As the revelations of illegality and excesses in the financial community begin to be exposed, those of us who are part of this community have to face a hard truth: a cancer has been spreading in our industry, and how far it will go will only become clear as the Securities and Exchange Commission and Federal prosecutors pursue the various investigations currently under way. The cancer is called greed.
It has grown in a more feverish climate of speculation than any we have seen since the 1920s; and it is not wholly unrelated to our continued huge fiscal deficits. It is encouraged by deregulation and the prevailing market ideology; it is specifically concentrated in the recent wave of huge takeovers financed by junk bonds—high-yielding bonds with relatively small backing—and on the various financial activities related to them. Its most deeply disturbing aspect, so far, has been the Ivan Boesky affair, involving the illegal use of insider information in the trading of securities.
The stock market is at an all-time high, while business is relatively slow and major sectors of our economy are in serious difficulty. Furthermore, looking to the future, aside from the devaluation of the dollar, which cuts two ways, we see little or no evidence of a realistic willingness on the part of government to solve our most fundamental economic problems: our budget deficit, our trade deficit, and the vulnerability of our banking system. The financial markets now have a life of their own, seemingly unrelated to any underlying economic realities. The need for productive investment in this country, together with the risks created by the level of existing speculation, makes it more important than ever that the integrity of the financial markets be assured and that capital be used to build and not to speculate.
The questions raised by recent events should be examined from two perspectives. First, the illegal activity itself and the adequacy of existing laws and regulations to deal with it; and second, the implications for the economy of the present level of corporate takeover activity, with particular attention to potentially dangerous levels of corporate borrowing.
With respect to the illegal activity, I will leave it to others to comment on enforcement and the possible need for new ways to catch wrongdoers. I would emphasize the broader issue involved, namely the ethics of a profession where integrity has to be fundamental. After all, the word “credit” comes from the Latin meaning “to believe”; belief in the integrity of our financial system is certainly open to question at this time.
The explosive growth in financial services, and the huge rewards they bring, have caused obvious strains on the ability to maintain relatively old-fashioned standards and traditions while adjusting to the pressures of the new, deregulated environment and the technologies that allow ceaseless development of new products. Employment in many investment banking firms, law firms, arbitrage firms, investment advisers, etc., has grown tenfold over the last few years. Much of the growth has been accomplished by hiring young college graduates, MBAs, or law students, and involving them in high-pressure, high-profile, and extremely sensitive activities such as mergers, large block trading, and arbitrage. (It is worth noting that, so far at least, not one woman has been implicated in any of the financial scandals despite the significant growth in the role of women in our industry.)
An industry which traditionally provided independent financial advice and distributed securities on behalf of its clients has turned into a business creating and selling new products and relying more and more on the trading of securities for its own account to generate profits. Long-term relationships are no longer valued; this is the age of the freewheeling financial samurai. The same is true of many law firms. And the behavior of financial institutions is mostly geared to short-term results. That this is as much the fault of the clients as of the lawyers or bankers is beside the point; the result is what counts. Too much money is coming together with too many young people who have little or no institutional memory, or sense of tradition, and who are under enormous pressure to perform in the glare of Hollywood-like publicity. The combination makes for speculative excesses at best, illegality at worst. Insider trading is only one result. No firm, even my own, is immune from it, no matter how carefully it handles sensitive information. We have to rely on the ethics and the character of our people; no system yet invented will provide complete assurance that all of them will behave ethically.
It is against this background that we must examine the public interest. It is important to remember that merger and takeover activities include not only investment bankers, raiders, and arbitrageurs. Lawyers, commercial banks, and, perhaps most importantly, large institutional investors all have an important part in them. Furthermore, these activities have become international in scope, with new emphasis on the London market. That London is not immune from the same disease is apparent from the growing scandal surrounding certain actions of Guinness in its takeover of the Distillers group.
Over the long run, the capital markets tend to correct themselves, but sometimes abuses become so widespread that the markets must be helped by legislation or regulation. Today that is the case in respect to corporate takeovers. The abuses fall into several categories:
(a) Unequal treatment of shareholders as part of offensive or defensive corporate actions;
(b) Unsound financial structures as a result of excessive “leverage,” or debt in relation to equity;
(c) Large-scale risk arbitrage—by which, for example, traders purchase stock in a company being acquired in order to cash in on the expected rise in the target company’s shares—and other short-term trading activities as an integral part of mergers and takeovers.
