly stands behind those presentations (it would be fraudulent to knowingly file falsehood); and also, may sets the stage for asking the SEC to investigate Valeant (since some assertions made by Allergan arguably border on accusing Valeant of fraud) (or, at least, instill some doubt in shareholders of both companies regarding Valeant's worth).

Roll-up -- A business model that affects a rapid series of acquisitions, with cost-cutting and duplication-elimination (see synergies) as the primary source of value creation. Because accounting rules are designed to treat acquisitions as unique "one-time" events, rather than an ongoing business model in its own right; the financial statements of roll-up companies are always considered complex and conducive to opaque, deceptive, or even fraudulent, reporting. Because acquirers often use their own stocks to pay for acquisitions, as Valeant is offering Allergan, there is every interest to manipulate such financial statements so as to artificially inflate the stock price. Roll-ups are a tiny fraction of all businesses, but account for almost all famously massive securities fraud events outside the financial sector of the last 20 years, including Enron, Tyco, WorldCom, Waste Management, Cendant, and others. Allergan made that point in its investor presentation when it openly compared Valeant to Tyco (whose CEO ended up in prison).

Contingent Value Right (CVR) -- When buyers and sellers have an unbridgeable difference of opinion with regard to the value of an asset, a contingent value right may provide a way to close the gap. The asset is carved out of the rest of the deal and it's value is allowed to surmise separately. Contingent on its future performance, the sellers will receive, in the future, some formula return value. The CVR itself is a security (like a stock) that investors can buy and sell. Allergan investors that Pershing Square and Valeant spoke with, apparently, indicated that they don't think Valeant will be able to nurse the mid-term R&D effort required to bring the potentially huge DARpin drug to commercialization; and that too much value will be destroyed by failing to do so (about $20B). Valeant publicly stated that they don't believe DARpin is that huge, but included a CVR in their latest offer where they will insulate the DARpin team, keep the R&D staff, and then apportion to selling Allergan shareholders a portion of the future DARpin sales. Analysts were unimpressed with the prospect of a carved out team without the overall Allergan R&D infrastructure and think that Valeant would be better off just selling DARpin to an entity that is R&D-enabled.

Leveraged Buy Out (LBO) -- Borrowing money to buy a company, and then paying off the debt using company profits (and potentially asset sales). Many acquisition strategies, friendly, hostile, and (especially) management, rely on LBO. In general, the level of debt required to buy a company outright bring the leverage (see entry) to such a high level that the debt used to make the acquisition is rated as junk bonds (see entry) and thus require high interest payments. LBO acquirers, facing the need to make high regular interest payments, are often forced into cost-cutting or investment-reductions to stay afloat. However, a successful LBO can be extremely lucrative to the buyer since they will end up owning the entire company (after paying off its debt). The Valeant offer to buy Allergan is partially an LBO (the cash portion). A potential management buy out (see entry) counter-play would almost have to be entirely an LBO.

EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) -- An accounting term that tries to measure how much cash the company generates (or will generate) available to pay on it's debt. Earnings, by accounting rules, is computed by subtracting expenses from revenues. However, some expenses do not actually use up any cash (depreciation and amortization), and thus are irrelevant with regard to the company's ability to pay it's debts. Likewise, taxes are only relevant if the company is still making a profit after paying interest, and thus also irrelevant for this purpose. The ratio of debt to EBITDA is a quick guide to how leveraged, or risky, is the company.

