Category: Corporate Finance

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Five Reasons to Cheer for Starr v. United States (AIG Nationalization Case)

AIG coverYesterday, the US Federal Court of Claims ruled that the US government and its leaders acted illegally in nationalizing AIG during the 2008 financial crisis, in a shareholder suit led by Hank Greenberg, the man who built AIG until his departure in 2005. But the judge (Wheeler) also ruled against awarding any damages, saying AIG shareholders were not harmed.

A top journalist at a major financial magazine asked me the following five questions, and I gave the answers indicated–being five reasons you should celebrate the ruling. Please note that I wrote the book, The AIG Story (Wiley 2013), with Greenberg, where we laid out the legal basis for Wheeler’s ruling on illegality.

1) Is this a moral victory for Hank Greenberg? Do you think he sees it that way? 
Yes, it is a moral victory for Greenberg and for everyone else who cares about the rule of law.  I can’t speak for Hank other than to say he cares deeply about the rule of law.

2) Andrew Ross Sorkin calls this a split decision in today’s New York Times. Is that true and if not who won?
It is a Solomonic split decision but designed to invite an appeal by Greenberg and not by the government, so Hank gets a second bite at the apple on appeal.

3) Given the collateral calls that were pending and the certainty of an AIG bankruptcy, did Greenberg ever have a real chance to recover $40 billion?
No, but given the possibility of hiving off the insurance companies outside of bankruptcy, Judge Wheeler’s conclusion on no damages is vulnerable to reversal on appeal.

4) What will this ruling mean for government intervention in future financial crises? Is that good or bad?
No more violating the law or the rule of law by government officials, whatever they may think at the time. Very good–a win for justice and true American legal values.

5) The judge says that government broke the law in taking over AIG. Do you agree with that assessment?
Yes. Virtually every major figure in the takeover violated the law, certainly fiscal authorities such as Bernanke and Geithner, and maybe cabinet secretaries such as Paulson, and many of their bankers and lawyers, including those from Davis Polk, Goldman Sachs and Sullivan & Cromwell. They should all feel disgraced.

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A Berkshire Opportunity Cost: Listed Family Firms

aaaaaThe following is adapted from “Berkshire’s Blemishes,” a working paper delineating the costs, rather than the vaunted benefits, of Warren Buffett’s Berkshire Hathaway as a management model.  

Warren Buffett loves family businesses whose owner-managers care more about their constituents than about profits, recognizing instead that customer care tends to translate into economic gain. Those entrepreneurs, in turn, love Berkshire Hathaway, Buffett’s company, because it offers intangible benefits such as managerial autonomy and a permanent home. When family businesses sell to Berkshire, they know they can still run them as they see fit and will not be sold if prospects falter: Berkshire has not sold a subsidiary in forty years and promises not to.

Buffett hates using Berkshire stock to pay for acquisitions, however, since few companies can match the time-tested premium currency Berkshire has come to represent. In fact, Berkshire’s worst acquisition was paid for in stock and Buffett still translates the cost into current values: $443 million paid in 1993, equivalent to more than $5 billion in Berkshire stock now. Preferring to pay cash, Berkshire is often able to acquire family businesses at a discount because selling shareholders value Berkshire culture. Buffett also hates auctions, plagued by frightful dangers like the winner’s curse, which can push bids well above value, rationally calculated.

Sensible as these tenets are, there is always an opportunity cost, in this case forsaking listed family firms–publicly traded companies controlled by a family. Unlike those owned solely by close-knit groups who all wish to sell to Berkshire, directors of listed family businesses owe duties to non-family shareholders when selling control. In most states, led by Delaware, they are duty-bound to get the best value for shareholders.  (The doctrine is known by famous cases illustrating it, including Revlon and Paramount v. QVC.)

In a stock deal where all holders share gains in future business value, directors could consider Berkshire’s special culture in valuing the transaction. But with cash, all such future value goes to Berkshire’s shareholders, not selling public stockholders, who would also gain nothing from the autonomy or permanence that family members prize in a sale to Berkshire. So directors resist an all cash sale at a discount and seek rival suitors at higher prices, even stimulating an auction to drive price up—repelling Berkshire’s interest.

An example can be drawn from Berkshire’s 2003 acquisition of Clayton Homes, a publicly traded family business bought for a modest (seven percent) premium to market. Many Clayton shareholders objected; one, Cerberus Capital Management, told Clayton it wanted the chance to make a competing bid; another sued. The result was a six-month delay in getting to a shareholder vote, which narrowly approved the Berkshire deal. Many Clayton shareholders were disappointed, but Cerberus opted not to outbid Berkshire, and the court dismissed the lawsuit.

