The Scarecrow of the Law: The Failure of GovernmentPrevious Chapter - Next Chapter - Table of Contents
The Scarecrow of the Law: The Failure of Government
What's Good for General Motors...
If You Can't Beat 'Em, Exclude 'Em: VRAs
Taking It Twice
Turning Scarecrows into Support Systems
Liability: Heads Business Wins, Tails Consumers Lose
Don't Do the Crime If You Can't Do the Time
State Legislatures: The Home Court Advantage
The "Race to the Bottom"
"The British Are Coming!"
Ambrose Bierce: "A Man Is Known by the Company He Organizes"
An Offer They Could Refuse
An Offer They Could Fight
Indiana to the Rescue
Corporations, as systems of power, work to expand and to compete with other institutions in the allocation of societalresources. This energy creates unexpected consequences, as shown by the experience of the automobile industry during the 1980s. There are a number of other examples of the failure of federallawwhether statute or regulation, civilor criminalto prevent or even punish actions that externalize costs.
We willsee how government unsuccessfully attempts to place limits on the unacceptable aspects of corporate behavior through laws relating to private wrongs (torts and punitive damages) and those concerning public wrongs (criminallaw). But the law is another mechanism for accountability that corporate management has co-opted, a "scarecrow" that has become an extremely cozy perch.
Perhaps the most powerfulmyth about corporations is that they are ultimately held accountable by the marketplace and they therefore must maximize profits to compete for investors. The reality is that the "profit maximization" modeldoes not provide an accurate explanation of the way in which large corporations function in our society. Essentially, modern corporations often use their power to reduce risks and transfer costs on to others, creating results that were not intended, that are not in the interests of society as a whole, and that have nothing to do with profit. In this chapter, we examine how that is done by influencing federaland state law; in the next chapter we examine how it is done through other means.
The Scarecrow of the Law
We must not make a scarecrow of the law, setting it up to fear the birds of prey, and let it keep one shape, tillcustom make it their perch and not their terror.
Source: William Shakespeare, Measure for Measure, Act 2, Scene 1, Line 1.
The Effect of PACs
PAC money is destroying the election process.
Senator Barry Goldwater (R Ariz.)
Because corporate power over government is so criticalin directing the country's energies, it is important to look at the importance of corporate money in elections. This topic is worth a book in itself and has been ably covered in several, so we willjust touch on it here to make two points. The first is that PAC money is a factor in neutralizing the federalgovernment's ability to hold corporate management accountableeither directly or indirectlythrough imposition of criminalor civilliability. As the forthcoming VRA and tobacco examples show, it is even a factor in the market's ability to evaluate products. The second point is that corporate influence on government, most recently through PAC contributions, is a nice paradigm for the topic of this chapter: how corporations have taken even those laws designed to restrain them and have transformed them into laws to protect them. These are the "scarecrows of the law."
Each effort to "reform" the federalelection process's sensitivity to large financialinfluence seems, ironically, to result in increased importance of corporate involvement. The Watergate scandalled to great concerns about blatant efforts to circumvent the plainly understood prohibition against corporate contributions to federalelections. Such pardoned "felons" as Armand Hammer of OccidentalPetroleum, George M. Steinbrenner III of American Ship Building, and Thomas V. Jones of Northrop were found to have funneled corporate funds illegally into the 1972 reelection campaign of Richard Nixon.
The resulting "reforms" permit the use of corporate personnelto organize, corporate resources to solicit, corporate professionals to ensure compliance with law-allso that corporate officers, shareholders, or constituents can make "personal" contributions net of overhead costs to a corporate PAC. Although the corporation can direct the PAC to make expenditures on behalf of candidates, the PAC can be funded only by contributions from shareholders, directors, officers, and managerialemployees; it cannot receive corporate treasury funds. This involves high administrative expenses, which can legally be borne by the corporation, estimated to be up to 50 percent of the sums raised. The ability of PACs to commit money early is indispensable to success in federalelections, because these contributions can be used to "prime the pump"to set up a professionalmoney-raising operation.
PAC contributions to congressionalcandidates have risen in the election years from $34.1million in 1978 to $150 million in 1988. Some 83 percent of the totalwent to incumbents. Says former Senator Barry Goldwater, "PACs set the country's politicalagenda and controlnearly every candidate's position on the important issues of the day."1he important issues of the day."l The power of such special-interest groups as the American Medical Association, the National Rifle Association, and the insurance industry is well known. The increasing reliance of congressional incumbents on PACs for financing their reelection campaigns suggests the capacity by those who control the flow of PAC fundstop managementto find willing listeners to their views on governance. One way to alleviate this problem in the future may be for institutional shareholders to organize their own PACs, although this kind of involvement presents the same problems related to collective choice as any other kind of activism.
Between 1980 and 1982, the "big three" automakersGeneral Motors, Ford, and Chryslerlost $8 billion pretax, and their domestic market share sank to 71 percent,2 from a high, in 1955, of 95 percent of the nation's sales.3
In 1980, the government "bailed out" Chrysler, saving it from almost certain bankruptcy. The vaunted discipline of the marketplace was overruled, establishing a basis for the belief that no corporation in America that is large and sufficiently well advised will be allowed to fail by a government unable to deny focused constituency pressures. It is well known how the most sophisticated of Washington lawyer-lobbyists choreographed the assault on elected officials by labor unions, suppliers, customers, dealers, and representatives of local communities where plants were located. The bailouts of Continental Illinois Bank, Lockheed, and Chrysler all prove that the government will not allow a company to fail, so long as it is of a critical size. Company management can successfully involve government; government will take the steps necessary to ensure survival; the interests of the constituency groups will be served in the short run. It has nothing to do with profit; it has to do with the continuance of a pattern of industrial functioning for which a politically effective coalition can be mobilized.
President Reagan, a free-market advocate, while campaigning in Detroit in 1980 addressed another "problem" of the automobile industry: "I think the government has a responsibility that it's shirked so far. And it's a place government can be legitimately involved, and that is to convince Japan that in one way or another, and for their own best interest, the deluge of their cars into the United States must be slowed while our industry gets back on its feet."4 Aswe will see, Reagan delivered on hispromise, illuminating how even the most ideologically opposed elected officialsultimately will serve asagentsfor the statusquo rather than let their constituents(or their political fortunes) risk creative adjustment to change.
