The case against Bear Stearns fizzled out after that. The plaintiffs saw the impediments to halting the transaction, withdrew their preliminary injunction motion before the New York court, and decided to pursue a monetary damages claim. Presumably, they decided that a monetary damages remedy, if any, would be more palatable to the court then enjoining the transaction and destabilizing the financial system. The plaintiffs’ attorneys were wrong. Their claim was subsequently dismissed by the New York court on December 4, 2008.59
On May 31, JPMorgan acquired Bear Stearns. At the time, it was greeted with great publicity and fanfare worthy of a funeral, but the public did not yet know what was to follow. Bear Stearns was only the first of a number of failed and acquired investment banks heralding the eventual destruction of the model. In hindsight, Bear Stearns’s shareholders were lucky to get their measly $10 or so a share.
Lessons Learned from Bear’s Fall
The Bear Stearns case said as much about dealmaking as it did about government intervention. First, the Bear Stearns case again displayed the importance of personality in deals. Bear Stearns’s fate was ultimately decided by Treasury Secretary Hank Paulson acting in tandem with then-President of the New York Federal Reserve Timothy Geithner. Paulson’s desire to avoid moral hazard and pay heed to political pressure by punishing the Bear Stearns shareholders led to the first low price. Paulson’s personality would play an important part in the government’s “regulation by deal” approach first used in Bear Stearns but then applied to a host of other bailout transactions, a topic discussed in full in Chapter 10.
JPMorgan CEO Jamie Dimon’s forceful personality was similarly on display. The acquisition was his recrowning as one of the kings of Wall Street after departing from Citigroup years ago in a dispute with then Citigroup CEO Sandy Weill. Dimon’s desire to acquire Bear Stearns drove the Wachtell lawyers to implement the heavy deal-protection devices placed in the second deal.
The Bear Stearns transaction also showed the importance of extrinsic factors such as employee satisfaction in driving a successful deal. It was not enough for JPMorgan to pay a bargain basement price for Bear Stearns. In the wake of the $2 a share price, the employees, seething in anger, initiated a slow-motion revolt at Bear Stearns’s ignominious demise. Integrating these employees would have caused significant losses for JPMorgan. This no doubt drove JPMorgan’s decision to assuage this employee dissatisfaction by paying a higher price.
Moreover, the lawyers for Bear Stearns, backed up by the federal government, had stretched the bounds of permitted deal-protection devices under Delaware law. But they did so only hesitantly. At first, they merely adopted the typical bank acquisition model with a few revisions that made it favorable to JPMorgan. In their haste to graft on these new changes, they provided a large unintended consequence, giving Bear Stearns a possible out. In the deal’s second iteration, JPMorgan’s lawyers further innovated pushing the deal to the limits of Delaware law. The negotiated structure paid enough heed to that law to survive, but did no more. The deal shows the remarkable innovation that deal lawyers given free rein can undertake. At the end, the JPMorgan lawyers could and did structure this second deal to push the envelope around Delaware law and the NYSE rules. The fact that this deal went through is testament to that creativity.
In structuring the transaction in this manner, JPMorgan’s lawyers also revealed many of the remaining open issues in Delaware law applicable to takeovers, including:
• Revlon: Does the Revlon doctrine apply to a stock-for-stock transaction where a change of control is clear on its face?
• Omnicare: Is the Omnicare doctrine still a viable one?
• Unocal: What is the type of threat that implicates Unocal and leads to an application of its review? Did a third-party bid have to be outstanding or only the potential of one?
• Insolvency: What are a board’s duties to equity holders, if any, when the company is considered technically insolvent?
I talk more about these open issues and Delaware law in later chapters. However, the number of questions showed the perpetual indeterminacy of Delaware law. The Delaware courts have a preference for keeping these questions open in order to allow market and judicial leeway. 60 Some of these questions may be resolved in the coming years, but in their resolution will lay new ambiguity to provide this flexibility. The abstention of Vice Chancellor Parsons showed that Delaware was not above using this flexibility to arrive at a predetermined political outcome.
More tellingly, the Bear Stearns story is the first of what would be a series of government-initiated deals. At the first instance, despite the legal-stretching that occurred, the structure of the Bear Stearns deal showed the limits of government’s authority to act in the crisis. The Treasury and Federal Reserve lacked any authority actually to seize Bear Stearns, an authority that bank regulators normally have over their regulatory charges. Instead, the government was forced to cobble together a deal that attempted to achieve its goals but required the cooperation of a private actor, JPMorgan, and pushed the limits of the law to effectuate. This limitation would come sharply into focus in the fall of 2008, a topic I discuss further in Chapter 10.
The Bear Stearns transaction was also the first of a number, including the bailouts involving AIG, Fannie Mae, and Freddie Mac, where the government attempted to penalize shareholders. The words thrown around at the time were “moral hazard,” “to prevent future misconduct,” and “the shareholders needed to be punished.” That may be part of it, but the government’s focus missed the point about the boards and officers of these entities. In the case of Bear Stearns, the government appeared to be avoiding penalizing its officers and directors. The government allowed JPMorgan to indemnify the Bear officers and directors for their conduct prior to the acquisition. Bear Stearns director and former Bear Stearns chief executive Alan C. Greenberg, who headed Bear Stearns’s risk committee, took a new job at JPMorgan as vice chairman emeritus. Meanwhile, former Bear Stearns CEO Jimmy Cayne still pocketed $61 million in stock in addition to any compensation he earned in prior years. It was on his watch that Bear Stearns made the risky business decisions that ultimately led to its demise.
