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Markets I do believe are efficient. I think the way efficiency is understood is wrong. That is the assumption that efficiency equals all information being contained all the time in all the stocks is instantly, is a kind of intrinsic view of markets which stocks somehow contain, contain their price immediately. Somehow that happens. The question that I have with people that I thought were really intelligent. Suppose maximizing profits. As if that is the gauge of the efficient market. As if anybody who doesn't maximize the profit, therefore this is only an efficient market. No, the market would be efficient. The stock market would be efficient as long as the price of the stock reflected the fact that they were maximizing or weren't maximizing. The point is that the price of the stock reflects exactly what's going on at that company. Okay, so today I want to get into a further concretization of the stock market. Taking one of the roles of the stock market. And that is its role in corporate restructuring. So we're going to be talking about this class and next class about financial markets and corporate restructuring. How corporate restructuring come into being. And how what role financial markets have in these restructuring. And facilitating them in initiating the restructuring. So corporate restructuring. Now a lot of corporate restructuring happened in the 1980s. You can all recall the takeovers, the LBOs and so on. I'd like to read you a short description out of an article called The Deal Decade. Verdicts on the 80s that was published in Fortune magazine in 1991. This is the quote. The financial civil war that swept across America in the past decade was a rip snorting string of shoot-em-ups like nothing ever seen on Wall Street or Main Street. Withering volleys of money shot back and forth as insurgents stormed one entrenched corporate position after another. Counting friendly and hostile deals, more than one-third of the companies in the Fortune 500 industrials were swallowed up by other concerns or went private. So two things to note here. One is again we see this use of war-like symbolism in order to explain financial phenomena. In order to explain in this case the restructuring of the 1980s. And of course the magnitude. One-third of all Fortune 500 companies in a sense disappeared as independent companies. At least as independently private, publicly owned companies. Now if we look at what happened in this decade let me just give you some numbers to give you a sense of the magnitude of what was going on. Well over 2,000 restructurings. Various forms. Takeovers, LBOs, different types of mergers and spinoffs occurred during this decade. The decade of the 80s. Between 1976 and 1990 there were $1.8 trillion worth of transactions. So these 2,000 plus transactions involved $1.8 trillion worth. Shareholders. Shareholders and takeovers. Made $750 billion during this period. On the other hand if you take the parties that might have lost money like banks, bondholders and other creditors that lost some money due to the takeovers. That is estimated about $50 billion. So there's a net gain, net wealth gain to shareholders or to financial participants. Of $700 billion. If you look more broadly the Dow Jones Industrial Average, one average that measures the performance of the stock market. Went from under $1,000 in the 1970s. Or about $1,000 at the beginning of the 80s, to $3,000 by the end of the decade, to 56 to 7,700. The value of publicly traded companies went from $1.4 trillion to 3 trillion, so it was more than doubled during this period. These restructurings took the form of either leverage buyouts, which we will talk about in more detail, or hostile takeovers, that is takeovers that were not wanted by the company being taken over. And many of the transactions involved very high levels of debt. For example, the Arjean-Ebisco deal, which was the largest leverage buyout in history, involved $24 billion of debt. Now the question is, why did this happen? Why did so many transactions of this nature happen? What role does this play in our mixed economy and our semi-free markets? And why did it happen when it happened? Why did it happen in the 1980s? Why didn't it happen in the 60s, or the 50s, or the 70s? It seems like all these transactions were concentrated in one decade. What is it that was going on during that decade that made these events possible? Then of course, is this a good thing or is it a bad thing? What purpose did it also serve? Okay, in order to understand this phenomenon, in order to understand these restructurings that occurred in the 1980s, we have to go back to a book written in 1932. The book was called The Modern Corporation and Private Property. Its authors were Adolf Bull and Gardner Means. And in finance we refer to this book just as Bulls and Means. Everybody knows exactly what you're talking about. Bull and Means talk about the large corporation. There was just, there was kind of in its infancy, large corporations were established in the US, significantly large corporations at the turn of the century. They talk about large corporations and they talk about the separation of ownership and control in these corporations. Remember we talked about that, the fact that the owners are lots and lots of shareholders? But the control lies with the managers, the professional managers. They made this observation, they said look, managers don't own any stock, yet they are the ones running the company. Shareholders who own the company have very little say in the management, have very little say in what managers cannot, cannot do. There's the separation, the separation of ownership and control. The people who own the corporation don't control it. So managers, once they're put in place, once they are hired and are now running the company, have really no incentives to perform in the best interest of the owners, the shareholders. They're not owners. They are going to try and maximize what they think is in their own best interest. This is Bulls and Meals' means talking. Which is not necessarily consistent with what is in the best interest of shareholders. So for example, they might be lazy, might not want to work hard. So there's an issue of effort. Do they really, really try to do the best possible to maximize shareholder wealth, to make this company the most profitable that it can be? Or do they care about prestige? Prestige might be very important to them, so they would prefer to run a $5 billion corporation versus a $20 million corporation, just makes them look better. So they might expand beyond what is good for the company. They might just expand the company, not for the sake of profits, but for the sake of their personal prestige. Or they just might be incompetent, and they might not be very good. Or they might like the good life and invest in corporate jets and penthouse suites and all the cities they do business in, and have summer and winter homes, all using the corporation's money. Not very