There are interesting implications: VRAs are increasingly being used (by the United States) as part of a web of devices to support domestic industry or improve its competitive position, without having to compete in the traditional sense. They form part of an unwritten industrial policy for which consumers pay the price.
The automobile industry was able to generate virtually unanimous political support for the government to intervene. The only real question was how. VRAs for the automobile industry constitute a particularly prominent and well-analyzed example of how corporations influence their regulatory environment, how wielding such influence can become a competitive weapon. Parenthetically, we may ask who benefits from this flexing of corporate muscle. We will see that, in the short term, all of the most affected constituencies benefited. The union workers were locked into their jobs with higher-than-competitive salaries for a few more years; the companies made profit and cash; shareholder values soared. Even the Japanese companies were happy: "[T]he quotas were a boon to the Japanese manufacturers, who did extremely well and greatly strengthened their position in the U.S. market. Thanks to the artificial hold-down of supply, they boosted their prices and profits....Buoyed by the profits from price premiums that often exceeded $2,000 per unit, the Japanese companies' U.S. dealer networks got bigger and stronger."6
VRAs are devices to limit foreign competitors in favor of domestic industry, based on the argument that because they do not play by the same rules, competition is unfair. The essence of the agreements is that they should be voluntary and temporary; in reality they are neither. The beauty of it, from the importing government's point of view, is that it shelters domestic industry without appearing protectionist, and it does not directly contravene the General Agreement on Tariffs and Trade (GATT) or domestic legislation. Because the arrangements are "informal," the traditional and expected legal protections against monopolistic behavior are simply suspended.
There is another beauty to VRAs that is more sinister. Powerful corporations can use VRAs to ensure their own "earnings" at the expense of other constituentsin this case the American consumers, "who paid over $5 billion a year in artificially elevated car prices and were deprived of product choices."7
There have been a number of studies of the impact of the VRA. One study estimated that the restraints produced an increase in cash flow estimated at some $6 billion. Accordingly, between 33 percent and 45 percent of the automobile industry cash flow for 1984-85 may be attributed to the restraints.8 The premium for consumers has been estimated at between $500 and $2,000 per car and total consumer losses of up to $5 . 3 billion . 9 One study estimates that "by 1984 the restrictions led to an $8 . 9 billion increase in U. S . producers' profits, virtually all of the industry's record profits of that year.10
The VRA produced pricing increases typical of successful cartels. Consumers stillpurchased imported cars, but paid up to $2,000 more for them. Not surprisingly, having achieved protection from competition, the domestic manufacturers substantially increased the prices of their own cars . Profits for the automobile industry in the mid-1980s were, therefore, really a government-mandated transfer from the American customer to the Big Three (and, as we willsee, to the Japanese manufacturer, the unintended beneficiary of the whole exercise).
The actual effect of the VRA was to boost short-term earnings and support wage levels (higher than those in Japan or those for other American manufacturing jobs). But it is another of the principal uses of the huge cash flows that deserves special attention. During this period the automakers repurchased upward of $10 billion of their own capital stock.
In our continuing efforts to understand the driving forces behind large American companies, the fact that $10 billion was allocated to the repurchase of stock rather than research and development, new facilities, or any other corporate purpose, is of seminal importance. The automobile manufacturers effectively exerted extensive political pressure to induce the federal government to adopt VRAs, which increased profits for the automobile companies by increasing prices for the American consumer. Approximately the same dollar amount as was extracted from the customer was used to reduce the capital of the corporations, or, in other words, to partially liquidate them.
Issue (Repurchase) of Stock, Millions of Dollars
This analysis is intended not to demonstrate causality, but rather to identify certain phenomena. Regardless of what else happened in the U.S. automobile industry in the 1980s, consumers paid approximately $10 billion more for their cars than they would have, had the auto industry not been successful in having the VRAs imposed. At the same time, the automobile industry used approximately the same amount of money to buy back its own stock. This is not a long-term plan for value enhancement.
It is difficult to correlate the operations of the American automobile system over the last decade with a dynamic of profit maximization for shareholders. Indeed, the only constituency that seems wellserved by these events is top management, whose reward is calculated not by market values but by the manipulable intricacies of accounting.
The statement that the eventual consequences of the VRA willbe beneficial to the U.S. auto industry is rather ironic, depending on one's perspective. In campaigning for the VRA, management spoke of "profit maximization," meaning that by protecting their oligopoly and creating an excess demand they could achieve a short-term boost in earnings. The United Auto Workers was concerned with preserving premium-wage jobs. Some public officials may have believed that the VRA would provide the "breathing space" necessary to invest, remodel, retool, retrain, automate, and introduce new management techniques in order to compete successfully with Japanese manufacturers. What actually happened, in addition to the short-term wage support and earnings boosts, was acceleration in setting up "transplant" factories and new capacities in the United States, as wellas an increased number of joint ventures between U.S. and Japanese companies.
This acceleration was not entirely due to the VRA. Yen/dollar exchange rates have had some impact, although Japanese decision making is so long-term that these fluctuations are not as significant as some have claimed. The VRA creates an immediate incentive to obviate the quota by producing within the United States. An industry that expends its energies to secure a VRA is likely to be a vulnerable one. The protectionism prolongs the distortions and the inefficient allocations in the economy that gave foreigners an advantage in the first place. This, in turn, makes direct investment in the United States very attractive, as the domestic industry has failed to take the essential reforming steps to make itself competitive.
The huge presence of Japanese manufacturers in the United States has continued to erode the market share of the Big Three. In fact, with Honda and Toyota capturing as much of the market as Chrysler, it is no longer the Big Three. For American companies, it is the Big Two. Counting allcomers, it is the Big Five. The irony is that the VRA may have cut short the breathing space and made a much more competitive environment than those who fought for it intended. Reports that "transplants" and imports combined willshortly achieve up to 40 percent of the U.S. market suggest that the consumer may well, at last, get a better product at a lower cost.