I would like to examine each of these briefly.
Our securities laws aim to enforce three basic principles: that there should be full disclosure of fundamental financial information, equal treatment of all shareholders, and no manipulation of the market. Both the techniques of current takeovers and current legal trends undermine these principles.
Takeover bids, for example, may take place in “two tiers”—a cash offer for part of the shares, to be followed by payment for the rest in paper obligations at a lower price. This heavily favors professional traders over nonprofessionals by providing higher values to the early sellers. The professionals are approached first and are always in a better position to take advantage of this opportunity. Moreover, bids that are made “subject to financing”—in many cases directly or indirectly financed by junk bonds—permit the bidder to manipulate the markets without committing himself to purchase. The raider’s bid is not really firm and his financing expenses are minimal. Yet when the bid is made, short-term traders and arbitrageurs may quickly acquire large speculative holdings of shares that, in the argot of the trade, “put the company into play.” The outcome may be “greenmail”—by which a takeover target buys back shares from a potential acquirer, usually at a premium, in exchange for an end to the takeover bid—or rescue by a “white knight”—a friendly acquirer. The result in either case is a large profit for the raider, at minimal risk.
Because of these tactics, defensive maneuvers have been devised that are equally objectionable to shareholders. The payment of “greenmail” is the most obvious and, in many ways, the most oldfashioned of these maneuvers. Selective repurchase of stock, “lock-ups,” “crown jewel options,” and “poison pills” of one kind or another, all have been designed to enable managements and boards of directors to interpose themselves between the shareholders and would-be acquirers making takeover bids. State takeover statutes giving management and directors almost unlimited license to entrench themselves are becoming more frequent. These can be used against bona fide bidders as well as against the more pernicious raiders.
The most basic elements of stock ownership, i.e., equal voting rights and equal equity ownership for all common shareholders, are now under attack. For instance, the New York Stock Exchange has allowed the listing of common shares with unequal voting rights; and recent decisions in Delaware permit, in certain cases, unequal payment among common shareholders.
As a result of these developments, financial structures are being seriously eroded. In recent years, some of the largest takeovers came about as a result of raids, financed by junk bonds, on the target companies. Many of these companies were then acquired by third parties. A large part of the oil industry has been reorganized as a result. The mergers of Chevron and Gulf, Occidental and Cities Service, and Mobil and Superior all occurred as a result of raids or the threat of raids. The deterioration in their combined balance sheets has been dramatic. Far from benefiting from a healthy restructuring, the oil companies involved are cutting exploration sharply, a practice our country will pay for dearly when the next energy crisis occurs. With their high levels of debt, the oil companies could be in serious difficulty if the price of oil declines again. If one were to conceive a scheme to get the US into trouble as far as energy is concerned, it would be difficult to improve on what has happened.
The use of junk bonds is particularly hazardous in large takeovers. High-yield, low-rated debt, in reasonable amounts, is a perfectly acceptable means of financing for many companies ineligible for investment-grade credit ratings. It is a different story, however, when this sort of debt, in the tens of billions of dollars, is used to substitute for equity in the takeovers of very large companies.
The risks of this type of takeover activity are twofold. First, the security of the junk bonds is often questionable. If the takeover is successful, the servicing of very high levels of debt, at rates of interest often in excess of the ability of the target to earn, requires that the corporation dispose of its assets in ways that may be neither desirable nor even possible. Such an approach also fails to take it into account that a large corporation has responsibilities to employees, customers, and communities, and that it cannot always be torn apart like an erector set. The alternative to breaking up a corporation in order to service debt is to generate significantly improved cash flow, and this in turn requires cutbacks in research and development, capital-spending, and, usually, significant reductions in employment. Some companies may be leaner and more competitive as a result; some may have to sacrifice the future.
The second element of risk posed by junk bonds is liquidity. Even though much of this paper is sold to financial institutions such as savings banks, insurance companies, and pension funds, in many instances no large-scale, liquid public market exists in such securities. Purchases and sales are handled through private transactions. And many of the investing institutions, such as the savings and loan industry, are in parts of the economy that are under considerable pressure at this time.