beneficial, not necessarily beneficial for shareholders. Some managers, because they don't have stock, don't have the same incentives as shareholders do, and they might behave in all these ways. For example, if they're incompetent, they have no incentive to fire themselves. I really don't know what I'm doing, so I'll quit and have somebody else do it. Now, what Boland means also point out is that it's very difficult to replace managers. For shareholders, it is very difficult to replace management. Remember, shareholders are all dispersed, there are lots and lots of them. To get together to fight managers would be very expensive and very difficult. So while it is the shareholders who bear the risk involved in running the business, bear the residual risk, if the company goes bankrupt they lose everything, but if the company does very well they gain all the profits, managers don't bear this risk. Let's assume we are compensating, let's say we are paying managers a fixed rate. We're paying them a fixed salary, they get a million dollars a year, that's it. So as long as they stay out of bankruptcy, they're fine, but they have no incentive to make lots of money because they don't see any percentage of that, they don't see anything up there. Some corporations in the past have compensated their managers based on sales. If you compensate a manager based on sales, what's he going to do? Well according to them, he would maximize sales at the expense, sometimes at the expense of what? A profit. So maximizing sales is not equal to maximizing profits. So Bowlin means, say, there is a serious problem about the structure of American big business, about the structure of American corporations, there is a fatal flaw in this structure and that is this complete separation of ownership and control. Stop by any of the 133 Los Angeles area O'Reilly Auto Parts stores where you'll find everyday low prices on the parts you need to keep your vehicle at its best. Our guaranteed low prices ensure you're always getting our best deal. In fact, we'll match any auto parts store's price on any like item. O'Reilly Auto Parts, better parts, better prices every day. So let's see if there's any evidence to support this idea and then we'll see where does this problem really arise from. Is this a flaw in capitalism? Is this a flaw in the free markets? What are the other reasons why this is a real problem? Was that a question? I'll take this as a problem because you gave the answer. It reflects the management, the efficiency of the management, it reflects in the price of the stock and if it goes down then the company is vulnerable to leverage buyouts and... We'll take over. Okay and we'll get to that. That's one of the solutions to the problem but let's see if the problem is real. First of all, let's see if this really is a problem. They do not have incentives if there isn't any problem, that's what I'm saying. Well, it's interesting because hostile takeovers in LBO came about in the 1980s. They weren't in existence in the 50s, 60s, and 70s and I would claim the reason is not that managers were so good during that period. So the 80s, I would say that the 1980s were the solution that you're proposing, that was the solution used for this problem. But it still doesn't explain if there is a problem and if so why it came about and why was the solution only adopted in the 80s, why wasn't it adopted in the 40s, 50s, 60s, and so on. So let's first see, look at the evidence. Is the evidence to support this? So what we're looking at is are there bad managers out there? Are there companies that are run poorly out there? They can do this for long periods of time but it's sustainable. And I would say that if you look at American business over the decades of the 50s and 60s and 70s, primarily into the 1980s and there are even businesses today, there are quite a few that were poorly run, that were poorly managed, that did not make the right investments. And I think the Japanese taught us that lesson in the 1980s. The automobile industry is one industry where they clearly were not innovating at the rate that the competition from a board was doing it. And I would claim that this is a result of bad management that started well before the 1980s. A lot of industries in the United States in the 1960s, for example, diversified widely and we'll see in a minute if that's a good thing or a bad thing. So I would say that the evidence is that there's some truth to what they're saying. There are some businesses out there that are very poorly managed and the question is why? Let's look at this a little bit more closely. In finance we identify at least two problems that could arise from the separation of ownership and control. Let's see if the evidence supports us. One is the overinvestment problem or free cash flow problem. Now this is a problem that primarily exists in mature and sometimes declining industries that generate lots of cash. There's a lot of profits but there's no room to expand. There's no real room for new R&D and new products. Like the cigarette companies for example or some food companies that have certain type of cookies that are always going to sell. They just generate lots and lots of money from those cookies. Some manufacturing companies, oil companies during certain periods generate lots of cash. Now in the 1950s through the mid-70s I would say, American business faced very little competition from the world, from other countries in the world and also was the supply of products to the rest of the world. So these businesses' profits were very, very high. Cash was streaming into these businesses. Now the question is given all this cash, given all these profits what does the company do with them? That has three options. One is to expand within its own line of business. It can expand either vertically by buying out its suppliers, its retailers. So control the whole from raw materials to the end product. It could expand that way or expand its factories to produce most, expand within its product line. That would be one option it would have. So use that cash for expansion. This second option would be use the cash in order to buy other companies that are not related to their business. Then you take the conglomerates of the 1960s and you can see this done. For example, General Motors has a car, automobile division, it has aerospace, it has EDS which does computers, it has financial services and a half dozen other businesses on the side. Yeah, they just spun off EDS. If you look at, again this is more prevalent pre-80s than post-80s, if you look at ITT of the past, they had a whole lot of different businesses, uncompletely unrelated. So you couldn't say putting these businesses together created some synergies, created some benefits, but these are completely unrelated. So that's a third way you could use the cash, a second way I'm sorry. The third way you could use the cash, just to give it back to shareholders. To pay it out as a dividend or to buy back your stock, but basically to return the money to