Gods at War: Shotgun Takeovers, Government by Deal, and the Private Equity Implosion

by Steven M. Davidoff

  Meanwhile,Vanderbilt coveted the Erie railroad for its railroad line out of New York and to Lake Erie. The combination of the line with his routes would provide Vanderbilt with a stranglehold over much of the railroad traffic out of New York.Vanderbilt began to build a position in Erie by purchasing the stock sold by the Erie Gang. When the Erie Gang discovered this activity, they quickly acted to their own advantage. The gang arranged for Erie to issue out bonds convertible into Erie stock to sell to Vanderbilt, thereby diluting Vanderbilt’s position.

  Vanderbilt soon became aware of the stock issuance and arranged for his lawyers to obtain a court injunction halting them. This was easy for Vanderbilt’s counsel as the judge issuing the injunction was on Vanderbilt’s retainer.The Erie Gang responded by arranging to have their own kept judge issue a competing injunction restraining Vanderbilt’s conduct. Meanwhile, Vanderbilt kept buying, and the Erie Gang circumvented the injunction by arranging for third parties to sell stock to the unknowing Vanderbilt. Fisk purportedly said at the time that “if this printing press don’t break down, I’ll be damned if I don’t give the old hog all he wants of Erie.”1

  Vanderbilt then upped the ante and arranged for an arrest warrant to be issued for all three of the Erie Gang, who promptly fled from NewYork to New Jersey.They smartly, but illegally, took over $7 million of Erie’s funds and yet more unissued Erie stock.The fight then became physical as Vanderbilt sent armed goons to attack the Erie Gang. Vanderbilt’s henchmen were repelled by the gang’s own hired men, and Fisk even went so far as to have 12-pound cannons mounted on the docks outside Erie’s New Jersey refugee headquarters. Ultimately, the war was resolved when the Erie Gang succeeded in bribing the New York legislature to enact legislation validating the trio’s actions. Vanderbilt was forced to cut his losses and settle, leaving the Erie Gang in control of the Erie Railroad, now forever known as the Scarlet Woman of Wall Street, and Vanderbilt was out an amount alleged to be over $1 million.2

  A modern-day observer of corporate America may dismiss this well-known story as an interesting and well-cited relic of long-ago battles from a wilder age. The rule of law has grown stronger since the Gilded Age, and machinations like those of the Erie Gang and Vanderbilt are no longer a part of battles for corporate control. But before you agree, compare the war over Erie with a thoroughly modern dispute.

  In August 2004, eBay Inc. acquired 28.5 percent of craigslist. The facts surrounding eBay’s acquisition are a bit hazy, but it appears to have occurred due to a break among the prior owners of craigslist, Craig Newmark, James Buckmaster, and Phillip Knowlton. But for whatever reason, and no doubt in pursuit of money, Knowlton arranged to sell his interest to eBay for a rumored $16 million.3 The sale placed Newmark and Buckmaster in an awkward position. Adamantly proclaimed anticorporatists, the two assert craigslist to be a community service and have publicly rejected the idea of selling any part of craigslist to the public or a third party. Nonetheless, perhaps because Newmark and Buckmaster had no choice, they acquiesced in eBay’s purchase. At the time, the reason cited by the two for accepting the sale was that they believed that eBay would not interfere in the core mission of craigslist. “They have no interest in asking us to change that in anyway,” Buckmaster stated. “They’re happy with us having our full autonomy. They recognize us as experts at what we do.”4

  The parties’ honeymoon was short. A dispute among them soon arose over eBay’s decision to launch its own free classifieds service, Kijiji. Apparently, eBay didn’t think the craigslist people were as expert as they thought. The business competed with craigslist and therefore triggered certain provisions in the shareholders agreement among eBay and the other two craigslist shareholders. Specifically, eBay lost its right of first refusal to purchase equity securities sold or issued by craigslist or to purchase Newmark’s or Buckmaster’s shares, should either attempt to sell them.