Tax Inversion -- The US is the only country in the world that taxes the worldwide earnings of its citizen (including corporate citizens). All other countries tax only the portion of earnings that takes place on their own soil. It is therefore potentially tax-advantageous for a US corporation to re-domicile to another country (and then continue doing business in the US as a foreign corporation). This is the corporate equivalence of renouncing one's US citizenship so as to not have to pay US taxes on foreign earnings. Furthermore, through carefully planned transfer pricing (the fees charged by one part of a company to another), a corporation can arrange to have all it's profits accumulate in a low-tax country. For example, the company can have a "patent owning division" in a low-tax country, and then have that division charge all operating divisions patent license fees that are so high as to make all other divisions unprofitable (and thus pay no local corporate income taxes in whichever countries they operate), while the "patent owning division" accumulate all the profits in it's low tax haven. This is all perfectly legal, but often attracts the scrutiny of tax auditors, who may then disallow various practices (for instance, argue that the patent fees are unjustified). The process of expatriating a US corporation is incredibly complex and expensive (and invokes various "exit taxes"), but is made a lot simpler when a foreign corporation buys a US corporation and the US corporation simply ceases to exist (without ever expatriating). The tax benefits can be so high that sometimes it is worthwhile for a US corporation to buy a foreign company but structure the deal as if it was the foreign company that bought the US one. This process is called Tax Inversion. Valeant, in its present form, was created when a California company (Valeant, formerly ICN) purchased a troubled Canadian firm, Biovail, but structured the transaction as an Inversion (so, technically, Biovail acquired Valeant and selected the latter's name for the surviving corporation). Some of the value creation Valeant claims will accrue through a merger will stem from this inversion process (since Allergan will no longer be a US corporation). Among the potential counterstrategies Allergan is rumored to pursue is to affect a tax inversion of it's own by buying a foreign corporation, for instance Ireland's Shire (and thus eliminate one of the benefits of a Valeant deal). In it's presentation, Allergan warned that Valeant's tax strategies are so complex as to be unmanageable, attract the attention of auditors and regulators, and may collapse altogether when national taxing authorities start cracking down on such techniques and legislators start closing such loopholes.


Important SEC Forms (All forms filed with SEC are publicly available)

(I'm only listing those because often analysts, reporters, and other financial community members mention SEC filings by form number with no further description. There are many more forms, but these are the most relevant ones here).


13D (5% ownership) -- Whenever any shareholder reaches 5% ownership of a company they must file a form 13D with the SEC disclosing their share ownership and intentions. The rules allow 10 days to make the filing and do not forbid additional buying during those 10 days. Ackman famously surprised everyone by rapidly accumulating from 5% to 9.7% during those 10 days (buying at a low price before the bid was announced). Consequently, there have been some calls, to eliminate the "anachronistic" 10-days "loophole."

10K (annual report) -- A report that must be filed by every public company once a year including its annual financial statements, discussion of business, and outlook. For large companies, it must be filed within 60 days of yearend. The report must be audited by an independent CPA.

10Q (quarterly report) -- A shorter version of the 10K annual report filed quarterly, including its quarterly financial statements. For large companies, it must be filed within 40 days of quarter end (unless its the last quarter of the year, in which case it is combined with the annual report). 10Q reports do not need to be audited. The report must include a contrast between the current quarter and the same quarter the prior year to allow investors to judge for themselves if the company is growing or shrinking and other trends of relevance, net of potential seasonality effects. A common criticism of Valeant is that such Year-over-Year comparisons are a near-impossibility because the rapid pace of acquisitions and accounting presentation choices that mask what component of revenues come from newly acquired business and what from previously. It is often noted that subsequent to the B+L purchase, in August 2013, Valeant made no acquisition large enough to distort the numbers significantly; and therefore, absent an Allergan acquisition (or a very large surprise transaction -- acquisition or divestiture -- between now and the end of the September), the 10Q for the 3rd quarter of 2014 (and even more so, the 4th quarter), for the first time in years, will begin to show how well Valeant is growing (or not) when it is not acquiring.

8K (special event) -- Whenever any of a broad spectrum of events that are outside the normal course of business happens, the company must file, within 4 days, an 8K form with the SEC where the event is disclosed and, if appropriate, explained. Example of events that trigger an 8K reporting requirement include the hiring, firing, or departure of a senior officer or board member; issuing material debt or equity; impairments, defaults, changes in corporate structure, change of accounting firm, and so on.