shareholders and let them invest it further. Let them choose where to invest it. Now if you have profit opportunities, if there are things you can invest in that are going to generate lots and lots of profits for you, then shareholders would say keep the cash and invest it and make me lots of money, that's good. But if you don't, if you don't have profitable investment opportunities, shareholders would like to see that money return to them so that they can go out looking for profit opportunities and invest in other companies. Now so companies face this alternative, companies face this alternative in the 50s and 60s and 70s, and most of them, most of them chose to diversify. Now one of the reasons they didn't choose so much to invest in their own product is probably for antitrust reasons. That is vertical integration and buying up your competitors is illegal in certain circumstances. You can only do it to a small extent, yeah and they're not definable and they change by administration and it's risky because of that, because of the legal consequences it's risky and therefore was not done. What most firms chose therefore to do with their cash was to diversify. Now think of what that means. It means that these companies, these managers now own not one business but many businesses. Now what do we know about diversification? Good or bad? In general what do we know about diversification? What does it do? It reduces risk. It reduces risk. Okay. So from a manager's perspective, if we view the manager like Bull and Means do, the manager now says by diversifying what am I doing? I'm reducing the risk of going bankrupt. I'm also now controlling a much larger firm so prospective prestige, this is very good for me and if I'm compensated based on sales or based on size, this is good for me as well. Is this good for shareholders though? Is it good for the shareholder for the management of the company that they own to diversify? I think so because they're not skilled in so many fields of whatever. It reduces the division of labor. Yes. This is a reduction in division of labor. The manager of one business is not necessarily competent in dealing with lots of other businesses and there's actually a reduction in efficiency that's generated by this. Now if shareholders value diversification, shareholders would really like to diversify. They don't need managers to do it for them. They can just buy lots of different stock of companies. Why delegate the responsibility for diversification to somebody else when you can do it yourself? And you can do it cheaper. What's cheaper? Buying up whole companies, reorganizing them, putting in new management and so on or buying up stocks? Buying the stocks. So it is much easier, cheaper, more efficient for the shareholder himself to diversify his portfolio than to have the manager do it for him. That's beyond this issue of efficiency for the company itself. Can it truly manage so many different businesses? Now it is true that there are some outstanding managers who can make each one of those businesses ten times better than they were before. Just because that specific manager is phenomenal. He's just so good. And I can think of one example for that. I wasn't thinking of Jack Walsh, was the one I was thinking. Jack Walsh is GE, GE, it makes engines for airplanes. It makes consumer products like refrigerators and stuff like that. And it has a very, very successful financial services division. And plus other, what's NBC, for example, owns NBC. Now completely unrelated businesses, yet it is the most successful, large, big business in the country today. It has been for many years. And then it's due for one reason and I think one reason only. It has a phenomenal CEO. Jack Walsh not only has he done phenomenally well, but people who managed under him and learned his techniques. If you track them and other businesses have done very, very well. So he is an exceptional manager, with exceptional ability. So more than a study about a year ago, the wealth of GE, it showed that I think at that point in time, more than half the profits were coming from the GE capital arm. And if you look at the other businesses that stand alone businesses, they weren't that great. They were not generating returns over and above the mean. Over the long run, GE has done very, very well, even though it has been diversified. So one would have to closely research to see if Jack Walsh just had GE capital and not have all the rest. Maybe they could all be doing a lot better, but that's hard to tell. But I would say that this is the exception to the rule to the extent that it works. Most managers have a hard enough time dealing with one business in the kind of competitive environment that we live in. On my mind, 10 different businesses that are completely unrelated. And usually what you get is a bureaucracy, lots and lots of managers. Very little gets done, lots gets wasted. So you have inefficiency as a result of the diversification. Stop by any of the 133 Los Angeles area O'Reilly Auto Parts stores, where you'll find everyday low prices on the parts you need to keep your vehicle at its best. Our guaranteed low prices ensure you're always getting our best deal. In fact, we'll match any auto parts store's price on any like item. O'Reilly Auto Parts, better parts, better prices every day. Sometimes dear like to J-Walk or a basketball forgets to look both ways before bouncing across the street. Will your tires make every stop? Compare wet braking distance at michelinman.com slash long lasting performance. So over investment, free cash flow is one type of problem that we see in a problem that we saw in the 1960s. 1960s was a merger boom. There were more mergers in the 60s than in the 80s, a lot more. Because in the 1960s we saw all these conglomerates being formed, these huge business enterprises that were not efficiently run. There's no accident that in the 1970s saw a completely flat downward sloping, somewhat downward sloping stock market. There was a huge crash in 1973 and the market was flat throughout the decade. That is because US business was not doing well. It's no accident that the Japanese were doing so phenomenally well in the 1980s because during the 70s they were building up whereas US industry was declining. It's the real decline in US industry that did not happen in the 80s like a lot of people would claim. It happened in the 60s and 70s. The rise in Japanese industry did not happen in the 80s. The 80s was just the consequence of the rise but it happened in the 60s and 70s while US business was asleep or was acting in a negative manner. Another reason for the flatness of the market was inflation. Inflation helped and the whole macroeconomic situation helped, make it worse. A second problem that can be identified as resulting from the separation of ownership and control is just this issue of lack of effort or perk consumption. If you look at Argyan and Biscoe before the LBO, they had a series of corporate jets, they had parties all night, they had penthouses all