  Newmark apparently thought this prenegotiated penalty was insufficient. He e-mailed Meg Whitman, eBay’s CEO at the time, and stated that he no longer desired eBay as a craigslist shareholder. Whitman responded with a polite no, instead expressing eBay’s own interest in buying craigslist. Clearly there was a communication gap among the parties. Newmark and Buckmaster, both directors of craigslist, responded by adopting (1) a share issuance plan under which any craigslist shareholder who granted craigslist a right of first refusal on their shares received a share issuance and (2) a poison pill preventing any current shareholder from transferring their shares other than to family members or heirs.

  The poison pill effectively prevented eBay from transferring its shares, except in discrete blocks below a 15 percent threshold, to any single person. Moreover, Newmark and Buckmaster agreed to the right of first refusal and received the authorized share issuance; eBay did not, probably because it wanted to reserve the right to freely sell its position.

  The result was to dilute eBay’s ownership of craigslist to 24.85 percent. This action was important, because under the parties’ shareholder agreement if eBay falls below the 25 percent ownership threshold, craigslist’s charter can be amended to eliminate cumulative voting.

  Cumulative voting provides minority shareholders the ability to concentrate their votes by allowing them to cast all of their board-of-director votes for a single candidate rather than one vote per candidate. So if, for example, there are three directors up for election, eBay would have three votes and could cast all of them for one candidate. In the case of craigslist, this right had enabled eBay to elect one director to the three-member craigslist board. But Newmark and Buckmaster now acted to amend craigslist’s charter to eliminate this right, and eBay thus lost its board seat. Moreover, the poison pill effectively prevented eBay from selling its shares. Who would want to buy a minority position in a company where the other shareholders did not want you and you were effectively without any control rights? The amendment and the poison pill thus combined to lock eBay into a voiceless minority position.

  So eBay sued craigslist, Newmark, and Buckmaster in Delaware, the place of craigslist’s incorporation, for breach of fiduciary duty and to have their actions nullified. Meanwhile, craigslist countersued eBay in California State Court for false advertising and unfair and unlawful competition. The parties remain in litigation at the time of this writing, with the two craigslist directors still firmly in control of the company.5 Given the tremendous dollar amounts at stake, whether the craigslist founders will succeed or desire to keep their grip remains to be seen.

  Approximately 140 years separate these two events, but the story of craigslist and eBay shows that in deals, companies and the people running them are still not above fighting to the figurative death, employing every available tactic. The big difference is that these fights largely play out in the courts, the regulatory agencies, or the plains of shareholder and public opinion rather than as brawls in the street or bribery. Microsoft Corporation and Google Inc. will battle over relevant acquisitions in the halls of their antitrust regulator, the Federal Trade Commission, or in the marketplace. The CEO of Google Inc., Eric Schmidt, is hopefully not about to attempt to send armed men to assault Steve Ballmer, Microsoft Corp.’s current CEO. They both will work within the rules, perhaps even stretching them, to fulfill their goals.

  The strengthening of the rule of law and the immense economic and social changes of the past century and a half have placed lawyers in a primary role.The structure and manner of takeovers has not remained static over the years. Nonetheless, as illustrated in these two stories, central tenets of dealmaking have emerged and remained. Deals are still in large part about money, earning a return on invested capital commensurate with the risk, but like so many things in life, it is not all about the money. Other factors come into play and skew the process. These include:

  • The personality element—individuals often determine the outcome of deals, sometimes by acting outside their company’s and shareholders’ economic interests. In doing so, these individuals act in their own self-interest and w
ith their own psychological biases to affect deals, sometimes acting to overtly enrich themselves or more subtly aggrandize themselves and build empires.

  • The political and regulatory element—Congress, state legislatures, and other political bodies can take direct and indirect action to determine the course of deals, particularly takeovers. Meanwhile, deals have steadily become more regulated and impacted by regulation, whether by the federal securities laws or antitrust or national security regulation.

  • The public element—popular opinion and the constituencies that are affected by deals increasingly matter.

  • The adviser element—deals have become an institutionalized industry; advisers and the implementation of their strategic, legal, and other advice now affect the course of transactions.

