CHAPTER TWENTY-EIGHT
The Hostile Takeover and Its Discontents
ALMOST EVERY WEEK THESE LAST few years there has been a report of another “hostile takeover bid,” another stock-market maneuver to take over, merge, or split up an existing publicly held company against determined opposition by the company’s board of directors and management. No such wave of stock-market speculation has hit the United States since the “bears” and the “bulls” of the 1870s, when the Goulds and the Drews and the Vanderbilts battled each other for control of American railroads. The new wave of hostile takeovers has already profoundly altered the contours and landmarks of the American economy. It has become a dominant force—many would say the dominant force—in the behavior and actions of American management, and, almost certainly, a major factor in the erosion of American competitive and technological leadership. Yet the papers usually report it only on the financial page. And very few people, outside of business, really quite know what goes on or, indeed, what a hostile takeover really is.
The hostile takeover usually begins with a raider—a company or an individual who is legally incorporated and works through a corporation—buying a small percentage of the target company’s share capital on the open market, usually with money borrowed expressly for this purpose. When, and as the raider expects, the target’s board of directors and its management spurn his takeover bid, the raider borrows more money—sometimes several billion dollars—buys more of the target’s shares on the market, and goes directly to the target’s stockholders, offering them substantially more than the current share price on the stock exchange. If enough of the target’s shareholders accept to give the raider complete control, he then typically unloads the debt he has incurred in the takeover onto the company he has acquired. In a hostile takeover the victim thus ends up paying for his own execution.
The raider not only now controls a big company: he has made a tidy profit on the shares he bought at the lower market price. Even if the takeover attempt fails, the raider usually wins big. The target may only be able to escape the raider by finding a white knight, that is, someone who is less odious to the management of the target company and willing to pay even more for its shares, including those held by the raider. Alternatively, the target company pays ransom to the raider—which goes by the Robin Hood-like name of greenmail—and buys out the shares the raider acquired at a fancy price, way beyond anything its earnings and prospects could justify.
Hostile takeovers were virtually unknown before 1980. Harold Geneen, who built ITT into the world’s largest and most diversified conglomerate in the 1960s and 1970s, made literally hundreds of acquisitions—perhaps as many as a thousand. But he never made an offer to a company unless its management had first invited him to do so. Indeed, in a good many of Geneen’s acquisitions the original initiative came from the company to be acquired; it offered itself for sale. In those days it would have been impossible to finance hostile takeovers: no bank would have lent money for such a purpose. But since 1980 they have become increasingly easy to finance.
At first, hostile takeovers were launched by large companies intent on rapid growth or rapid diversification. This phase reached a climax in 1982 with a months-long battle of three giants: Bendix (defense and automotive), Martin-Marietta (defense, aerospace, and cement), and Allied (chemicals). Bendix began the fight with a hostile takeover bid for Martin-Marietta, which promptly counterattacked with a hostile takeover bid for Bendix. When these two, like two scorpions in a bottle, had finished each other off, Allied joined the fray, paid ransom to an exhausted Martin-Marietta, took over Bendix, and in the process ousted the Bendix management that had started the battle.
Since then, raiders increasingly are individual stock-market operators whose business is the hostile takeover. Some, like Carl Icahn, range over the lot, attacking all kinds of business. T. Boone Pickens, originally a small, independent oil producer, specializes in large petroleum companies—his targets have included such major companies as Gulf Oil, Phillips Petroleum, and Union Oil. Ted Turner of Atlanta specializes in the media and was embroiled in a hostile takeover bid for the smallest of the three television networks, CBS. But there are dozens of smaller raiders abroad, many of them looking for fast-growing medium-size companies, especially companies in such currently “sexy” fields as electronics, computers, or biotechnology. Others primarily raid financial institutions. Practically all of them do so on money borrowed at high interest rates.
Why the Raider Succeeds
How many hostile takeover bids there have been, no one quite knows. Conservative estimates run to four hundred or five hundred, with at least one-half ending in the disappearance of the target company either because the raider succeeds or because the target finds a white knight. Such a massive phenomenon—whether considered destructive or constructive—surely bespeaks fundamental changes in the underlying economic structure and the environment of American business and the American economy. Yet to my knowledge there has so far been practically no discussion of what might explain the takeover phenomenon, of its meaning, and of the policy questions it raises.
What, for instance, explains the vulnerability of companies, among them a good many big, strong, well-established ones? Few of the raiders have much financial strength of their own. Most have little managerial or business achievement behind them. In the 1960s and early 1970s, the managements of big, publicly owned companies were widely believed to be impregnable; nothing short of the company’s bankruptcy could threaten, let alone dislodge, them. It was then considered almost a “self-evident truth” in highly popular books (those of John Kenneth Galbraith, for instance) that we had moved into “corporate capitalism” as a new and distinct “stage,” one in which professional managers perpetuated themselves and ran the country’s big business autonomously, ruling without much interference from any of their supposed “constituencies.” But in the last few years, any number of companies, and particularly large companies doing well by any yardstick, have been swallowed up by hitherto unknown and obscure newcomers despite the most vigorous defense by their management.