The scenario remains unattractive to Berkshire, however, given the risk of litigation, delay and rival bids. After all, courts might require directors to take affirmative steps, presenting the risk of an auction, which in itself suffices to deter Berkshire from bidding in the first place. The upshot: the publicly traded family business is outside Berkshire’s acquisition model, amounting to an opportunity cost for what would otherwise be a sweet spot. On balance, it is probably a price worth paying, but it’s useful to know the price.

Lawrence A. Cunningham, a professor at George Washington University,  has written numerous books on a wide range of subjects relating to business and law. 

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DuPont Victory Good Sign for Buffett’s Berkshire

aaaaaYou know the activists have made an impact when the prospects of targeting Berkshire Hathaway are taken seriously enough to warrant a question on the subject to Warren Buffett at the company’s famous annual meeting.  Buffett scoffed at the idea by stressing a combination of performance and size—but there is a bit more to say, and now is a good time to say it, in light of yesterday’s stinging rebuke of the notorious activist Nelson Peltz by shareholders of DuPont. (No, greed is not good.)

Berkshire is among the largest, most diversified and profitable corporations in American history. It owns nine subsidiaries that, if they stood alone, would each be a Fortune 500 company, and boasts scores of diverse companies generating revenue from $1 billion to $8 billion apiece. At present, no sensible activist would target the firm, since Warren Buffett built, runs, and controls it by owning 34% of the voting power.

But just as the 84-year old conglomerate builder plans for Berkshire’s fate beyond his lifetime, no doubt activists are planning too. After all, despite a whopping market capitalization of nearly $400 billion, most analysts agree that Berkshire is worth more—that the sum of the parts is greater than the whole.

Citing criticisms of the conglomerate business model, activists will urge management to sell Berkshire’s struggling units, spin-off the mediocre, and install new managers at any failing to meet publicized performance standards.  In the process, they would call for distributing the cash to shareholders. They would explain how what they offer is worth more than Berkshire shares alone: cash plus shares in spun-off subsidiaries along with the continuing Berkshire shares.

The counterargument, familiar to Berkshire’s stalwart shareholders, will stress the value Berkshire has created from its unique business model. It pledges to business sellers that it will hold them indefinitely and give managers autonomy. Such commitments have great economic value not necessarily reflected in either today’s stock price or the valuations of individual business units.  The only way to preserve that premium is sustaining the conglomerate. The value is amplified by the capacity to relocate capital across subsidiaries without taxes, interest, covenants or hassle. Keeping the whole together reinforces the economic value of these and other intangibles, including a culture of trust, thrift, and teamwork. Read More

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Warren Buffett & Charlie Munger Annotated by Experts in Wall Street Journal

WB1996Warren Buffett’s latest letter to Berkshire Hathaway shareholders is annotated in The Wall Street Journal by 30 professors, authors, and investors.  Editors Erik Holm and Anupreeta Das assigned us each two sentences in the letter, and/or Charlie Munger’s addendum, to amplify.  Here are my two, followed by the list of contributors. Mine address the role Warren’s son Howard will play in succession and what Munger believes concerning what made Berkshire succeed.

Regarding Buffett’s reference to his son Howard (p. 36):   Buffett tries again to defend the choice of Howard to succeed him as board chairman. Many remain skeptical. But critics should appreciate the plan’s savviness. It deftly carves a niche for the son of a legend, as Howard will: (1) not be asked to perform any task his father has performed (like investing or capital allocation) and (2) be asked to perform only one task, which Warren has never performed (monitoring the CEO for adherence to Berkshire culture and dismissing any who fail). This shrewdly avoids the trap many children of legendary parents face of never being able to measure up.

Notably, besides Munger, Howard is the only individual Buffett identifies by name among Berkshire personnel in his anniversary message and, besides Buffett, Munger only names Abel and Jain. In fact, while Munger and Buffett mutually credit the other for minting the Berkshire model, they never credit any other Berkshire personnel for its success. The omission contrasts with Buffett’s letters, which rightly herald specific executives who power Berkshire and animate its culture. The difference is that these messages, while in form historical, are really about the future, and all three people identified by name are referenced in discussions of succession.

