Why Bad Stock Happens to Good Investors

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Why Bad Stock Happens to Good Investors
Creating the "Artificial Citizen"
The Externalizing Machine
From Common Stock to Junk Stock
The Path of the Proxy Card
Junior Invests in Boothbay Harbor
Junior Loses Control
The High Cost of Transferability
Trip Invests in Boothbay Harbor
Who Invests in Boothbay Harbor?
The Postwar Era: One Big Unhappy Family
The 1980s: Myth Meets Reality
Milken's Money Machine
The Investors Who Can't Say No and The Offer They Can't Refuse
Management Defends
1,000 Poison Pills
Lawyer's Poker
Flom v. Lipton
The Delaware Factor and the Polaroid ESOP
America in the Global Market
Privatization: The LBO as the Model of the Future Corporation
Endnotes

Why Bad Stock Happens to Good Investors


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I remember going to my great-grandfather's office as a child and being told solemnly that the great man never purchased any security other than common stock, and that I shouldn't either. To do otherwise was not merely a poor investment, it was a breach of faith. When Nell was born, her Russian Jewish immigrant grandfather gave her two shares of common stock in AT&T, as close to a piece of America as he could find to present to his first grandchild. She still holds them.

Common stock turned out to be one of the most successful "products" ever marketed in this country. It continued to be an attractive investment even into the 1970s and 1980s, when exotic variations like puts and calls were developed to tantalize Wall Street. But some of the aspects of common stock that make it attractive have been eroded, even eliminated. In theory, common stock's unique advantages account for its value. In reality, the problem is that some of those advantages are more theoretical than real.

Equity is the only investment with a limit on liability and no limit on returns. Microsoft, the innovative software company in Bellevue, Washington, did not just make founder Bill Gates wealthy. The prescient investors who bought stock when it went public at $21 a share in 1986 found these shares worth $300 a few years later. One hundred shares of IBM stock in 1925 would now be 300,000 shares. The rising tide that lifts all the boats lifts the shareholder's most of all. Because everybody else gets paid first, the shareholder is uniquely at risk, to the limits of the investment. To pursue the metaphor: In a falling tide, the shareholder is the first investor to drown.


Creating the "Artificial Citizen"


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The Corporation Defined

Corporation. An ingenious device for obtaining individual profit without individual responsibility.

Ambrose Bierce


Source: The Devils Dictionary. Dover Publications, New York, 1958, p. 25.
We rarely ask ourselves today whether private corporations are a good thing for a society to have. Indeed, our only concept of life without them is the stereotype of the Soviet Unionconsumers standing in line for hours for products that only come in one style, brand, and flavor, and even that is all gone by the time you get to the front of the line. But free societies prospered without corporations for many years, and the original concept of ceding influence to private entities was deeply troubling in the eighteenth century, a time when the legitimacy of the exercise of any kind of authority was being questioned.

The United States was founded by people who wanted something different from the old world. European tradition for many centuries involved a competing presence of "artificial individuals"nobility, guilds, church, professional army, professional bureaucracyso that the emergence of business corporations in the nineteenth and twentieth centuries represented simply an addition to a centuries-long continuum of accommodating large, powerful institutions. The prior history of municipal corporations, ecclesiastical corporations, guilds, joint stock companies, and educational and philanthropic corporations provides a backdrop in which the private exercise of power was familiar. Life in the new world reflected individual rather than establishment concerns.

The thinking of Revolutionary War-era leaders was based on a suspicion of power. This involved the development in the area of public power of an elaborate written constitution explicitly designed to balance different elements of power against each other.

But the parallel concerns about private power were addressed in a different context. The colonial-era citizens were familiar with corporations. Indeed, the early colonies began their existence in the form of joint stock companies. The earliest history of the Massachusetts Bay and Plymouth companies demonstrates the evolution of governmental powers from a commercial charter. Thus, corporations were not in and of themselves suspect. What was essential was that the corporate form be available on a free and open basis. Within this framework, the emerging corporate form of business organization was based on democratic principles. To fit the corporation for American service, attention was focused on stripping away the elements of special privilege that clung to its European form. Colonial leaders rejected the British practice of issuing corporate charters by royal prerogative. It was a substantial popular victory when the privilege of incorporation was first declared a right during the presidency of Andrew Jackson.

As concerned as they were with rights, the founding fathers did not consider the rights of "artificial citizens," and the Constitution and its attending Bill of Rights did not easily accommodate them. As recently as 1990 the Supreme Court was still trying to decide how the protections of the Bill of Rights apply to corporations. 1 Indeed, the American tradition of denying express power to government encouraged the belief that power granted to corporations would further the interests of the individual against the state.

In the central document of American history, the Constitution, the word corporation never appears. The makers of public policy were still very wary of the impact that private entities could have on American life. One worry was the problem of reconciling the interests of management and owners (as representatives of the community interest). Another was that a corporation's size and indefinite duration would overwhelm the interests of individual citizens. As the idea of the corporation evolved, it was designed to have checks and balances like those built into the political system, and for the same purpose: to assure stability, accountability, and legitimacy. After all, the same year that America declared its independence, English economist Adam Smith was writing in The Wealth of Nations that directors of publicly held corporations could not be expected to watch the company "with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own.... Negligence and profusion, therefore, must always prevail, more or less, in the management of such a company."2 He went on to say that for this reason publicly held companies (which he called "joint stock companies") had seldom been able to compete with privately held companies, unless they had a monopoly.

To resolve these concerns, an essential part of the system was a kind of corporate democracy, with each "citizen" entitled to vote according to his investment. If we were going to permit the government to exercise public power through the accountability imposed by the electoral system, it seemed logical to permit corporations to exercise private power on the same basis.

Louis Brandeis, in 1933, eloquently warned that it was a mistake to "accept the evils attendant upon the free and unrestricted use of the corporate mechanism as if these evils were the inescapable price of civilized life." He continued:

[I]ncorporation for business was commonly denied long after it had been freely granted for religious, educational, and charitable purposes. It was denied because of fear. Fear of encroachments upon the liberties and opportunities of the individual. Fear of the subjection of labor to capital. Fear of monopoly. Fear that the absorption of capital by corporations, and their perpetual life, might bring evils similar to those which attended mortmain. There was a sense of some insidious menace inherent in large aggregations of capital, particularly when held by corporations.3
So the corporation was welcome in its "enlarged conception of legal persons."4 Clearly, the demands of emerging capitalism required a conglomeration of people, money, and property beyond the capacity of individuals. The life of the new continent required such institutions to construct the harbors, build the canals, maintain the highways, and ultimately, create the railroad that would tame the wilderness continent.

A corporation is a fictional "person" with some of the rights of a citizen but not all of themand some rights that citizens do not have. A corporation has some of the rights of freedom of speech guaranteed by the First Amendment, but there are limitations on "commercial" speech. A corporation cannot vote in an election, but it can provide a good deal of financial support (directly or indirectly) for a cause or a candidate. Indeed, as we will see in Chapter 4, corporations have been enormously effective at rallying state and federal protection. Almost two centuries ago, the Lord Chancellor of England, Edward, First Baron Thurlow, fumed at the corporation's amorphous existence: "Did you ever expect a corporation to have a conscience when it has no soul to be damned, and no body to be kicked?"5 It cannot be jailed. It cannot even be fined, in any real sense; even when a fine is imposed, it is the shareholders who pay it.


The Externalizing Machine


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Despite attempts to provide balance and accountability, the corporation as an entity became so powerful that it quickly outstripped the limitations of accountability and became something of an externalizing machine, in the same way that a shark is a killing machineno malevolence, no intentional harm, just something designed with sublime efficiency for self-preservation, which it accomplishes without any capacity to factor in the consequences to others. With checks and balances of the marketplace intended to keep its focus on maximizing profits, that is just what it did. But it did so in a manner quite different from that intended or predicted. Instead of maximizing profits by making better, cheaper goods, it did so in less challenging ways, by restricting competitionsometimes with the help of the government. Instead of maximizing profits for shareholders, corporate management often maximized profits for themselves, lowering dividends but raising salaries. Instead of devoting creative energy to productivity, they devoted it to ever more unbreakable entrenchment devices.

The idea of the corporation evolved slowly. At first, the states chartered each company individually and limited the kinds of ventures corporations could undertake. This system was perhaps inspired by suspicion, but it created "a process that invited bribery and corruption since it involved negotiating specific charter provisions with legislatorsamong others, the purpose of the enterprise, the location of its activities, the amount of capital to be raised by stock sales, and the power of its directory."6 The many impediments - some intentional, some not - to incorporation began to fall in the late nineteenth century, less as a result of any public policy in favor of corporations than as a way to increase tax revenues for states. Businesses, seeking the protections available through trusts and holding companies, for the first time provided a political base that supported, even encouraged, these changes.

In the nineteenth and early twentieth centuries, the very absence of traditional institutions stimulated the growth of business, in terms of both its favorable and in its unfavorable characteristics. Entrepreneurial energies literally knew no bounds. By the outbreak of World War I, the United States was the premier industrial power in the world. It also was a country shaken to its core by pressures that business wealth brought to the legitimacy of the political process. State and federal governments alike had been tainted by bribery and corruption; the Erie scandals and the administration of U. S. Grant are only a few examples of the government's struggle to survive the threat of unlimited private power.

Adam Smith predicted that businessmen would try to maximize profit by eliminating competition rather than beating it. "Without an exclusive privilege, they have commonly mismanaged the trade. With an exclusive privilege they have both mismanaged and confined it."7 He was right. Some companies became monopolistic and threatened to destroy the competitive marketplace that was the essential ingredient in ensuring that commercial pursuit would result in the public interest. At the turn of the twentieth century, this brought about the first comprehensive federal laws respecting business: antitrust and antimonopoly legislation.

Business also tried to maximize profit by externalizing costs, placing the costs of unsafe working conditions on their employees and the costs of unsafe products on the consumers. So the antitrust laws were followed by the first health and safety laws. None of these laws was antibusiness; their objective was to save business from itself, to liberate the business system to function in a manner that would result in the public good. But they represent a suspicion of business and businesspeople, which is still a strong theme in the economic and political debate.

The stock market crash of 1929, the disgrace of prominent business leaders,8 and unacceptable levels of unemployment led to a political decision that business could not and should not be unilaterally responsible for solving the nation's economic problems. Following the election of Franklin Roosevelt in 1932, big business accepted a federal presence as a permanent factor in the pursuit of profit. A business council consisting of the principal leaders of the major corporations was organized as a part of the U.S. Department of Commerce and functioned as an official liaison between business and government from the early days of Roosevelt until the Kennedy administration. Thereafter, an independent business organization, the Business Roundtable, became the most prominent mouthpiece for the major industries.


From Common Stock to Junk Stock


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In the early twentieth century, as corporations began to produce more of America's goods and services than proprietorships and partnerships,9 it became possible for anyone with enough money to buy a share of stock and participate in the profits of the industrial revolution. Buying common stock was buying America and betting on its future. Anyone could buy a piece of the people, the inventions, and the companies that were transforming the world. As the century progressed, anyone could invest in companies that produced cars, electric lights, telephones, birth control pills, airplanes, movies, computers, televisions, rocket ships, and the Tang(R) they carried. You didn't have to be smart enough to invent these things, only smart enough to buy a piece of the company that made them.

The ability to participate through inexpensive, easily transferable investments also made it possible to diversify a portfolio to minimize risk. Not only did investors not have to be smart enough to invent something, they did not have to be smart enough to pick the right companies to invest in. Just spread the investments around and sell out when they started to drop, and you would do fine. America's love affair with common stock was dampened by the crash in 1929, but the government stepped in to regulate the markets, to provide a level of safety that would encourage investors to returnand they did return, in record numbers.

The expectations of a holder of common stock are clearly defined and easy to understand. After the obligations of the corporation have been settled, what is left belongs to stockholders. A shareholder's rights are also clearly defined. The holder of common stock is entitled to a share of all dividends paid that is proportional to the amount of stock owned. The shareholder has the right to transfer his shares in the market, to vote proxies to elect directors, to approve amendments to the corporate charter and changes of the state of incorporation, and to vote on resolutions proposed by other shareholders or even initiate them himself. Finally, if the directors or managers abuse the authority entrusted to them by shareholders, the holder can sue the directors and management either as an individual, on behalf of the class, or as a representative of the corporation itself. (The last form of lawsuit is called a shareholder's derivative suit, because shareholders "derive" the right to sue from the failure of management to pursue its own claims.)