These raiders often have no capital of their own, but have to borrow every penny they need to buy a small percentage of the company’s stock and then to make their takeover bid. By now, to bar a hostile takeover bid even giants like General Motors are forced into expensive and complicated subterfuges such as splitting their shares into a number of different issues, each with different voting rights. What has happened to corporate capitalism and to the absolute control by professional autonomous management, seemingly so firmly established only a little while ago?
Fundamentally, there are three explanations for this extreme vulnerability of established companies to the hostile takeover.
One explanation is inflation.
Then there are structural changes within the economy that make a good many of yesterday’s most successful companies no longer appropriate to today’s economic realities.
Finally, corporate capitalism—that is, the establishment of a management accountable only to itself—has made managements and companies exceedingly vulnerable. They have no constituencies to come to their succor when attacked.
Inflation distorts: It distorts values. It distorts relationships. It creates glaring discrepancies between economic assumptions and economic realities. The fifteen years of inflation in America which began during Lyndon Johnson’s presidency and continued into the early 1980s were no exception. And the most predictable, indeed the most typical, distortion of inflation is between the value of assets and their earning power. In any inflation the cost of capital goods tends to rise much faster than the price of the goods they produce. It thus becomes economical to buy already existing capital assets rather than to invest in new facilities and new machines. So any company that is rich in fixed assets is worth more when dismembered—that is, when its capital assets are being sold as pieces of real estate, as factories, as machinery and equipment—than it is worth on a realistic price/ earnings ratio based on the value of its output. This is one of the distortions that the raiders exploit.
The stock market values companies on the basis of their earnings. It values them, in other words, as “going concerns.” It does not value them on their liquidation value. As a result, a company heavy with fixed assets—and especially a company that also has a lot of cash with which the raider, after the takeover, can repay himself (and make a sizable profit to boot)—becomes a most inviting target. This situation accounts for one-quarter, perhaps even one-third, of all the successful hostile takeovers.
Equally important are the tremendous structural changes in the American and world economies in the last fifteen years. They have made inappropriate a good many of the traditional forms of economic integration. The best example is probably the large, integrated petroleum company. One need not sympathize with Mr. T. Boone Pickens, the raider who successfully forced one of the country’s largest and proudest petroleum companies, Gulf Oil, into a shotgun marriage with a white knight and almost succeeded in taking over two other old and well-established petroleum companies, Union Oil and Phillips. But Pickens has a point. He has forced the petroleum companies at which he leveled his guns to do something sensible: that is, to split the company into two parts, one making and selling petroleum products, one keeping reserves of crude oil in the ground.
Large integrated petroleum companies have performed poorly since 1980 or 1981. Their earnings basically reflect a crude oil price of around $12 or $15 a barrel, which is what the market price would have been all along had there been no OPEC cartel. But all of them have tried desperately, since the OPEC oil shock of 1973, to build up underground crude oil reserves for the future. And these reserves were priced in the market, and especially by people looking for a long-term tax shelter, on the expectation of a petroleum price many times the present price, twenty or thirty years hence. In fact, to justify what the market was paying for crude and crude oil reserves in the ground, one would have to assume a petroleum price of around $100 a barrel by the year 2015 or so; otherwise, on a discounted cash-flow basis, the present valuation of these proven underground reserves could not possibly be justified.
Whether the expectation of high petroleum prices twenty or thirty years hence is rational is not the point. (Every historical experience would indicate that the only rational expectation is for the petroleum prices thirty years hence to be lower than they are today—but this is another issue.) The fact is that it makes little sense today to be an “integrated” petroleum company. The interests of the people who want the earnings of the present petroleum company, and the interests of the people who look for a long-term tax shelter (and who, in other words, do not care much about present earnings), are not compatible. Therefore Pickens’s proposal, that the integrated petroleum company split itself into two pieces, made sense.
A similar situation exists in the steel industry, and in fact in a good many of the traditional large-scale, integrated, capital-intensive materials producers. Every one of these situations invites a raider.
But perhaps the biggest single reason companies are vulnerable to the raider is “corporate capitalism” itself: that is, autonomous management, accountable to no one, controlled by no one, and without constituents. It has made management arrogant. And far from making management powerful, corporate capitalism has actually made it impotent. Management has become isolated and has lost its support base, in its own board of directors, among its own stockholders, and among its own employees.
Wherever a management threatened by a raider has been able to organize a “constituency,” it has beaten off the hostile takeover. One example is Phillips Petroleum in Bartlesville, Oklahoma, which mobilized the employees and the community; this was enough to defeat Pickens. But where managements have given in to the temptation to become omnipotent they have in effect rendered themselves impotent. When they are then attacked, they have nobody to support them if someone offers a few dollars above the current market price to the company shareholders.