Where Munger asserts (p. 39) that “The management system and policies of Berkshire . . . were fixed early”:   Munger’s statements about how Berkshire’s “system and policies” were “fixed early” is vague. In one sense, it sounds as if they were part of a master plan at the outset back in the 1960s.  But Buffett has often stressed that Berkshire never had a strategic plan nor any business plan. And through the 1980s, most of Berkshire’s “business” consisted of investments in securities for its insurance companies, not wholly owned operating subsidiaries. So it doesn’t seem likely that, in the 1970s or even as late as the 1980s, Buffett’s goal was to create “a diffuse conglomerate.”

On the other hand, Munger subsequently clarifies (p. 40) that Buffett “stumbled into some benefits [of these policies] through practice evolution” over his career. And Buffett sculpted much of Berkshire’s culture late in the company’s life as part of a process that is still ongoing and extends well beyond these policies. Therefore these passages should not obscure the fact that the “Berkshire system” looks sharper from today’s vantage point than from Buffett’s desk “early” on. That’s important to recognize lest observers commit errors associated with hindsight bias like believing that observed outcomes were predictable, a weakness of human psychology which Munger often lectures against.

Cunningham is the author of Berkshire Beyond Buffett: The Enduring Value of Values and editor and publisher, since 1997, of The Essays of Warren Buffett: Lessons for Corporate America. For more commentary on this topic, see today’s New York Times Dealbook column, here. Read More

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Fed Officials Accused of Perjury in AIG Bailout Trial

In the financial trial of the century, the most important document is missing. The document is the term sheet that the government says it gave AIG’s board right before taking the company over in Sept. 2008.  The government says the AIG board thus approved the Draconian terms that benefited Goldman Sachs and other rivals. But other evidence, including  AIG’s contemporaneous securities filings, suggests the board was agreeing only to sell the government warrants not transfer 80% of the common stock to it for a song.  The missing document would prove which side is telling the truth.

That’s one of many amazing points of contention noted by Yves Smith of Naked Capitalism in her relentless digging into what government really did during the financial crisis. Most recently, she alleges and documents perjury and obstruction of justice by top federal officials in the pending case of former AIG shareholders against the US. The case alleges that the government trampled on corporate law rights and that the Fed exceeded its authority—allegations that I document in my book, The AIG Story, written with Hank Greenberg, lead plaintiff in the case.

Smith lays out her claims in an extensive blog post at Naked Capitalism, accompanied by reams of additional documents and examples. For those looking for a skinny version, here is an abridged adaptation. Most examples concern Scott Alvarez, general counsel of the Board of Governors of the Federal Reserve; there is one with with Tom Baxter, general counsel of the New York Fed, who worked with Tim Geithner. The shareholders are represented by the noted trial lawyer, David Boies. The point about the term sheet is at the end.

Example 1

Boies: Would you agree as a general proposition that the market generally considers investment-grade debt securities safer than non-investment-grade debt securities?

Alvarez: I don’t know.

 

Example 2

Boies: [Presents a copy of the Financial Crisis Inquiry Commission report stating that the Fed had lowered the standards it applied for the quality of collateral for its loans under two programs then devised to support lending and asks] Do you see that?

Alvarez: I see that. . .

Boies: . . . [W]ould you agree that the Federal Reserve had lowered its standards regarding the quality of the collateral that investment banks and other primary dealers could use while borrowing. . . ?

Alvarez: No.

Boies: You would not agree with that?

Alvarez: Right.

 

Example 3 Read More

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Walmart versus Apple aka Revenue versus Profit

Which business would you want to be? The Economist Espresso reports that Walmart takes “about 65 seconds to collect $1m in revenue,” but Apple needs “very nearly three minutes.” Looks like Walmart is where the money is. And it is, but when it comes to profit, “Apple, with its high margins, is fastest in the profit stakes: chalking up $1m takes it less than 13 minutes and 20 seconds, whereas Walmart needs more than half an hour.” Looking at the chart, Apple and Google have good profit margins but banks like JPMorgan Chase and Goldman Sachs do even better (all above 20%). Coke (17.4) and Pepsi (10.4) are quite good too. So how much does the law affect these sectors and which the best to be in? Hard to tell.

No matter what, any regulation be it about disclosures about practices or nutrition or oversight or safety or labor or where a good is made or liability for property rights or ability to weather an economic downturn, can shape a sector. Given the high profits in some of these sectors, you will see some arguing that they are getting away with too much and others saying that any regulation will kill the sector. Both positions are likely incorrect. That said, watching where new money, new offices (for old and new ventures), and start ups go may tell us something about where people believe they can do well.