 

On the recent (Motion to Expedite) Court Decision:

• To get the merger to happen, Allergan Board must approve.
• Since the current Board won't approve, Ackman wants to replace enough members to change the balance of power.
• To replace board members, there must be a shareholder meeting (the corporate analog of a general election).
• We just had a shareholder meeting (but the candidates nominations deadline was before the Valeant bid), the next one is May 2015.
• To move faster, Ackman wants to call a special shareholder meeting (the corporate analog to a recall election).
• To call a specail shareholder meeting, holders of 25% of the voting shares must sign papers (the corporate analog to a recall petition).

Question: If holders of 25% of shareholders agree to do something that is for the purpose of bringing about an acquisition; would that trigger the Poison Pill (see glossary)?

The text of the poison pill language would seem to say so. But that would mean that the poison pill, which is a resolution of the board (the corporate equivalent of a law passed by a legislative body), is frustrating the intent of the Bylaws (the corporate equivalent of a constitution -- only amendable by a shareholder vote).

Ackman has taken the position that he can call the special shareholder meeting without triggering the poison pill. Other shareholders may not be willing to take the risk that he is wrong and lose half their shares in the process.
So Ackman asked the Board to clarify.
The Board responded "it says what it says." (Not much clarity).
So Ackman asked a judge to clarify.
Allergan responded that he is asking the judge to rule on a hypothetical question ('what would happen if ...'); In general, judges are only supposed to rule on actual situations, not imagined ones. [Allergan is effectively saying 'Go ahead, call your special meeting, if you dare, and if we trigger the poison pill on you and every shareholder who helped you, then you can sue and try to reverse it].
Ackman also asked the judge not to wait too long because this is really important and all about speed ("Motion to expedite").
The judge agreed that he shouldn't wait too long ("Motion granted").
Hearing set for 3 weeks from now. (Which, in the world of corporate law suits, passes for "expedited"). Decision might be made on the spot, or a later date.

Just because the judge agreed to "expedite," doesn't mean he is leaning one way or another; it simply agrees that delaying is to the material benefit of one side (Allergan) and therefore denies justice to the other.

Hope this all makes sense.

Dan.

 

On the Settlement:

Basically, Allergan and Ackman agreed that the act of calling a special shareholder meeting does not trigger the Poison Pill (see glossary).

To a large extent, this lawsuit was a tempest in a teapot; but in this hyper-hostile battle, everyone is extra careful -- looking for ambushes in every direction. In a normal hostile takeover, when cordiality rules still apply, no one would even be concerned with a poison pill blocking a shareholder meeting (as mentioned in my prior post, the right to a special shareholder meeting is enshrined in the Bylaws, whereas a poison pill is a mere board of directors resolution); and if they were even minimally concerned, they would ask the board for assurances and the board would give such; and even if they didn't, they'd call the meeting anyway and the board won't trigger the pill over it (because it would be immediately reversed by the Chancery court and the board would get on the judge's bad side for other battles that are more important). In this hyper-hostile battle, with the other (beside Ackman) pro-merger shareholders all scared that Allergan might be just waiting in ambush to trigger the poison pill on them at the slightest excuse, they weren't ready to sign up for the special meeting until they got an explicit assurance from either the board or a judge that it won't happen. Allergan, in a "why should we help you?" kind of maneuver, didn't provide the assurance; so Ackman asked a judge to do it. In all likelihood, a judge would have, but it would have burned about 3 weeks to get there (any delay is to Allergan's benefit -- it gives Valeant more time to break, and gives Allergan more time to find options).

Question: Why did Allergan agree to everything that Ackman asked for?
Answer: Because the judge would have agreed with Ackman anyhow. Notice that this isn't a loss for Allergan. A loss is when a side takes a position and then ordered by a judge (or reach agreement) to reverse that position. Allergan never said that calling a special shareholder meeting triggers the poison pill, they just didn't say that it won't. If they had gone in front of a judge, with some (losing) argument to the contrary, then it would have been a loss. What's worse, the judge might have openly disciplined Allergan from the bench (telling Allergan that he doesn't want to again waste his time overruling a delay tactic). Having not (yet) been disciplined by the judge, Allergan can still pull some stunts (like trigger the poison pill on some borderline excuse -- other than the calling of a shareholder meeting), with the penalty being no worse than the reversal of the stunt (while wasting a lot of time, which is what Allergan wants).