These rights have had varying impact and value. Transferability of shares is essential to make the corporation an attractive investment. It allows shareholders to diversify the risk of investment among several ventures and to change the level of risk easily. Transferability has been so important, in fact, that the market has willingly, if inadvertently, relinquished many of the other rights of ownership in order to preserve it. In early days, stock certificates were like checks or like other kinds of property: you transferred stock by giving someone the actual certificate. My first job, at age 16, was as messenger for Paine, Webber, delivering the documents necessary for every transfer of stock (at least five for each transaction), all pinned together with great ceremony by a man who worked behind a cage in the front of the office.

This system worked, briefly. In the summer of 1950, for example, when I was a runner, the market never traded over 750,000 shares in a day. The system, however, was inadequate for the volume that was to come. Last year, for example, the New York Stock Exchange alone traded 292,363,500 shares in a single day. The old system proved too cumbersome and too invasive of shareholder privacy.


The Path of the Proxy Card


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"Like pilgrims, the proxy card and the right to vote follow a long and tortuous path before returning home to the issuer," wrote Betty Linn Krikorian.10 The current process (see Figure 1 ) begins with the company sending a notice of its shareholder meeting date to one of three depositories, the largest being the Depository Trust Company (DTC), and to the stock exchanges. The depository informs its participants (in the case of the DTC, this includes 400 broker-dealers and 200 banks) and sends to the company a list of participants that hold that stock with the bank. The company has 20 days to send cards to the depository's participants asking them for the number of sets of proxy materials they need and, if the participants are banks, a list of their respondent banks. Within one day of receiving the list, the company must send cards to those respondents, who must identify their respondents, and so on, until all the respondent banks have been contacted.

The company sends out proxy materials and voting cards to all banks and shareholders of record. It is up to the bank to determine who is the beneficial owner of each stock (and thus who has voting rights) and how many shares each owner can vote. If the bank is deemed beneficial owner, it votes according to its own policy. If the bank does not have voting power, either it can forward the proxy material to the beneficial owner within five business days of receiving the material from the company or it can forward the material with a request for instructions on how the stake is to be voted. The DTC sends an omnibus proxy to all participants, detailing the number of shares held by each participant as of the record date. Within five days, each bank must assign voting rights to their shares held for the respondent banks and notify the respondents and the company.

The bank marks, signs, and returns the proxies to the company for stock held by the bank beneficially and stock for which they have received instructions from the beneficial owner. If the beneficial owners handle the votes themselves, the bank signs the proxies and forwards them to the owner.

Broker-dealers usually vote on the instructions of the beneficiary. Thus, the broker-dealer votes a master proxy by adding the votes based on the voting instructions received and the votes it casts internally and returns these to the company. Due to a desire on the part of management to communicate directly with as many shareholders as possible and to a concern over whether shareholders are receiving complete information brokers are required to ask all clients whether their identity can be disclosed to the company. Owners who refuse are called objecting beneficial owners (OBOs) and are not included on the list of beneficial owners the broker submits to the company. The names of nonobjecting beneficial owners (NOBOs) are known to the issuer company, which means that although their shares are still physically voted by the broker, they are receiving direct communications from the company on proxy matters.

The operational aspect of the process often involves a third party. A company such as the Independent Election Corporation of America (IECA) provides NOBO lists to companies and will serve as the intermediate between the owners and the corporation. IECA will also code proxies and track votes cast.

This system was great for making it easy to buy and sell stock, but it made it even harder to exercise the other rights of share ownership and, by doing so, created something of a vacuum. Wall Street, like nature, abhors a vacuum (which it refers to as a "market niche"). This one was filled by corporate managers and, sometimes, by raiders. In this chapter, we focus on the original contract between shareholders and the companies they invest in. In Part II, we consider the ways in which the other rights of ownership all but disappeared and the impact that had on companies and their stock, for which this discussion provides a context.


Junior Invests in Boothbay Harbor


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The traditional relationship between entitlement to receive the benefits from a venture and responsibility for its impact on society was charmingly put early in this century, as a father advises his son in Main Street and Wall Street:
Now, Junior, before you go to college I want to give you my investment in the Boothbay Harbor Electric Light Company. This concern serves our old neighbors and friends, and I want you to feel a continuing interest in, and a responsibility for, our share in this local enterprise. If properly managed it should be a benefit to this community; and it will yield you an income to be applied to your education through the next few years. But you must never forget that you are partly responsible for this undertaking. Our family had a hand in starting it. That responsibility is an inseparable part of your ownership. I read something the other day, in an opinion by Justice Brandeis of the United States Supreme Court, which bears this out: "There is no such thing to my mind . . . as an innocent stockholder. He may be innocent in fact, but socially he cannot be held innocent. He accepts the benefits of the system. It is his business and his obligation to see that those who represent him carry out a policy which is consistent with the public welfare." He is right in that. This accountability for wealth underlies and justifies the whole institution of private property upon which the government of our great country is founded.11

There was a certain parity in the traditional characteristics of common stock: investors could limit their risk of loss and enforce their entitlement to management's loyal attention, management could secure the capital necessary for a successful enterprise, and society could be confident that what was good for business was good for the citizenry at large. Investors, managers, and workers were all accountable to each other.

Through their power to vote for directors, shareholders have traditionally been considered the ultimate source of authority and legitimacy for corporations. Those whose money is at risk are the appropriate source of overall direction for the enterprise. The intention was that the holder of common stock would provide this guidance not by making decisions about product lines or retained earnings but by requiring that management run the venture with competence and loyalty to generate long-term value enhancement. The shareholder's entitlement was enforceable in court. So when the first Henry Ford wanted to sell his cars for below-market value out of social concern, the courts reminded him that it was wrong to sacrifice shareholder interests for social ones.12 Nor, until the most recent times, was management legally free to make charitable contributions.13 The theoretical capacity to require accountability is essential: "But the fact remains that the power, even if rarely exercised, and then only under extreme provocation, was there; and every once in a blue moon some resolute individual or stockholder could rise in his place and organize a protective committee or dissenting groupand, if nothing else happened, at least there was a thorough ventilation of what sometimes proved to be a musty or unsafe tenement.''14

This remembered sense of balance is so powerful that it persists despite unmistakable proof that it no longer exists. Management accountability to shareholders is more than an economically beneficial arrangement; it is the basis on which we, as a matter of public policy, give legitimacy to the impact that private entities have on our lives. We would no more create a private entity without accountability than we would a public one; we don't want corporate dictators any more than we want political ones. But today, any remaining accountability is little more than a vestige of the original contract, the last remaining trace of the myth that no one seems to want to give up.

Practically no one has any incentive to challenge it. The myth of accountability to shareholders is like a mantra that justifies their continued passivity while allowing them to continue to invest. Management takes comfort from the same myth because it justifies their actions; after all, if there was anything wrong, the shareholders would have stopped them. Why should politicians challenge the notion of accountability to shareholders? What kind of political support can there be for such a challenge when both sides embrace the status quo?


Junior Loses Control


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Academics alone have been willing to make heretical attempts to demonstrate the lack of accountabilityusing the helplessness of shareholders as justification for legally downgrading their "right" to primacy among corporate constituents. They sometimes express this by calling the modern shareholder "shirking" or "laggard," and they echo Berle and Means in concluding that because shareholders have abandoned their legitimating role, they "deserve" diminished rights.

A long line of distinguished scholarship points out that, to the extent the theoretical rights of shareholders do exist, they have become impossible to exercise. Berle and Means accurately put it over half a century ago: "[T]he owners of passive property, by surrendering control and responsibility over the active property, have surrendered the right that the corporation should be operated in their sole interestthey have released the community from the obligation to protect them to the full extent implied in the doctrine of strict property rights."15

When Berle and Means wrote their book on the helplessness of shareholders, the problem seemed insolvable. Graham and Dodd, writing at about the same time, urged shareholders to understand that the holding of stock required vigilance in the exercise of ownership rights as an investment matter. In their first edition, Graham and Dodd plainly stated that "the choice of a common stock is a single act; its ownership is a continuing process. Certainly there is just as much reason to exercise care and judgment in being as in becoming a stockholder.''16 They later admitted that being a conscientious shareholder was more difficult than it looked, noting that shareholder activity has "yet to come to grips with the real issues involved in the confrontations of stockholders and their management.''17 It seemed impossible, for the reason Berle and Means identified. With so many shareholders, it did not make economic sense to evaluate the opportunities provided by ownership rights with any enthusiasm, much less to exercise them.

It is currently fashionable in some academic circles to endorse this approach, and, as discussed in detail in Chapter 3, it appears in slightly different form in the push for "stakeholder" laws. Berle and Means pointed out half a century ago that the wide dispersal of stock, its easy transferability, and the diversification of even modest portfolios made it impossible for shareholders to play the supervisory role originally intended. So why not do away with it entirely? Why should shareholders have any more of a say than managers, customers, employees, suppliers, or the state?

Shareholders, the great short-term beneficiaries of this system, have no reason to consider the consequences of their noninvolvement, as they now freely trade the stock instead of devoting resources to monitoring and providing direction for the company, without the slightest reduction in the stocks's value on account of the costs that the companies are able to externalize. Rather than deal with the problems of pollution, public utilities and other fossil fuel-burning industries have simply lobbied government bodies, denying that the problem exists. When Ralph Nader exposed the Corvair's safety defects, General Motors did not immediately address the problem but instead hired a private investigator to follow Nader and "substantiate completely false rumors that Nader was anti-Semitic and a homosexual.''18 Those who are so willing to abandon the role of shareholder neglect the huge social cost of doing so. The long-term loser is society as a whole, like a player in an "Old Maid" card game, with each party trying to push the costs on to another.

Adam Smith's notion was that individual pursuit of self-interest would ensure the collective interest through an "invisible hand," despite his own reservations about the way this would work in a system riddled with agency costs. But the power of this "invisible hand" was such that it was used to justify freedom from government intervention needed to ensure the compatibility of corporate power and the public interest.


The High Cost of Transferability


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Shareholders' ability to perform what James Willard Hurst has called "their legendary function" of monitoring has been substantially eroded, initially, as noted by Berle and Means, by sheer numbers. Management has every incentive to increase the number of holders.19 First, to do so increases available capital and helps transferability by keeping the prices of individual shares comparatively low. Ease of transferability is not a priority for Warren Buffet, for example, whose Berkshire Hathaway trades in four figures per share. But he is a rare exception; most companies split their stock before it reaches $100 a share.

Increasing the number of shares has another significant advantage for corporate management: it reduces the incentive and ability of each shareholder to gather information and monitor effectively. Even the $250 million investment in General Motors by one of the largest equity investors in the United States, the California Public Employees' Retirement System, is not of much significance in a company with a market value of more than $30 billion. When the number of shareholders is in the hundreds of thousandseven the millionsand each holds stock in a number of companies, no single shareholder can monitor effectively. Is monitoring worth it when your investment (and liability) are limited and when, even if you do understand the issues, there is nothing you can do about them?

Universal transferability has also critically changed the nature of the shareholders' relationship to the corporate structure. As investors, stockholders had to look to corporate performance for protection and enhancement of their investments; they had to consider the efficacy of capital investments; they were directly influenced by the way the corporation conducted itself and by how society perceived it. In the absence of readily available "exit," or sale, the traditional shareholder used "voice," or ownership rights.20 "[T]he corporation with transferable shares converted the underlying long-term risk of a very large amount of capital into a short-term risk of small amounts of capital. Because marketable corporate shares were readily salable at prices quoted daily (or more often), their owners were not tied to the enterprise for the life of its capital equipment, but could pocket their gains or cut their losses whenever they judged it advisable. Marketable shares converted the proprietor's long-term risk to the investor's short-term risk.''21 The increased number of shares and ease of transferability acted as a vicious circle, because the inability to use "voice" to influence corporate activity made "exit" the only option.

The costs implicit in acting as an owner are far easier to justify in the case of a long-term holder. It is virtually impossible to argue that extensive monitoring is cost-effective for investors whose profit is principally derived from buying and selling in the short term. The prospect of buying low and selling high is so beguiling that a lucrative industry of "active money management" has flourished, notwithstanding the reality that institutional investors are the market and therefore cannot hope to beat its performance.


Can the Market Beat Itself?

Investment management, as traditionally practiced, is based on a single basic belief: Professional investment managers can beat the market. That premise appears to be false, particularly for the very large institutions that manage most of the assets of most trusts, pension funds, and endowments, because their institutions have effectively become the market.