over the place, all of this at the expense of shareholders because there's no need for this. It wasn't like they were doing something important at these parties or that they needed these luxurious penthouses for something real. This was purely perk consumption on behalf of the managers. At the same time, for example, Argyan and Biscoe was heavily investing in R&D and the smokeless cigarette, which was again a way of taking that free cash flow and spending it on something that really shareholders did not value. There are lots of projects like that, Satin, GM Satin, which costs $4 billion in order to get any kind of return on that investment. They're going to have to make astronomical profits in the future and they'll probably never return the investment on that car. But somehow GE with five car divisions anyway decided to create a six, a GM, I'm sorry. Talk about examples of bad management, bad investments. So the question is if all these bad things are going on, big businesses doing poorly, they're not managing, managers are not managing well, and we know that big businesses, we need it. You can't manufacture automobile with small little plants. You can't manufacture steel with small little units. You need big business. Economies of scale are very important. Size is very important to manufacture these goods. So what is the problem? Is this just a failure of the system? A failure of capitalism, a failure of free markets? I'm sure I don't have to tell you that. That's not the answer. Let's look, you know, to try and find out what's going on here. Let's look at what the control mechanisms are on the behavior of managers on the way these businesses are run. So what control mechanisms are in place? And then we can see what are the flaws in the control mechanism and why they exist there. So I would say there are three basic control mechanisms. One is the product market. The second is what I call internal control mechanisms or the board of directors. So the product market, internal control mechanisms or the board of directors. And the third is capital markets. Product markets and other markets for capital. So those are the three control mechanisms. Now let's look more closely at each one. The product market. This is important because if you're a bad manager, ultimately, at some point, you just won't be able to sell your product and you will go bankrupt. So the ultimate, the ultimate judge of whether you're doing a good or bad job is whether people buy your product or not. Whether there's some value. So ultimately, all these bad businesses would go bankrupt. Now this is a slow, very, very wasteful process. It can take years if not decades for this to actually happen. In the meantime, there's a huge waste of resources, there's a lot of destruction going on, a lot of inefficiency. Also bankruptcy itself is very unpleasant. We would like to be able to stop bad managers a lot earlier than the point where they've driven the company into bankruptcy and then what can you do? There's not much you can do at that point. So the product market acts primarily as the last resort in terms of punishing managers. We would like to have some other mechanisms work before we reach that drastic measure. So let's look at the internal control mechanisms or the board of directors. Ideally, the board of directors represents shareholders. Board of directors is responsible legally to shareholders. They are supposed to work in their best interest in monitoring and controlling managers' behavior. They're the people supposed to be sitting over the manager's shoulder, checking what they're doing, making sure they're doing the right thing. Shareholders elect, officially elect the board of directors and they are supposed to service their representatives. Now the question is, does this work? And again, if we look at the evidence, we find that CEOs are the ones who actually choose the directors, not shareholders, and they usually choose their golfing buddies. And they usually choose CEOs of companies where they themselves are members on their boards, there's a reciprocality there, that boards very, very rarely, and again this is particularly true of the 50s, 60s and 70s, things have changed. So directors very rarely challenge the CEO, but usually just rubber stamp whatever decisions he makes. So directors function more as the cronies of the CEO than they do as representing shareholders. Now, I'm saying all this with a caveat that there are exceptions. And these might even be the exceptions. I don't know that this is 40% of companies or 60% of companies. But this is clearly dominate, it's a dominant number within American corporations pre-early 1980s. Now from the shareholders' perspective, they can't really closely, they don't have the knowledge and information to clearly monitor the directors and managers and make sure that they're doing a good job. They don't have the expertise, they don't have the time. Shareholders are typically small, they have lots of them. It's very, very expensive for them to organize and say, no, we don't want this director, we want somebody else. And the fact is that it's very rarely done. So shareholders land up in a position of if they don't like what the managers are doing, they do what? They sell their stock. It's easier, simpler. They sell the stock and buy it to a company where they do like what the manager's doing. They don't fight. It doesn't make any sense for them. So that's what they typically do. And one of the reasons is because the things that they can do are very difficult. So let's look at some of the things that shareholders can do when they're not satisfied with directors and offices. The first thing is they can initiate what's called a proxy fight. Proxies is what you get when you're a shareholder. It's kind of a ballot where you get a vote on the slate of directors and then any other thing that's on their agenda of the annual meeting of shareholders. Is your check engine light on? Don't ignore it. Stop by O'Reilly Auto Parts today and let our professional parts people scan your vehicle for free. We'll retrieve the codes, discuss possible solutions, and even help you find a professional technician if needed. Visit O'Reilly Auto Parts today for our free check engine light help. O'Reilly Auto Parts, better parts, better prices, every day. Shareholders could theoretically organize, have their own slate of directors, communicate among each other, and try and vote down managers slate of directors and vote up their own slate of directors. Now this is very hard and expensive anyway. SEC regulations, security and exchange commission regulations, make it even harder and more difficult. For example, you can only get the mailing list of all the shareholders under very specific circumstances. It's not available just to anybody on demand, any shareholder on demand. The mailings that the company does on their behalf to market their own people are paid by the company versus the mailings that you as a shareholder who are challenging the company would be at