One thing I am thinking about is how much state-by-state regulations and barriers to labor mobility influence business decisions. Although work on intellectual capital and noncompetes is quite strong that lower restrictions help business overall, alleged protection of voting systems and other entry barriers matter too. Someone may have studied this point. If so, please share. But my guess is that a company that has trouble getting people (and I mean U.S. citizens) to their headquarters won’t be happy about that cost.

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JOBS Act, Sarbanes-Oxley and US Stock Market Competitiveness

Steve Bainbridge posts that we now have evidence that the facilitations that the JOBS Act provided to emerging growth companies for going public are ineffective. Steve also points out that since the early 2000s we have seen the US stock markets appearing less competitive than foreign markets. Let me add that we also have evidence that the Sarbanes-Oxley Act of 2002 (SOX) lengthened the time to going public and increased the probability of a private sale instead of an IPO. (SSRN has tons of papers on the mostly negative consequences of SOX but also a couple of papers suggesting indeterminate answers.) This means that SOX moved returns away from entrepreneurs and public investors to private equity funds. Although the costs of compliance have dropped and perhaps we cannot definitively say that SOX was a mistake, we cannot say it was a success either and the JOBS Act did not cure the inefficiencies that SOX produced. So, it is time to accept that the way to restore competitiveness is to repeal the dubious SOX provisions. Read More

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Argentina and Sovereign Insolvency

Thanks to Gerard for the nice introduction. Indeed, I am here to rant about bankruptcy, securities, and corporate, mostly. The vineyard lies dormant now (but any offers for it will be considered).

So, how about Argentina and Elliot? We pay our nice subsidy to the IMF out of our taxes and it finances sovereign restructurings by essentially buying the vote of bondholders into accepting restructurings that are good for both the bondholders and the insolvent sovereign (compared to it wallowing in a depression for years). Then, after the sovereign turns around its economy, our own courts let the holdout bondholders collect on the bonds that, if everyone had held out as they did and the sovereign stayed in a depression for decades, would not have had much value.

We could have a sovereign insolvency regime but the banks opposed the IMF charter amendment to that effect and it did not go through. Or our courts could go back to their equity receivership jurisprudence and try to fashion a sovereign insolvency regime.

Instead, our courts give ammunition to the holdouts, making bonds of insolvent sovereigns more attractive gambles, and pushing up the amount that the IMF will have to pay to buy out the bondholders’ vote in the next restructuring.

How would a sovereign insolvency regime work? It would not be pretty but it would be much prettier than this. Think of Detroit. It makes a bankruptcy filing and proposes a plan that keeps taxes rational and the city viable. No lender of last resort needs to get involved. Bondholders cannot extract any favorable bargains. Our tax dollars do not get wasted.

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Buffett’s Evolution: From Stock-Picking Disciple of Ben Graham to Business-Building Devotee of Tom Murphy

While everyone knows that Warren Buffett modeled himself after Ben Graham for the stock picking that made Buffett famous in the latter 20th century, virtually no one knows a more important point for the 21st century: he has modeled himself after Tom Murphy in assembling a mighty conglomerate.   Murphy, a legendary executive with great skills in the field of acquisitions that resulted in the Capital Cities communications empire, engineered the 1985 $3.5 billion takeover by Capital Cities of ABC before selling it all to to Disney a decade later for $19 billion.  You did not hear that explicitly at Saturday’s Berkshire Hathaway annual meeting, but Warren mentioned it to me at brunch on Sunday and, when you think about it, it’s a point implicit deep in the meeting’s themes and many questions.

In fact, Berkshire mBBB COvereetings are wonderful for their predictability.   Few questions surprise informed participants and most seasoned observers can give the correct outlines of answers before hearing Buffett or vice chairman Charlie Munger speak. While exact issues vary year to year and the company and its leaders evolve, the core principles are few, simple, and unwavering.  The meetings reinforce the venerability and durability of Berkshire’s bedrock principles even as they drive important underlying shifts that accumulate over many years.  Three examples and their upshot illustrate, all of which I expand on in a new book due out later this year (pictured; pre-order here).

Permanence versus Size/Break Up. People since the 1980s have argued that as Berkshire grows, it gets more difficult to outperform. Buffett has always agreed that scale is an anchor. And it’s true that these critics have always been right that it gets harder but always wrong that it is impossible to outperform.   People for at least a decade have wondered whether it might be desirable to divide Berkshire’s 50+ direct subsidiaries into multiple corporations or spin-off some businesses.  The answer has always been and remains no.  Berkshire’s most fundamental principle is permanence, always has been, always will be. Divisions and divestitures are antithetical to that proposition.