Charles D. Ellis Source: Investment Policy, Dow-Jones Irwin, Homewood, 111., 1989, p. 5.


Hope always exists for a particular institution that it can be the exception and can beat the averages. This hope, rather than any statistical evidence, accounts in part for the change in the way shareholders see themselves, from owner to speculator (or investor). Another component is short-term self-interest, an objective that does nothing to encourage monitoring, which involves the commitment of resources for gains that are not immediately quantifiable (with the possible exception of shareholders who are large enough and aggressive enough to underwrite contests for control). In the longer term, this altered role has involved a high price for the business system as whole.

Transferability has had significant adverse consequences for corporations as well. It means that the interests of shareholder and manager are not necessarily the same; indeed, they are based on incompatible premises, because the investor will want to sell at the first sign that the stock may have reached its trading peak, and the manager wants stable, long-term investors. The American corporate system was initially based on the permanence of investor capital. Unintentionally, the growth of the institutional investors may have reintroduced elements of stability in stock ownership.

The market has become so complex that it is increasingly uneconomic for individuals to invest on their own behalf. Nearly half of all equity securities are therefore held by institutional investors on behalf of individuals. As a result, shareholding is now further subdivided between trustees, who are legally responsible, and beneficiaries, who are financially interestedyet another instance of agency costs in the myriad of lines between agent and principal that make up the corporation. Trustees are picked not by the beneficiaries, who pay their fees, but by the people establishing the trustin this case corporate managers, whose interests (as we will see) are often competing with, if not directly contrary to, the interests of the people they pay the trustees to look out for.


Trip Invests in Boothbay Harbor


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Let's look at a typical shareholder under this system and contrast him with Junior, who got the fatherly advice about the Boothbay Harbor Electric Light Company described in Ripley's book 65 years ago. We will begin with the largest single class of ownership, comprising perhaps 15 percent of the total outstanding equity.22 Junior's son Trip is now an employee of Widget Co., a midsize manufacturing company with a "defined benefit" pension plan. That means that no matter what Trip puts in before he retires, once he does he is guaranteed a set retirement check every month. Let's say that Trip has been with the company for 20 years, with about another 15 to go before retirement, and let's keep in mind that his office matesone who just started work and one who is 5 years from retirementmight have very different sets of priorities.

The concerns of Trip and his colleagues are a far cry from Junior's "sense of responsibility" for the companies he invests in; indeed, Trip could probably not say what stocks he holds, bought by several investment managers hired by the fiduciary designated by the corporate chairman. To make things even more complicated, while one of the investment managers employed by Trip's company is buying Boothbay Harbor, another is selling it; indeed, sometimes they sell to each other, leaving Trip and his colleagues with the same shares and a loss on the transaction costs. Trip "owns" a minuscule fraction of perhaps thousands of publicly traded companies. Not only has he no say about which securities are purchased on his behalf, he doesn't even find out until after the fact, and sometimes not even then. Between Junior and Boothbay there was a reliable system of communication. Between Trip and Boothbay there is an investment manager, a custodian, a trustee, a named fiduciary, and the CEO of Trip's employer, Widget Co.

Trip and the other employees whose pension money is invested really have no legally enforceable interest with respect to a particular holding of the plan; their only right is to be paid the promised benefits. Whether these come from stocks, bonds, or gold bullion is irrelevant to him. His only right is to require that the trustee act loyally and competently in his interest.

That could be complicated. The trustee, usually a bank, may have business relationships that create uncomfortable conflicts, putting Trip in a situation quite different from Junior's. For example, the trustee will be voting stock in the same companies it makes loans to or handles payrolls for. There have been a number of reports of cases where a trustee attempting to vote against corporate management was stopped by its own management. Why not? The trustee has no economic interest whatsoever in the quality of the voting decision, beyond avoiding liability. No enforcement action has ever been brought and no damages ever awarded for breach of duty in voting proxies. Trustees earn no incentive compensation, no matter how much energy and skill they devote to ownership responsibilities. And, crucially, the corporation knows how the trustee votes, whereas Trip has no idea. The trustee has nothing to lose from routine votes with management and everything to gain. Even if the trustee wanted to view ownership responsibility more energetically, it would be all but impossible as a practical matter, because of further inhibitions to shareholder activism arising out of the problems of "collective action" and "free riding," the pervasive problem of conflict of interest by institutional trustees, the legal obstacles imposed by the federal "proxy rules," and state law and state court acquiescence to management entrenchmentall described later in substantial detail.


Who Invests in Boothbay Harbor?


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Meanwhile, at the top of the chain, the CEO's interest in the investment in Boothbay is also quite different from Trip's or Junior's. His interest is, first and foremost, being able to pay Trip his defined benefit when he retires, with a minimum of contribution by Widget Co. and, probably, a minimum involvement of his own timeafter all, pension benefits don't have much to do with Widget Co.'s products or sales. So the CEO will push the investment managers to provide results (while he decries the "short-term perspective" of investors with other CEOs). If he is involved, he is faced with what has been called "ERISA's fundamental contradiction."23 As a corporate manager, he would tend to favor provisions that, as a shareholder, he might find unduly protective of management, either as a matter of general principles or more specificallyhe could even be a member of Boothbay's board.

In the 1920s, Trip's father, Junior, and his grandfather, who spoke of Boothbay Harbor with such proprietary interest, felt a real connection to the company they invested in. In the 1990s, the trustee, the custodian, the investment managers, and the CEO stand between Boothbay and Trip. Do any of these people "feel a continuing interest in, and a responsibility for" their share in this enterprise? Are any of them able to exercise, or even interested in exercising, the responsibility of providing overall direction for the company?

And is such monitoring by owners a "right," to be discarded if inconvenient, or is it a "responsibility"? Although academics cite shareholders' "shirking" of their responsibility as justification for their diminished status, they have neglected the consequences. The result has been that shareholders have managed to foist off all manner of liabilities onto society as a whole. Ultimately, society has paid the highest price for such "mistakes" as Rely(R) tampons, the Dalkon shield, and DDT. The corporate system does not provide a way for those who profit from corporate operations to share some of their bounty to pay for related social costs. We are left with three choices: legitimating the exercise of corporate power through accountability to shareholders, by enabling (or requiring) shareholders to provide their "legendary supervisory role"; finding some other kind of accountability (perhaps government) to limit the imposition of externalized costs; or leaving things the way they are, allowing those costs to fall as they do.


The Postwar Era: One Big Unhappy Family


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It is a simplification, if not an outright misrepresentation, to speak of the stock Junior and Trip held in Boothbay Harbor as though Boothbay were the same company for both of them. As shareholders have changed, so have the companies they invested in. Trip's many-times removed investment was probably not in Boothbay Harbor but in a company that had bought Boothbay and a dozen other companies something called, say, Global Unodyne. During the era just after World War II, the fad was for conglomerates. The theory was that conglomerates would have (to use a word not popular until much later) synergy, that the various businesses would help each other, and that the diversity of interests would make the company safe from any kind of economic downturn. It was not enough, maybe not even relevant, to have expertise in the product line; a certain business expertise was thought to apply whether the product was computers, hamburgers, or hotel rooms. Put another way, the product of such a conglomerate was no longer computers, hamburgers, or hotel roomsit was stock.

This was at the same time one of the most beguiling and one of the most damaging industrial concepts in the history of the American economy. "Tell me the story," the business school educated analysts would ask. If the story was right, there was no limit to the stock price. Some of the cleverest people in AmericaFord Motor Company's "best and brightest," Roy Ash and Tex Thorntonwith their "whiz kid" credentials, brought forth to a hungry public the new phenomenon in the form of Litton Industries.

Litton was as close to glamorous as a business can get. With its former movie headquarters in Los Angeles, with Crosby Kelly, the inventor of "financial public relations," and with a record of increasing quarterly earnings for over 10 years, Litton seemed able to do anything, despite the fact that no one could single out any particular value that was added. Here's how it worked: Litton's stock would be selling at 40 times its earnings. An attractive company would be located, for example, Fitchburg Paper Company. Either the marketplace or appraisers would value Fitchburg Paper Company at around 10 times its earnings. The Litton team would descend on the shareholders (in this case, the Wallaces, the family of the founders of Fitchburg) and offer them a "premium" of 70 percent to acquire their company. How's that? Well, Litton would issue new Litton common stock to the Wallace family with a market value of 170 percent of their present holdings.

How could they do it? Assume that Fitchburg Paper had annual earnings of $5 million and a market value of $50 million. Litton would issue them stock worth $85 million and acquire $5 million of new earnings. With Litton's price/earnings ratio, this translates into $200 million of additional value for which they have only paid $85 million. So long as the market continued to accord a 40x multiple to Litton, Litton could continue to make the Wallaces of the world rich and generate "instant profits" for themselves. The Litton principals had charm and a sense of the dramatic. Acquisitions were seductions; work went on around the clock; the world stood still. Their goal was to acquire 50 companies a year.

Litton began by acquiring companies with related businesses in 1958. In the 1960s, however, it branched out into "typewritters, cash registers, packaged foods, conveyor belts, oceangoing ships, solder, teaching aids, and aircraft guidance systems."24 The story ended badly. Litton's radiance ultimately became tarnished. The stock "tanked" in 1968.25 That is, the stock fell 18 points in one week. It did not merely fall in an orderly manner; it disintegrated. The Wallaces and other shareholders were left with no company, a lot of paper losses, some fine memories, and very little of lasting value.

Other companies managed to make the conglomerate structure work by making more careful acquisitions, but the American economy is saddled with a substantial portion of its industrial capacity misorganized in the inefficient conglomerate form, from which it will take two decades to extricate itself. Here was the fertile breeding ground for the leveraged buyout, the restructuring, and the hostile takeover.


The 1980s: Myth Meets Reality


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Perhaps this system would have lumbered along indefinitely, had it not been for two unprecedented developments, on a collision course with each other and with traditional notions of corporations, management, and shareholders. The first was the emergence of institutional investors (discussed in Chapter 6), required, as fiduciaries, to take their ownership responsibilities seriously and big enough to begin to surmount the problems that had prevented effective exercise of ownership rights in the past. The second was what made such exercise so importantthe takeover boom. The creation of securities to make a takeover of just about any size possible gave ownership rights a more immediate value than they ever had before. Such takeovers were in part made possible by the separation of ownership and control, which had created a value gap (the "control premium") between the market value of the shares and their absolute value. Junk bonds enabled raiders or managers to cash out the difference between the two, and inevitably, shareholders noticed that it was their moneyor should have been.

In 1969, Saul Steinberg seized the commercial world's attention with a $9 billion tender offer for the Chemical Bank. The Wall Street establishment's ability to cripple this effort by shutting off Steinberg's sources of credit reinforced the conventional wisdom that hostile takeovers could not be done in America. In the intervening decades, prosperity in Europe and Asia increased liquidity substantially. Worldwide financial sophistication has developed, and the U.S. establishment no longer has the capacity to prevent foreigners from putting together bank syndicates to provide virtually limitless amounts of money to close deals. And many scholars studying the "market for corporate control" became convinced not only that hostile takeovers were tolerable, but that they were essential as the only real way in which managerial power could be held to accountabilityafter all, shareholders could not do the job, and raiders, or the threat of raiders, could.

Political and economic theory required that the marketplace be the ultimate judge of management. It was clear that accountability couldn't really be achieved by holders' selling shares of companies that did not perform satisfactorily. As Edward Jay Epstein points out, "just the exchange of one powerless shareholder for another in a corporation, while it may lessen the market price of shares, will not dislodge managementor even threaten it. On the contrary, if dissident shareholders leave, it may even bring about the further entrenchment of managementespecially if management can pass new bylaws in the interim."26 As discussed in detail in Chapter 3, shareholder lawsuits to enforce the fiduciary duty of managers were ineffective. The overwhelming advantages of incumbency made contests for control through the electoral process virtually impossible. So the only basis for ensuring management's commitment to profit maximization was vulnerability to hostile takeover. Takeovers were not only feasible, they were legitimate - almost.

The comfortable legal balance that had for a century provided a nurturing framework for the financing of corporations and the increasing of share values was brutally tested in the commercial environment of the 1980s. As is often the case with myths, the theories behind the corporation served a useful purpose long after they ceased having more than a tenuous relationship to reality. Although in theory shareholders could get relief from the courts if a conflict of interest with managers or directors could be proven, an appropriate context proved elusive. The intrinsic character of a business corporation involves conflicting interests: managers want to pay themselves more, owners want higher dividends; managers tend to favor size, owners profitability. Under the business judgment rule, courts would defer to the decisions of management and directors, as long as there was no obvious self-dealing or fraud.