If the government was going to punish moral hazard, then it should have set up a system that clawed back this compensation and prevented this indemnification. This would punish the real parties responsible for Bear Stearns’s demise. Perhaps the shareholders also needed to be disciplined, but the focus on them to the absence of the officers and directors of Bear Stearns missed the entire point. Then again, this was also an authority that the government for the most part lacked, and the shareholders were a much easier target.The government needed the cooperation of the Bear Stearns management and board. And ultimately, the failure of Bear and what followed are such extreme events that their occurrence is something that is unlikely to be a calculus in a future manager’s mind. This is a view the government would also eventually adopt.
Bear Stearns also had much to say about systemic risk and the investment banking model. The fall of Bear Stearns illustrated the hazard of a financial institution losing market trust. There was no doubt that Bear Stearns’s liquidity vanished because of the market’s loss of confidence. Bear Stearns’s failure also symbolized more. It showed the riskiness of the investment banking model that placed leverage at 30:1 ratios and above on their balance sheets, all the time relying on short-term lending and deposits for liquidity. In times of crisis, this meant that there might not be enough equity to carry the day and keep the confidence of counterparties and lenders.
This problem was reinforced by the opaqueness of these banks’ financial positions, which encouraged counterparties and lenders to assume the worst. Bear Stearns’s downfall also illustrated the riskiness of the investment bank model and its overreliance on trading profits. Bear Stearns suffered from too-large bets in mortgage-related assets, and it suffered accordingly.
More tellingly, Bear Stearns illustrated the problems with traditional models of corpor
ate governance as applied to financial institutions. Bear Stearns was a complex financial beast that was poorly understood even by its own chief executive officer. It was the prototypical modern financial corporation with a trading operation that yearly engaged in hundreds of thousands of sophisticated financial transactions. However, these transactions were the realm of advanced mathematics not operational management.
The operations of Bear Stearns required little input from the Bear Stearns board of directors. This was for multiple reasons, but primarily because the nature of Bear Stearns’ business—complex financial alchemy—was beyond traditional comprehension. The board was simply incapable of monitoring Bear Stearns’ trading operations, let alone able to serve a decision-making or information-aggregating function with respect to the Bear Stearns business. The story of Bear Stearns is thus one of limits, the limits of board and shareholder governance and ultimately people themselves. If one is going to create a proper oversight and monitoring mechanism for a complex financial institution, it is likely not going to arise from traditional corporate governance models or metrics involving the board or shareholders. Instead, it is likely to come from regulatory and other forces that can directly intervene in and comprehend the financial institution architecture.
Even so, Bear Stearns’s management had been remarkably hands-off in the months before its demise, as had its board. Cayne, then CEO of Bear Stearns, was reported to be noticeably absent during the July and August 2007 beginning of the market crisis, leaving on a helicopter on Thursday afternoons to play Friday golf at his New Jersey country club and spending 10 days in Nashville to play bridge.61 Bear executives would later claim that they were stuck in a catch-22 of wanting to appear strong to the market but knowing that if they raised needed equity they might then be seen as in a deteriorating position.The result was that they took no action. Bear Stearns’s rapid downfall illustrated the need for quick action in corporate governance and the resolution of this possible dilemma. It also illustrated the utility of a strong and proactive market regulator. Had such a regulator existed, then Bear Stearns might have been assisted earlier.
Instead, Bear Stearns was largely unregulated, primarily subject to voluntary compliance with the Consolidated Supervised Entity program under the SEC’s oversight. When Bear Stearns rapidly failed, the SEC was nowhere in sight to aid the investment bank, and instead Bear Stearns became subject to the vicissitudes of the Department of Treasury and Federal Reserve. In the wake of Bear Stearns’s and Lehman Brothers’ failure, the SEC would ultimately shut down the CSE program, and ex-Chairman of the SEC Christopher Cox would famously state that “voluntary regulation does not work.”62
Chapter 7
Jana Partners, Children’s Investment Fund, and Hedge Fund Activist Investing
The demise of Bear Stearns caused a significant shock to the financial system. In the days after Bear Stearns’s fall and forced acquisition, stock market volatility increased, and the credit markets once again froze up. Bear Stearns’s implosion had provided a fright to the equity markets, but the economy, though weakening, appeared stable. A $168 billion stimulus package passed by Congress in February 2008 was about to be distributed to taxpayers, and initial economic reports would state that the economy would grow less than 1 percent in the first half of 2008.1 It would, of course, turn out that this appearance was terribly wrong.These false reports of growth and the stimulus were hiding the credit-driven market correction occurring outside public view.This correction would emerge in September 2008 to hit the global economy like a category five hurricane.