Where the Cash Comes From
The vulnerability of the victims does not, by itself, explain how the raiders finance their takeover. To mount a hostile takeover bid for a large company takes a very large war chest. One and a half billion dollars is just about the minimum needed to attack a big company. In some recent cases the amount went up to $4 billion. It has to be in cash, as a rule. To be sure, if the takeover bid succeeds, the target company then pays. But the money has to be available from the beginning—that is, when it is by no means sure that the takeover bid will succeed. If the takeover bid is launched by an individual, as more and more of them have been in recent years, there usually is no security whatever for the cash that the raider has to borrow. The raider himself usually has negligible assets, certainly compared to the sums needed. Even if the takeover bid is being launched by another large company, the amount needed to finance it is usually way beyond anything the company could normally raise as additional debt. Yet the only “security” for the loan that a raider has to obtain is the promise of repayment if the raid is successful. This is hardly what was once normally considered a “bankable” loan, yet the raiders have had no difficulty obtaining these loans. Indeed, when the financing of hostile takeover bids switched (mostly for regulatory reasons) from being done by means of bank loans to being done by means of bonds, the market promptly named the bonds junk bonds, and with good reason. Nevertheless, there is no difficulty in getting such bonds underwritten and issued, with commercial banks being avid buyers.
Bank loans—or junk bonds—to finance hostile takeovers are available for the same reason that enabled countries like Brazil, Zaire, or Argentina, in the early 1980s, to obtain loans from Western banks in amounts that were clearly beyond their capacity to pay interest on (let alone to repay the loan itself), and for the same reason that large money-center banks, such as Continental Illinois in Chicago, were willing, indeed eager, to snap up highly speculative and sometimes fraudulent loans often to nonexistent oil and gas speculators. The American commercial bank is pinched by the shrinkage of its traditional sources of income and almost desperate to find new ones, and especially to find borrowers willing to pay very high interest rates. And the raider who makes a hostile takeover bid is, of course, perfectly willing to promise very high interest rates; after all, he will not pay them—the company he is aiming to take over will, after it has succumbed.
Commercial banks, as every textbook states, make their living as liquidity arbitrageurs: They obtain their money from “demand deposits” which have perfect liquidity—that is, the right to withdraw the money at any time. The bank then lends out that money for longer periods of time (from ninety days to three years is the ordinary time span of a commercial loan); so the amounts owed to the bank have far less liquidity than the amounts it owes. This, then, justifies the bank’s charging a substantially higher interest rate, with the difference between the interest rate on what the bank lends out and the interest rate on what the bank borrows being the bank’s income.
Increasingly, this does not work anymore, for the bank either is not able to be the liquidity arbitrageur or does not get paid for it. One reason is, of course, that zero-interest demand deposits, once prescribed by the regulatory authorities, have all but disappeared. Historically, businesses have provided the bulk of the demand deposits. But few businesses these days keep large cash supplies, and the typical checking account of individuals now pays 5.5 percent interest. Adding to this the costs of administration, acquisition, and so on, the bank probably ends up paying 8 or 9 percent for the money on deposit in customers’ checking accounts—which means that even demand deposits no longer provide a substantial “interest spread.” And most American consumers today keep in their checking account only a minimum balance. The rest is in accounts that pay much higher interest, such as money-market accounts, which still allow high liquidity.
On the demand side, too, the liquidity arbitrage has become far less profitable. Increasingly, American businesses do not finance themselves through commercial loans, but through commercial paper—the business version of an installment loan. This, however, bypasses the banking system. The company with a temporary cash surplus directly buys commercial paper issued by another company with a temporary cash need. But the “spread” on commercial paper between what the borrower pays and what the lender gets is much lower than that between the traditional noninterest on demand deposits and the bank’s lending rate on commercial loans. That spread may be 1.5 percent as against 4 or 5 percent previously.
By now, most U.S. banks, especially the larger ones, know that they cannot hope to continue to build their business on the “spread” of interest rates between what they pay for their money and what they charge for it. They will have to shift their income base to fees and commissions. But even those few banks which accepted this ten years ago and which since then have been working hard on shifting their source of income from being paid for money to being paid for information and service—Citibank in New York was probably the first, and is by far the leader—still have a very long way to go. And in the meantime the banks are hurting for sources of income. Hence the pressure on them to look for borrowers willing to pay higher interest—or at least to promise they will—whether they be Oklahoma wildcatters, military governments engulfed by inflation in their own country (such as Brazil and Argentina), or takeover raiders.
The Lure of Easy Money
That the raiders can obtain money they need still does not explain why the shareholders team up with the raider to take over, merge, or liquidate the company they own.
They do not do so, it is abundantly clear, because they believe the takeover will be advantageous to the company. On the contrary, the shareholders clearly know that the takeover bid is usually a disaster for the company. Increasingly, they sell their shares to the raider only if they get cash, that is, if they get out of the company and have nothing to do with it anymore. Or, if they take securities in exchange, they immediately sell them. And yet, again and again, the shareholders, in their great majority, either accept the bid of the raider or turn it down only if a white knight offers more than the raider does. But then they also immediately sell whatever the white knight has given them in exchange against their holdings in the company that has disappeared.