Milken's Money Machine


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Hostile takeovers in the 1980s arose primarily because virtually unlimited amounts of money were available to entrepreneurs who had energy and were willing to play. The difference between the takeovers of the 1980s and Saul Steinberg's 1969 attempt was simple: all of the funds could be provided. This "money machine" was the work of one man: Michael Milken. An utterly focused and creative financial mind combined with energy and ruthlessness made Milken the dominant financial force in America. Coming out of the Wharton School into the sleepy ranks of the Drexel bond department, Milken quickly demonstrated the elements that would in short order make him the most highly compensated individual in the worldand appear to be underpaid at that.

He negotiated a personal compensation arrangement with Drexel that depended entirely on his own production; he would be paid a percentage of the gross, no matter how high. In 1988 alone, his salary was reportedly $552 million,27 which did not even include the value of the warrants he kept from various deals.

Finally, he negotiated the move of his operation to Los Angeles, to a building that henot the firmowned at the intersection of Rodeo Drive and Wilshire Boulevard. As would become apparent in subsequent criminal investigations, the move meant that Milken was effectively beyond the supervision of the "home office" in New York, which was all too content with the lavish fees of the new business to pay much attention.

He understood a new way of valuing "high-yield" (junk) bonds. What he "proved" was that the interest rate spread between so-called junk bonds and bonds of "investment grade" was so large that a buyer could, with a well-chosen portfolio, self-insure against the higher risk and still be substantially better off with junk. In other words, the rate was so high that you could afford to have a few failures in the portfolio; the successes would more than make up for it. From the perspective of 1990, this analysis seems badly flawed.

For many years, insurance companies had made loans of the same kind that Milken was now "discovering," except that they were called "private placements." What Milken did was create a public market for these loans and, in doing so, lower the costs for the borrower. In keeping with the theme of mythology, Milken's most powerful innovation was not in what he created, but what he called it. He changed the name for the financial instrument from a loan to a "security." The consequences were as astounding as if that were an incantation.

Three critical elements were there for anyone to see, but only Milken saw them. Combined, they created a capacity to raise money quickly in volumes never before dreamed of. The first was essentially eliminating the restrictions on loans. Government regulators worked to maintain a tolerable level of risk in the financial system by controlling debt-to-equity ratios.

Milken took what had traditionally been known as a loan and made it into a security, a bond.28 As a consequence of this name change, it was considered an investment for the bank, part of its capital like any other bond, and therefore not subject to limitation on account of the traditional regulatory loan ratio standards. Thus, so long as a financial institution could get cash, it could acquire Milken's "bonds," as the Reagan administration's widely ballyhooed deregulation program permitted ever-greater latitude for investment.

The cash was close at hand. The second element of Milken's package was the Reagan administration's extension of federal insurance of bank deposits to $100,000 per account. Deposit insurance had been considered one of the enduring reforms arising out of the Great Depression, essential for creating confidence in the banks. Bank accounts were insured up to $40,000 until 1983, when the amount was raised to $100,000. Deposit insurance in its new guise set off a major "feeding frenzy." All the best Wall Street houses tried to interest their customers in the magical new security$100,000 bank deposit, fully guaranteed by the federal government, but with interest rates substantially more attractive than for other available securities backed by federal credit. The financial institutions could not believe their good luckdeposits flowing in on the one hand and Milken's bonds available on the other. It was a banker's dreamno work, no risk, and a huge spread between what they paid for money (as the deposit cost was subsidized by the U.S. government) and what they could get by investing it in huge quantities of available junk bonds. Milken invented the ideal merchandise for an ever-willing buyer.

The money machine was now in place, and Milken was quick to exploit the third element, his understanding that the market value of many American companies was substantially below their "real value." Some of this was due to a rather depressed stock market. A great deal of it was due to the fact that the stock market valued each share of stock as a minority share in a company. If one could acquire enough shares to exercise "control" over the company, values could be realized that, on a share basis, were substantially above the publicly quoted price. "Control" plainly was worth a premium, at least at a company with perceived inefficient management. It conveyed the right to determine the corporation's strategy, its capital structure, perquisites for management, and control over its cash flow. Because shares traded in the marketplace with no expectation on the part of the buyer of being able to achieve the control premium, prices did not reflect the underlying value of the business. Thus, for someone in a position to make an offer for all of the stock, a substantial premium over market could be paid and still leave enormous profit. This was the ultimate posture of the hostile takeover movement of the mid-1980s, Milken's money machine in search of the raidersand targets. Nelson Peltz's takeover of National Can, William Farley's successful raid on Northwest Industries, and Stephen Wynn's refinancing of Golden Nugget are only a few of the many examples of Milken's enormous power in this arena.


The Investors Who Can't Say No and The Offer They Can't Refuse


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Milken's money was one side of the deal. But all the money in the world cannot buy something from an owner who does not wish to sell. Milken's buyers found the perfect sellers, and they were able to make shareholders an offer they couldn't refuse. As noted earlier and explained in detail in Chapter 6, by the 1980s a substantial portion of equity securities were in the hands of institutional investors. If Milken had tried to peddle to Junior, tried to get him to give up his Boothbay Harbor investment, he might not have gotten very far. But Milken and the people he funded made their offers to institutional investors, and their nature is an important element in understanding the appeal of the hostile takeover.

Institutions are fiduciaries and are therefore risk-averse. No one ever got the "Fiduciary of the Month" award for coming up with a new idea; fiduciaries are most secure when they are doing what everyone else does. Trustees are paid a fee that is usually a percentage of the assets under management; trustees do not earn incentives through superior performance.29 There is no level of performance that entitles them to a meaningful participation in gains. They have an incentive to manage the property as well as others, so that they will be able to compete for new business, but the laws prohibiting fiduciaries from having interests in conflict with their beneficiaries do not permit payment at a level that would make risk attractive. A trustee thus has no upside potential but has a downside exposure if he acts differently from others similarly situated.

In that context, consider that a tender offer for shares may be at a price substantially higher than cost, market price, or, in many cases, projections for years to come. How can a fiduciary refuse? A good example is the comment by a money manager on the late 1990 AT&T offer for NCR. "As a stockholder, I have to say 'Take the money and run...' It's a major premium on the market by a qualified buyer. I don't see how they can say 'no."'30

Trust law tends to penalize those who lose money by acting differently than other fiduciaries similarly situated, so a cash tender has its coercive aspects in the context of large institutional investor holdings. With this behavior pattern, large institutional ownership in a company came to be taken as the equivalent of a "for sale" sign. Although the government agencies with jurisdiction over institutional investors have consistently said that pension fund trustees are under no "legal" obligation to tender stock to a high cash bidder (most recently in a joint statement by the secretaries of labor and the treasury in the first week of the Bush administration, in 1989), it has had no real impact. Why should it? Is there any possibility they will be at risk for tendering? Not really. Has such a case ever been brought? No. But the legal question is not the real problem. Suppose that an institution had owned MD Oil for several years at an average cost of $20 per share and that a "raider" offers $40. The management may be entirely correct in pointing out that the pro rata value of shares as a percentage of the total value of the company is in excess of $40, but this is cold comfort to a trustee who must periodically account to his beneficiaries for his performance. Suppose that he fails to tender and the tender fails. The price will probably drop from near $40 back to around $29. How is he going to explain his performance? How many years will he have to wait for the full value to be achieved, and how many clients will he lose while he waits? Is he compensated for taking this risk? What does he lose by tendering? In the answers to these questions lies the success of the hostile takeover movement of the 1980s.

In Britain, the country with an institutional ownership pattern closest to ours among OECD nations, hostile takeovers never assumed the epidemic proportions seen in this country. One reason is that in Britain, a shareholder can vote against the tender and still get the tender price if the deal goes through. The system is less coercive. But a possibly more important reason is that the British institutions are in touch with each other, have some shared sense of value, and therefore have the ability to avoid being "cherry-picked" by the acquirer. The impediments to collective action present in this country are minimal over there, which gives British institutions more of a connection, more of a relationship to the companies they invest in, and which thus makes them more like Junior than like Trip. In this country, risk-averse trustees have not yet discovered how to act collectively and how to gain for their beneficiaries a substantial portion of the value gap between market price and the control premium.

Essential to the success of hostile takeovers was the emergence of a class of well-financed "risk arbitragers." These were the mirror image of the institutional investors, the other half that helped make a perfect whole. Arbs, financed by the banks, were precisely the converse of the fiduciaries. Their entire business was to take huge risksfrom which they stood to profit hugely.

When a deal is first announced, the market appraises its likelihood of being consummated. The stock price rises to some amount, usually higher than the previous trading price and lower than the offer, to reflect both the probable final amount and the likelihood of its being paid. In the 46 How We Got Where We Are

instance of UAL, investors drove the price up and down based on "whether or not the airline would be sold.''31 Returning to the MD Oil example, suppose the price rises to $35 on announcement of the proposed tender; what is the position of the institutional investor? Should the investor wait for the last buck, thus taking the chance that something will go wrong and the deal will not be consummated, or sell out and ensure a handsome profit (though less than might be realized by waiting)? This is what is called a market niche, and the arb arrives to fill the niche. Arbs run risks; that's how they make money. Is the fiduciary worried about what to do? Uncle Arb is here to take the risk away.

Here is how it is done: The arb borrows $35 to take the stock off the fiduciary's hands and then sees to it that a transaction does in fact take place; whether it is in the original form or another is only a matter of time and money. The arbs end up with control over the company long before the final denouement. Thus, the offer, by triggering the flight of the fiduciary to the safe profit and moving control to the arbs, is self-fulfilling.

Corporate management see it that way, too, which is why they react so strongly to hostile offers. When Donald Trump made an offer for American Airlines, the airline tried to stop him by going to the United States Congress for special legislation. I spent an afternoon calling American's largest shareholders, asking them what their reaction was. Every one of them agreed that if there was ever a time to support management, this was it. American's management was excellent, and Trump's offer was, to put it kindly, not credible. Every one of them agreed that they would make such a commitment to management, if asked. By the end of the day, I had lined up enough shares to block any hostile offer. But not one of them had been called by management at American Airlines, who were sure that the institutions would have to take any offer that was made to them. After all, when Cummins Engine, trying to protect itself from a potentially hostile acquirer (Hanson), offered its largest institutional investors a seat on the board if they would agree to hold their stock in Cummins for six years, every one of them turned Cummins down.

We use the word shareholder to describe institutions and arbs, individuals with a few shares, and individuals who have enormous blocks and are seeking more to describe both "passive" investors versus "active" investors. But it is clear that we are dealing with very different concepts of equity ownership. On the one hand are the active investors who intend to appropriate control. On the other hand are the institutions who have in effect concluded that they cannot or should not afford to be more active.

With all these pieces in place, all but the largest American corporations were fair game. The amounts involved were so large that the effect was seismic. A fee structure arose for bankers, lawyers, and investment professionals of every kind that quickly converted any question from whether a deal should take place to how it should take place. Bryan Burrough and John Helyar's Barbarians at the Gate (Harper & Row, New York, 1989) pinpoints with devastating accuracy the intrigues and machinations on all sides as everyone wanted a piece of the biggest deal in history.

Without going into detail about the tax advantages of debt financing and purchase price allocation among depreciable assets, we can agree with Michael Blumenthal that "[s]ome would argue that even if the distinction between 'good' and 'bad' deals is correct, nothing should be done. In a free-market environment, investors are best left to their own devices. No regulation or interference should or could save them from their folly. I have much sympathy for that viewpoint, but the problem is that we already have interfered with the free functioning of the market for deals. We have built artificial incentives into the system and created systemic distortions which induce people to make deals that should never be made, or to structure them in irresponsible or dangerous ways."32


Management Defends


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Corporations are ideally suited for self-preservation, which is the definition of the externalizing machine. When they saw what Milken was doing, corporate management proceeded to do whatever was necessary to protect their capacity to direct enterprises, and they found that protecting themselves from raiders meant protecting themselves from shareholders and squeezing any remaining semblance of accountability out of the system. As described in detail in Chapter 3, the notion of management having an enforceable obligation to maximize the interests of ownership was submerged in the expansion of the "business judgment rule." The courts also permitted the creation by management of new captive artificial shareholders, leveraged employee stock ownership plans (ESOPs), literally in the middle of an attempted takeover, with a sufficient percentage of total ownership to block it. The ultimate death of the corporate myth, the theory under which management owed shareholders a greater duty than they owed themselves, came with the widespread acquiescence to the so-called management buyout (MBO).