This would come only later. Instead, during the false stability of the spring of 2008, the equity markets experienced significant activity in three areas. The first two would be a relative rise in activity by strategic buyers, as well as in hostile takeover offers, topics for the next two chapters. The third would be the emergence of hedge fund activist investors in a number of high-profile shareholder disputes. Notably, many of these hedge funds utilized new financial instruments and techniques to implement their dissident campaigns.This development was not met with joy by all, and targeted corporations struggled to resist this onslaught. The ensuing battles and inevitable litigation engendered two important judicial opinions on the regulation of shareholder activism. These opinions, respectively, arose from Jana Partners’ targeting of CNET Networks, Inc., the Internet media company, and Children’s Investment Fund’s and 3G Capital Partners’ targeting of CSX Corp., the railroad operator.
The hedge fund as activist investor is a new species, more activist and interventionist than other institutional investors, such as mutual funds. Hedge funds may have the capacity to change the corporate governance of companies and drive increased dealmaking activity in ways other institutional investors have not.This will be particularly true in the coming years because of heightened shareholder focus on executive compensation and proxy access in light of the perceived failings of management leading up to the financial crisis.2 To understand why and how this is the case, as well as the future of hedge fund activism in distressed times, we must first briefly discuss the problem of corporate governance and the potential of activist investors.
A Brief Overview of the “Agency Problem”
A fundamental corporate governance problem for public companies is agency costs. Public corporations are run by agents. Officers are selected by directors, who are elected by shareholders. The officers and directors are agents of the real owners of the corporation, the shareholders. Ownership of the corporation is thus separated from control, resulting in a cost to owners known as agency costs. What are agency costs? At its most basic level, agency costs are the salaries paid to officers and directors, the cost of hiring these agents to operate the business.
There are also other less economic costs these agents impose. Officers may take advantage of their position to rent-seek, which is an economic term for obtaining their own private benefits at the expense of the corporation and its owners. They may pay themselves excessive amounts that do not correlate with their performance, or they may arrange to receive perks that are otherwise inappropriate. The former problem is exemplified by CEOs who, in hindsight at least, received shockingly excessive compensation. The poster boys for this issue are Countrywide Financial Corp.’s founder and ex-CEO Angelo Mozilo, ex-Merrill Lynch CEO Stanley O’Neal, and ex-Citigroup CEO Charles Prince, who collectively were paid $460 million between 2002 and 2006 despite the billions in losses their companies subsequently incurred from their wrong decisions.3
A paradigm example of the perk problem is the corporate jet, which until the financial crisis was a seemingly mandatory part of any pay package.The perk aggravates shareholders who are still stuck flying commercial. Some have argued that perks like these are simply cheaper, indirect forms of compensation and so justified. This may be true, but their class-separating nature clearly results in avoidable shareholder resentment and friction with officers and directors.4
Sometimes, agency costs are more direct, and managers may have outside competing interests that divert them from the corporate enterprise. The problem is particularly acute in the takeover context. Delaware law allows a board to just say no and to implement takeover-protection and deal-protection devices. Management can use these protections to attempt to entrench themselves, thereby depriving shareholders of a takeover premium. Agents can also be outrightly disloyal, entering into arrangements that explicitly benefit them at the expense of the company. The activities of the Rigas family with Adelphia Communications Corp. are one such example. There the Rigas family, led by Adelphia founder John Rigas, conspired to conceal about $2.3 billion in Adelphia’s debt and appropriated approximately $100 million from Adelphia for their own purposes, including purchase of a golf course.5
The problem of agency costs, and particularly executive compensation, has occupied corporate governance experts for decades. One remedy proffered for the agency cost problem is the existence of substantial shareholders.The theory is that a contro
lling shareholder will provide a monitoring function and have an economic incentive to undertake this task because it has a significant interest in the company. The substantial shareholder will also ensure that officers and directors do not unduly profit. However, these types of shareholders have not proven themselves in practice. For example, Sumner Redstone, the controlling shareholder of Viacom and CBS Corporation, has awarded himself more than $80 million in compensation over the past three years while engaging in disputes with two of his children over their shareholdings in the two companies’ parent, National Amusements Inc. As of February 2008, the stock prices of Viacom and CBS had declined 52 percent and 71 percent, respectively, since 2007.6
In this vein, a substantial or controlling shareholder can reap private benefits to compensate them in outsize proportion to the value they bring to the corporate enterprise. From 2001 to 2006, the CEO of Ford Motor Company was Henry Ford’s great-grandson, William Clay “Bill” Ford Jr. He was paid more than $63 million during that time, all while refusing to accept a salary until Ford turned a profit. Fortunately for Bill Ford, stock awards and options did not count as salary.7 Did he receive this job because he was the most qualified? Or was it because his family still controls 40 percent of the voting stock in Ford? And perhaps this “salary” was indeed justified given that Ford has thus far been the only one of the Detroit three automakers to avoid government assistance. This may have been due to the outsize attention the Ford family provides to Ford.
Gods at War: Shotgun Takeovers, Government by Deal, and the Private Equity Implosion Page 19