With the benefits of hindsight, let's contrast the automobile industry's recourse to its political power and the "protection" of the VRAs with a genuinely competitive industrial strategy.11ategy.ll We have seen that the artificial VRA profits in effect were applied to partially liquidate all of the Big Three. Suppose that U.S. automakers had lowered their prices and reduced their margins and earnings. This means that they would probably have sold more cars and would have been more successful in preserving their market share.
On the other hand, the course of action they took resulted in a 10 percent direct loss of market share, and the indirect loss through the transplants is substantially higher. Even with $10 billion of reduced earnings, they would have ended the decade in the same financial position they were in following the repurchases of their own stock. From this we understand that the dominant trend in the principal American industry is to use its power over government for short-term protection rather than in trying to compete in international markets. It is impossible to correlate this behavior with the profit maximization model.
From this experience, we will try to identify some of the characteristics of modern-day American business. The interrelationship of business with government, both national and local, creates the structure against which commercial activity takes place. The automobile industry, through the Chrysler bailout and the VRAs, together with a decades-long negotiation on pollution and energy efficiency standards, illustrates graphically some of the direct ways in which corporations extract preferential treatment from government. At the same time, in a more subtle way, business attempts to influence the "rules" so as to permit the appropriation of profit from commerce while externalizingplacing on society as a wholeas much as possible of the related costs.
This is not as hard as it sounds. Regulatory agencies are well-known "scarecrows of the law" that follow set patterns. First, the system is set up to protect against some harm, such as predatory pricing or unsafe food. Who is selected to staff the agency? Almost inevitably, an "expert" from the regulated community. Even the most vigorous opponent of the industry, however, soon becomes co-opted, for a variety of reasons. Perhaps he wants to expand the agency's jurisdiction or budget, for which he needs industry support. Perhaps he just wants a job with industry when the administration ends. Possibly an influential senator has an influential constituent. Or maybe all of the information coming into the agency is prepared by the industry itself.
For all of these reasons and many others, government regulation turns scarecrows not just into perches, but into props on which the industry is dependent. When Nell and I worked with the Presidential Task Force on Regulatory Relief, during the Reagan administration, we found that business representatives continually sought more rather than less regulation, particularly when it would limit their liability or protect them from competition.
A good example of an industry that is utterly dependent on government "props" is the tobacco industry. This might make sense if it were an industry that provided a benefit of any kind to anyone (other than the corporations that manufacture tobacco). On the contrary, of course, the tobacco industry has the distinction of selling the single legal product most injurious to health. As an economic matter, its only advantage is that it keeps the Social Security system's books balanced by killing people before they can begin to collect.
The tobacco grower enjoys an extensive system of subsidies. Costs for the tobacco industry are reduced by placing the costs of smoking on users, their families, medical service providers, and society as a whole.
The federal government's minor attempts at reducing smoking (dwarfed in cost by the amount spent indirectly encouraging it) have, not surprisingly, failed. The requirement that a warning be prominently printed on each pack of cigarettes has given the industry an effective defense in lawsuits where smokers claim damages for wrongful death. The companies simply argue that the federal government has, through its notice requirements, evaluated the risk and prescribed measures appropriate. And the ban on broadcast advertising was seen by some in industry as a benefit, because radio and television were most effective at introducing new brands; thus, the old, established (high-tar and high-nicotine) brands were made even safer from competition.
Suppose that the real costs of smoking were charged to the cigarette manufacturers. Add back growing and other subsidies, calculate and charge medical and workplace costs, and impose liability for shortened life. Would there still be a tobacco industry? Experience in Europe with a drastically increased cigarette tax indicates that cost significantly reduces consumption. Arguably, this is an industry that would not exist were it not for the variety of societal subsidies that its effective use of power has managed to command. The business logic would be to reduce or eliminate investment in cigarette manufacturing, were the industry not so successful in dumping a substantial portion of the external costs on society. Society is a double loser, first in paying the various subsidies and second in fostering a reduced standard of living.
But it is shareholders who pay the cost of criminal activity by corporations; and they pay for it three times. First they pay as members of a society with polluted water or rigged markets or dangerous products or workplaces. Then they pay the costs of both the prosecution (as taxpayers) and defense (as shareholders) when charges are filed. Then they pay again, for the fine comes not from the bank accounts of the men and women who participated in the criminal activity, but from the corporate coffers.
Criminal convictions, nolo pleas, and routine involvement in illegal activity by all of the largest and most respected American corporations have become commonplace. Such conduct both trivializes the relevance of society's determinations of what constitutes unacceptable activity and demoralizes the citizenry in the face of continued inability to hold corporations meaningfully accountable to societal standards.
Why do corporations engage in criminal behavior? It has to be because, at some level, they find that the benefits outweigh the costs. Or, more likely, management finds that the benefits accrue to the corporation while the costs are borne elsewherethe externalizing machine at work. This question becomes increasingly pressing as Congress investigates the defense procurement scandals, as hospital refuse washes up on beaches, and as Wall Street brokers are led away in handcuffs. These events have shown that companies do not have adequate incentives to obey the law and that shareholders can play a constructive and important role in creating appropriate incentives.
It is important to emphasize here that some infractions are inevitable. Laws and regulations are complex, and their interpretation and enforcement vary enormously from one administration to another. Shareholders do not want companies to be so risk-averse that they always adopt the most conservative interpretation possible; sometimes it is worthwhile to challenge the law. And Congress has a tendency to react to a problem by criminalizing it; Congress tries to appear to be cracking down on defense contractors and polluters and does so by characterizing relatively minor violations as criminal. But directors must take the responsibility for setting some standards for the company.
Morton M. Lapides of Alleco was convicted of a price-fixing scheme that resulted in record-breaking fines. The judge found the facts of this case so disturbing that he took the unprecedented step of issuing a prison sentence for the corporation. Four of its top managers were directed to spend up to two years performing community service. The judge said, "I cannot imagine any company being more tied up with illegal activity." This is simply and clearly unacceptable in corporate leadership. Yet, despite a challenge in court, Lapides was permitted to take the company private.