your expense. You would have to pay for them. There are all sorts of little rules about what you can and cannot do that make this very, very difficult and very expensive and rare. You very rarely hear a proxy fight. And when they do happen, almost always management wins. So you put up this thing, you decide, okay, I'll spend a million dollars and I'll really try and do this because I really care and there's profit in it. If the company is better managed, I will make more money. And then you lose and you have to take that into account before you start so that most people don't even start. So that's one avenue. It's used, but it's rare. And again, pre-1980s, it was hardly ever used. Second is you can sue directors and managers. You can sue them for violation of their due diligence towards you as a shareholder. They owe you a due diligence obligation, a fiduciary obligation to act on your behalf, to maximize your wealth. That is, in a sense, the contract between the shareholder and the manager. Now this is tricky stuff. Pre-1984, a court decision in 1984, courts were very reluctant to rule against managers. The idea was we do not want a second guess, management's decisions. Unless this is a clear case of extreme negligence or a clear case of corruption and fraud, we will not touch it, which I think is a very healthy attitude. We do not want our businesses run by judges and juries. We want our legal system to function only in the very extreme criminal cases. So that pre-1984, this was not really an avenue even open to shareholders again, unless it was extreme. Post-1984, I could tell you unbelievable horror stories about what the judicial system has been doing. But it is open. This one decision of Van Goghom versus, I can't remember who this versus, the case is called Van Goghom. Since this case, courts have been happy to second guess managers and directors and award large, what do you call it, large damages to shareholders for supposed bad decisions on the behalf of managers. If you go and, for example, small startups, small firms are very sensitive to this. They are lawyers in California who have a network of people who own one stock in a lot of different companies. And the lawyers will basically watch the tapes. And as soon as the stock of a company will go down, they will call the person that they know who owns the one stock in this company and follow the lawsuit. And they don't really care why, they just make up something for them. Now, since there's a history of the courts deciding for shareholders, companies won't take it to court. 95% of these cases are settled out of court. So the lawyer has very little to lose because he's probably never going to go to court. And he's got a 40-60 split with his client. And it usually becomes, if there's some hint of legitimacy to the claim, it becomes a class action lawsuit where he's suddenly representing all the shareholders. So now the booty's a lot larger. It's actually the race because the first person to file a lawsuit gets to represent the class action. So there's a competition between the lawyers who can get the courtroom to file a lawsuit first. CEOs today spend almost 30% of their time in some of the high-tech companies in Silicon Valley fighting or dealing with lawsuits, dealing with legal issues. And most of these are completely frivolous. They have nothing, yeah, yeah. My understanding was that you can only sue a director for self-dealing corruption and not for incompetence. You can sue a director for violating his fiduciary duty to maximize your shareholder wealth, not just for corruption and stuff. I can cite you that. So a fiduciary duty, you can be very stupid and incompetent manager and still perform your fiduciary duty. I think the lawsuits that you're alluding to, and correct me if I'm wrong, I'm trying to understand, they're based on the lack of disclosure when the securities were sold, whether it's true or not. But they're based on the fact that you're not disclosed risk, as much as it is ludicrous in some instances. The lawsuits on these high-tech companies are primarily focused on the issue of disclosure, either as a startup in the initial prospectus, or, for example, if earnings have suddenly gone down and you said that you expected earnings to go up. You said they expected. You didn't say they would. They'll sue based on that. So they sue based on things like that. But in addition, throughout the 1980s, every time there was a merger, there was a lawsuit. Every time there was an attempt at a merger, there was a lawsuit. Every takeover was associated with lawsuits. There were lawsuits all over the place in Wall Street. So it wasn't just about this, because, for example, Van Goghom was a suit. Van Goghom agreed to a merger with another company. This was a company. Van Goghom was a company. They agreed to a merger with another company. They agreed to the merger to premium to shareholders about double what the stock price was worth at the time. So shareholders made a lot of money. Some shareholders sued. And they claimed that the director did not spend enough time considering the merger, and they could have got maybe three times, which was a completely arbitrary number pulled out of nowhere. And the court ruled for shareholders. And I think it was like $50 million. The shareholders had to be compensated for the difference of what arbitrarily they could have got versus what they actually got. And it turned out that a lot of that money had to pay directly from the directors that it put, because the director's office of liability insurance only paid a certain amount. And that opened the doors, because up until then, there was something called the business judgment rule, where courts did not touch these cases. Yeah. But isn't this these lawsuits a good safeguard against managers selling to companies or investors that are going to give them a personal good deal at the expense of shareholders? Only if it's a corrupt activity, but no. Not unless there's some clear-cut violation of criminal law. Otherwise, how do you tell? It becomes very subjective. There are no clear-cut objective standards here. Unless it's a violation, you can show off contract law or something like that. Let's see if we can talk about it afterwards. And the fact is that it created a whole industry. Now, it is appropriate to sue under very stringent conditions that that option be available to shareholders, but it got out of control. The third option, in terms of what shareholders can do, is an option that was really discovered in the mid to late 80s, which is heavily used today primarily by high-tech, more innovative companies. And that is, let's make managers shareholders. Simple. This is a market solution, if you want. One way we can solve this problem of ownership and controls is make managers owners. Force the managers, for example, to put up a certain amount of money upfront before they take the job and buy shares with it, and make it somewhat difficult for them to sell the shares until they're out of their job or they