There were dozens of other colorfully named devices that management used for protection against the hostile takeover deluge. Collectively, they were known as "shark repellents." Some of them were utterly justified, by any standard.33 For a while there was an unconscionable practice called a "two-tier tender offer," which was an all-out robbery of shareholders. A two-tiered tender offer was used to accomplish the largest non-oil takeover in history, R. J. Reynolds' $4.5 billion acquisition of Nabisco in 1985. In such a deal, a buyer would offer, for example, $10 per share over the market price to everyone who tendereduntil 51 percent was received. The last 49 percent to line up would be left, like Oliver Twist, asking for more, and with no better chance of getting it than Oliver had. What they would get would be thinner than Oliver's gruel, for example, notes for the tender amount but not payable for 15 years. Present an offer like this to a group of institutional investors and watch them push and shove their way to the front of the line, for all the reasons just described. After all, fiduciaries were being given a choice between $10 now and $10 in 15 years. The better choice, the $15 or $20 that the buyer would realize from this transaction, was not available. These offers were inherently coercive, as trustees in particular could not legally turn down the offer.34

These offers can be compared to the classic "prisoner's dilemma," where two coconspirators are captured and placed in separate rooms by the police. They are each told that if neither confesses, there will not be enough evidence, and both will go free. If one confesses, only that prisoner will get a reduced sentence. If both confess, both go to jail for a reduced term. Each must sit, unable to communicate with the other, and decide what to do. The dilemma is that an action that may benefit the individual making the choice (whether silence or confession) may have adverse consequences for the group (prison), whereas an action that benefits the group (silence) may have adverse consequences for the individual (prison, if the other confesses). This kind of situation is deemed "coercive" because someone is receiving an inappropriate incentive to do something contrary to his best interests.35 By exploiting self-interest, the police could obtain confessions from both prisoners. If the prisoners could have communicated, however, they would have undoubtedly remained silent. Similarly, a shareholder facing a two-tiered tender offer knows that what is best for the group is for all shareholders to turn it down. But with no way to identifymuch less communicate withthe other shareholders, the only choice is to try to get in the front of the line for the first tier of the offer.


1,000 Poison Pills


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Quite properly, lawyers for corporate management came up with a way to stop two-tier offers. Corporate managers call them "rights plans." Everyone else calls them "poison pills." Nearly 1,000 companies have adopted poison pills,36 most of them since November 1985, when the Delaware Supreme Court upheld a company's right to adopt a poison pill without shareholder approval in Moran v. Household International. The plans generally take the form of rights or warrants issued to shareholders and that are worthless unless triggered by a hostile acquisition attempt. If triggered, pills give shareholders the ability to purchase shares from or sell shares back to the target company (the "flip-in" pill) and/or the potential acquirer (the "flip-over" pill), depending on the circumstances, at a price far out of line with the fair market value. Unfortunately, they not only protect shareholders from coercive tender offers, they also protect managers from shareholders. Even though they are designed as protection and not intended ever to be triggered, the pills are poison, indeed.

The basic function of pills is, simply stated, to confront a hostile purchaser with immediate and unacceptable dilution of the value of his investment. 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. Sir James Goldsmith circumvented the Crown Zellerbach plan by acquiring control through a creeping acquisition. In 1985, Goldsmith ignored the threshold set by Crown Zellerbach's pill and boldly bought enough shares in the conglomerate until he had control. Although the pill made it impossible for him to merge with Crown Zellerbach, he permitted its shareholders to swap their Crown Zellerbach stock for stock in divisions of the conglomerate, thereby dismembering the company. The remaining chunk was sold to a third company, which operated it as an uncontrolled subsidiary. Thus, no company actually "acquired" Crown Zellerbach, so no purchase rights could be flipped over into an acquiring company.37 A more recent example is Instron. Management and family members purchased 39 percent and then issued a statement stating that they would collectively resist any change in control. As a result, a shareholder filed suit (the case has since been dismissed) claiming that the directors have acted as a "controlling group" and inadvertently triggered their own pill. Metaphorically, pills have the impact in corporate wars that nuclear weaponry had in the Cold War: they could not be used.

Depending on the type of pill, the triggering event can either transfer a huge amount of wealth out of the target company or dilute the equity holdings of the potential acquirer's preexisting shareholders. In either case, the pills have the potential to act as doomsday machines in the event of an unwanted control contest, providing a target's board with veto powerall the board has to do is refuse to redeem the pillover takeover bids, even if they are in the best interest of target shareholders. The power of redemption is the crucial issue for shareholders. To date, the courts have allowed target company boards great leeway in deciding when a pill must be redeemed, even in the event of bona fide offers. However, the courts indicated there are limits.38 This is widely believed to be the reason for the 1990 Pennsylvania statute, discussed in Chapter 3, specifically permitting directors to act for nonshareholder constituencies .

Pills have changed form considerably since their inception, in response to court challenges, shareholder complaints, and the development of strategies that have been used successfully in overcoming earlier versions. Currently popular pill plans do not have the strategic shortcomings that were manifested in, for example, the Crown Zellerbach plan.

The widely used flip-over plan gives target shareholders the right to purchase shares of the potential acquirer's common stock at a steep discount to market value, usually 50 percent, should the acquirer attempt a second-stage merger not approved by the target's board. Since the builtin discount would encourage all of the target shareholders to exercise their rights and purchase shares from the acquirer, and since the potential acquirer's shareholders would be prevented from participating, the result would be that the acquirer's preexisting shareholders would find their own equity interests substantially diluted once the pill is triggered and the rights exercised. This is the "poison" in the flip-over plan.

The flip-in plan is often combined with a flip-over plan. Upon the triggering event, rights in a flip-in plan allow target company shareholders to purchase shares of their own company at a steep discount, again usually 50 percent. The right is discriminatory in that the potential acquirer cannot participate. As in the flip-over pill, the potential acquirer is excluded from participating should the flip-in be triggered by a transaction not approved by the target's board. Despite their similarity to discriminatory self-tender offers, flip-in plans have been found to be exempt from Williams Act strictures because they are in the form of a rights plan. The poison in the flip-in is a substantial dilution of the acquirer's position in the target company, which makes the acquisition much more, if not prohibitively, expensive.39

All poison pills raise questions of shareholder democracy and the robustness of the corporate governance process. They amount to major de facto shifts of voting rights away from shareholders to management, on matters pertaining to the sale of the corporation. They give target boards of directors absolute veto power over any proposed business combination, no matter how beneficial it might be for the shareholders; all the board has to do is refuse to redeem the pill, and no bidder would dare trigger its poison. Yet because they are implemented as warrants or rights offerings, the plans can be put in place without shareholder voting approval, under state law, which controls corporate governance.

Managements claim that although the potential for abuse is there, poison pills will not be used against shareholder interests. They say that pill plans are merely designed to ensure shareholders equitable treatment in the event of a takeover bid, specifically, to ensure that two-tier and other coercive acquisitions will not occur. However, effective protection from coercive offers can be obtained through the adoption of a fair price amendment, which provides a far more straightforward protection than does a pill plan, by stipulating equal but not unreasonable treatment for target shareholders. The fair price amendment had been part of the charter of many American corporations. In general terms, this required that a person who acquired a given percentage of a corporation's shares would have to pay a fair price for the balance. With a bit of focus, fair price provisions could have stopped all two-tier offers. In addition, fair price proposals must be approved by shareholders, which means that management has some incentive to design them to ensure shareholder support.

The evidence to date on the value of pills has been inconclusive. One type of study has examined the price movement of company stock following the adoption of a pill. Some have suggested that adoption of a pill increases share value; some say the opposite.40 Another set of studies has focused on how pills are used in practice. Some of these suggest that companies with pills generally receive higher takeover premiums than companies without pills; others disagree.41

Without voting approval, poison pills constitute not just another, more potent takeover defense, but a fundamental threat to the process of corporate governance. They signal that management is able, unilaterally, to substantially redefine the shareholder-management contract.

Why poison pills? Great Britain, as stated earlier, is the country that most resembles the United States in the pattern of public ownership of its largest corporations (since the denationalization efforts of Margaret Thatcher) and the predominance of institutional investors. The same elements of vulnerability to hostile takeover are present there. But Britain's solution through its Take-Over Code has been very different. An acquirer who reaches the 30 percent threshold level is required to make a cash offer for all the remaining shares, and management is barred from interfering with the ultimate offer being communicated to shareholders, who make the ultimate determination. That this entirely sensible solution was not adopted in America is attributable to two factors: the skill of our corporate lawyers (who, after all, are hired and paid by management, not shareholders) and the vagaries of our federal system.


Lawyer's Poker


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Why this solution was not adopted here is another fascinating chapter in the continuing corporate wars. As managements found themselves threatened, they turned to their lawyers and investment bankers for help. Lawyers behaved like businesses and created new and improved productsendorsed as "fair" by investment bankersto replace last year's model. Takeovers quickly lost the characteristics of business transactions and became the province of lawyers and investment bankers. Thus, the solutions and the fees charged for their creation soon lost any relationship to traditional patterns. Management came to believe that their very survival depended on hiring the "best" lawyers and the most aggressive bankers and following their advice beyond any limits thought reasonable in the past. T. Boone Pickens, the consummate raider of the 1980s, found himself relying on the omnipotent Manhattan lawyers to complete his run at Cities Service: "The day was the low point in the [Cities Service] deal; I felt helpless. Then I thought of someone who might be able to help and called Joe Flom.... We got to his office early Wednesday morning. Joe seemed glad to see us and a bit amused; he seemed to be saying 'What took you so long?'42

What is legal has never been limited to what is right. But at no time in commercial history have the top leaders of American industry been so utterly in the thrall of lawyers that concern for enduring or long-term values simply dropped off the agenda. Survival was the imperative; the lawyers were the indispensable means. The future would take care of itself.

Who the "best" lawyers are is no secret; they are very well known. Within the top ranks of corporate America their names are household words. It is genuinely noteworthy for a handful of rather scholarly professionals to acquire the level of influence over a wide spectrum of the country's business as was achieved by Manhattan takeover specialists in the 1980s.

We should pause to meet three of them who were on everybody's list: Joseph Flom of Skadden, Arps, Slate, Meager & Flom; Martin Lipton of Wachtell, Lipton, Rosen & Katz; and Arthur Fleischer of Fried, Frank, Harris, Shriver & Jacobson. On first examination this is an unlikely trio to control corporate America. At the start of the 1980s, they were all respected and their firms were solid, but they were not the "cream of the corporate bar," this distinction being reserved to the old-line firms of Sullivan & Cromwell; Cravath, Swaine & Moore; and Davis, Polk, & Wardwell. Although the three individuals had some promotional skills, they were scholarly rather than flamboyant. Fleischer had worked at the SEC and was the author of a widely respected treatise, and Lipton authored a case book and published law review articles; but there was something special about Flom.

The ascetic-appearing Harvard Law School graduate accomplished nothing less than total revolution in the legal community. So great was his reputation and expertise that American corporations by the hundreds had his firm on retainer simply to ensure that he would not be involved on the other side. When Flom started to practice law, a large firm had 100 lawyers and a single office. At the peak of his career he had managed to build a multinational firm with nearly 1,000 lawyers. Lipton kept his firm substantially smaller, but year after year it achieved the highest earnings per partner of all firms, averaging over $1 million for each of the 46 partners.

These were bold, imaginative, and ingenious people; their capital was in developing new weapons and defenses in the frenzied pace of the corporate wars. They worked hard, prompting Lipton to conclude that if they were smarter than investment bankers and worked harder, they should be paid as well. His $20 million fee in the Philip Morris-Kraft merger for two weeks' work established a new sense of the "value" of lawyers to corporate America.43 As time passes, one can question whether this kind of expense is metaphor for the increasing noncompetitiveness of American industry or for the decline in the reputation of lawyers. It was a rare major transaction that did not involve these threeFlom for the attack in later years, Lipton for the defense. Fleischer probably most of all gave the impression of "fairness," of a wider view, of a traditional role as counselor.


Flom v. Lipton


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The formal law reports say that the "poison pill" was first upheld by the Delaware Chancery and Supreme courts in the case of Moran v. Household.44 The case would more appropriately have been called Flom v. Lipton. This time Marty Lipton won, and it was a very significant victory: it resulted in the adoption of poison pills by almost all major American corporations within a very few years, and, more important, it was another significant blow to the few remaining rights of shareholders.