The president and vice president of Beech-Nut admitted that they knowingly permitted sugar water to be sold as apple juice for consumption by babies. The company pled guilty to 215 counts of violating federal food and drug laws and paid a $2 million fine. This severely damaged its credibility. According to the New York Times, its market share has dropped 15 percent.12 It is reasonable for the shareholders to expect the directors to make sure that this kind of thing does not happen again. Did the directors of Nestle, the parent company, fire these men? On the contrary. They paid all of their legal fees and continued to pay their salaries during the prosecution.
Shareholders can reasonably conclude that by providing such assistance the directors have made it clear to the company's employees, its customers, and the community that it will tolerateeven supportthe knowing sale of colored sugar water as apple juice, to be fed to babies, who cannot complain about it. The directors have made it clear that they will tolerateeven supportactions that result in record-breaking criminal penalties. Shareholders can reasonably conclude that the directors have made it clear that they do not deserve the shareholders' support. And the shareholders should not give it.
From the point of view of the institutional investorparticularly the pension funds, who are the epitome of the long-term investor, acting as proxy for millions of working Americans who want to retire in a country that is, among other things, law-abidingthere is no issue more important than their capacity to require that corporations comply with the standards of criminal behavior established by society. Owners must insist that their managers run their businesses in compliance with the laws of the country in which they operate.
Although there is great public concern over the existence and extent of corporate crime, there is remarkably little baseline scholarshipvirtually no centralized sources of information, no agreement on terminology, and only the slightest sense that we are even now grasping the extent of the problem. The "scholarship" boils down to two studies: Sutherland's White Collar Crime, first published in 1949, 13 and the various collaborative works of Marshall Clinard and Peter Yeager, sponsored by the U.S. Department of Justice, including Illegal Corporate Behavior (1979)14 and Corporate Crime (1980).15 Illegal Corporate Behavior confirmed Sutherland's principal finding: corporations violate the law with great frequency. "The 582 Corporations surveyed by Clinard and Yeager racked up a total of 1,554 crimes, with at least one sanction imposed against 371 corporations (63.7 percent) of the sample. And although 40 percent of the sample had no actions initiated against them, a mere 38 parent manufacturing corporations out of a total of 477less than 10 percenthad ten or more actions instituted against them. These 38 recidivist corporations accounted for 740, or 48.2 percent, of all sanctions imposed against all the parent manufacturing firms surveyed."16 In 1980, Fortune magazine surveyed 1,043 large companies and concluded that a "startling" number of them had been involved in "blatant illegalities." "Almost two years after the Fortune story, U.S. News & World Report conducted a survey of America's 500 largest corporations and found that '115 have been convicted in the last decade of at least one major crime or have paid civil penalties for serious misbehavior,'" defined as criminal convictions, civil penalties, or settlements in excess of $50,000.17 Recent concern over the extent of criminal activity by defense contractors has attracted wide attention.
The problems presented by corporate criminal activity leave one with a sense of resignation. While almost no one condones it, no one seems to know what to do about it, raising the worry that corporate criminality may be part of the inevitable price for the undoubted benefits derived from large business organizations.
The applicability of criminal law constraints to corporations has been mired in an apparent effort to treat artificial entities as if they were natural persons. One of the most astute current observers concluded, "At first glance, the problem of corporate punishment seems perversely insoluble: moderate fines do not deter, while severe penalties flow through the corporate shell and fall on the relatively blameless."18 It is worth noting that the United States Sentencing Commission concluded its multi-year study in 1990 with sentencing recommendations for corporate crime, but Bush administration support for them was withdrawn weeks later, after some discreet lobbying by business leaders and a phone call from the office of the White House Counsel.
California, on the other hand, with a GNP that would be the world's ninth largest if it were a separate country, is the physical location of many of the nation's largest company headquarters. If there is such a thing as a "race to the top," California is in it alone. The state legislature has a real commitment to the notion that accountability to shareholders is the best guarantee of productivity and competitiveness. The result? While 56 of the S&P 500 are located in California, only seven of the S&P 500 are incorporated there. Times Mirror, Occidental Petroleum, Wells Fargo, and Disney are among those who left California for Delaware during the 1 980s . The state senate's Committee on Corporate Governance, Shareholder Rights, and Securities Transactions, on which I serve, has recommended federal preemption of corporate law in utter frustration. At the federal level, California has 2 senators and 45 representatives in Congress. However, under the current system, laws governing California corporations, and other corporations invested in by California shareholders, are enacted by the Delaware state legislature, where California has no representation at all. Massachusetts, concluding a long, thoughtful study of its takeover laws, came to a similar conclusion .
No one thinks any more that state control of corporate law is useful because it has some connection with local interests, but there are still those who think it is a good idea because it encourages diversity and innovationthe "states as laboratories" theory. This theory holds that states will compete with each other for corporations by enacting better laws. But, as former SEC chairman William Cary has memorably noted, what we have is a "race to the bottom."20 Management picks the state of incorporation, and, to the extent that there is competition, the result is a contest to see who can treat management the best. So far, Delaware has been the clear winner. A state cannot give a CEO a higher salary, but it can give him a more secure job. When Nell and I testified before the Delaware legislature, in opposition to its antitakeover law, every single representative of shareholders, every scholar, every economist, every representative of the U.S. government was on our side. But when the CEOs suggested that they might have to consider reincorporation elsewhere, there wasn't a chance that our side would prevail. How many shareholders vote in Delaware? And if they don't like the outcome, what can they do about it?
Not much. Although the state of incorporation must be approved by shareholders, there has never been a case where the vote has even been close. And shareholders do not have a meaningful right to change a company's state of incorporation; this is typically a prerogative of the board of directors. Indeed, as a technical matter, a company does not "change" its state of incorporation; it ceases to exist in one state and is recreated in another.
The first state antitakeover law, enacted in Virginia in 1968, inspired 36 states to pass similar laws over the next 13 years. In 1982, the U.S. Supreme Court ruled in Edgar v. MITE21 that the Illinois takeover law was invalid due to interference with interstate commerce, in effect canceling the majority of existing laws.
The states then devised another method of corporate protection: regulating business combinations and shareholder rights. This time the Supreme Court upheld the state laws. With the landmark 1987 decision, CTS Corp. v. Dynamics Corp. of America,22 the Supreme Court ruled that the Indiana control share antitakeover law was constitutional, opening the floodgates for more antitakeover legislation that used this tactic.