vest over a certain number of years, or give them options. An option is an instrument that only pays if the stock does well. Since the better the stock does, the more the manager gets. We know stocks are directly related to profits, so the more profitable the company is, the more high the stock will be, the better the CEO gets compensated. If you think about salaries that Michael Eisner's got at Disney, $200 million one year, almost all of that came from stock options. He did a phenomenal job. The stock price went way up, and he made a lot of money. So you're linking now the compensation, you're linking the incentives of managers with the interest of shareholders. And that I would say would be one of the market solutions to these kind of problems. And it's one that is, at least in Silicon Valley, almost all the companies use, and they use it not only for CEOs, but they use it for many of the engineers and the upper management. And even, I think some companies give it all employees, give them something. And then they are basically making the employees at least have a small stake in the company, and supposedly increasing the incentive to do a good job. Except for this last one. None of the other mechanisms have worked very well in the past. The Board of Directors has not worked well. Proxy fights don't work, and suing has not worked. So the question is, why? Why have the internal control mechanisms failed? I just wanted to comment. A few weeks ago, I saw the triumph of the nerds, and they were saying, like, Bill Gates, when he started Microsoft, he would give people a stop instead of high salaries. And today, they're like three millionaires, and a few millionaires. I think 200 millionaires from Microsoft. Yeah, a bunch of millionaires from Microsoft. And for that reason. Yeah, Microsoft today, 200 millionaires, that's pretty phenomenal. They still give stock options to everyone. Yes, and most of the high-tech companies in Silicon Valley do as well. Thank you. Cash. Well, one reason is you don't have the cash. It makes it easier, but there are other reasons which make a lot of sense, because they could borrow the cash if they needed it. That's what traditionally companies would do. So why have these failed? Is this really a structural problem? A problem that is inherent in the nature of large businesses, inherent in the nature of capitalism, in the corporate form? And I would say the answer to that is no. To get an idea of this, we have to go back to the late 19th century, early 20th century. Why were these problems not evident then? And the reason was that people like J.P. Morgan, bankers like J.P. Morgan, not only held large equity stakes that has owned major stakes in these companies. But that they and their representatives sat on the board of directors of these companies. J.P. Morgan, the company, had people on 120, at least 120 boards of directors of U.S. corporations, the largest businesses in the country. Managers had people from J.P. Morgan and other banks sitting over their shoulders, peering over their books, sitting in board rooms and arguing with them, kicking them out when they didn't like what they were doing. So shareholders were active in those days. They were active monitors of managers. Not only did J.P. Morgan put some of these industries together, in a sense, create these industries. He's the one who created U.S. Steel. But he actively participated in the management of these companies, him and his representatives, and there are lots of, not just him, but lots of other bankers did the same thing. Were they participating as equity holders or because they had lent money and therefore, as more as bond holders? They were participating as equity holders. They owned large equity stakes in these businesses. And for that matter, if you look at Germany today, the German banks, there are three major banks in Germany, hold equity stakes in many of the large corporations in Germany. They sit on the boards of directors. They were presented as often the chairman of the board. If you look at Japan, banks and corporations have very, very close relations, where the bankers are heavily involved in the managing of the corporation. Why is this not being done today? The reason is that it's not allowed today. Banks are not allowed to own any equity in non-financial institutions. If they form a bank holding company, they're allowed to own up to 5% of the stock of any given company, but they're not allowed to sit on the board of directors. Mutual funds, insurance companies and pension funds, the other large institutional investors, that could serve a similar role, are either completely banned or there are severe restrictions on their ability to own large equity stakes in these companies. And from looking at boards of directors of many, many hundreds of companies in the United States, it is rare, it is very, very rare to find a representative of a financial institution on the board of directors. They're just not there. They might own, even if an insurance company or pension fund owns or Fidelity Magellan, even if they own 10% of the stock, they are not represented on the board. So they do not have direct access to management. And they have not traditionally been involved in the managing of the corporation. Now again, this is somewhat changing lately and hopefully at the end of next class, we'll, I'll say a few words about why. But they have not been involved because regulatory they've been prohibited. I've got a whole list of regulations about at least a dozen different regulations. They make it either difficult or impossible for these financial institutions to get involved in the running of a corporation. Yeah. They were, I think they were trying to prevent the kind of power that JPMogus was perceived to have had. That is the joining of banking and commerce into a huge business that takes over the world. I mean, it's that kind of nonsense. But that's the main thing. So financial institutions in general who should be doing this, who have the expertise to do it, these are people who know not only finance, but are often specialists, so you could hire specialists in specific industries. So these are the people that have expertise and they have the capital. Now, if you take an individual investor, why does an individual investor do this? Well, think of the billions and billions of dollars you would need in order to systematically own a large stake in many large corporations in the country. The only investor who does this, they're probably a few, but the one big example is Warren Buffett. And he clearly serves to motivate managers to do a good job. Not only does he only invest in good companies with good managers, but once he's there, he's over their shoulder. If Warren Buffett leaves, if Warren Buffett sells his stock, which happens very, very rarely, you're in big trouble because that is taken by the market as a sign that you're worthless because he so rarely does this. Yeah. What about corporations sponsored retirement plans all? They have the same restrictions? They have many restrictions. Yes. They have many, many restrictions. Again, I can- Do you think normal retirement plans are, is it beyond, above and beyond? Different retirement plans have different restrictions. All of them are controlled by ERISA, which was the main law that created them. I don't know all the differences. I've actually got an article here that lists some of them if you're interested. I can show you a list. Do you want the financial restrictions? There are all sorts. You can only own a certain percent as one stock from your portfolio. You can only own so many stocks in a total. All kinds of restrictions. And if you want, you can after class, I can show you the specifics. Okay. Something incredible has arrived at Disney California Adventure Park. Darling, I want action. We're going big. Elegance. And we're going fast. Speed. The Incredicoster is here and now open at Pixar Pier at Disney California Adventure Park. 