The shareholders who control our large, publicly held companies simply have no choice but to accept the raider’s offer. They are forced, perhaps even legally forced, to accept the raider’s bid if it is higher than the currently quoted price for the stock. This is essentially a result of the shift of share ownership from individuals to institutions who are “trustees,” and especially to pension funds. Pension funds (increasingly also mutual funds) are the legal “owners” of the publicly owned companies of America, with their holdings amounting to about 50 percent of the common shares. The percentage is even higher for large companies because the institutional holders concentrate on them. The people who manage these large and growing aggregations of capital, especially the pension fund managers, are trustees rather than owners. They are trustees both for the management of the companies which owe the pensions to their employees and for the ultimate beneficiaries, the employees and future pensioners. As trustees they have, however, little choice about whether they want to sell their shares if someone bids substantially above what the same shares fetch at the market price. They have to accept. If they were to say no, they would lay themselves open to an enormous and uninsurable liability. The trustees could be sued by both the management of the company and the ultimate beneficiaries, the employees, were those shares, six months later, quoted below the price the raider had offered. Trustees do not have the right to superimpose their judgment on what a “prudent man” would do. And a prudent man surely will take the bird in the hand, especially if there is no reason to believe that there is a bird in the bush.
Pension fund managers are also under tremendous pressure to show better-than-average returns—and yet are unable to do so as a rule. The pension funds of most American businesses are defined-benefit plans: The company promises to pay the employee upon retirement a fixed proportion of the employee’s salary, usually 60 percent or so of the last five years’ earnings. What the employee is to receive is fixed, or rather will be fixed by the time the employee reaches retirement. What the company contributes, however, is flexible. The contribution payable by the company goes down if the pension fund increases in value—if, for instance, it shows a high return or profit from its investments. If the pension fund does not show earnings, or shows earnings lower than anticipated, the company’s contribution goes up.
This is in sharp contrast to plans based on a defined contribution, under which what the company pays in each year is fixed, with the employee upon retirement receiving either a fixed stipend or a variable one which depends upon what the earnings of the pension fund have been.
In the defined-benefit plan, therefore, management constantly pushes the pension fund manager to show profits, especially from investments, so that the company’s contribution can be minimized. But this is a total delusion. it is in fact an impossibility. The pension funds by now are the American stock market. And if one is the market, one cannot possibly beat it. The performance record of the pension funds bears this out. It has been abysmal, almost without exception. In fact, the desire to “beat the market” is in itself the reason that most pension funds have performed substantially worse than the market. As a result, the pension funds waste their substance by supporting a huge stock market that only fritters away in commissions the money that should go to the future beneficiaries. In the long and checkered history of investment and finance, there is probably no more uniformly dismal record than that of American pension fund management in the last twenty years.
And yet company managements still believe that their fund can “beat the odds”—the way each slot machine player in Las Vegas believes that he can beat them. And the pension fund manager who does not operate short term, and who refuses to speculate, to trade, and to show “results” over the next three months, is likely to lose the account quickly. There is probably no more competitive industry around. This makes irresistible an offer by the raider to pay $55 for a share that is quoted at $40 on the market.
Pension fund managers know that the raider’s bid is deleterious to the company whose stock they own. But they cannot consider the welfare and interests of their “property.” They are not owners. They are of necessity speculators, even though they are legally vested with the owner’s power. And so they behave as speculators. They have to accept the raider’s bid unless a white knight makes a better offer.
The Dangers of Defensiveness
The wave of hostile takeovers is a result of profound structural changes in the American economy. But it is in itself a serious disorder. There is a great deal of discussion about whether hostile takeovers are good or bad for the shareholders. There can be absolutely no doubt, however, that they are exceedingly bad for the economy. They force management into operating short term. More and more of our businesses, large, medium-size, and small, are not being run for business results but for protection against the hostile takeover. This means that more and more of our businesses are forced to concentrate on results in the next three months. They are being run so as to encourage the institutional investors, on which all publicly traded companies today depend for their supply of capital, to hold onto the company shares rather than to toss them over-board the moment the first hostile takeover bid appears.
But worse still, companies are being forced to do stupid things to prevent themselves from being raided. It is, for instance, becoming dangerous for any company to be liquid. Liquidity can only attract the raider who can expect to repay himself, and the debt he incurs in bidding for the company, out of the company’s own cash. And thus companies who find themselves in a liquid position, no matter how much cash they may need only a few months further on, hasten to squander the cash—for instance, in buying up something that is totally alien to their own business and has only one advantage: it absorbs a lot of money. Even worse, companies increasingly cut back on expenses for the future, such as research and development. One of the most ominous developments for the future of America is the speed with which the Japanese are taking over the markets of the rapidly industrializing countries: Brazil, for instance, or India. They do so because they can invest in the distribution system in these countries in anticipation of the future market. American company managements are perfectly aware of this. But when asked why they do not do likewise, they tend to say, “We cannot afford to set aside this money and invest it in tomorrow. We need it to make a good showing in next month’s or next quarter’s profits.”