  • The game theory element—tactics and strategy continue to matter in deals and dealmaking, as these disputes show. As I discuss in Chapters 8 and 9, structuring deals within (and sometimes) outside the law and the tactics and strategy used to implement that plan can define the success or failure of a deal outside of economic drivers.

  But of these five noneconomic factors I would argue that personality, the psychological biases and foundation of individuals, has historically been the most underestimated dealmaking force.

  The Import of Personality

  The Erie story was as much about culture as it was about economics. Vanderbilt was self-made but also established money. He represented the period’s dominant economic interests.The Erie group, and particularly Jay Gould, could best be characterized as new money, taking advantage of the emergent U.S. capital market to extract their own benefits. The intensity and length of the parties’ dispute was no doubt enhanced by this cultural gap, which made each party want to win despite the benefits of compromise. Vanderbilt contemplated settling with these hooligans only when the New York legislature acted and he was left with no choice.The eBaycraigslist story is similarly one of stubborn will and cultural difference. The craigslist controlling shareholders have proclaimed that their opposition to eBay is moral. It is a desire to maintain an environment free from corporate influence in contrast to ex-eBay CEO Meg Whitman’s seeming disbelief in Newmark and Buckmaster’s expressed intentions and her and her successor’s wish to exploit a very exploitable economic asset.

  The cultural aspect to these disputes is not unique. Like many facets of our society, deals and takeovers in particular are often driven by culture, as well as other extrinsic factors such as morality, class, ideology, cognitive bias, and historical background. These affect not only whether deals succeed after they are completed but also whether they even occur.The epic battle for Revlon Inc. in the 1980s was likely as contentious as it was because of then Revlon Inc. CEO Michel Bergerac’s deep hatred for Ronald O. Perelman, the hostile raider who controlled Pantry Pride Inc., the company that made a hostile bid for Revlon in competition against Teddy Fortsmann’s Forstmann Little & Co. Perelman was described as an upstart Jew from Philadelphia, a corporate raider with a penchant for gruff manners and cigars. He was the antithesis of Bergerac’s world; Bergerac could not see his prized company going to such a man and often referred to Perelman’s bidding company as “Panty Pride.”6 Bergerac’s hostile reaction lost him not only his company but also the $100 million pay package Perelman had initially offered Bergerac to induce him to support the takeover.

  Similarly, the battle over Paramount Pictures Corp. between Viacom Inc. and QVC, Inc. in the 1990s was as much about Barry Diller, the CEO of QVC, needing to prove that he had escaped the grasp of Martin Davis, CEO of Paramount, as much as it was about building an integrated media empire. Davis had previously been Diller’s boss when Diller had been the head of Paramount. Diller had left the company after repeatedly clashing with Davis. The takeover of Paramount was his payback.7

  The reason for this bias is in part that takeovers are a decision-driven process helmed by men (and they have been almost uniformly men) who make these choices about when and what to pay or otherwise sell for assets. It was, after all, J. P. Morgan who singlehandedly decided to purchase U.S. Steel and consolidate the steel industry in order to rein in price competition. As such, these are people driven by their own psychological considerations and backgrounds. It’s not just about business. These biases can distort the deal process, most prominently injecting uneconomic or economically self-interested factors into takeover decisions. This has tended to be exacerbated by the increasing tendency of the media to personify corporations through the personality of their CEO: Microsoft becomes Bill Gates and then Steve Ballmer, Viacom becomes Sumner Redstone, JPMorgan Chase & Co. becomes Jamie Dimon, and so on.

  The result has not been just a centrality in CEO decision making but the encouragement of CEO and individual hubris. In the 1960s, dealmaking was about conglomerates—the idea was that management was a deployable resource and a company in diverse industries could resist a downturn in any single sector. But again it was about the individual who could ultimately control these empires. People like Charles Bluhdorn at Gulf + Western Inc., nicknamed Engulf and Devour for its acquisition practices, and James Joseph Ling at Ling-Temco-Vought were headline-making actors and stars of the business media. In the wake of the conglomerates, acquisition activity sharply rose from 1,361 acquisitions in 1963 to 6,107 in 1969.8 It created an atmosphere ripe for investment in these conglomerates, but it also set up spectacular failures, as many of these companies were built on the idea of an individual CEO’s capability without sound financial underpinning.