Question: If this was a delay tactic all along, why settle with still a week left?
Answer: This one baffles me too. A week is not a lot, but when playing delay tactics, why not wait to the last day? Since the lawyers making the deals are no dummies, I have to assume there is a well-though out reason. Possibly to save some judge-good-will for future testy situations ("your honor, we are not just using bad faith delay tactics; as evidenced by our agreement over the poison pill a week before the hearing"). Another possibility is that they are readying activation of the poison pill over a different issue, and want to clear the docket before firing (now that Paulson, a pro-merger hedge fund, has amassed about 2% of Allergan Shares; the slightest evidence of collusion with Ackman's 9.7% could give Allergan an excuse to trigger the poison pill).

Question: Can this agreement be viewed as a thaw between Allergan and Ackman; potentially signalling that deal negotiations are already starting in the background?
Answer: Absolutely not. One must remember, that the agreement is about mechanisms to remove the board, not about how the board and Ackman can cooperate on anything.

So, what's next:
Ackman will continue with the torturous path toward a special shareholder meeting, a shareholder vote to replace board members, appointment of new board members, and making a deal with Valeant. At each step, expect stiff opposition, delay tactics, and skirmishes lawsuits like this one, from Allergan board and management. In concert, Allergan is already deploying it's "soft powers" (doctor's letters, media barrage, congressional attention, and other attacks-by-others on Valeant), but has yet to use any of it's heavy guns (acquisitions, shares buyback, management LBO, and other actions that would change the nature of its capitalization). In my opinion, it is essentially a certainty that no gun will be left untouched before this is over.

Dan.

 

Other People's Money

While we are in a bit of summer hiatus, as Ackman is going through the mechanics of his game and the Board is running the clock down before doing anything dramatic, I thought I'd lighten the thread a bit with a movie recommendation.

The movie is Other People's Money, a 1991 comedy-drama starring Danny DeVito and a 75 years old Gregory Peck (I believe it was his last full movie). The plot revolves around, you guessed it, a hostile takeover. The reason for the recommendation is the outstandingly (for Hollywood) accurate portrayal of the rationale and process of a hostile takeover. The financial and legal maneuvers by the takeover investor (DeVito) and CEO (Peck) are all from the standard playbook and are properly explained at every step. They even use the correct SEC form numbers. Basic concepts such as Green Mail, Balance Sheet, Proxy Fight, shares buyback, and others are presented in a clear and compelling fashion. The final speeches (immediately before the decisive shareholders vote) given by the two antagonists provide a fair presentation of the competing arguments (real takeover fights, at least in modern times, don't actually have dueling live speeches -- that's a Hollywood dramatization -- but the concept of the two sides presenting their arguments to the voting shareholders is quite accurate).

There are major subplots of sexual tensions and family dynamics involving the smart and hot attorney (Penelope Ann Miller) and the antagonists (or, maybe those are the major plots, and the hostile takeover is actually the subplot -- can't be really sure ). While it may seem that these dynamics are significantly impacting the actions taken by the two sides; in fact they do not, the actions each side is taking is exactly as they would have at that point in any event -- and whenever they agree to do something that would be different; they break their words immediately and make it obvious they never intended otherwise. So, if you are watching the movie to see how a typical hostile takeover plays out, rest assured that these dynamics are not interfering with the developments in the least bit.
(In a real situation, the slightest hint of any such dynamics would be more than just a harmless no-no -- it would destroy the careers of all involved -- but here too, I give Hollywood a creativity license; without such subplots, a movie about hostile takeovers would be 90 minutes of watching suit people redlining legal documents ).