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I've heard it argued that in Japan and to some degree in Germany, this has resulted in inefficiency in that there's not a, that problems in the firms may get covered up or papered over by their financial firm, well, okay, you lost money, we'll pay for that. And the result is there's not, like, the companies aren't run as efficiently as they might otherwise be and there's not a efficient market. The governance has even worked. Yeah. Well, I'm not convinced that that's true. The, I've done a little bit of research into what goes on in Germany. And in Germany, banks own high-growth companies. They stay away from the rest of the market. Where these problems are particularly acute. I think Deutsche Bank had a very large position down the bends. Yeah, it doesn't guarantee success. And don't forget that you're talking about markets that in other ways are more heavily regulated and have all sorts of other problems. The problem with Germany and Japan is not the bank, is not the relationship between banking and commerce. In Japan it's a relationship between the Ministry of Finance and the banks. And the fact is that the banks were doing in terms of the relationship with a customer, with the commercial clients, they were doing what the Ministry of Finance wanted them to do. So they heavily regulated in other ways. So it's not like we have a clean example somewhere that we can compare this to. But the cleanest example is US pre 1930s. And it worked very well. And the examples that we have and the studies that we've got from JP Morgan and what he did to these companies, if you compare them to a set of companies that did not have JP Morgan and other bankers intervention, you see big differences. Now, okay, so that is the internal control mechanisms. And we've seen why they might have failed because a big segment of very important contributors to that internal control mechanism, to the boards of directors, are excluded from the market. Now let's look at the financial markets ability to control managers. How can financial markets, and capital markets, discipline managers? Well, Lebe mentioned this earlier. If stocks, if the managers do not do well, then the stock price would decline, providing an opportunity for somebody to come up and purchase all these stocks. Therefore, kicking out the managers and instilling their own managers. Now, the problem with this is, it requires, A, that there be people monitoring and looking for these opportunities that want to do this, and B, that they have enough capital to pull it off. You know, Arjana Bisco was a 24 plus billion dollar company. You have to have access to 24 billion dollars in order to buy everybody's shares and kick off managers and own the company yourself. Now, I can't get into this, but there are tons and tons of regulations that make this hard. Even in the early 80s, there are even more today. In the early 80s, there were tons of regulations that made this difficult. So how come it happened in the 80s? Why didn't it happen in the 70s and 60s? I would say that the main reason is there was not the capital available in the 60s and 70s to make these possible, to make it possible for people to do these large takeovers. The regulatory environment, of course, did not help. During the late 1970s and the early 1980s, a number of things happened to make this easier. Taxes were lowered in the 1980s, providing more capital. Deregulation of both investment banks and SNLs saving loans provided lots of fresh capital. Remember, SNLs up until 1980 could only invest in mortgages. Suddenly in 1980, they could invest in anything. And they were looking for high-yield investments, which often carried high risk. Takeovers were a form of high-yield investment, which they jumped into. Pension funds, the amount of money in pension funds suddenly grew to astronomical numbers. We're talking about trillions of dollars. The reason is there's a certain cycle in pension funds, where most of these pension funds were started in the 40s, 50s, 60s, and they reached some kind of critical mass in terms of capital in the early 80s, which ERISA, for those of you know, the regulation that establishes private pension funds, or regulates private pension funds, helped. Because in the past, companies would do what? They would fund their pensions from profits, from revenue. ERISA forces companies to set money aside in a separate pool to fund their pensions, and the money in this pool cannot be used to invest in the company itself. So it has to be used externally. So suddenly there's another source of capital. In addition, we saw financial innovation. Big one is Michael Milken. And on the product side, we saw competition, international competition, which put a lot of pressure on companies, which showed them, made evident, made visible the fact that they were not well-run. Because suddenly they were exposed to competition and they folded, they couldn't compete. So the stock market plummeted even more than it would have otherwise. Many industries in the United States did not do well against the Japanese and Germans in the 1980s. As a result of the capital being available, the deregulation, the low valuation on many companies because of their inability to compete in their bad management, hostile takeovers became, during the 1980s, a tool for disciplining managers. Hostile takeover is a takeover where the target, the company being taken over, doesn't want to be taken over. That's why it's called hostile, because you're doing it even though they don't want it. Now, let's look at who benefits from these hostile takeovers. Who would benefit from a hostile takeover? Yeah. Shareholders benefit. They get a premium, usually between 10 to 40%. Sometimes a lot greater than 40%, like in Van Goghom, example I gave before. They make a lot of money from these. So a stock that they owned that was relatively low, suddenly they get a lot more money for it. Who else benefits? Sometimes the bondholders in that... The financing will be done, as you said, through high yield bonds, and so there