The fear of the raider is undoubtedly the largest single cause for the increasing tendency of American companies to manage for the short term and let the future go hang. The fear of the raider demoralizes and paralyzes. The impact on the morale of management people and of professional people in the company can hardly be overestimated. And worse still, after the successful takeover, the morale in a company is destroyed, often forever. The people who can leave, do. The others do their minimum. “What’s the point in my trying to do a good job if the rug will be pulled out from under me tomorrow?” is a frequent comment. Add to this that the raiders, in order to reimburse themselves, usually start out by selling off the company’s most promising businesses. Hence the impact of a takeover on morale is total catastrophe.
Altogether, the record is poor for all companies that have been merged, especially into a conglomerate or into a business with which they had little in common: for example, the typical financial conglomerate. Only three out of every ten such acquiring companies do as well two years later as they did before the merger. But the record of companies that have been acquired in a hostile takeover is uniformly dismal.
Clearly the hostile takeover cannot be justified as leading to a more efficient allocation of resources. Most of them have no aim except to enrich the raider. To achieve this end, he offers the stockholders more money for their shares than they would get on the market, which is to say, he bribes them. And to be able to pay the bribe he loads a heavy debt on the company that is being taken over, which by itself severely impairs the company’s potential for economic performance. The fact that, almost without exception, the result of the hostile takeover is also a demoralization and severe impairment of the human organization disproves the argument that the hostile takeover results in a more efficient allocation of resources. Actually, all it proves is that “resources” in the modern business enterprise are not primarily bricks and mortar—or even oil in the ground. They are the human organization.
There are indeed cases where a human organization becomes more productive by being dissociated from its former enterprise, by being set up separately—in fact, a good many of today’s large organizations, and especially the conglomerates, would greatly increase their productivity by being split into smaller units, or by establishing parts as separate businesses. But this is not what the hostile takeover accomplishes. On the contrary, the most valuable parts of the acquired business are invariably put on the block after a hostile takeover so as to raise money to pay off some of the debt. And this impairs both their productivity and that of the remaining assets.
There are serious questions about resource allocation in the American economy. But the hostile takeover is clearly not the right tool to bring about a more efficient allocation. It does severe damage to the true productive resource, the human organization, its spirit, its dedication, its morale, its confidence in its management, and its identification with the enterprise that employs its people.
Even if hostile takeovers are “good for the shareholders”—and they are “good” only for the very shortest time—they are surely not good for the economy. They are indeed so bad that we will be forced to put an end to them, one way or another.
One way to do so might be to emulate the British and create a “takeover panel” with the power to stop takeover bids considered to be contrary to the best long-term interest of the enterprise and the economy. Whether such a panel could be set up in this country—or whether it would just become another troublesome government agency—is very debatable. The way the British are doing it would immediately run afoul of our antitrust laws.
It is therefore more probable that we will put an end to the hostile takeover—or at least put serious obstacles in its path—by abandoning the concept of “one share, one vote” and go to shares that, although participating equally in profits (and in the proceeds of a liquidation), have unequal voting power, at least as long as the company shows adequate financial results. General Motors has already gone this way, and quite a few smaller firms are following. This would not be a radical departure. The British, for many years, had the private limited company, in which management held the voting power as long as it showed specified results. Similarly, the Germans, for well over a hundred years, have had the Kommanditgesellschaft auf Aktien, in which management holds the majority of the voting power even though it has a very small minority of the share ownership—again, as long as there is adequate performance and results. In other words, a shift to a system in which different classes of shares have differential voting power—with Class A shares, for instance, having one hundred times the votes of Class B shares—would only need a few fairly simple safeguards to be functional: One, vesting the Class A shares, with their superior voting power, in a truly independent and strong board of directors rather than in management, a board on which independent outside directors have a clear majority (which is what the Germans require, by the way). Second, making the extra voting strength of the Class A shares conditional on the company’s showing specified results and adequate performance. Thus a two-class system of shares would control the hostile takeover and yet give protection against managerial malperformance and even against managerial mediocrity.
But perhaps the takeover wave will come to an end with a whimper rather than a bang by losing its financial underpinnings. It would not take much to bring this about. One default on one big loan to finance a hostile takeover, one “billion-dollar-scandal” similar to the Penn Square collapse in Oklahoma that brought down Chicago’s mighty Continental Illinois Bank—and there would be no more money available to finance hostile takeovers. And in the long history of finance, every single scheme that lured lenders into advancing money for economically nonproductive purposes by promising them returns substantially above the going market rate has come to a bad end sooner or later—and usually sooner.
Even if we control the hostile takeover, however, there will remain the underlying structural problems of which the hostile takeover is only a symptom. It clearly raises basic questions about the following: the role, functions, and governance of pension funds; the legitimacy of management; and finally, the purpose of business enterprise, especially large enterprise. Are the stockholders the only constituents to whom all other interests, including that of the enterprise itself as a going concern, must be totally subordinated?