The issue in that case was an Indiana statute that limits takeovers of Indiana corporations by requiring shareholder approval beyond the requirements in federal law. The Indiana statute provides that the shareholders of the company have the opportunity to decide whether a would-be acquirer obtains voting rights along with the shares if the shareholders' company is chartered under Indiana law, and there are a significant number of shareholders in the state. This type of statute is called a control share statute. Its effect is to make taking over an Indiana corporation very difficult.
The Court found that the Indiana control share statute was valid, even if its effect was to decrease the number of successful tender offers for Indiana corporations, because it treated in-state and out-of-state corporations equally. The Court also found that the Indiana act served a legitimate purpose.
This decision led to a real scramble as states moved quickly to protect local companies. Since the CTS decision, over 40 states have successfully enacted antitakeover laws, including Delaware, despite the fact that studies have consistently shown that they depress share value.
The CTS Decision
It thus is an accepted part of the business landscape in this country for States to create corporations, to prescribe their powers, and to define the rights that are acquired by purchasing their shares. A State has an interest in promoting stable relationships among parties involved in the corporations it charters, as well as in ensuring that investors in such corporations have an effective voice in corporate affairs.
There can be no doubt that the Act reflects these concerns. The primary purpose of the Act is to protect the shareholders of Indiana corporations. It does this by affording shareholders, when a takeover offer is made, an opportunity to decide collectively whether the resulting change in voting control of the corporation, as they perceive it, would be desirable. A change of management may have important effects on the shareholders' interests; it is well within the State's role as overseer of corporate governance to offer this opportunity. The autonomy provided by allowing shareholders collectively to determine whether the takeover is advantageous to their interests may be especially beneficial where a hostile tender offer may coerce shareholders into tendering their shares...the possibility of coercion in some takeover bids offers additional justification for Indiana's decision to promote the autonomy of independent shareholders.
Source: 481 U.S. 69, 91, 92 (1987).
One of the first states to pass a post-CTS antitakeover bill was Washington, to protect Boeing from a possible 15 percent acquisition by T. Boone Pickens. The only problem was that Boeing was incorporated in Delawarenot Washington, where it was physically located. But Boeing accounted for an estimated 8 percent of Washington employment. A special clause was therefore included to cover out-of-state companies, narrowly drafted so that, in effect, the only company it applied to was Boeing. Thus, Boeing is doubly entrenched: it receives not only the protections of the state where it is chartered, but those of the state where it is located. Needless to say, its shareholders get no protection from anyone.
The Benefits of Protecting Entrenched Management
Nothing in the Constitution says that the protection of entrenched management is any less important a "putative local benefit" than the protection of entrenched shareholders.
Justice Antonin Scalia
Source: 481 U.S. 69,95 (1987).
The traditional justification behind such laws, that worthwhile experimentation is incubated by competition among the states, simply makes no sense any longer, if it ever did. Competition works only if the states must bear the costs of the benefits they provide to entice corporations. State corporation law is just another opportunity to impose externalities on othersin this case, shareholders. Delaware can make its laws as liberal as it wants because it bears such a tiny proportion of the consequences, with that proportion vastly outweighed by the benefits of the tax revenue, and the people adversely affected are almost all outside the state. The Delaware state pension fund, probably the largest shareholder in the state, was prepared to testify against the same antitakeover law we opposed, but it was rolled at the last minute by the governor.
When lobbying for or against such legislation, managers use corporate funds, whereas stockholders, who are dispersed geographically and unable to identify each other without great expense, are not as able to pool resources. Thus, shareholders are again faced with the problems of collective choice; those who would oppose such legislation would likely incur individual costs greater than the individual benefits.
As of 1988, some 17 states had passed statutes for the specific purpose of protecting a specific local company from a specific pending takeover. Another study concluded that, in the vast majority of cases (28 out of 40), state antitakeover legislation was introduced on behalf of at least one large firm headquartered and/or incorporated in the state. In 1990 alone, there were three more statutes, all worth examining for the process that produced them and the impact they had: Pennsylvania, for Armstrong World Industries, Inc.; Massachusetts, for Norton; and Indiana, for Cummins Engine. Interestingly, all three states had recent antitakeover provisions on the books; the Indiana law was the one upheld in CTS, and the other two states made comprehensive revisions, Massachusetts' enacted after thoughtful review by a special commission and legislative hearings, and Pennsylvania's based on a proposal developed over more than a decade by the Pennsylvania Bar Association.
The earlier revision to the Pennsylvania law included what is called a stakeholder statute, discussed in Chapter 3. It gave directors the authority to "consider" the views of employees, customers, suppliers, the community, and other concerned parties in evaluating various options. This apparently was not enough, and when local company Armstrong World Industries was a takeover target, the law was amended to make it clear that directors owed no special duty to any one corporate constituency, including shareholders.23 In other words, under Pennsylvania law, it is apparently now permissible to say that a takeover would have been good for shareholders, but the directors voted against it because of some speculative concern about its impact on any segment of any group having any connection to any aspect of the company. In order to exempt directors from any possibility of liability if they "just say no" to potential acquirers, irrespective of price and term, this statute was passed, destroying the basis of corporate legitimacy by eliminating any enforceable obligation of competence or loyalty by management to ownership.
In effect, Pennsylvania rendered common stock obsolete for those companies that chose to be covered by Act 36. It eliminated the guarantees that are an essential part of the contract with stockholders: the duty of loyalty that ensures that their interests are paramount in the directors' minds and the ownership rights that enable them to make changes if management fails to act responsibly.
The new Pennsylvania law also included a control share provision and a few new twists.24 Anyone who unsuccessfully tries to take control of a company incorporated in Pennsylvania may have to "disgorge" the profits, that is, pay them back to the corporation. In addition, it provides for tin parachutes for employees who lose their jobs following a change in control and prevents abrogation of labor contracts for up to five years following a change in control.
Possibly no investment group in the Western Hemisphere had acquired such a reputation for the successful extraction of greenmail as the Canadian Belzberg family. When they acquired significant minority interest in Armstrong, the legislature, acutely aware that 1990 was an election year, came to Armstrong's aid.
