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.
To protect themselves against this type of takeover, companies have begun large-scale restructurings of their own in which they assume significant amounts of additional debt in order to shrink their equity and increase the price of their stocks, thus making themselves less desirable targets for raiders. FMC, Colt Industries, Owens-Corning Fiberglas, Gillette, and Goodyear are the most recent examples of this trend. In addition, Goodyear and Gillette have paid vast amounts of “greenmail.” Excessive ratios of debt to equity are the result. These restructurings are clearly driven more by the fear of takeovers than by straightforward economic forces.
Junk bonds, of course, are not the only source of excessive leverage in recent takeover activity. Large-scale leveraged buy-outs, and other types of “going private” transactions, have been financed by bank and institutional loans as well as by junk bonds. Such transactions have to by judged on a case-by-case basis. In many cases, some simplification of corporate structures may be quite appropriate, and no junk bond financing is involved. But the result, in virtually all cases, is more and more substitution of debt for equity and less and less stable financial structures.
Added to this combination of unequal treatment of shareholders and unsound financial structures is the market speculation which has become an integral part of the process. Very large pools of money are managed by arbitrageurs looking for rapid returns; some of these pools of money are created by issuing junk bonds. Equally large pools of money, similarly financed, are in the hands of corporate raiders. This creates a set of potentially interlocking relationships between the two groups which may have, as their basic purpose, destabilizing a large corporation, and profiting from its subsequent sale or breakup. The combination of forces creates, at the very least, the appearance, if not the reality, of professional traders with inside information who, in collaboration with raiders and junk-bond buyers, are deliberately driving companies to merge or liquidate.
The last but certainly not the least important factor that deserves attention is the behavior of institutional investors. Between $75 and $100 billion of junk bonds have been placed over the last five or six years. Possibly more than half this amount has been directly related to takeovers, leveraged buy-outs, and restructurings. Only financial institutions can provide purchasing power in such size. The cornerstone of junk-bond take-overs is the willingness of financial institutions—with legal responsibilities as “fiduciaries” toward depositors, retirees, and policyholders—to acquire this paper in vast amounts. Insurance companies, savings and loans, pension funds, commercial banks—all want to show short-term profits from high-yielding assets; so far, the experiment has largely been a success. Interest rates have declined steadily over the last five years and the stock market has boomed. But what will happen in a downturn, especially if that downturn is accompanied by rising interest rates as a result of the flight of foreign capital from the US? Of the several financial time bombs ticking in our closet, this is potentially one of the largest and most dangerous. And if large-scale defaults occur in the junk bond market as a result of a recession, it will, as always, be the taxpayer who ultimately pays. The government will not allow large financial institutions to go down in a time of crisis.
The dangers of the proliferation of large-scale takeovers actively financed by excessive use of high-cost debt should be clear:
—At a time when we should be trying to encourage long-term investment, this activity encourages speculation and short-term trading.
—At a time when we should be trying to strengthen our important industries to make them more competitive, this activity weakens many of our companies by stripping away their equity and replacing it with high-cost debt. Borrowing can promote growth when the borrowed funds are used by a company to make new investments in order to meet future market needs and to be more competitive. It is quite another story when leverage is created to pay out shareholders today at the expense of growth tomorrow.
—At a time when many of our financial institutions (banks, savings banks, insurance companies) are under considerable pressure, this activity preempts more and more general credit and causes the weakest sectors of the economy to acquire large amounts of risky and possibly illiquid paper in order to show a strong performance. Much of this paper has never been tested in a period of economic downturn.
—At a time when we need to continue attracting capital from throughout the world, our securities markets appear to be more and more under the control of professionals and insiders.
I believe that these issues are sufficiently serious to warrant consideration by the relevant regulatory authorities and the Congress of more stringent regulation coupled with new legislation. Some or all of the following measures should be considered.
For junk bonds:
(1)Limit the amount of junk bonds and other below-investment grade paper that can be acquired by federally and state-insured institutions.
(2) Require that directors, officers, or trustees investing in this type of paper observe a higher standard of care and prudence if they are to be protected by indemnification provisions under their charter of bylaws; make it clear that achieving the highest short-term investment returns is not their main fiduciary obligation.
(3) Limit the tax deductibility of interest by highly leveraged companies which have acquired significant amounts of their own stock or that of another company.
(4) Review whether “disclosure” is a sufficient standard to qualify securities for registration under the Securities Act. We should consider whether the public sale of securities should be allowed whose prospectus merely states that “the company may be unable to pay interest or principal on these bonds.”