I do want to add an important comment with regard to the Allergan-Valeant battle: The takeover target of the movie is an old-style industrial company that was going through a protracted decline -- the typical target of successful hostile takeovers. Allergan, is far from it; it is an above-average growing company with a strong pipeline -- almost never the target of a successful hostile takeover fight (I'll probably dedicate a post to just this subject at some future point). If you choose to watch this movie to learn more about hostile takeover, note that there are many similarities in the process; but also crucial differences in the target.

Get some popcorn, and enjoy!

Dan.

 

DeVito, in Other People's Money, would represent the Valeant-Ackman team -- who believe that the target company is worth more liquidated than alive.

Stock buyback, by itself, doesn't give much defense. It has to be in combination with something else. Valeant is offering Allergan's shareholders all the cash it is able to borrow (entirely on the basis of Allergan's borrowing capacity; they have no remaining borrowing capacity on their own), plus about 40% of Valeant's shares. Every dollar Allergan borrows to buy shares back reduces the amount of cash available for Valeant to borrow, but it also reduces the number of shares Valeant need to buy. As long as the price Allergan is buying its shares at is not far from the value of the Valeant offer, the effect is neutral -- Valeant will have to modify the cash and equity components, more equity and less cash, but the total offer would remain about the same. In affect, the Allergan board would be transforming equity into debt exactly as Valeant would have without sabotaging the Valeant offer in any meaningful way. The shareholders who want cash more than Valeant equity would take the (buyback) cash, and those who do want Valeant equity would stick around for the takeover (and get more Valeant shares each).

A buyback in combination of other activities that will move the share price up (such as cost cutbacks, selling assets, accretive acquisitions), will sabotage the Valeant offer, because it will move the trading value of Allergan above the Valeant offer value. Valeant will then be forced to walk away or increase the share component of their offer (above the current ~40% of the combined company), this will likely reduce the trading value of Valeant (since current Valeant shareholders will be diluted down further), reducing the value of the offer back again. At a sufficiently high Allergan share price, it becomes effectively impossible for Valeant to win even if they hand the entire company over to Allergan shareholders.

Dan.

 

On the Recent Allergan Restructuring

Until now, Allergan takeover defenses has been, exclusively, what I call soft powers: Doctors' letters, press releases, slide presentations, media barrage, attention from elected officials, and other verbal attacks. (In addition, of course, to the poison pill). These have served an important purpose: They kept Valeant share price unstable, and near the lower edge of the trading range since the initial bid was made. This is very important, since more than half the value of the bid is in Valeant shares, and since Valeant's borrowing power is tapped out (in fact, the cash portion of the Valeant offer is entirely made up of Allergan's, not Valeant's borrowing power); there is very little room for Valeant to raise, or even maintain, the value of their offer with a depressed share price (they could offer more Valeant shares to Allergan's shareholders; but that will dilute the current Valeant shareholders and further depress their share price). Allergan hasn't delivered a downward-spiral punch to Valeant, but they blunted and reversed the initial rapid price rise following the bid (when Valeant shareholders believed that they would quickly, easily, and cheaply gain control of Allergan and it's spectacular balance sheet).

The current restructuring, is the first use of what I would call hard powers: A material change in the capitalization dynamic of the company. By itself, it provides some level of defense; but not a complete defense. By halting some of the longest term research, and reducing sites duplication, Allergan becomes more profitable in the immediate future. That increased profitability is entirely to the benefit of Allergan shareholders. If those steps were taken after an acquisition, only 44% of the gain would benefit Allergan's shareholders (since Allergan shareholder will, collectively, own 44% of the combined company). Valeant promises to cut much more (so much more that Allergan and most independent observers think it's unrealistic and would destroy too much valuable research), but the incremental benefit they can gain is now reduced, and therefore the attractiveness of the deal is diminished. To put some numbers behind this: Valeant promises to cut $2.7B expenses per year. Let's say that $2B is the most they can realistically achieve even when they completely eliminate R&D (there is a minimum level of expenses a pharma company is legally obliged to incur just to stay in business). 44% of that benefit, $880M, are to the benefit of Allergan shareholders. By reducing $475M worth of expenses, Allergan is more than halfway there without sacrificing any of the high-potential R&D. Since Allergan has now sucked the best cost-cutting opportunities entirely to the benefit of Allergan shareholders (rather than just 44%), to continue offering the same premium to Allergan shareholders, Valeant will now need to offer more (analysts are using words like "North of $200"). Since Valeant is effectively tapped out, and can't easily increase their offer, their value proposition is now less attractive than it was beforehand.