The New York Times editorial section called Act 36 "the sorriest example of state intervention.... Pennsylvania's gain is the nation's loss. By protecting poor managers, the law perpetuates inefficiency. There will be more jobs in Pennsylvania, fewer elsewhere . . . the effect would be to absolve management of accountability for the property they manage."25 Forbes wrote that if managers of "underperforming companies catch on, Pennsylvania - long the legal residence of some of this country's greatest companies - could end up as the last refuge of corporate laggards."26 And a Wall Street Journal editorial simply said, "It is indeed an awful piece of legislation."27
As noted in Chapter 3, two studiesone by Wilshire Associates and one by Karpoff and Malatestahave concluded that the adoption of the law caused a significant drop in Pennsylvania stock values. Karpoff and Malatesta estimate that the economic loss to shareholders of firms affected by state antitakeover laws passed before 1988 is at least $6 billion.28
These studies provide such strong evidence of an adverse impact on share value that they provide a strong basis for other kinds of shareholder action. A fiduciary will find it hard to support change of the state of incorporation to Pennsylvania. There may even be sufficient basis to encourage, even require, a fiduciary to initiate action to encourage a company to opt out of one or more provisions of the law, or to incorporate in another state.
It is important to note that any Massachusetts corporation could, at any time, have adopted this provision (with shareholder approval). Every such proposal has been approved by shareholders, except for Honeywell (discussed in Chapter 6). There was something sadly ironic in watching the state legislators voting as elected officials to disenfranchise shareholders.
Legislators, in fact, unanimously supported the bill. James Segal, who was BTR's counsel at the time, believes that legislators felt there was "no clear political advantage in opposing the bill...BTR didnt have any constituencies in Massachusetts. People just don't think of themselves as shareholders, for the most part. They think of themselves as employees, or they think of themselves as managers, or they think of themselves as neighbors, but certainly not as shareholders."29
The result of the new law is that no matter how large a percentage of the company's stock is acquired, the shareholders can elect only one-third of the directors and will not be able to dismantle the various antitakeover provisions in effectprincipally the poison pill. In turn, this means that the tender offer cannot be consummated, so the vote cannot be cast, and thus the effort is stillborn before it can begin. Within a week of the effective date of the new statute, Norton management concluded an arrangement with St. Gobain on terms more satisfactory to themselvesand, it should be said, to the shareholders. (Another irony: one of Norton's objections to BTR was that it was foreignapparently not a problem with the French St. Gobain.) The result is that the Massachusetts legislature has permitted its corporations, for no reason, to sever the accountability of management to ownership that existed through the annual election of directors, and they. have left nothing in its place.
But the story of Cummins Engine outdoes them all. Like GAF, Cummins is worth looking at because it is a good company with a good record of commitment to shareholder value. Yet Cummins galvanized all of its corporate resources and political power over a two-year period to successfully repel two uninvited shareholders and recapitalized the company on terms that specifically entrenched current management. It might fairly be said that Cummins represents the state of the art in corporate governance in the 1990s, demonstrating the ultimate externalization of costs and the subordination of all other concerns to establishing the absolute "right" of current management to direct a public company's affairs, with no accountability to anyone, public or private, shareholder or government.
Earning the Right to Corporate Existence
No corporation has an inherent right to exist. It wins its right by producing needed goods and services within the parameters set by law and acceptable conduct. In industry we have long accepted the fact that if a corporation cannot compete effectively in the marketplace, it will fail; we are less ready to accept the fact that the justification for our existence depends also on meeting the requirements set by the societies in which we operate.
Henry B. Schacht and Charles W. Powers.
Source: Henry B Schacht and Charles w. Powers, Business Responsibility and the Public Policy Process, in David Vogel and Thornton Bradshaw (eds.), Corporations and Their Critics: Issues and Answers to the Problems of Corporate Social Responsibility,: McGraw-Hill, New York, 1981, pp 27-28.
Cummins is one of the crown jewels of the American industrial establishment. Its longtime chief executive officer and founding family member J. Irwin Miller, now 81 years old, is the archetype of a business statesman. National finance chairman for Nelson Rockefeller's political efforts and midwestern Medici in bringing the world's best architects to Columbus, Indiana, Miller also developed what was probably the only fully staffed corporate "ethics" office inside a major company. Esquire once picked him as presidential material. In short, Miller is an authentic culture hero.
Henry Brewer ("Hank") Schacht, of Yale and the Harvard Business School, was widely applauded for turning down "a relatively glamorous opportunity on Wall Street to work in the boondocks."30 His resume reads like the dream of every young MBA. A director of CBS, Inc., the American Telephone & Telegraph Company, and the Chase Manhattan Bank, a trustee of the Yale Corporation, the Brookings Institute, the Conference Board, and the Ford Foundation, and a member of the Business Council and the Council on Foreign Relations, Schacht became CEO of Cummins at a relatively young age and has presided for more than a decade over a company that, until the most recent times, was widely admired.
No corporate cast of characters would be complete without the board, and this one glitters. Cummins's outside directors include former cabinet officers and chief executive officers, a university president, and the chairman of the Ford Foundation. They sit on each other's boards in an interweaving that might be considered the summit of America's business establishment.
As a company, Cummins long epitomized the paternalist corporation of the post-World War II years. It paid its workers handsomely, it poured millions of dollars into its home town, it expanded rapidly, and it produced productsengines for the heavy truck marketof the highest quality. But in the 1970s, demand for heavy truck engines declined. To make matters worse, Cummins's Japanese licensee, Komatsu, bolstered by a 30 percent cost advantage due to its extraordinary efficiency, began producing a replica of the Cummins engine. Cummins's response was much admired. In contrast to virtually all other sectors of the economy who were clamoring for government protectionnotably the automobile industry, as we discussed aboveCummins made the brave and virtually unprecedented decision simply to cut engine prices to whatever level was necessary to maintain market share. That price was below cost, forcing Cummins to lose money on every engine sold. This, of course, guaranteed a period of losses and cash drain.31
Year after year, Schacht predicted that the bottom had been reached and that a return to profitability was in sight. But despite improvements in quality and delivery time, and savings in production costs, the company's performance did not improve. Part of that could be attributed to overall market conditions, but not all; Cummins lost market share not just to the Japanese, but to a U.S. competitor as well. Management set a target of a 5 percent return on sales as the chief measure of its performance, a standard met only twice in the past 11 years and not at all since 1985. Cummins's losses and declining management credibility have caused stock losses of nearly half the market value since 1983, during a period when the Dow Jones Industrial Average has doubled. In the past two years Cummins has fallen from first place to seventh (out of 10) in its industrial category in Fortune's annual survey of America's most respected companies.