John A. Moran was a partner in the firm of Dyson, Kissner & Moran, which very quietly and very effectively had been doing leveraged buyouts, takeovers, and reorganizations for 30 years. It is hard to imagine people less likely to involve themselves in such a public brouhaha as a major lawsuit. Dyson had been a partner in one of the Big Seven accounting firms, and Kissner, first in his class at Harvard, had a world-famous collection of rare books. Over the years, they had bought and reorganized literally hundreds of American corporations, becoming in the process among the richest of Americans, even if virtually unknown. Their only moment in the spotlight was when Charlie Dyson managed to make Nixon's "enemies list" by providing office space to former Democratic National Chairman Larry O'Brien on the strength of their sons' having served together in Vietnam.

DKM had merged one of its significant industrial groups into Household, thereby becoming its largest shareholder. John Moran, as director, was also the owner of many millions of dollars of the corporation's equity. Having successfully made deals all his life, it was second nature for John Moran to approach the management about a leveraged buyout of Household. Management preferred independence to well-paid service in the DKM empire. The Household board retained Marty Lipton's firm and, Moran dissenting, adopted a poison pill.

The board declined to consider a fair price amendment out of concern that they may not get shareholder approval. Part of the appeal of the pill was that it could be adopted without the requirement at any time of shareholder approval. Joe Flom argued eloquently:

The underpinning for the Plan and the board's adoption of it was the belief, articulated by director Whitehead, that directors are better able than stockholders to decide whether an offer is fair and should be accepted. On that basis he, and the other directors, justified removing the decision from the owners of the shares and granting it to themselves. If such a fundamental right of personal property can be arrogated simply because the professional managers believe in good faith that they can better exercise it, is any stockholder right immune from seizure? More than 50 percent of Household's shares are held by institutions who are themselves fiduciary holders. On what basis do the Household directors claim to be more capable of deciding at what price to sell shares than these investment professionals? If it is in the interests of Household's stockholders to have their directors decide whether a tender offer is acceptable, why have the directors been unwilling to ask the stockholders for this power?45
The Delaware court knew what was at stake and chose to ignore it.46 This decision thus holds that management, having a choice between equally effective mechanisms to deal with the problems of "coercive offers," may choose the one carrying no legal requirement to seek approval by shareholders, and that the board of directors is the ultimate decider as to whether a corporation is to be sold.

This was the first of many steps that would result by the end of the 1980s in shareholders having virtually no capacity for involvement in the important questions regarding the long-term direction of their corporation. This case illuminates the way that management, with control over the corporate pocketbook and professional relationships, has the ability to advance its own interests, even when they conflict with those of the owners. Management's agenda over the rest of the decade has been the successive denial to shareholders of even their minimal traditional rightsto elect the full board at the annual meeting, to call special meetings of shareholders, to act by referendum between meetings, to vote without revealing their identity, and even to freely transfer their shares to a willing buyer at a mutually agreeable price.

It has become clear that courts will not protect shareholder rights or values. One of the reasons may well be frustration with the automaton character of the risk-averse institutional investor and its resulting tendency of putting all corporations up for sale. During the oral argument of the Time-Warner case (broadcast live on CNN), the judges asked what percentage of stock was held by institutional shareholders. Possibly, the development of a class of genuinely long-term holders who do not "shirk" their responsibility might give judges a different perspective. But, as discussed in Chapter 3, through ignoring or even denying the self-interested nature of many management decisions, courts have broadened the deference given to boards and officers under the "business judgment rule," producing increasingly grotesque results.

Certainly, courts should not second-guess the business judgment of managers and directors, any more than shareholders shouldunless those making the decision in question have conflicts of interest that provide a real or apparent impediment to their acting as fiduciaries for shareholders.


The Delaware Factor and the Polaroid ESOP


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The "Delaware factor"the commitment of Delaware to being a hospitable forum for major corporation managements explains the otherwise incomprehensible chancery court approval of the Polaroid employee stock option plan (ESOP). The Roy Disney organization, pleasant but tenacious, headed by Stanley Gold, had been accumulating a position of slightly less than 4 . 9 percent of Polaroid's stock during the first half of 1988. On June 22, Roy Disney wrote asking for a meeting "to establish the ground work for a good relationship with the Company." Polaroid imposed several conditions, with which Disney complied at considerable expense, and agreed to a meeting to be held on July 13 in New York. The board hastily convened a special meeting on July 12. Polaroid CEO I. MacAIlister Booth explained to the board that everyone wanted to put together an ESOP quickly because of the Shamrock meeting. "The meeting was called on less than one week's notice and, as a result, three outside directors were unable to attend and a fourth had to leave the meeting before any votes were taken. Contrary to the general practice, the directors received no written materials prior to the special meeting."47 The directors had never considered an ESOP as large as $300 million (indeed, this was three times the size earlier discussed) or the likely impact that a 14 percent ESOP would have under the new Delaware corporation law. As a practical matter, an acquisition cannot be made unless 85 percent of the shares are obtained. The court blithely concluded: "The ESOP may mean that a potential acquirer will have to gain the employees' confidence and support in order to be successful in its takeover effort. However, there has been no showing that such support is or would be impossible to obtain."48 Perhaps this is the place to point out that it is not the employees' confidence and support that are necessary to get the votes of the ESOP shares. The trusteeappointed by managementvotes the "unallocated" shares in an ESOP, virtually all of them when the ESOP has just been created, and it is highly unlikely that they would vote those shares against themselves.49

In the world of common sense, when a hastily convened board meeting inadequately considers a major change in the corporation's capital structure by creating a 14 percent ESOP in the face of a potential acquirer who needs 85 percent, a "defensive" action has been taken. The practical impossibility of ever obtaining the requisite majority is manifest. But in the world of the "Delaware factor," 0.5 percent is all that is needed to manifest management commitment to shareholders.


American KeiretsuCorporate Partners

When Shamrock Holdings indicated an interest in acquiring Polaroid in July 1988, the management of Polaroid mobilized their defenses quickly. Besides the now-classic maneuver of selling a 14 percent stake in the company to their own Employee Stock Ownership Plan and buying $1.1 billion of their stock back on the open market, Polaroid began shopping a major piece of the company to a single, friendly investor. By January 1989, Corporate Partners, a so-called "white squire" fund allocated by Shearson Lehman, agreed to purchase a $300 million block of preferred, which at the time could be converted into over 6 million shares, or 7.7 percent of Polaroid's total votes. Because of the structuring of the deal, which included pay-in-kind dividends of stock, Corporate Partners' holdings have grown over time. As of 15 January 1991, the Corporate Partners' shares could be converted into 6.97 million shares, representing 12.2 percent of Polaroid's votes. The Corporate Partners deal, however, was more than a simple management-saving device, due in part to the conscience of Lester Pollack, who heads the concern.

Corporate Partners was conceived in 1986 as an investment concern that would purchase stock in only a few companies, but would take a large and active role in each company. In all five companies Corporate Partners currently invests in, Pollack or a representative of Corporate Partners sits on the board. Investors in the $1.645 billion fund, which consists of banks, insurance companies, and public and private pension funds, in effect pay Pollack to be an active director. Because Corporate Partners' investments typically include special privileges, in effect the shareholders pay him, too. But they get what they pay for. Warren Buffett has played the same role at other companies.

David Gollub, vice president of Corporate Partners, explains Corporate Partners' approach this way: "We have a small number of investments, a deep relationship with management in those companies we invest in, a staff that can support Lester in his role as director so he can stay fully apprised of events, and a significant financial stake in each company."

In the case of Polaroid, Corporate Partners received between 11 and 11.5 percent guaranteed annual return, immediate voting rights equivalent to 6 million common shares, and two board seats. Pollack holds one seat. The other is held by Delbert Staley, the former CEO of NYNEX. And unlike the placement deals at Cummins Engine, Pollack's Corporate Partners is under no obligation to vote with management. Explains Pollack: "I entered the board unfettered, but constructive, clearly with the benefits of shareholders first. With $300 million invested in the company, if shareholders benefit, we benefit." As a board member, Pollack believed that this views "have some weight from having done the investment analysis in due diligence and owning a major economic stake, which means I have a more active knowledge of the company and more of a stake in its stock performance than an ordinary director."

Before investing, Corporate Partners completed a review of Polaroid's books and investigated Polaroid's proposed restructuring. In effect, Corporate Partners did not come to the aid of Polaroid as much as they came to the aid of the restructuring and subsequent business plan. Corporate Partners, in Pollack's words, was an entity that "bought into the corporation's plan. We could see the benefits of a restructuring, recapitalization, and a business plan that would lead to long-term growth, all of which would increase shareholder wealth. We could buy a stake, and they could keep their leverage low." Implicit in the agreement was the fact that Corporate Partners would not necessarily be a "friendly" presence if management reneged on the restructuring.

"I see it this way," says Jonathan Kagan, Corporate Partners' managing director. "Eighty percent of institutional investors are legitimate long-term investors. Now, let's say eighty percent of corporations want to benefit shareholders. So they have the same interests, but they often miss each other in the night, and a level of distrust often exists between most corporations and their shareholders. These groups can find each other by finding someone who can bridge that gap. That's where we come in." Corporate Partners represents a new breed, perhaps a hybrid of institutional investor. While many investors purchase blocks in hundreds of companies, hoping that the economy as a whole will bring them profit, Corporate Partners selects only a few companies, and becomes a knowledgeable, active force in those companies, promoting the long-term business strategies that create shareholder value.


One of the most notorious abuses of a company's ESOP was the Carter-Hawley Hale defense against a tender offer from The Limited. When The Limited announced its offer in April 1984 of $30 per share, a 50 percent premium over the present market price, the Carter-Hawley Hale ESOP covered 56,000 employees and held nearly 40 percent of the outstanding stock. The plan was administered by the trust department of the Bank of America, a bank where Carter-Hawley Hale chairman and CEO Philip M. Hawley served on the board as chairman of the compensation committee. Bank of America had been the company's primary lender, to the tune of $75 million in outstanding loans and credit lines in 1988. Bank of America also agreed to loan $900 million to help Carter-Hawley Hale resist The Limited's offer and revised their loan agreements to provide that, if CHH suffered a change in control, all loans would be in default. Carter-Hawley Hale paid the Bank of America an up-front fee of $500,000.

The conflicts of interest were mind-boggling. As Ben Stein notes, "Bank of America was supposed to administer the plan in the interests only of the stockholder-employees. But it was simultaneously in the active, highly paid service of CHH management, a party with a life or death interest in how the shares were voted.... The interests of the shareholder-employees and the interests of CHH management were, at least apparently, sharply different, and the trustee for the employees was getting paid by CHH management."50

Bank of America had a "pass-through" policy in its contract to provide for such situations: If CHH was subject to a tender offer, the bank would detail the terms of the offer to employee-shareholders, who would then vote confidentially whether they wanted to tender. If 50 percent of the ESOP stock supported the tender offer, all the shares would be voted for the offer; otherwise, all shares would be voted against it. But when The Limited announced its offer, the Bank of America revised its policy to one that could not guarantee confidential voting. The bank also informed employees that all unvoted shares would be voted for management, as would the 800,000 unallocated shares.

The ESOP proved a vital factor in The Limited's decision to give up the chase. Management at Carter-Hawley Hale demonstrated that they would stop at nothing to retain their positions, buying nearly 18 million of their own shares in one week and selling a $300 million chunk of preferred stock, representing 37 percent of the vote, to General Cinema, a friendly third party.

The Limited picked up the pursuit again in 1986, however, and ran into problems with the ESOP again. The Bank of America had new rules for voting Carter-Hawley Hale's ESOP: In the event of a tender, employees could do nothing and have their share voted for management, or they could ask for their share certificates. Since the share certificates were kept at Carter-Hawley Hale, management could easily figure which employees did not want management to vote their shares. Furthermore, the trustee insisted that six to eight weeks were necessary to send the certificates, and The Limited's offer only lasted five weeks from the date it was announced. In all respects, members of the Carter-Hawley Hale ESOP had no choice but passive support for management the second time around. The directors, however, still didn't let it go to a vote, turning down The Limited's $60 per share offer in favor of a restructuring.