However, just a restructuring doesn't provide a complete defense; but it sets the stage for the next step -- most likely a large acquisition (but potentially a stock buyback). While I'm not fluent in Allergan's bylaws, typically, a company of this size would be allowed to borrow money and make acquisitions without shareholder vote (which may now be hard to secure), so long as no new shares are issues (treasury shares, if any exist, typically may be used) and there is no degradation in credit rating. Allergan's current credit rating is near the top (it was at the very top, but took a bit of a dent with the Valeant offer, since bondholders are concerned that Allergan debt would become Valeant's -- which has Junk Bond status), and it's actual debt level is very low. Since the dominant factor in establishing credit rating is how many years' worth of profit will it take to pay the debt amount (Valeant's is around 4 -- making their bonds "junk," Allergan's is less than 1 -- making their debt "low risk"), an increase in profitability add several times it's own worth in borrowing capacity (and, if the target company also has a low-debt balance sheet, than their borrowing capacity is also available). By making Allergan more profitable, through restructuring, it is able to buy much larger companies than otherwise. The larger the company Allergan buys, the harder it becomes for Valeant to keep their offer viable. By using much of its borrowing power, Allergan will deny Valeant the ability to borrow the money needed for the cash portion of their offer. Some analysts (including Seeking Alpha -- the same guys whose analysis of this deal heralded the media barrage that so damaged Valeant earlier) have gone as far as saying this will get rid of Valeant altogether.


On a personal note, as I pointed in my opening remarks, while I have no relationship with Allergan whatsoever, a family member with a different last name (specifically, my wife) is an employee. We have just learned that the facility where she works is among those that will close. We don't yet know if she'll be offered to transfer, and if she does, if it will be an offer she will want to accept. Nonetheless, I'll try to stay here with periodic commentary intended to explain to people impacted by, but not familiar with, the mechanics and language of this hostile takeover attempt.

Dan.

 

If the company is doing well, management is in control; if not, the investors are

I promised myself I'd write something about why I believe this merger won't happen.

Aside from all the tactics, gamesmanship, financial and legal maneuvers, and the agendas of the many constituencies in the mix -- I believe it comes down to a fundamental rule of business (and perhaps of organizations in general).

This rule applies to a teenage boy borrowing money from his parents to buy a bicycle for a paper route, a team of entrepreneurs raising funds from Angel investors and Venture Capitalists, privately held companies, publicly traded ones, government-owned companies, multinationals, and even non-profit organizations; and it applies regardless of who owns what percent of the business or the capitalization structure or the debt or the bylaws or the covenants or the governance -- If the company is doing well, management is in control; if not, the investors are.

In the realm of hostile takeovers, over the past 30 years, I watched, with varying degrees of attention, perhaps 100 hostile takeover battles. Not once did I see this rule violated. Successful hostile takeovers have always been against companies that were under-performing. Either the company was under-performing it's industry, or the industry was under-performing other sectors. When companies are over-performers, they have options that will create more value than the takeover; under-performers often do not. When there are options that will create more value, there are constituencies available to finance such options in exchange for a portion of the incremental gain. When there are counter-constituencies with a superior value proposition, hostile takeovers fail.

Maybe Valeant is doing well (as a pharma company), as they claim; or maybe their stock price is entirely the product of financial engineering, as Allergan and much of the media claim; but they are certainly not doing better than Allergan. While my other posts (and much of the media and analysts community) speculated on which options Allergan will take when they finally make their Hard Power move -- acquisition, share buyback, special dividend, management buyout, or likewise; the bottom line is that Allergan has options; and Valeant hasn't shown any value creation that will come out of the merger.

