What is Dead Hand Provision?

Bad management and negative internal decisions can lead to a company failing in achieving its goals and heading towards a path of bankruptcy. The best solution for a company is to be acquired by a financially stronger one that has better resources. In most cases, the business deal happens without any issues as the acquirer and acquiree are both in agreement. However, some companies may initiate a hostile takeover. In such a case, the acquiree uses a technique called Dead Hand Provision to protect itself from a hostile takeover.

What is Dead Hand Provision?

A dead hand provision is a business strategy used by companies against another that has initiated a process of a hostile takeover of the former. The dead hand provision is also called the dead hand poison pill and requires the issuance of new shares in the market. Once a company knows that the unwanted acquirer has grabbed enough of its shares from the secondary market, it issues new shares in heavy volume, making the shares acquired by the unwanted acquire dilute massively. Due to the dilution, the value of the held ownership of the unwanted acquirer becomes less than the designated amount, so it fails to acquire the company.

Understanding a Dead Hand Provision

Acquisitions are a vital part of a normal business cycle where companies that are not doing well tend to look for a fundamentally better company to acquire and save the business. It allows the current executives to keep their jobs, earn salaries and yet have a new source of capital through the acquisition amount. However, some companies that are fundamentally strong and want to expand, try to acquire companies that are in direct competition.

A hostile takeover may be initiated when such companies deny the acquisition offer. Although the hostile takeover process is frowned upon, buying shares from the secondary market is fully legal. If a company denies an acquirer for acquisition, it may use the secondary market channel to buy enough shares that it holds a significant stake in the company to influence its decision making.

However, to protect the company from getting acquired by an unwanted entity, the company used the process of dead hand provision. The process involves issuing numerous new shares to dilute the ownership of the unwanted acquisition. It makes the takeover significantly expensive for the unwanted acquirer as the eligible members of the Board of Directors can buy the newly issued shares at a low price.

Example of a Dead Hand Provision

A company XYZ is trying to acquire a company named PQR using the hostile takeover process. It buys 1,00,000 shares at the current price of Rs 500, making up 10% of the company. However, PQR does not want XYZ to acquire it but can’t restrict XYZ from buying its secondary market shares. Hence, it knows that XYZ will have 10% of the company, which will entitle it to have voting rights and influence the decision making of the company.

To stop the hostile takeover, PQR uses the dead hand provision technique and issues 1,00,000 new shares, increasing the company's total outstanding shares. The share price drops since the supply has increased with the demand being the same. Now, if XYZ wants to hold 10% again, it has to buy 1,00,000 more shares, making it expensive. Since XYZ won’t want to spend more to hold the same ownership, the hostile takeover plan fails, allowing PQR to avoid the hostile takeover.

Effects of the Dead Hand Provisions

Here are some of the effects of the dead hand provision on companies:

• Bargaining Tool: A company may use dead hand provision as a bargaining tool to get a better and favourable deal from the bidders. The current board of directors receive better leverage and can negotiate a higher acquisition deal just by the idea that the company can use the dead hand provision. In the absence of the dead hand provision, a company may directly buy shares from the secondary market rather than negotiating a deal with a company.
• Protect the shareholders: Since the dead hand provision is activated by the board of directors, they can use the proposal for abusing their power and ensuring their tenure is extended even when the shareholders think otherwise. Hence, active shareholders include a proposal to have the dead hand provision approved by the shareholders before the board of directors can initiate the process. It allows for better protection of shareholder interest.

Final Word

Dead hand provision is considered to be the crown jewel of the business world that ensures an unwanted entity does not acquire a company. It gives utmost control to a company and ensures that the acquisition is done on ideal and agreed-upon terms. Furthermore, it protects the shareholders against the board of directors who may indulge in abusing their powers for personal gains. Overall, the dead hand provision is a controversial yet ideal business strategy that allows a company to retain control in a worst-case scenario.