Trust and Autonomy versus Internal Control. Every time there is a problem at a given subsidiary or with a given person—spotlighted at 2011’s meeting by subsidiary CEO David Sokol’s buying stock in Lubrizol before pitching it as an acquisition target—people want to know whether Berkshire gives its personnel too much autonomy. The answer is Berkshire is totally decentralized and always will be-another distinctive bedrock principle. The rationale has always been the same: yes, tight leashes and controls might help avoid this or that costly embarrassment but the gains from a trust-based culture of autonomy, while less visible, dwarf those costs.

Capital Allocation: Berkshire has always adopted the doubled-barreled approach to capital allocation, buying minority stakes in common stocks as well as entire subsidiaries (and subs of subs).  The significant change at Berkshire in the past two decades is moving from a mix of 80% stocks with 20% subsidiaries to the opposite, now 80% subsidiaries with 20% stocks.  That underscores the unnoticed change: in addition to Munger, Buffett’s most important model is not only Graham but Murphy, who built Capital Cities/ABC in the way that Buffett has consciously emulated in the recent building of Berkshire.

For me, this year’s meeting was a particularly joy because I’ve just completed the manuscript of my next book, Berkshire Beyond Buffett: The Enduring Value of Values (Columbia University Press, available October 2014). It articulates and consolidates these themes through a close and delightful look at its fifty-plus subsidiaries, based in part on interviews and surveys of many subsidiary CEOs and other Berkshire insiders and shareholders.   The draft jacket copy follows. Read More

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Individuals & Teams, Carrots & Sticks

I promised Victor Fleisher to return to his reflections on team production. Vic raised the issue of team production and the challenge of monitoring individual performance. In Talent Wants to Be Free I discuss some of these challenges in the connection to my argument that much of what firms try to achieve through restrictive covenants could be achieved through positive incentives:

“Stock options, bonuses, and profit-sharing programs induce loyalty and identification with the company without the negative effects of over-surveillance or over-restriction. Performance-based rewards increase employees’ stake in the company and increase their commitment to the success of the firm. These rewards (and the employee’s personal investment in the firm that is generated by them) can also motivate workers to monitor their co-workers. We now have evidence that companies that use such bonus structures and pay employees stock options outperform comparable companies .”

 But I also warn:

 “[W]hile stock options and bonuses reward hard work, these pay structures also present challenges. Measuring employee performance in innovative settings is a difficult task. One of the risks is that compensation schemes may inadvertently emphasize observable over unobservable outputs. Another risk is that when collaborative efforts are crucial, differential pay based on individual contribution will be counterproductive and impede teamwork, as workers will want to shine individually. Individual compensation incentives might lead employees to hoard information, divert their efforts from the team, and reduce team output. In other words, performance-based pay in some settings risks creating perverse incentives, driving individuals to spend too much time on solo inventions and not enough time collaborating. Even more worrisome is the fear that employees competing for bonus awards will have incentives to actively sabotage one another’s efforts.

A related potential pitfall of providing bonuses for performance and innovative activities is the creation of jealousy and a perception of unfairness among employees. Employees, as all of us do in most aspects of our lives, tend to overestimate their own abilities and efforts. When a select few employees are rewarded unevenly in a large workplace setting, employers risk demoralizing others. Such unintended consequences will vary in corporate and industry cultures across time and place, but they may explain why many companies decide to operate under wage compression structures with relatively narrow variance between their employees’ paychecks. For all of these concerns, the highly innovative software company Atlassian recently replaced individual performance bonuses with higher salaries, an organizational bonus, and stock options, believing that too much of a focus on immediate individual rewards depleted team effort.

Still, despite these risks, for many businesses the carrots of performance-based pay and profit sharing schemes have effectively replaced the sticks of controls. But there is a catch! Cleverly, sticks can be disguised as carrots. The infamous “golden handcuffs”- stock options and deferred compensation with punitive early exit trigger – can operate as de facto restrictive contracts….”

 All this is in line with what Vic is saying about the advantages of organizational forms that encourage longer term attachment. But the fundamental point is that stickiness (or what Vic refers to as soft control) is already quite strong through the firm form itself, along with status quo biases, risk aversion, and search lags. The stickiness has benefits but it also has heavy costs when it is compounded and infused with legal threats.