(Even if one were to accept Valeant's view that R&D is wasteful and Allergan would be better off without it; it is still not an argument as to why Allergan shareholders would be better off handing Valeant shareholders 56% of the gains from restructuring Allergan's R&D level).

Dan

PS: Allow me to thanks those who posted in response to my last comment. In our household, we are always optimistic!

 

On the Allergan Vs Valeant and Pershing Square Lawsuit

Hello again.

I got a chance to read the entire text of the filed Allergan lawsuit -- 193 allegations and claims paragraphs and 9 requests for relief. I'm not a lawyer, but I was able to read and understand almost all of it (except the really obtuse statements identifying various legal codes by section number).

The main claim is that Pershing Square acquisition of 9.7% of Allergan shares prior to the announced takeover attempt amounts to Insider Trading (see Glossary entry). Paragraph #2 summarizes this claim in plain English:

"This case is about the improper and illicit insider-trading scheme hatched in secret by a billionaire hedge fund investor on the one hand, and a public-company serial acquiror on the other hand. The purpose of the scheme was to generate windfall profits on the backs of uninformed Allergan stockholders and to park a substantial bloc of shares with a stockholder predisposed to support an acquisition proposal. The method the Defendants chose was to operate in secret, flouting key provisions of the federal securities laws designed to protect investors from precisely this type of predatory conduct" (P#2)

There are also many minor infractions outlined (I didn't count, but easily over 100). The minor infractions are presented less in a manner of complaining about the infractions themselves, but rather in support of the main claim. For example, "[Valeant's Salespeople] Visited Allergan customers, announcing that they were Allergan’s new sales representatives" (P#124) is presented as evidence that "Valeant’s aggressive and hostile tactics from the outset – as detailed herein – constituted a de facto tender offer in everything but the actual name" (P#116). (In the context of this lawsuit, "Tender Offer" is effectively synonymous with "Hostile Takeover Attempt")

The idea that PS acquisition of 9.7% of Allergan constitute Insider Trading is not new. In fact, from the moment PS announced their position, the Wall Street media immediately started speculating loudly that this sure looks like illegal Insider Trading. The prevailing opinion in the security legal community settled on the notion that it does not meet the legal definition of Insider Trading because Pershing Square is effectively a co-bidder and not in violation of any fiduciary duty. The media then dogged Ackman asking if, even if not illegal, isn't he simply profiting from a loophole in the Insider Trading law (at the expense of those who sold him shares cheaply without the Insider knowledge he had). His answer was that no shareholder was hurt -- all the shareholders are benefiting from the price increase his action has caused, even the ones who sold him share during his accumulation phase were benefiting from the upward pressure on share price his rapid acquisitions were causing; and even the ones who sold him the first shares, did no worst than where they would have been had the PS-Valeant offer never existed.

In general, trading on insider information that was provided without violation of fiduciary trust (for example two co-bidders agreeing to buy shares together before announcing their bid), does not constitute Insider Trading. However, in the specific event of an upcoming "Tender Offer," fiduciary trust or not, no one who knows about it, except the entity making the offer, may buy any shares. Period.

Valeant couldn't secretly buy $3B worth of Allergan on their own because they had too much debt ("Because of the crippling debt required to finance its many previous acquisitions, Valeant was unable to borrow enough money to acquire Allergan" -- P#6) and also because, as a competitor, they would have to disclose it under anti-trust rules ("Under the Pershing Agreement, Valeant agreed to contribute $75.9 million – the maximum allowed without triggering antitrust disclosure requirements – to the purported “co-bidder entity” " -- P#59); so they needed PS.

So the key questions are:
1. Are Valeant and PS separate entities?
2. Did PS know that a hostile takeover is being prepared by Valeant?

If the answer to both questions is "Yes," than, wholla, we got "Insider Trading."