Where Wall Street Meets Las Vegas
Abatement of the boom in hostile takeovers can, paradoxically, only aggravate the pension fund problem. It would eliminate the windfall profits pension funds now reap by accepting the inflated prices the raider offers. These windfall profits are, by and large, the only way for pension fund managers to obtain the quick stock-market gains that their bosses, the company’s managers, expect and demand of them. If they are eliminated, company managers will predictably put even greater pressure for quick results on the people who manage their company’s pension fund; and those in turn will put even greater pressure for short-term results on the companies in the shares of which the fund invests—thus pushing businesses even further toward managing for the short term, which, as by now everybody agrees, is a significant factor in the steady erosion of America’s competitive position in the world economy. As long as American pension funds are based on “defined benefits,” no relief is in sight.
It might have made sense for the labor unions to push for defined benefits when pension funds first became widespread some thirty years ago. For under that system, the employer shoulders all future risks. Actually, in the negotiation of the contract that set the pattern for today’s pension fund, the General Motors contract in the spring of 1950, the United Automobile Workers strongly opposed defined benefits and wanted “defined contributions” instead.* It was the company that chose defined benefits, even though General Motors’ president at the time, Charles E. Wilson, recommended a defined-contributions plan as financially much sounder. He as well as Reuther were, however, overruled by GM’s finance committee, and the rest of the country’s pension plans then followed GM’s lead. Yet the choice of defined benefits—as we now realize, a major blunder—was based on the same delusion that makes people in Las Vegas believe that they will “make a fortune” if only they keep on feeding more quarters into the slot machine.
Under defined benefits the company commits itself to paying the future pensioner a fixed percentage of his wage or salary during his retirement years. The contribution the company makes is then dependent on the value of the fund’s assets in a given year, as against the present value of the future pension obligation. The higher the fund’s present value the lower the current contribution, and vice versa. And so management deluded itself into believing that an an ever-rising New York stock market is a law of nature—or at least of history—and that, therefore, under a defined-benefits plan, it would be the stock market, through its preordained continuing rise, that would eventually provide the money to discharge the pension obligation rather than the company itself. Indeed, quite a few managements then promised their boards of directors that the defined-benefits plan would in the long run become a “money spinner” for the company and would produce income well above anything it would have to put into the plan.
And then the second delusion: Practically every company adopting a defined-benefits pension plan did so with the firm belief that its own pension plan, if only administered “professionally,” would “beat” even an ever-rising market.
There is, of course, no law that prescribes an ever-rising stock market. Stock markets historically have not even been particularly effective as hedges against inflation: The American market in the last twenty years, for instance, barely kept pace with it. Indeed a large pool of money which over any long period of time grows at all, let alone as fast as the economy, is the rarest of all exceptions—neither the Medici nor the Fuggers, nor the Rothschilds nor the Morgans, succeeded in this endeavor. Similarly, no large-company pension fund, to the best of my knowledge, has over the last twenty or thirty years done as well as the stock market. The only performance that counts in the pension fund is performance over the long run, because the obligations extend over twenty-five years or longer. Indeed, some of the large defined-contributions funds have produced better results for their beneficiaries, the employees and future pensioners, and at lower cost to the employers, than the great majority of the large defined-benefits plans. This is most definitely true of the largest of the defined-contributions plans, that of the employers and employees of the American nonprofit institutions, the Teachers Insurance and Annuity Association.
The misconceptions that led American management into opting for defined benefits thus practically guaranteed from the beginning that the funds would have to become “speculators” and increasingly short term in their focus.
The choice of defined benefits also explains in large part the poor social performance of the American pension fund. For it was conceived, as Walter Reuther quite rightly suspected, as much to be a social as to be a financial institution. It was conceived to create a visible center of common interest between employer and employee. Indeed, what General Motors had in mind was very similar to what the Japanese, acting quite independently a few years later, achieved by “lifetime employment.” But unlike lifetime employment the American pension fund has not created any community of interest in the worker’s mind.
The laws that govern the private pension plans in America define their managers as “trustees” for the eventual beneficiaries, the employees. In reality the managers of defined-benefits plans are of necessity appointed by and accountable only to company management. For the one at risk is the employer—and so the fund has to be run to reduce, as much as possible, the burden on the employer. As a result, the employees feel no responsibility for the fund. It is “deferred wages” rather than a “stake in the company.” The employees do not feel that it makes any difference how the fund performs. And they are right: Unless the company goes bankrupt it does not make any difference to them. They also, in a defined-benefits plan, cannot in any meaningful way be brought into the decision-making process through the pension fund, the actual owners of America’s productive resources.