The final word on ESOPs has yet to be written. The Department of Labor consistently takes the view that the voting of unallocated shares by "formula" violates fiduciary requirements, and yet this remains the operative provision in many plans. It is not at all clear what elements must be demonstrated to satisfy that the trustee bank is "independent" of the plan sponsor. In the absence of definitive guidelines, the field is expanding chaotically in many directions, right up to NL Industries' allegation, in connection with its 1990 proxy contest, that Lockheed's management intends its ESOP to acquire an actual majority of the outstanding capital stock and, thereby, control of the company itself.51 When and how these allegations will be disposed of by the judicial system is unknown, but the language of the complaint itself provides the clearest indication of the theoretical possibilities of the ESOP as the "ultimate entrenchment device."


An ESOP's Fable: NL Industries' Complaint

16 The Lockheed Board of Directors approved the ESOP on April 3, 1989. That same day, the ESOP Trust was established and U.S. Trust Company of California, N.A. appointed as trustee. On April 4, the ESOP was funded through a circular series of transactions, the effect of which was that Lockheed borrowed $500 million to buy its own shares to place them in hands friendly to the incumbent directors and management.

17 The ESOP borrowed $500 million from private sources and used those funds to "purchase" 10.7 million common shares from Lockheed. Lockheed, however, guaranteed the loan and is contractually obligated to the ESOP to provide sufficient funds to pay all debt service, regardless of the company's earnings and profits. The entire unpaid balance of the loan is treated on Lockheed's books as Lockheed's debt and, correspondingly, a reduction in shareholders' equity.

18 The ESOP shares were put into a "suspense account," where they serve to collateralize the loan. Shares held in the suspense account are "unallocated." Over time, these unallocated shares are credited to the accounts of individual workers through the mechanisms of the Lockheed Salaried Employee Savings Plan Plus. 19. Under this plan, compensation contributed by participants to any of four funds is matched by Lockheed up to specified levels. Lockheed's match takes the form of contributions to the ESOP trustee to pay off the ESOP debt, which contributions then "release" shares from the suspense account. The released shares are allocated to the accounts of plan participants as "match stock."

20 No worker has any assurance that he or she will eventually own unallocated shares. If the worker quits, is fired, or retires, he or she cannot buy any more shares. Moreover, Lockheed has expressly reserved the right to terminate the ESOP at any time. In the event of plan termination, the unallocated sharesi.e., the shares in the suspense accountare to be "sold back" to Lockheed or to some other person and the proceeds are to be used to pay off the loan. If there is a shortfall, Lockheed must make up the difference.

21 Even after the shares are allocated, workers do not own them. They do not have even a partially vested interest in their match stock until one year after it is credited to their accounts. Moreover, they do not have a fully vested interest in the match stock until four years after the date it is allocated to them. The ESOP was implemented less than a year before workers voted in this proxy contest. Thus, the match stock allocated to workers' accounts was not even partially vested when they voted those shares.

22 Until workers perform services to ensure the allocation and vesting of match stock, they have not paid for, and do not own, either the unallocated shares held in the suspense account or the match stock credited to their accounts.

23 So far, according to information distributed by the ESOP trustee during the proxy contest, approximately I million shares have been allocated from the suspense account to individual employees' accounts as ESOP match stock. Approximately 800,000 more shares have been purchased by employees directly through their salary contributions to the ESOP. Approximately 10 million ESOP shares remain unallocated in the suspense account.

24 Notwithstanding that the unallocated shares and match stock have not been paid for, and might never be paid for, Lockheed and the incumbent directors have provided that these shares shall be voted. Under the voting provisions of the ESOP, a worker who has ESOP match stock credited to his account can instruct the trustee not only on how to vote those shares, but also on how to vote a proportionate number of unallocated shares.

25 As a result, the ESOP permits salaried employees, including management, who own about I percent of Lockheed's outstanding shares to vote a block of over 17 percent which they do not own. NL and every other non-company shareholder of Lockheed receives only one vote for every share of common stock purchased. The ESOP plan participants as a group, however, currently have 15 votes for every share of common stock they own through the ESOP. This is true even though there is no assurance whatsoever that an employee who votes unallocated shares or unvested match stock will ever own those shares.

26 Defendants structured the ESOP voting provisions so that all unallocated shares must be voted, even if a substantial percentage of ESOP participants choose not to vote. If any employee chooses not to vote his or her portion of the unallocated shares, the ESOP plan requires the trustee to vote those shares in the same proportions as instructions received from other plan participants. In this way, the ESOP plan places disproportionate influence over the voting of unallocated shares in the hands of senior employees and management, who may believe their futures are linked to re-election of the incumbent board, and who, therefore, have the greatest incentive to vote for management.

27 The defendants' decision to transfer supervoting power to a select employee group has been costly for Lockheed's shareholders. In 1988, Lockheed paid $71 million in matching contributions under the employees' savings plan. In 1989, when the ESOP was established, Lockheed increased the level of its matching contributions to $82 million. In addition, Lockheed paid $14 million in dividends on the unallocated shares in the suspense account and another $9 million to cover the shortfall between the ESOP's debt expense and Lockheed's matching contributions plus the dividends. No employee concessions were made in exchange for this increased funding from Lockheed.

28 There is no telling how much more the ESOP will cost shareholders in the future. The price per share "paid" by the ESOP was about $47. When an ESOP loan repayment is made, shares are released from the suspense account based on the $47 price. However, when the released shares are allocated to individual employees' accounts as Lockheed's matching contribution, they are valued at the current market price (currently about $37 per share). If the current market price is lower than $47, Lockheed must make up the difference by contributing additional cash or shares to the ESOP trustee who, in turn, allocates more match stock to employees. Thus, the lower the price of Lockheed's stock, the greater the expense of the ESOP to Lockheed's shareholders.

29 In addition to the increased cost to Lockheed shareholders described in paragraph 28, another consequence of the ESOP is that more shares of Lockheed stock are placed in friendly employee hands as matching contributions when Lockheed stock performs poorly than when it trades at $47 per share or higher. The poorer the stock performs, the greater the percentage of outstanding shares controlled by Lockheed workers through the ESOP.

30 The ESOP has diluted the holdings of other shareholders. When the incumbent directors set up the ESOP, they said that dilution would not occur because the company would repurchase on the open market approximately the same number of shares transferred to the ESOP (10.7 million). The buy-back program was suspended, however, after less than 7 million shares were repurchased.


Source: Complaint, NL Industries v. Lockheed, Case 90-1950 RMT (BX) in the United States District Court for the Central District of California.
A recent amendment to the complaint alleges that, in reality, the ESOP is contemplated to purchase not only 17 percent of the total outstanding shares but actual control of Lockheed.


Where You Stand Depends on Where You Sit

Even in the post-Milken 1990s, the market for corporate control continuesand continues to make headlines. As we write, Matsushita is acquiring MCA for $6.6 billion, the latest in a series of international business combinations. Perhaps more emblematic of the future of the corporate control market is the prospective hostile takeover of NCR, not by Carl Icahn or Donald Trump, but by blue-chip behemoth AT&T. Perhaps there was some AT&T director who sensed the irony in approving the hostile takeover; the directors include Cummins CEO Henry Schacht, Philip Hawley, who defended Carter-Hawley Hale with an excessive amount of leverage that ultimately bankrupted the company, and Drew Lewis, president of the Business Roundtable, an organization that has consistently defended management's interests. It will be interesting to see how these directors respond to NCR's claims that its corporate culture and corporate constituencies require its continued independence.



America in the Global Market


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Any discussion of the role of owners in American corporations must include a global context. Both our products and our stock compete in global markets. Foreign companies are increasingly aggressive in taking over American businesses. And institutional investors, America's "sleeping giants," are increasingly investing in equity securities denominated in foreign currencies. For these reasons, it is important to examine the governance structures abroad. It is immediately clear that ours is the only system without meaningful accountability to owners.

The world can be divided into three parts. In the United States and the United Kingdom, the major corporations are preponderantly publicly owned, and accountability, to the extent it exists, arises out of the pattern of large institutional ownership. The big difference is that in the United Kingdom, the institutional investors work together and with management on questions of overall direction. There has not been a proxy fight in Britain, in recent memory. The issues are settled earlier in the process, through discussion. And the institutions have joined together to fund ProNED, a clearinghouse/headhunter organization, to recommend independent director candidates for corporate boards.

In the United States and the United Kingdom, companies rely on the marketplace as a source of capital. The majority of outstanding shares can be purchased "in the market." Elsewhere corporate control is not for sale. Takeover battles like those we saw here in the 1980s do not occur in the United Kingdom because the institutional investors are able to make "midcourse corrections" at an earlier stage. They are simply not possible elsewhere because the shares necessary for obtaining control are not in the market.

In Germany and Japan, control over major enterprises is held by "permanent" shareholders, who have very close surveillance over operations. In the continental European Community (exclusive of Germany), private and governmental ownership is the pattern. In both cases, corporate management is accountable to "permanent" owners. In Germany, the universal banks own up to 20 percent of the total of outstanding capital, and, because the custom there is to use "bearer" shares (rather than "registered" shares, as is the case here), the banks also vote enough proxies to be able to exercise voting control at shareholder meetings. The German banks are capable of exercising the most direct control over portfolio companies, as in the recent example of the Deutsche Bank changing the management of Daimler Benz.

Shareholding in Japan is an element of the industrial paradigm. Each company is "owned" by its customers and suppliers. It is interesting to note, as we shall later discuss, that this is a pattern emulated by Cummins Engine in the summer of 1990, when it sold a 27 percent stake of the company to Ford, Kubota, and Tenneco. It is an essential part of the commercial relationship. The pattern by which manufacturers relate to suppliers and customers is one of mutual dependency and accountability. The Japanese industrial groupings involve an intensive interrelationship that is not primarily concerned with profit in our sense.

In other countries there seems to be virtually no agreement as to what constitutes profit and what relationship "profit" may have to the value of the shares. Thus, in Japan, some of the largest companies are only marginally profitable in the American sense, but they have been successful in achieving huge increases worldwide in market share. Turning to the example of the American auto industry in the 1980s, one can speculate which measure of "profit" is the more meaningful. Is it the record levels of profit reported in the United States that were coupled with stock repurchase and loss of market share, or the marginal earnings reported by such companies as Mitsubishi Corporation and their expansion of manufacturing base and market share within the United States?

In the industrial companies of other countries, debt and bank capital are more prevalent as the financing modality. Figure 2, which was prepared as part of a study for Great Britain's Department of Trade and Industry,52 illustrates the great discrepancy between the United Kingdom structure, with extensive reliance on stock market equity capital, and that of the balance of the EC countries, with far greater emphasis on banks as the source of industrial financing. This study suggests the relative unimportance of "institutional investors," as we know them, in continental Europe. They are not significant holders of equity securities and do not participate in corporate governance. "Institutional" holdings (as of 1986) are concentrated in four member states, with totals as follows (in millions of pounds): France 148, Netherlands 147, and Germany 142, which, taken together, total less than the holdings of UK institutions (580). On the continent, only the Dutch pension funds could be considered a major institutional investor, with £100 million.53


Privatization: The LBO as the Model of the Future Corporation


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The typical shareholder of a modern large business enterprise is different from the owner of tangible property: the ownership of the former is both indirect and temporary. Treating the shareholder of a large modern corporation as a traditional owner entitled to the legal protection of his or her unique right of property fails to consider the gradual change in ownership over the last 50 years from the direct and permanent to the indirect and temporary.54


The Evaporation of Property

The capitalist process, by substituting a mere parcel of shares for the wall of and the machines in a factory, takes the life out of the idea of property. It loosens the grip that once was so strongthe grip in the sense of the legal right and the actual ability to do as one pleases with one's own; the grip also in the sense that the holder of the title loses the will to fight, economically, physically, politically, for his" factory and his control over it, to die if necessary on its steps. And this evaporation of what we may term the material substance of propertyits visible and touchable realityaffects not only the attitude of holders but also that of the workmen and the public in general. Dematerialized, defunctionalized and absentee ownership does not impress and call forth moral allegiance as the vital form of property did. Eventually, there will be nobody left who really cares to stand for itnobody within and nobody without the precincts of the big concerns.

