Scorched Earth Policy

What Is a Scorched Earth Policy?

A scorched earth policy is an extreme defense strategy employed by a target firm to dissuade an acquirer's hostile takeover effort.

Scorched earth policy, named after the guerilla warfare method of destroying anything of potential value to an opponent when retiring from a location, often necessitates the business chosen for a takeover to do everything in its capability to make itself least appealing.

Even though, in the event of a hostile takeover, this policy may be very beneficial. As a result, target companies typically only use this policy as their last resort.

However, when employing such strategies, the target company must exercise extreme caution because it could easily backfire. Using scorched earth policy strategies could result in significant irreversible losses if the hostile takeover is unsuccessful.

Additionally, there is a chance that this policy strategy will fail if the bidder obtains an injunction to stop the target company from taking defensive action.

Or, despite these obstacles, the bidder still sees value in the proposed acquisition and moves forward with its plan.

How a Scorched Earth Policy Works

The last line of defense is a scorched-earth policy. It can be viewed as a last-ditch effort to thwart an aggressive, undesired predator in both the military and business worlds. Here, the objectives devalue the business and jeopardize its potential to generate future profits.

As part of these strategies, prized assets are sold, mountains of debt are accrued that must be repaid after the hostile takeover is completed, and policies are enacted that provide senior management with sizeable compensation packages, such as golden parachute bonuses, in case a new management team is hired.

No company would likely want to take such a course of action unless it was unavoidable, and neither would its shareholders. As a result, target companies are more likely to undergo numerous different, less detrimental anti-takeover actions when attempting to quash a hostile bid.

A flip-in poison pill is one example. The scorched earth policy strategy allows shareholders other than the acquiring firm to pay for additional company shares attained at a discount.

The value of the shares that the acquiring company has already purchased is diminished by the oversupply of new shares, which reduces its position and makes it more difficult and expensive for it to take possession. However, only some have access to this alternative. 

Because poison pills can only be used if they are mentioned in the target company's charter or bylaws, a scorched earth policy is occasionally the only effective way to ward off enemies.

Types of Scorched Earth Policy Strategies

Businesses can apply this policy in various ways. Among these measures are increasing debt, implementing golden parachutes for senior executives, liquidating priceless assets, or prolonging existing debt.

In other instances, the goal of all scorched earth policy's defensive strategies is to decrease the target company's appeal to a potential hostile buyer.

Let's examine some particular examples of scorched earth policies.

Dead Hand Clause: Put A High Price On It

A goal can easily thwart a hostile takeover by implementing a "poison pill," which allows existing investors to buy at a discount. A poison pill smartly diminishes a potential aggressive acquirer's ownership stake and tries to make the target firm outrageously pricey.

Using this strategy, the hostile bidder will have to pay more for the target company. Such a strategy is advantageous when there is cross-shareholding or the acquiring company already owns a portion of the target company.

The company in question would issue the appropriate shares to everyone (other than the bidder) at a meager cost. So, naturally, this significantly dilutes the bidder's holding, reducing his ultimate control.

The term "poison pill" is another name for this tactic. To fend off an aggressive takeover attempt from Xerox in 2020, tech giant HP employed a similar strategy.

Regrettably, hostile bidders can defeat this strategy by choosing a new board of directors. Also controversial and possibly illegal is the dead-hand clause, also known as dead-hand poison pills or dead-hand redemption.

Crown Jewel Defense: Sale Of Important Assets

A potential acquirer's desire to obtain a particular target company's "crown jewel" asset is a significant factor in hostile takeovers. A possible takeover may be challenging if the target company deals with a reliable third party.

Information on the customers, patented technology, or even a vehicle fleet can be considered a core or crown jewel attribute. The major disadvantage of this strategy is that attempting to sell off significant resources can irrevocably harm the company.

Selling core assets is not an action that can be undone, so it is usually reserved as a last resort.

In other words, this involves the target selling its "crown jewel" or valuable assets to a competitor or on the open market. Furthermore, the target company might separate those valuable assets into a brand-new company. For example, Sun Pharma and Taro merged similarly.

To keep Sun Pharma away, the Israeli firm (Taro) used strategies such as trading its Irish unit and not publicizing financials. As a result, the hostile bidder's appeal and value would decline, and the company could still endure the bid.

Pac-Man Defense: Acquire The Acquirer

The video game Pac-Man is where the term "Pac-Man Defense Strategy" originates. In this game, consuming a power bullet allows a player to kill the ghosts trying to kill them.

Taking control of the acquirer is the goal of this strategy, also known as the "Pac-Man Defense." It's an aggressive tactic, but its purpose is the same as any defensive one: to make the acquirer's hostile takeover attempt very challenging so that they give up.

This strategy involves the target company taking actions that could shock the investor. The target company might, for instance, take out a sizable loan or waste reserves. Purchasing shares of the company being acquired is another strategy it.

Put another way, a target business utilizes a Pac-Man Defense when a hostile takeover is attempted against them.

The company requires significant assets for a Pac-Man Defense to perform. In addition, because Pac-Man Defense entails purchasing the aggressive acquirer, the company in question must have sufficient resources to be regarded as a legitimate threat.

The target has several options for raising the money required for a Pac-Man defense, including selling non-core assets and non-core business units, borrowing money, and employing its cash reserves.

Lobster Trap Defense

A defense of this type seeks to capture large targets while ignoring tiny ones. For example, the particular company may devise a policy prohibiting large shareholders from converting their equities into voting stocks as part of this approach.