A defined-contributions plan is no panacea, but it minimizes the problems. The right model was easily available thirty years ago—for the Teachers Insurance and Annuity Association goes back much further, to the early 1920s. The TIAA runs on “flexible contributions” rather than on defined contributions. The contribution made each year into the plan by a university, or a nonprofit organization such as the Boy Scouts, or for a minister in a Protestant denomination, is a fixed percentage of salary. It goes up as the employee advances. It thereby also—an important point—automatically adjusts the annual contribution to inflation. And yet this annual premium is known and predictable. And because of this, the TIAA can, and does indeed, invest for the long term, which in turn explains why its results have been better than those of any of the large defined-benefits plans. At the same time, the TIAA, precisely because the employer has discharged his obligation in full once he remits a fixed percentage of the employee’s salary, has been able to bring the future beneficiaries, that is, today’s employees, into the government of the institution. University faculty do not consider the TIAA the “employer’s pension fund"; it is “our pension fund,” in which they take an active interest and which to them meaningfully symbolizes the basic identity of economic interest between their employer, that is, the university, and themselves.
Pension plans are beginning to change, albeit very slowly. Many companies, especially medium-size ones, now encourage employees to make their own pension provisions, often out of company-provided funds, for example, through an Individual Retirement Account. That at least makes possible a rational (that is, a long-term) investment policy. But for the foreseeable future the bulk of our corporate pension plans will remain committed to the defined-benefits formula. The principal legal owners of our large companies, the large pension funds, will therefore continue to be forced to act as speculators rather than as investors, let alone as owners. And thus there will, for the foreseeable future, be a need to protect the economy’s wealth-producing resources—that is, its businesses, and the pension funds themselves—against the pressure to manage for the immediate, the short term, the next month, the next quarter, and above all against the takeover.
Demise of the Corporate Guardians
Corporate capitalism—the rule of autonomous managers as the “philosopher-kings” of the modern economy accountable at best to a professional code but not controlled by shareholders or by any other constituency—was first proclaimed more than fifty years ago by Adolph Berle and Gardner Means in their 1932 classic, The Modern Corporation and Private Property. “Control,” Berle and Means argued, had become divorced from “property.” Indeed, property was no longer ownership. It had become investment, concerned only with dividends and capital gains but not with the welfare or the governance of the property itself.
From the beginning, anyone with any knowledge of political theory or political history could have predicted that this would not work. Management, one could confidently say, would not last any longer as philosopher-king than any earlier philosopher-kings had, which was never very long. Management has power. Indeed, to do its job, it has to have power. But power does not last, regardless of its performance, its knowledge, and its good intentions, unless it be grounded in some sanction outside and beyond itself, some “grounds of legitimacy,” whether divine institution, or election, or the consent of the governed. Otherwise, power is not legitimate. It may be well-meaning, it may perform well, it may even test out as “highly popular” in surveys and polls. Yet illegitimate power always succumbs to the first challenger. It may have no enemies, but no one believes in it, either, and no one owes it allegiance.
This should have been obvious to American management fifty years ago when Berle and Means first pointed out that there was no more real ownership in the American corporation. After all, that the philosopher-king—that is, power grounded in performance rather than in legitimacy—would not last had been known since Aristotle’s dismissal of Plato’s philosopher-king, all of twenty-three hundred years ago. But American management did exactly what all earlier philosopher-kings have done—for example, the “enlightened despots” of eighteenth-century Europe. It gloried in its good intentions. And American managements busily engaged in removing what they considered as the last obstacle to their enlightened rule, an independent and powerful board of directors. And then, when the investors of Berle and Means became the speculators of the pension fund, management found itself powerless against the first challenger, the raider. The hostile takeover bid is thus the final failure of corporate capitalism.
But we do need management. The business enterprise needs a government, and it needs a government that has power, has continuity, and can perform. In other words, it needs a government that has legitimacy. How can legitimacy be restored to the management of America’s large, publicly owned companies?
One step, surely the first one, is to restore an independent and strong board of directors. Indeed, as has already been pointed out, where such a board exists, raiders, by and large, have been beaten off. Even shareholders whose only interest is the quick buck are likely to listen to a strong and independent board that has standing and respect in the community and is not dismissed as management’s puppet. The hostile takeover may thus finally succeed in bringing about the reform and restoration of the strong, independent board of directors which a great many voices within the business community have been demanding for many years.
But such a board would not and could not be a representative of the shareholders alone. The board member who commands enough respect to be listened to is likely to be an independent director, that is, somebody who does not represent any constituency, including the nominal owners, but rather the integrity and the interest of the enterprise itself. The hostile takeover is thus almost certain to speed up a development that is already under way: the emergence of professionally qualified men and women who serve on a very small number of boards, maybe no more than four at a time; who have independent respect and standing in a broader community based on their achievements and known integrity; and who take seriously their responsibilities, including the responsibility to set performance goals for top management and to police them, to monitor the behavior and ethics of top management, and to remove even the proudest chief executive officer who does not live up to the standards set by the board in the interest of the enterprise.
But is this not simply replacing one set of philosopher-kings by another group of technocrats or wise men? To be sure, independent outside board members, unlike a company president, do not fight for their own jobs when they resist a takeover. But they still do not represent any identifiable constituency, neither do they have any grounds of legitimacy other than disinterested performance and knowledge. Will the large public corporation in America have to learn to mobilize new constituents, to bring in other “interests” to balance the former owners now become speculators, and to create new bonds of allegiance?