This low stock price and the company's historic reputation caught the attention of two prominent foreign industrial groups. First, Hanson from Great Britain bought a 9.9 percent stake, which was purchased by the Miller family in July 1989. In that same month, New Zealand's Sir Ronald Brierley of Industrial Equity (Pacific), Limited (IEP) first disclosed his accumulation of stock, which ultimately rose to 14.9 percent.
Cummins's reaction to these investments by large foreign industrial groups exemplifies the conflicting considerations underlying corporate governance. Simply put, Cummins, the essence of what is best about American industry, with a combination of leaders who define the establishment, has failed the test of the marketplace. In theory, then, there should be some kind of correction. The ultimate discipline of corporate managements, the structure that legitimates their exercise of power, is the accountability that should provide this correction. The only thing that prevents them from being dictatorships (even, as might be the case with Cummins, benevolent ones) is the capacity of shareholders to change the board of directors. In this case, it didn't happen, because Cummins changed the rules. Accountability to shareholders is no longer convenientmanagement develops strategies for whose ultimate success or failure it is not accountable to anyone.
Cummins management developed a full panoply of antitakeover devices to shield itself, and to protect the company (to the extent that the two are different), from the impact of declining earnings. They were legitimately concerned that the institutional shareholders who held a majority of their stock would jump at any offer over the depressed trading price. In 1986, the board enacted a poison pill that prevented any person from acquiring more than 25 percent of the outstanding common stock without board approval.
Incorporated in Indiana, Cummins then lobbied the Indiana state legislature to rid its corporation statutes of a provision requiring a company to allow any shareholders owning 25 percent or more of a company to call a special meeting. The legislature was more than happy to oblige. It is interesting to note that even Delaware, the most popular state for incorporations, does not alter its laws so blatantly for corporate interests. In Delaware, corporations instituting antitakeover measures generally make changes to their charter and bylaws. In Indiana, like Massachusetts and Pennsylvania, corporations seem to make changes to state statutes as well. In January 1989, the board amended the bylaws accordingly, eliminating shareholders' ability to call a special meeting or to put particular items on the agenda. None of the Cummins changes was submitted to shareholders for their consideration or approval. In its most recent financings, the 1987 series A preferred stock and two debt issues, Cummins inserted so-called poison puts. In the event of any change of control that is not approved by the board of directors, each holder has the right to require Cummins to repurchase the security. The stock option and bonus plans provide for vesting and extraordinary payouts in the event of a change of control. Cummins had circled its wagons to fend off any form of unwanted involvement.
It was represented widely that the Millers had actually lost money in these transactions, and that this was really the ultimate act of corporate statesmanship, the ultimate statement of the Cummins culture. It showed the willingness of the principal owners to incur personal loss to remove any distraction from their ability to continue to conduct the business in the long-term direction they were convinced was ultimately of maximum benefit.
Also in July 1989, the board established a leveraged ESOP, holding approximately 11.5 percent of the shares outstanding.32 As we earlier learned, ESOPs, with the unexceptionable purpose of increasing employee ownership, can be used as a defense against takeovers, because they put a large block of the company's stock under management controlenough to prevent a takeover under Delaware and some other state laws. The Cummins ESOP provides a formula for voting the shares. Most of the shares will not be allocated for some time, and they are to be voted in proportion to the directions received from the participants with respect to the allocated shares.33 Allocation will initially be made to those employees, including officers and directors, with the longest service and the highest pay. They might be willing to vote against management; but this would be not only highly unlikely, it would be unprecedented. The ESOP is therefore the greatest rabbit management ever pulled out of a hat; it is a way for management to get control over sufficient stock to stand off just about any would-be acquirer, absolutely free.
This scheme to increase incumbent management's voting control was underscored with a provision in the preferred stock issued to the Millers in July 1989. The Millers gave up voting rights for both the stock they bought from Hanson as well as the stock they held before.
Certainly, lawyers have found takeovers to be an unmitigated bonanza. As with most of these cases, litigation, countersuits, and federal and state investigations ensued, all focused on one specific aspect of the subsequent discussion between Brierley and Cummins. The facts are clear, at least in their broadest outline: First quarter bullishness about Cummins's earnings prospects was succeeded by the September 21 announcement that there would be a substantial third-quarter loss, with the outlook for the fourth quarter uncertain. This announcement caused the price of Cummins stock to fall by more than $5 per share. Brierley (this part depends on whose filings you believe) either merely requested a board seat or threatened to wage a proxy fight against Cummins if he didn't get a board seat. The various legal challenges center on whether IEP made appropriate public disclosure of its intentions.
Although there is some question as to the tenor of the request, there is no question that Brierley asked fordemanded, if you willonly a single representative on the board of Cummins. Why, one might ask, is it not utterly reasonable for the holder of approximately one-seventh of the corporation's equity to have representation on a board of more than 10 directors? In a state like California, which until 1990 required cumulative voting in the election of directors, Brierley's ownership could, as a matter of right and mathematics, require Cummins to give it a board seat. What was Cummins so afraid of? One director can, at most, make motions. He is not even guaranteed that anyone will second his motions, to allow them to be discussed, much less that they will be adopted.
Management firmly controls the process of nominating directors, notwithstanding many bylaw provisions and public statements purport- ing to encourage nomination by shareholders. At Cummins, directors are nominated by the board's nominating committee, which has turned down some management suggestions, but has not generated any of its own candidates. We have been unable to find a single instance of any company accepting a director candidate nominated by shareholders; the closest a company has come was when Texaco selected New York University president and former congressman John Brademas from a list provided by the California Public Employees' Retirement System.
