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

by Steven M. Davidoff

  The growth in non-U.S. acquisitions was due to a number of reasons: a decline in the U.S. dollar during this period, which made U.S. acquisitions more economical for foreign buyers; the industrialization of countries in the Mideast and China, as well as India, Brazil, and Russia, which created significant corporate enterprises in these regions bent on expansion into the United States; the globalization of the economy and the creation of transnational corporate entities, which led to more cross-border acquisitions; and the continuing prominence of the United States as a profit-making center for business, which served to attract this capital (see Figure 5.3).These forces combined to increase foreign direct investment in the United States and probably mark a continuing U.S. dependence on foreign investors for lifeblood in the deal market. Again, this dependence will be exacerbated because of the financial crisis due not only to the capital needs of the United States but also to its perceived status as a safe haven for global investment.

  Despite the rise of the BRIC (Brazil, Russia, India, China) and Mideast countries, foreign capital has still largely come from more traditional sources. In 2008, 6 of the 10 largest foreign buyers were European. The other four were Japan, Israel, Canada, and India. The largest buyer was Belgium, due to the InBev transaction; the second largest was Switzerland. Ironically, the Japanese were particularly acquisitive in 2008, acquiring $36 billion worth of U.S. companies, including three significant bids made on a hostile basis. Moreover, the largest non-Western buyer on the list of foreign investors was India, with $5.02 billion in acquisitions. Notably, China was not among the 10 largest buyers but was the fourth largest recipient of U.S. takeover funds, with $13.23 billion worth of acquisitions. While non-Western acquisitions are in an embryonic stage, due to their increasing industrialization, when economic normalcy returns, they are likely to be the growth areas for non-U.S. to U.S. takeovers (see Figure 5.4).46

  Figure 5.3 Global Takeover Volume by Region 1997-2008

  SOURCE:Thomson Reuters

  This investment has raised public outcry like that against sovereign wealth funds. The most significant protest seemingly appeared out of nowhere in 2006, when Peninsular & Oriental Steam Navigation Company (P&O) based in Great Britain, agreed to be acquired by Dubai Ports. Dubai Ports was based in the United Arab Emirates and controlled by that country. P&O had provided contract services under long-term contracts at over 20 ports in the United States, including New York, New Jersey, and New Orleans. The deal did not initially raise any concerns. CFIUS cleared the transaction without an extended review under its normal process. However, one of Dubai Ports’ potential business partners under the new arrangement, Eller & Company, objected to the deal and began lobbying Congress. A firestorm soon erupted as New York Senator Chuck Schumer and others openly questioned the deal, asserting that it would harm U.S. national security. On March 8, 2006, the House Appropriations Committee voted 62 to 2 to block the deal. Dubai Ports then capitulated and announced that it would sell these ports to a “U.S. entity,” which later turned out to be an asset management division of AIG, Inc.47

  The dispute was puzzling: Dubai Ports was acquiring an English company with port operations in the United States, and Dubai Ports is headquartered in the United Arab Emirates, one of our strongest allies in the Middle East. Television interviews with the representatives of Dubai Ports at the time showed their frustration, but the undertone of Dubai Ports’ opponents was clear: The Middle Eastern country could allow some type of weapon to be smuggled into the United States. Dubai Ports could not be fully trusted. Here, the concerns seemed overstated and inappropriate, given the fact that the United Arab Emirates frequently and reciprocally allowed the use of its territory by U.S. military forces.

  Figure 5.4 Non-U.S. Buyers Acquiring U.S.Targets (Value in Millions) 1995-2008

  SOURCE:Thomson Reuters

  Congress won its victory against Dubai Ports and retained its interest in national security and foreign acquisitions. Congress turned its attention to the Exon-Florio Amendment. On February 28, 2007, the U.S. House of Representatives passed FISA by a vote of 423 to 0.Who, after all, would vote against increased national security? As already noted, the bill heightened congressional oversight of the review process, mandated CFIUS review of any transaction where the acquiring entity is owned or controlled by a foreign government, and broadened the scope of potential review areas.48

  Still, the bill was relatively mild. It only slightly heightened U.S. supervision of foreign investment. However, the real test would be in implementation.The rhetoric surrounding the congressional action had poisoned the atmosphere for foreign investment, despite the fact that U.S. companies were the larger beneficiaries of foreign investment. In 2008, U.S. companies made $189.4 billion in non-U.S. takeovers, significantly lower than the $289.1 billion in U.S. takeovers by foreign companies.49

  In the wake of this new law, CFIUS has indeed stepped up its review of foreign transactions. In 2008, CFIUS conducted 22 full transaction reviews, a contrast with only 2 such reviews in 2004.50 Nonetheless, despite an uptick in formal reviews, the true scope of CFIUS review is still largely unknown, as national security review remains a murky world and the transparency of CFIUS review limited. The reason is that many deals do not enter the formal review process but instead are found wanting prior to any extended review and abandoned.