Joseph A. Schumpeter


Source: Capitalism, Socialism, and Democracy; Harper & Row, New York. 1942, p. 142.
When ownership of property involves responsibility, risk and reward are properly matched and accountable to each other. An owner of tangible property is required to avoid causing nuisance to others. Yet even this limited responsibility has been obscured in the context of shareholders. Harvard Business School professor Michael Jensen suggests that the optimal corporate mode is a company in which the managers are the equity owners and the basic capitalization is debt.55 In his view, the debt serves as a discipline, and the alignment of managers' interests to be congruent with those of owners eliminates what the lawyers call conflict of interest and the economists call agency costs. It is this "cost" that has contributed to the lack of competitiveness of American industry. Jensen writes:

The current trends do not imply that the public corporation has no future. The conventional twentieth century model of corporate governance disperse public ownership, professional managers without substantial equity holdings, a board of directors dominated by management-appointed outsidersremains a viable option in some areas of the economy, particularly for growth companies whose profitable investment opportunities exceed the cash they generate internally.... The public corporation is not suitable in industries where long-term growth is slow, where internally generated funds outstrip the opportunities to invest them profitably, or where downsizing is the most productive long-term strategy.56

In effect, Jensen concludes that the legal and commercial restrictions on effective monitoring by shareholdersparticularly institutional investorsinevitably will lead to inefficiencies that require privatization or going out of business. Michael Jensen has looked at the same question that bothered Adam Smith and Karl Marxthe problem of making a manager care as much about the value of the company as the investor and like them, he has decided it is insoluble. Unlike Smith and Marx, Jensen had the chance to examine years of historical and empirical data, but his conclusions are consistent with their theories. In other words, after less than a century, there is serious question as to whether the modern corporate form has become obsolete.


The Psychological Difference Between Debt and Equity

Equity is soft; debt is hard. Equity is forgiving; debt is insistent. Equity is a pillow; debt is a dagger. Equity and debt are the yin and yang of corporate finance. Equity lulls a company's management to sleep, forgiving its sins more readily than a deathbed priest. A surplus of stock muffles the alarms that should be heard when earnings decline. Forgive and forget is equity's creed.

But put a load of debt on that same company's books and watch what happens when its operating profits begin to fall off even a little bit.... But the actual problem is the same.... it just feels a lot more pressing if debt is at the door.... what a perfect device for the land of Disney and Coca-Cola, where illusion is more important than reality.

G. Bennett Stewart III


Source: The Quest for Value, Harper Collins, New York, 1991, pp. 580-581.


Endnotes


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1 See Austin v. Michigan State Chamber of Commerce (for discussion, see Chapter 1).
2 Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations, vol. 2, University of Chicago Press, Chicago, 1976, pp. 264 265.
3 Brandeis, dissenting in Liggett v. Lee, 288 U.S. 517, 458 (U.S. Sup. Ct. 1933).
4 John P. Davis, Corporations, vol. 2, Capricorn Books, New York, 1961, p. 246.
5 John C. Coffee, "No Soul to Damn, No Body to Kick: An Unscandalized Inquiry into the Problem of Corporate Punishment," Michigan Law Review, 79, January 1981, p. 388.
6 Harvey H. Segal, Corporate Makeover: The Reshaping of the American Economy, Viking, New York, 1989, pp. 5-6.
7 Smith, The Wealth of Nations, vol. 2. p. 265.
8 John Brooks, Once in Golconda (Harper & Row, New York, 1969), gives the account of the downfall of Richard Whitney, founder of Richard Whitney & Co., a prominent bond firm. Another prominent businessman who was forced to defend his business practices was Albert H. Wiggin, the head of Chase National Bank, who shorted the stock of his own firm, making $4 million on the 1929 stock market crash.
9 Segal, Corporate Makeover, p. 2.
10 Betty Linn Krikorian, Fiduciary Standards in Pension and Trust Fund Management, Butterworth Legal Publishers, Boston, 1989, p. 187. The discussion of the mechanics of the proxy system is adapted from pp. 187-193.
11 William Z. Ripley, Main Street and Wall Street, Scholars Book Co., Lawrence, Kans., 1972 (reissue of original edition of 1926), pp. 78-79. The quotation from Brandeis is not from his opinions on the Supreme Court, but rather from testimony before the Commission on Industrial Relations, January 23, 1913.
12 James Willard Hurst, The Legitimacy of the Business Corporation in the Law of the United States: 1780-1970, University of Virginia Press, Charlottesville, 1970, pp. 82-83. "[I]n Dodge Brothers v. Ford Motor Company: management's prime obligation was to pursue profit in the interests of shareholders and not to adopt pricing policies designed to promote the interests of wage earners or to effect wider sharing on the gains of improved technology." Interestingly, in light of the current "stakeholder" rhetoric, the court refused to enjoin the price reduction, observing that Ford's policies had benefited shareholders in the past and might do so again. The only thing the court ordered was a distribution of excess surplus.


13 A.P. Smith Mfg. Co. v. Barlow, 98 A.2d 581 (N.J. 1953).
14 Ripley, Main Street and Wall Street, p. 98.
15 Benjamin Graham and David C. Dodd, Security Analysis, 1st ed., McGraw-Hill, New York, 1934, p. 509.
16 Ibid.
17 Graham and Dodd, Security Analysis, 4th ed., 1962, p. 664.
18 Maryann Keller, Rude Awakening: The Rise, Fall, and Struggle for Recovery of General Motors, William Morrow, New York, 1989, p. 49.
19 The effects of increasing the number of shares, and thus holders, has become increasingly limited due to the rise of institutional investors.
20 Albert O. Hirschman (Exit, Voice, and Loyalty: Responses to Decline in Firms, Organizations, and States, Harvard University Press, Cambridge, Mass., 1970, p. 4) noted that deterioration in performance of an institution produces two options for its members and consumers: exit ("some customers stop buying the firm's products or some members leave the organization") and voice ("the firm's customers or the organization's members express their dissatisfaction directly to management or to some other authority to which management is subordinate or through general protest addressed to anyone who cares to listen").
21 Nathan Rosenbery and L.E. Birdsall, Jr., How the West Grew Rich: The Economic Transformation of the Industrial World, Basic Books, New York, 1986, p. 229. (Emphasis added.)
22 Pension plans in the aggregate own some 25 percent of all publicly held equity in U.S. companies (William Taylor, "Can Big Owners Make a Big Difference?" Harvard Business Review, September/October 1990, p. 5). Of this equity held in pension funds, two-thirds is in defined benefit plans.
23 Daniel Fischel and John H. Langbein, "ERlSA's Fundamental Contradiction: The Exclusive Benefit Rule," University of Chicago Law Review, 55(4), September 1988, pp. 1 105-1 160.
24 John Brooks, The Go-Go Years, Weybright and Talley, New York, 1973, p. 155.
25 Ibid., p. 181.
26 Edward Jay Epstein, Who Owns the Corporation? Management vs. Shareholders, Priority Press, New York, 1986, pp. 24-25.
27 Paul Zane Pilzer and Robert Deitz, Other People's Money: The Inside Story of the S&L Mess, Simon & Schuster, New York, 1989, p. 146.
28 In another sense, in terms of the role that the money played in the corporation, he turned stock into a bond. Thus, another of Milken's accomplishments was removing the limits imposed by accountability to shareholders. The investors in junk bonds were providing the kind of capital usually provided by stockholders, but they had none of a stockholder's ownership rights.
29 The Department of Labor in 1985 issued a release permitting incentive compensation in limited cases.
30 Randall Smith, John J. Kelle, and John R. Wilke, "AT&T Launches $6.12 Billion Cash Offer for NCR After Rejection of Its Stock Bid," Wall Street Journal, December 6, 1990, p. A3.
31 Doug Carroll, "UAL a Year Later: Still Up in Air," USA Today, October 9, 1990, p. 8B.
32 W. Michael Blumenthal, "How to Tell Good LBOs from Bad," Washington Post, January 1, 1989, p. B4.
33 One particularly heinous raider tactic was the "Saturday Night Special," whereby a raider would get agreements to purchase 51 percent of the stock and buy it all on a Saturday night. When the market opened on Monday, the deal was over. The Williams Act of 1968 put a stop to this tactic and "leveled the playing field."
34 Efficient market theorists argue that the initial offer for 51 percent would have to contain such a premium as to make the ultimate "blended" price a fair market value.
35 For discussion of the prisoner's dilemma, see Robert Axelrod, The Evolution of Cooperation, Basic Books, New York, 1984.
36 Ray C. Smith, The Money Wars, Dutton, New York, 1990, p. 145. See also "Majority of Large Corporations Have Adopted Poison Pills, IRRC Finds," BNA Securities Regulation & Law Report, 22(47), November 30, 1990, p. 1659.
37 Epstein, Who Owns the Corporation? p. 33.
38 See Grand Metropolitan PLC v. Pillsbury, 558 A. 2d 1049 (Del. 1049).
39 A third type of pill, the voting rights plan, hinges on the dilution of the acquirer's voting rights rather than financial dilution. Under this type of plan, should the acquirer trigger the pill, the target shareholders would receive supervoting rights for each share of stock they held, while the acquirer's would be nullified. Few companies have adopted this sort of pill, however, since Asarco's voting rights plan was struck down by the New Jersey courts in Asarco, Inc. v. M.R.H. Holmes a Court, 611 F. Supp. 468 (D.N.J. 1985).
40 See, for example: Analysis Group, Inc., The Effects of Poison Pills on Shareholders: A Synthesis of Recent Evidence, Belmont, Mass., November 4, 1988; Office of the Chief Economist, Securitities and Exchange Commission, The Economics of Poison Pills, March 5, 1986; Office of the Chief Economist, Securities and Exchange Commission, The Effect of Poison Pills on the Wealth of Target Shareholders, October 23, 1986; Michael Ryngaert, "The Effect of Poison Pill Securities on Shareholder Wealth," Journal of Financial Economics, 20, 1988, pp. 377-417; and Nancy Sheridan, Impact of Stockholder Rights Plan on Stock Price, Kidder, Peabody & Co., New York, June 15, 1986.
41 Analysis Group, Inc. The Effects of Poison Pills on Shareholders: A Re-Analysis of Georgeson's Sample, Belmont, Mass., December 1988; Ryngaert, "The Effect of Poison Pill Securities on Shareholder Wealth"; Richard Wines, Poison Pill Impact Study, Georgeson & Co., New York, March 31, 1988; and Richard Wines, Poison Pill Impact Study 11, Georgeson & Co., New York, October 31, 1988.
42 T. Boone Pickens, Boone, Houghton Mifflin, Boston, 1987, pp. 156 157. Anyone who doubts the exorbitant fees of corporate lawyers need only read the next paragraph, when Flom simply suggests, "Why don't you make a Dome-Conoco offer?": "It was a million dollar suggestion, and that's about what he billed us."
43 Stephen J. Adler and Laurie P. Cohen, "Even Lawyers Gasp over the Stiff Fees of Wachtell Lipton," Wall Street Journal, November 2, 1988, p. Al.
44 500 A.2d 1346 (Del. 1985).
45 Reply brief of appellants, John A. Moran and the Dyson-Kissner-Moran Corporation, May 7, 1985, p. 5.
46 "In addition appellants contend that the deterrence of tender offers will be accomplished by what they label 'a fundamental transfer of power from the stockholders to the directors.' They contend that this transfer of power, in itself is unauthorized. The Rights Plan will result in no more of a structural change than any other defensive mechanism adopted by a board of directors" [Moran v. Household, 500 A.2d 1346, 1354 (1985)].
47 Shamrock v. Polaroid, 559 A.2d 257, 267 (Del. Ch. 1989); also see 559 A.2d 278 (Del. Ch. 1989).
48 559 A.2d 257, 274 (Del. Ch. 1989).
49 Although the Polaroid ESOP mandated that the trustee vote the unallocated shares, in the same proportion as the allocated shares, the Department of Labor has said that ESOP trustees are fiduciaries, and the "decision whether to tender employer stock held by a plan with regard to a tender offer for the plan sponsor is a fiduciary act plan asset management." Thus, the trustee has sole voting authority for the unallocated shares, regardless of how the allocated shares are voted. See letter from Alan D. Lebowitz, Deputy Assistant Secretary for Program Operations, February 23, 1989 (the Polaroid letter).
50 Benjamin J. Stein, "A Saga of Shareholder Neglect: Whose Interests Was This Management Protecting?" Barron's, May 4, 1988, p. 9.
51 Complaint filed in NL Industries v. Lockheed, case 90-1950 RMT (Bx) in the United States District Court for the Central District of California.
52 Coopers & Lybrand, Barriers to Takeovers in the European Community, vol. 1, the Department for Enterprise, Her Majesty's Stationary Office, London, 1989, p. 15.
53 Ibid., pp. 11-12.
54 Hurst, Legitimacy of the Business Corporation, p. 104.
55 Michael Jensen, "The Eclipse of the Public Corporation," Harvard Business Review, 67(5), September-October 1989, p. 61.
56 Ibid., p. 64.