The suggestion that an investor with more than $90 million invested in the company should be permitted to have representation on the board was such a threat to Cummins management that they engaged in defensive maneuvers that set a new standard for energy and scope. As we have already noted, Brierley had 14.9 percent of Cummins stock, had triggered the Indiana freeze-out provision, and could not buy more without triggering the poison pill. If he did go on the board, he would be subject to restrictions on insider trading, further limiting his ability to buy or sell this stock. Thus, Cummins was protected against any threat to control for at least five years. Nevertheless, the presence of an outside shareholder with a major financial interest in the company initiated a commitment of corporate resources virtually without precedent in its ferocity.
But the ball got a bit harder with the involvement of the Indiana Securities Commission (ISC). As background, we note that the commission has been known to be friendly to local businesses. In an unusual suggestion of bias by an administrative agency, federal Seventh Circuit Court Judge Richard D. Cudahy said in an earlier case, "Without trying to anticipate the conclusion of the Indiana courts, to us Coons' [the Indiana Securities Commission's executive officer] construction of the Act has all the earmarks of a 'hometown call.' Indeed, were his interpretation to be sustained by the Indiana courts, the conflict with the Williams Act might well prove irreconcilable."34
The ISC initiated formal proceedings without conducting any preliminary investigation or demonstrating any Indiana jurisdiction. The staff attorney at the ISC originally in charge of the case was removed, according to some sources, because she tried to coordinate with the federal investigation.35 In essence, she agreed not to take action unless the federal court turned up something tangible. Ultimately, the ISC spent a day at Cummins and a total of approximately four hours in the office of IEP's counsel reviewing the extensive discovery materialsexamining only 2 of the 25 depositions taken for the caseand set a hearing date without advance notice to Brierley. "A reasonable observer," said one source close to the case, "could conclude that what the Commissioner did was in line with what the Commissioner had done for the past 20 years: when faced with the possibility of a hostile takeover of an Indiana company, they've done everything they can to aid management."
Brierley's representative was served with an ISC subpoena while in Indiana attending the Cummins annual shareholders' meeting on April 3. To the Brierley representatives from New Zealand, it seemed clear that the home court advantage was insurmountable. Although they believed they would continue to prevail in the federal challenges to the truth of their filings with the SEC, it seemed impossible to overcome the state's protection for local interests. The ISC hearing was scheduled to commence on May 10. On May 7, the ISC agreed to drop its claim that Brierley did not properly disclose the intent of their investment in Cummins. The next day, Brierley signed a standstill agreement with Cummins. The single essential provision from Brierley's point of view was the termination of the Indiana Securities Commission proceeding; Cummins was able to deliver freedom from the ISC without any need for Brierley or its counsel to so much as answer a letter or speak by phone with the ISC ever again. In our view, a state agency was acting as a subsidiary to a local corporation.
Secretary of State Hogsett's press release of May 10, 1990, sounds like a Cummins press release: "Without the aggressive enforcement of our state's Securities' Laws, this dispute may have still been unresolved. With this dispute behind it, Cummins may once again focus on its long-term plans, the long-term interests of its employees and suppliers, and its future as an important part of the Indiana economy." The Indianapolis Business Journal noted, in a classic understatement, that "Indiana Securities Commissioner Mark Maddox thinks pressure from his office may have speeded up the [Brierley/Cummins] settlement."36
Brierley surrendered by agreeing not to increase its holding, not to seek representation on Cummins board, not to attempt to acquire the company, not to make any shareholder proposals, and not to seek control of the management or policies of the diesel engine maker. Furthermore, for five years, Brierley is required to vote for management nominees for director in the same proportion as shares voted by disinterested stockholders.
Schacht had long proclaimed his interest in outside capital. His struggle to obstruct uninvited industrial groups made clear that he wanted to choose the investors. By early summer, he found somethree companies with close business ties to Cummins. Ford, Kubota, and Tenneco invested $250 million in exchange for a 27 percent stake in the company at a price highly favorable to the company and its shareholders. Like the IEP stock, after the standstill agreement, this stock also carries voting restrictions: "The Investor will vote (whether by proxy or otherwise) all Voting Securities then beneficially owned by the Investor for the election of all nominees included in the Company's slate of directors at each shareholders' meeting of the Company." Management now controls the new 27 percent, the ESOP (now slightly under 11 percent), and the Millers' 5 percent; moreover, Cummins placed significant restrictions on Brierley's 14.9 percent. Furthermore, under the company's financing arrangements, if there is a change in control of the company, the debts become due.
What this means is that a majority of the vote is guaranteed to be for management nomineesno matter whatfor the foreseeable future. They still have the right to vote on other proxy issues, but not on the most important issue, selection of the board. This would be like a hostile takeover from the inside, except that the shareholders never got paid for what was taken from them. The company has taken a lot of the value out of the common stock; it will be interesting to see how this is reflected in the market's valuation.37
The Cummins saga raises squarely the question of whether the chief executive officer acts properly when he acts as a "benevolent dictator," the modern incarnation of Plato's philosopher/king. Cummins deserves praise for adopting a competitive industrial strategy. This is not "entrenchment" in the usual sense. Schacht has no employment contract and no salary increase since 1985. He is utterly devoted to Cummins and its constituents, including shareholders. His strategic plan is courageous. But we can admire the strategy without giving up the right to evaluate its implementation. Schacht has arrogated to himself the choice of suitable shareholders, a class composed of people who are prepared to confer their voting rights to the incumbent management. He has thus also arrogated to himself the choice of suitable directors. There is a sort of implicit bargain: management says that they will take chances and compete aggressively, but only on the condition that they foreclose involvement by owners who might have an independent opinion in the governance of the corporation. In sum, having wrapped themselves in the American flag, are Cummins management entitled to claim that industrial virtue exempts them from the obligation to be accountable to anyone?
One final note. In July 1990, Hank Schacht agreed to serve as a director of United Airlines if the employee-led leveraged buyout was successful. Why not? He has plenty of time to devote to directing a new company, because no amount of outside commitments can get him removed from Cummins.