are some investors who will be earning very high return, although with also a lot of risk. Well, I would keep those aside because I'm assuming that those are making a return based on the risk, so they're not really benefiting beyond what they're taking on. I'm gonna go through these because we're a little bit out of time. The takeover artists themselves, the people putting the takeovers together benefit. They get to run the companies they wanted to run. They get to do what they want to do and they're gonna make a lot of money if they're successful at it. The people who put the deals together, the Michael Milkins, the Drexels, investment bankers who put the deals together benefit. The fees can be in the tens, hundreds of millions of dollars. And then the company's getting taken over benefit because their productivity is now increased. So the company being taken over is going to benefit by increased productivity. Who loses? Who are the biggest losers? The old managers because they're the first ones to go. Who else loses? Well, some employees lose because some employees are gonna lose their jobs because if the managers beforehand were not using labor efficiently and hiring more people than they needed then people would get laid off. But then that labor would be put to more efficient use somewhere else. In addition, old bondholders might lose. So people who owned bonds of the company before they were taken over might lose. They of course would lose only if they didn't, only if one, the company went bankrupt and they didn't get money because of this takeover and some companies, some takeovers don't make sense. Or if they don't hold the bond to maturity, if they sell it early they might lose. Now why did they lose? Because a lot of these deals were financed by debt. A lot of these deals were financed with debt. So now let's say you owned a certain amount of debt and if they sold, let's say 10% of their assets, they could pay you off. Now there's a lot more debt, you're just a little bit of the total debt. Now selling all the assets might not pay off, yield debt. So a lot of companies that had ordinary bonds suddenly became very high yield bonds because the price crashed, the price went way down. But again, if you hold it to maturity, you'll get the yield that was promised. Okay, so those are the losers. The takeover artists are the, and the shareholders, the deal makers are the ones who make money. Who do you think opposed these deals? Management unions, in the other class, somebody said everybody. And I thought that was pretty correct. Because if you think about it, who came to the defense of takeovers in the 1980s? Absolutely nobody. Not even the companies doing the deals. The only people who came to the defense were the deal makers themselves. People like T. Boone Pickens, Carl Icahn, Sir, something Goldsmith, I can't remember. James Goldsmith, that's right. The people who opposed the deals, well first and foremost, were managers of big business. The business round table, and if you've heard of the business round table, it is a group of CEOs of the largest 200 companies in the country who formed this organization in order to lobby Congress on their behalf. Say, if originally they would lobby Congress against regulation, against limiting what they could do, they later would regulate Congress in an attempt not to regulate themselves, but maybe to regulate somebody else who was their competitor. And they took on all the lobbying business that business would like to do, these big companies would like to have. I gave some quotes of members of the business round table. This is from Andrew Sigler, the CEO of Champion International, who was a leading spokesman for the business round table. He wrote, the unfettered buying and selling of U.S. corporations solely for the purpose of financial speculation and profit is one of the most destructive phenomena of the 20th century. Or one of the biggest opposers to the takeover moves, a CEO who was threatened by a takeover by T. Boone Pickens who managed to resist and managed to survive it was the CEO of Unicor, Fred Hartley. He is quoted as, this speculative binge, this chain letter must eventually collapse, leaving wreckage of ruined companies, failed jobs, reduced U.S. oil production, failed banks and saving and loans, and governed bailouts, not to mention unemployment and empty buildings. Which is an interesting way of phrasing it because he has also mixed in some truths, SNLs do fail, there is a government bailout, there are empty buildings. And he gives it the cause of relationship, oh it's because takeovers. As we'll see, all these were, as we'll see or as I've told you, all of these are consequence of failed government policy and regulation. So the business round table actively organized and lobbied Congress throughout the 1980s to pass anti-takeover legislation. They lobbied regularly, they got support from a variety of different organizations. One of them being organized labor. Organized labor strongly opposed takeovers. Now remember that the CO's opposed it because they were the targets, they were the ones who were gonna get kicked out of a job. Just to quote Lane Kirkland, the president of AFL-CIO at the time. I think corporate raiders on outrage and a bloody scandal. Who all supposed? Well politicians opposed this, they were getting lobbied by labor and by big business. I mean, those are big constituencies and they worked hard throughout the 80s to try and find ways to stop the takeover market and we'll see next class some of their successes. And of course the media. The media was just out to destroy this. Now politicians I would add from both sides of the aisle, both Republicans and Democrats, it wasn't uniquely a democratic phenomenon. In addition, just one last group, Wall Street. Old line investment bankers who did not like the Milkins and the Drexels coming in and taking their business. Coming in and doing these risky speculative, what they considered outrageous deals. These bankers were also very closely related to the big business interests that were opposed to this. Now, excellent reference on all of this and a lot more. You can get a really lot of information out of this. It's payback. I think I mentioned the book before in class with payback. By Daniel, I think it's Feichel, is an excellent source for what happened in the 1980s and to what extent it was driven by the business round table, these lobbying groups, politics and corruption. Payback by Feichel, yeah, Feichel. It's on sale at Sycamena Sons books, I should really say that, yeah. It's on sale across the hall at Sycamena Sons and it's highly recommended. This course continues with lecture six. Stop by any of the 133 Los Angeles area O'Reilly Auto Parts stores where you'll find everyday low prices on the parts you need to keep your vehicle at its best. Our guaranteed low prices ensure you're always getting our best deal. In fact, we'll match any auto parts stores price on any like item. 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