  Conglomerates have largely been buried by Wall Street, but hubris often masked by labels such as “vision” still persist: Perhaps the most spectacular failure and example of the later age is the merger of America Online, Inc. (AOL) and Time Warner Inc. orchestrated by Time Warner CEO Jerry Levin and AOL co-founder Stephen Case. The deal is cited as one of the worst bargains in history and has resulted in the destruction of up to $220 billion in value for Time Warner shareholders.9 Moreover, in the dealmaking arena, the market constantly proclaims winners and losers based on the outcome of takeover and other contests, rather than on pure economics. Whether it is the clash of wills in Yahoo! and Microsoft—will Steve Ballmer prove his mettle as the newly anointed CEO of Microsoft—or another Stephen, Stephen Schwarzman of Blackstone, out to crown himself the king of private equity, the need for perceived success and the psychology of the actors drive deals.

  This latter phenomenon has a name in economics: the winner’s curse. Auction theory predicts that winning bidders in any auction will tend to overpay because of a psychological bias toward winning. In takeovers, this has a documented effect that has caused many to overpay for assets, caught up in the dynamics of a given takeover contest. 10 A notorious example again comes from the 1980s, when KKR entered into a bidding war for RJR Nabisco, Inc. against CEO F. Ross Johnson’s management-led buy-out team. In frenzied bidding, KKR ultimately won RJR but was forced in the 1990s into a refinancing of the company and an ultimate loss of $958 million.11 In that time, this philosophy was personified by Bruce Wasserstein, the legendary investment banker sometimes labeled “bid ’em up Bruce.” Wasserstein was allegedly notorious for his dare-to-be-great speeches, which egged on his clients to pay higher prices to win a deal. Some of these deals worked out perfectly fine, but others, such as the RJR Nabisco deal on which he advised KKR, didn’t fare as well. Wasserstein, by the way, has also authored a book on takeovers, entitled Big Deals. 12 Notably, private equity is now suffering the same hangover during this downturn as it struggles with portfolio companies for which in hindsight it overpaid during the headier time of 2004-2007. The recent bankruptcies of such notable private equity acquisitions as Chrylser, LLC, Linens ‘n Things and Mervyn’s are examples.

  This CEO hubris has been reinforced by the institutionalization of dealmaking. The dealmaking industry is now vast. It involves the investment banks who provide financial advice and debt financing, the law firms who structure and document these deals, the consultants who w
ork on strategic issues, and the media that cover it all. The deal machine provides its own force toward dealmaking and completion. In many circumstances, the vast proportion of the fees of these ancillary actors are based on the success of the transaction. If a deal is not completed, they are paid little. But if a deal does succeed, the deal machine reaps tens of millions, too often with little accountability for the future of the combined company. The result is that the voice heard by corporate executives is too often one that pushes their own biases toward completing and winning takeovers.13

  If dealmaking is an industry of individuals, noticeably absent from much of its history has been the board of directors, the entity with primary responsibility for running the corporation. Until the 1980s, deals and particularly takeovers were almost wholly an individual’s decision, typically the CEO’s. That changed in the 1980s, as a series of decisions in the Delaware courts starting with Smith v.Van Gorkom in 1985 placed seemingly heightened strictures on boards to exercise due care and oversight of the takeover process.14 Since this time, the Delaware courts have tended to place the board as the ultimate decision maker in the sale of the company. This is perhaps the greatest lasting impact of the controversial Van Gorkom decision. And although the CEO maintains his or her ability to negotiate and influence the process, the Delaware courts have not hesitated to overrule sale decisions where the CEO has overcontrolled or overtly skewed the process. 15 The result is that today’s board is significantly more involved in the sale decision, though boards still too often rubber-stamp CEO wishes.