For takeovers and tender offers:
(1) Require 100 percent financing commitments before allowing a tender offer to begin.
(2) Lengthen the tender offer period from twenty days to sixty days, to allow time for more deliberate reaction by the management and the board of directors of the target.
(3) Require a one-price, 100 percent offer for any buyer wishing to acquire more than 20 percent of another company. This would help prevent a raider from acquiring control from professionals at one price while squeezing out the public shareholders at lower values.
For financial institutions:
Consider a tax on the profits on securities transactions of currently tax-free institutions in inverse proportion to the holding period of the securities sold.
For arbitrage, hedge funds, etc.:
Consider limiting the right to vote on major corporate matters, such as mergers or restructurings, to shareholders who own stock for a minimum period of, say, one year.
If takeover excesses are curbed, abusive defensive tactics must also be curbed. Both kinds of restrictions should be part of a single integrated regulatory and legislative package. Raiders have tried hard to create the impression that they are saving the country and the shareholders from inept and venal managements. This is a canard. Most managements consist of hard-working professionals trying to improve the performance of their business. During the last few years, particularly, the performance of American industry has improved remarkably. At the same time, one must recognize that not all takeovers are bad, not all managements are good, not all directors represent the shareholders’ best interests. Takeovers do not have to be friendly; they have to be fair and soundly financed. The following measures should be considered:
(1) Outlaw all forms of “greenmail.”
(2) Reestablish the principle of “one-share–one-vote.”
(3) Eliminate any form of “poison pill”—a strategic move by a takeover target to make its stock less attractive to an acquirer, such as issuing preferred stock that shareholders can redeem at a premium after a takeover.
(4) Require that shareholders vote on any bona fide offer for 100 percent of a company, or on major restructuring proposals.
(5) Eliminate “crown jewel options,” “shark repellents,” and all other defensive stratagems designed to discourage a bona fide bidder.
(6) Eliminate state takeover statutes which provide management and directors with almost unlimited license to turn away bona fide bidders and entrench themselves.
I am obviously not suggesting that all of these measures should be adopted. The objective of any legislative or regulatory approach should be to create a “level playing field,” in the SEC’s phrase, for both bidders and targets, to maintain sound financial structures, and to return as many major corporate decisions as possible to the hands of shareholders whose central interest is in the soundness of their investment.
I have been an investment banker for more than thirty years. It has been an honorable profession; I want it to stay that way. I have been involved in the negotiation of hundreds of mergers and acquisitions for a variety of corporate clients. Most of these were the result of negotiated agreements; some were bitterly contested, hostile takeovers. All of them were conservatively financed.
This activity is an integral part of the service an investment banker should provide his clients and is an important factor in maintaining a competitive marketplace. There is no question in my mind that thoughtfully negotiated mergers have a better chance of achieving their objectives than multibillion dollar takeovers or major restructurings that are decided on over a weekend, as a result of a raid on a company’s stock. Nonetheless, there should be room for many types of transactions in our market system; but very clear lines should be drawn between what is acceptable economic and corporate behavior on the one hand, and what is runaway speculation on the other. That is not the case now.
Certainly the pressures against any changes will be formidable. The political power of the junk-bond lobby was in evidence last year when Federal Reserve Board chairman Paul Volcker, against fierce opposition, barely won the right to effect a minor change in the margin rules. Both in the Senate and the House, arguments for legislative change were brushed aside. However, the integrity of our securities markets and the soundness of our financial institutions are vital national assets. They are being eroded today.
The picture of greed and corruption currently in the headlines could unleash a vicious backlash against financial institutions as well as individuals. Those who break the law must be punished; institutions should be reformed. The securities industry has been heavily and successfully regulated since the 1930s. The notion that additional legislation would interfere with the workings of a free market is a myth in this particular case.
I believe that as a result of the current scandals, the securities industry will have to accept new legislation and regulation to curb the speculative abuses of the past several years. This is long overdue. Instead of trying to fight against the inevitable, I hope that financial industry leaders will cooperate with the Congress in the coming legislative hearings to help shape rational laws and rules to reform the system. If they do, our financial market system will emerge stronger and cleaner from its inevitable torment; if they do not, the resulting legislation could be so punitive as to result in damage to us all.
What is at issue here is not just the behavior of the financial industry or the success or failure of a few corporate raiders. What is involved is the bread-and-butter issues of jobs and growth and new investment. If America is to compete with Japan, we must invest in and create new products, instead of tearing apart our industries and simply inventing new kinds of paper.
March 12, 1987