While, it would seem fairly obvious that the answer to both is "Yes," the smart lawyers working for Valeant/PS did a lot of preparatory work trying to turn both answers to "No." They created a jointly-owned entity: "On February 11, 2014, Pershing Square formed shell entity PS Fund 1 to acquire Allergan stock, an entity controlled entirely by Pershing Square and in which Valeant later made a relatively miniscule investment. Hidden behind this shell fund, Valeant blatantly tipped Pershing Square regarding Valeant’s tender offer, and Pershing Square – through its shell entity PS Fund 1 – embarked on a massive acquisition of Allergan stock on that inside information." (P#7). They also started out by saying that they were looking for a friendly takeover: "In its first communications, Valeant carefully avoided disclosing that it planned to launch a “tender offer,” but instead claimed to be interested in a friendly merger. " (P#14).

So, we are back to the core question: Did the structure of the PS/Valeant deal manage to outsmart the Insider Trading rules, or are their maneuverings merely facades to pretend one thing while, in all actuality, doing the opposite?

The equally smart lawyers at Allergan, have presented a vast amount of evidence that show the opposite. It shows that whenever Ackman speaks with Allergan shareholders, including when calling the special meeting, he claims that he is just another Allergan shareholder (in fact, the largest one), acting in the interest of all Shareholders. How can that square with being the same entity as the buyer? Allergan also provided vast evidence that Valeant (and, for that matter, everyone) knew from the start that there is no possibility of a friendly takeover and were preparing a hostile takeover right from the start.

So, how will this go? Hard to handicap. The Valeant/PS route for a hostile takeover is on entirely unexplored legal territory, so not much case law or precedents to go by. But this may be Allergan's strongest card: Because this is a new play, the likelihood of a judge throwing it out of court (or ordering some minor corrections issued to proxy material) is less than for a typical skirmish technicalities-violations lawsuit. If it is not thrown out of court, than this could be bottled up for years, with discovery rights, and multiple legal maneuvers. In the mean time, Allergan can refuse to recognize the affected shares (the 9.7% PS shares) as valid for calling special meetings and votes. PS can ask the Delaware Chancery Court (which is also a Federal court, but a separate one, focused on corporate governance issues) to over-rule; but getting two Federal courts to argue about which trumps which is never going to speed anything up.

Incidentally, this was exactly the crux of a hearing in Congress a week before the suit. Congressman Royce (Republican, from a district near Irvine) asked: “Does labeling the takeover offer a joint bid insulate the firm from insider trading charges?,” making it clear he is talking about Allergan. “That’s a question I don’t think the commission or the courts has answered on weather two parties getting together constitutes insider trading,” SEC Director Higgins responded.

And there you have it. Whether this is a speed bump (if the case is thrown out of court), a major detour (if it is not), or game-changer (if the suit actually wins); I can not tell.

One last point: If PS committed Insider Trading, Allergan wouldn't be the victim; it's shareholders would be. In particular, any shareholder who sold during PS accumulation phase (when PS knew a bid was coming, but the seller didn't). To have a standing to sue in civil court, you have to show that you've been damaged. For this reason, Allergan is co-suing with one such victim shareholder (Karah H. Parschauer). "Ms. Parschauer exercised and sold Allergan stock options on February 26, 2014, for a price of $127.60 and on March 11, 2014, for a price of $129.08" (P#21). (BTW, Karah is not a random victim, she is a VP and an attorney working at Allergan). The day after the bid was announced, the share price went to $163, so she lost about $35 per share. The suit doesn't say how many shares she sold; but probably not a huge number (she is an employee exercising and selling some stock options, not some big-time market mover). Let's say it's 1000 shares. Then, she lost $35K -- maybe a lot of money for an employee (even a VP) -- but in the overall context of this battle; pocket change. One would think that it would be easiest for PS to just give Karah $35K and then she is no longer a victim and can't sue (and therefore Allergan can't either), but that won't work. Because then every shareholder who sold during the acquisition period would have gained the legal right for an equal amount (and since for every share that PS bought, many more changed hands at pre-takeover-announcement price, this will be a staggering number of shares -- many times the value of PS).

Dan.