Essentially, it prevents large shareholders from increasing their voting privileges. This strategy is effective only when a business issues convertible securities, such as bonds, preference shares, and convertible debentures.

By doing so, the influence of significant stakeholders is likely lessened.

For instance, Company A wants to fend off Company B's hostile takeover attempt. However, the former learns that an insurance company owns 13% of its voting shares.

In addition, the same insurance company is the owner of convertible warrants that could increase its voting power by 7%. Therefore, Company A's management adds a "Lobster Trap" clause to ensure the insurance company won't aid the hostile bidder.

As a result, the insurance company cannot transfer the warrants into a controlling stake and grant the hostile bidder additional voting privileges.

Restrictions of a Scorched Earth Policy

A scorched earth policy refers to the drastic measures the company takes to prevent an aggressive and unwanted takeover. While these measures may be extreme to gain a competitive advantage, they have several restrictions attached to them. 

The restrictions of the policy are as follows:

1. Reputation Damage: The decision to intentionally destroy or dispose of a company's main assets and value channels can drastically impact its reputation and economic value.
   • Trust and reliability are greatly valued in the field of finance, and a tarnished reputation will adversely impact relationships with clients, suppliers, partners, and stakeholders.
2. Market Investor Backlash: Markets are extremely sensitive to unethical and suspicious behavior. Implementing such policies may lead to negative reactions from investors and stakeholders, causing a decline in the share price.
3. Loss Of Talent: When such extreme measures are taken, the workforce is discouraged and creates an environment of distrust since they aren't considered in the decision-making. Uninterested and disheartened employees may leave the company.
   • This amounts to the loss of talented employees and negatively impacts an organization's ability to replicate past performances and innovations.
4. Limited Industry Support: An attempt to destroy the key areas of the business will severely impact a company's relations across the industry. Companies within the industry or across the supply chain would withdraw their support because of the uncertainties surrounding the company.
5. Financial Instability: Financial stability is one of the core elements for organizations within the industry and individuals to thrive in an economic environment. Such policies challenge this stability.
   • Uncertainties in the creditors, lenders, suppliers, debtors, and internal and external stakeholders create instability in the financial ecosystem.
6. Industrial Regulations: Ethical committees, regulatory bodies, and industrial watchdogs may actively oppose and inquire about any organization's extensive efforts. 
   • This can lead to extended legal challenges, public scrutiny, and further deterioration in the company's overall image.

Other restrictions and challenges an organization can face during the devising/implementation of the scorched earth policy include the potential for escalation in the matters, strained relationships with the stakeholders, other legal and regulatory constraints, and the opportunity cost of employing a short-term strategy for long-term growth.

Strategies like this, to vend off predatory corporations from hostile takeovers, never come and go easy. Extensive measures should be taken to avoid further backlashes.

Limitations of a Scorched Earth Policy

Every coin has two sides. Regardless of how rosy one may portray this policy, some significant drawbacks should be ignored.  

Employing a scorched earth policy has five main problems. The following are:

1. Long-Term Reputation Damage: In the economic and financial sphere, reputation, trust, and credibility are integral and, once tarnished, can't be regained easily. Since the scorched earth policy encompasses a lot of speculation, rumors, and false news, it all leads to damaged relationships.
2. Collateral Damage: A scorched earth policy involves parties, competitors, or adversaries, but its effect extends to innocent parties like customers, employees, or shareholders.
   • This collateral damage can lead to negative publicity and tarnished company image.
3. Inefficient Resource Allocation: The resources committed to destroying the key elements of the organization can be directed to more productive and strategic projects, enhancing the value of the company and positively contributing to the stakeholders.
4. Lack Of Adaptability: In an ever-changing financial and economic environment, flexibility and the ability to adapt to new challenges are crucial for long-term strategic success.
   • Implementing such drastic measures to protect an organization will lead to difficult situations, adding to the misery.
5. Missed Opportunities For Cooperation: Sometimes, working together or cooperatively with other industry participants can produce advantageous results for both parties.
   • A scorched earth policy may block potential alliances, joint ventures, and partnership opportunities, reducing chances for expansion and success.

Arguments against a Scorched Earth Policy

Although there are reasons against employing the scorched-earth policy that highlight the potential long-term damage, ethical difficulties, uncertainty of success, and legal limits connected with this extreme strategy, the policy may act as a temporary defense mechanism against hostile takeovers.

Long-Term Damage

These practices are highly hazardous. The objective is to avoid a hostile takeover. A scorched earth policy might accomplish this because it is so deadly.

The issue is that the scorched earth policy might also leave the target company, or acquiree, in such a disaster that its newly acquired liberty is starting to wane.

Uncertainty Of Success

What was done to frighten the suitor away will determine a lot. If severe steps are taken, like selling significant assets and taking on a great deal of debt, it might only be a matter of time before the target company fails.

Attempting to kill itself is a hefty price to pay for liberation, and it is likely to spark a public outcry, regardless of how opposed they are to being gobbled up by another firm. In the occurrence of a takeover, they will receive a payment or stocks in the new firm.

Insolvency, on the other hand, will almost certainly leave them penniless.

Ethical Concerns

Regardless, in the military or financial context, a scorched earth tactic raises ethical concerns about ruining key assets and valuable resources.

The strategy can have severe effects on civilians, infrastructure, and the environment, leading to criticism for its grand impact.

Free Resources

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