Reportedly, would-be raiders refrain from making a hostile takeover bid for a company in which employees hold a substantial portion of the shares. They know that employee-owners are not likely to accept the raider’s offer. Most employees stand to lose more, of course, if their jobs are endangered than they can possibly gain by getting more for their stock. Above all employees identify with the company and are personally and emotionally attached to its remaining independent. And the most spectacular defeat of a hostile takeover bid was not achieved by a management with a strong performance record. It was the previously mentioned defeat of the bid for Phillips Petroleum in Bartlesville, Oklahoma, when the town itself rallied to the defense of its major employer.
Thirty years ago it was popular in American big business to talk of management as being the “trustee for the best-balanced interests of stockholders, employees, plant community, customers, and suppliers alike.” In many cases, of course, this was pure phrase meant to clothe with respectability the managerial philosopher-king and his enlightened despotism. But even where there was more to this assertion than self-interest, nothing has been done as a rule to convert the phrase into reality. Few attempts have been made to institutionalize the relationship of these supposed “constituencies” to the enterprise and its management. Will this now have to be undertaken in earnest to safeguard both enterprise and management? And what form should such institutional relationships take?
The Challenge to Free Enterprise
The question being most hotly debated currently is whether hostile takeovers are good or bad for shareholders. But what other groups may have a legitimate stake in the fight for the control and survival of the enterprise is probably more important, though less discussed. Does the modern, publicly owned, large enterprise exist exclusively for the sake of the shareholders? This is, of course, what orthodox “capitalism” asserts. But the term free enterprise was coined forty or fifty years ago to assert that the shareholder interest, although important, is only one interest and that the enterprise has functions well beyond that of producing returns for the shareholder—functions as an employer, as a citizen of the community, as a customer, and as a supplier. The British, in establishing a “take-over panel,” have expressly recognized that a decision on mergers and takeovers affects the public interest. So far in the United States, this is expressed only negatively, that is, in forbidding mergers that violate antitrust laws. Will we have to bring in considerations of the impact on other groups and on the community and economy as a whole—and in which form? That is the central question. The answers this country will give to it will largely define the future shape of the American economy.
If the answer is, however, that the speculator’s interest—never mind that the speculator has legal title as an owner—is the only interest to be considered, the free-enterprise system is unlikely to survive. It will rapidly lose public support. For most people, even though they do benefit—however indirectly (that is, as ultimate beneficiaries in a pension fund)—from the speculator’s game, stand to lose more from the hostile takeover as employees, whether blue-collar or managers, and as citizens of a community. And more and more people are concerned with the hostile takeover as a moral issue. It deeply offends the sense of justice of a great many Americans.
Most Americans today are employees of an organization. There is a good deal of evidence that people in an organization, and especially managerial and professional people, will accept even the most painful adjustment, such as the closing of a business or the sale of parts of it, if the rationale is economic performance or the lack thereof. But this of course is not the rationale for the purchase or sale of the human organization or of its parts in the hostile takeover. There the only rationale is to enrich somebody who has nothing to do with the performance of the enterprise and who, quite admittedly, has not the slightest interest in it. And this goes against the grain of employees who feel that the hostile takeover treats them as “chattel” and not as a “resource,” let alone as human beings. “Is the hostile takeover even compatible with our laws against peonage and involuntary servitude?” the middle-level executives in my advanced-management classes have been asking me of late.
Almost a hundred years ago the United States decided that the rights of the creditor are not absolute and amended its bankruptcy laws to put maintenance and restoration of the “going concern” ahead of the rights of the creditor, which till then had ruled when a business got into difficulties. This has worked remarkably well. The protection of the going concern during reorganization has indeed proved to be in the ultimate interest of the creditor, too. Will we now do the same thing with respect to the hostile takeover and give consideration to the protection of the going concern as a resource, and to the interests of employees, whether blue-collar, white-collar, or managerial; of the community; of suppliers and customers? Actually we are already moving in this direction through extending the protection of the bankruptcy laws to non-bankrupt going concerns threatened by subjection to one single interest. The Johns-Manville Corporation—a leading producer of asbestos and other building materials—successfully invoked the bankruptcy laws to preserve itself as a going concern and to protect its shareholders and its employees against a tidal wave of asbestos-damage liability suits. Continental Airlines similarly used the bankruptcy laws successfully to preserve itself against union wage claims that had become unbearable when deregulation made airfares and airline routes hotly competitive. It is by no means inconceivable that a clever lawyer will similarly construe the bankruptcy laws to preserve the going concern against the hostile takeover—and that the courts will go along as they did in the Johns-Manville and Continental Airlines cases. But one way or another—by law, by moving to multitier stock ownership, or by judicial exegesis—we surely will find a way to protect the going concern against hostile takeovers that subordinate all other interests—employees, the enterprise’s long-range growth and prosperity, and the country’s competitive position in an increasingly competitive world economy—to short-term speculative gain.
(1986)