  The most prominent example involved the 2005 proposed acquisition by CNOOC Ltd., the Chinese oil company, of Unocal Corporation, the U.S. oil company. There the U.S. government privately blocked a bid by CNOOC for Unocal, citing inappropriate access by Chinese government to Unocal’s specialized drilling technology. This was that CNOOC’s bid was reportedly $2.1 billion higher than a competing successful bid by the American oil company Chevron Corporation, and that the majority of Unocal’s oil assets were located outside the United States. CNOOC never even had a chance to plead its case before CFIUS, though to be fair, its bid may not have been as firm as the media led people to believe.51

  To date, only one transaction has been officially blocked under the Exon-Florio Amendment. Not surprisingly, this also involved China. In 1990, the president unwound the acquisition of MAMCO Manufacturing, an aircraft parts manufacturer, by the China International Trust & Investment Corporation (CITIC). CITIC supposedly had a significant relationship with the Chinese army—more formally, the People’s Liberation Army of the People’s Republic of China. CFIUS unanimously recommended that President George H.W. Bush order the divestiture of MAMCO by CITIC, an action the president promptly took, citing the fact that this acquisition threatened national security because of CITIC’s relationship with the Chinese military and the “unique access” to U.S. aerospace technology CITIC would obtain.52

  President George H.W. Bush’s action was unusual, though, and most buyers realize the futility of their acquisition well before a presidential recommendation is made under the CFIUS review process. More typical of CFIUS regulatory action is CFIUS’s review of Hong Kong-based Hutchison Whampoa Ltd.’s attempted acquisition of Global Crossing Ltd., the fiber-optic network company. CFIUS initiated a second-stage 45-day review of the pending acquisition. In the wake of this investigation, Hutchison Whampoa terminated the acquisition.53

  The growing role of CFIUS highlights the importance of public relations and media in transactions, particularly those with a regulatory component. A singular example of this in the modern age came with the agreement of Bain Capital and Huawei Technologies Co., Ltd. to acquire 3Com Corporation, announced on September 28, 2007. In a conference call with the CEO, Edgar Masri, on the day of the transaction announcement, an analyst inquired about the Huawei component of the investment. Instead of answering the question, Masri stonewalled, refusing to say whether the transaction was conditioned on CFIUS clearance or what Huawei’s stake in the combined company would be. This information would later be publicly disclosed, but 3Com would never disclose whether the deal was conditioned on CFIUS clearance. Nor would 3Com ever publicly disclose the postacquisition governa
nce rights of Huawei over the company.

  Unfortunately for 3Com, Huawei had a bad reputation with the U.S. government. Huawei had extensive ties with the Chinese military and was promoted by the Chinese government as a national champion, and 3Com had reportedly neglected to make pretransaction announcement inquiries with the U.S. government beforehand. The government balked at clearing the transaction, and on February 20, 2008, 3Com announced that it, and its agreed buyers, Bain Capital and Huawei, had agreed to withdraw their application for clearance of the acquisition under Exon-Florio.54 Both parties subsequently attempted to terminate the acquisition agreement.

  On March 20, 2008, 3Com also announced that it intended to pursue the $66 million reverse termination fee from Bain Capital. The odd silence from 3Com about the involvement of Bain Capital and the need for Exon-Florio clearance extended to the acquisition agreement, which provided that Bain Capital and Huawei were required to pay 3Com a $66 million termination fee if “a U.S. Federal regulatory agency (that is not an antitrust regulatory agency) has informed [Bain Capital] or [3Com] (or their Representatives) that it intends to take action to prevent the Merger.”55 Presumably, this was meant to pick up the Exon-Florio clearance. However, the fact that it was the regulatory approval that dare not speak its name in the acquisition agreement shows the length 3Com and its buyers were going to keep the Exon-Florio process private.

  Bain Capital disputed the applicability of this provision to a failure to achieve Exon-Florio clearance, and the parties are now in litigation over the termination fee. Ultimately, 3Com’s failures highlight the importance of public relations in deals, as well as government cooperation and early communication. In this deal, 3Com came off as hiding something, and the national security apparatus reacted badly to 3Com’s secretive conduct.56 In the wake of 3Com’s failure, it replaced its CEO with Robert Mao, who ironically announced his intention to be based in Hong Kong in order to grow the company’s Chinese operations.57 Mao’s relocation illustrated the difficulty of cabining off technology and expertise in a global age.

  In addition, 3Com’s failures illustrates the political nature of the national security process. Foreign buyers, including sovereign wealth funds, need to be alert to both regulatory realities and political sensitivities. The stumbles of Bain Capital and 3Com show the importance of obtaining public relations and government presence early in the process. As foreign investment grows, these controversies are likely to continue. However, in today’s age of $700 billion bailouts, foreign money is needed to sustain the United States. So, public outcry is likely to be muted by the U.S. government’s limited desire to intervene and be seen as hostile to this investment.

  Certain countries such as China will still continue to receive heightened scrutiny. And while CFIUS review and U.S. public outcry at foreign acquisitions have focused on non-Western buyers, our allies in Europe and elsewhere in the West are not immune. For example, CFIUS imposed extensive restrictions as a condition to its clearance of the French telecommunication company Alcatel SA’s acquisition of Lucent Technologies Inc., and in Chapter 8, I talk about the public outcry over Belgium-based InBev’s proposed acquisition of Anheuser-Busch, the American beer-maker.

  The process with 3Com and Bain Capital also shows the often hazy difference between sovereign wealth funds and foreign investors, suggesting that the distinction between the two may be overstated. This may change if sovereign wealth funds truly become more like investment banks and function as alternative capital providers. But right now, this is a potential that has not blossomed. The result is that the jurisdiction of origin of investment is likely to continue to be more important than the form of capital.This may be borne out in future CFIUS reviews.

  Figure 5.5 Cross-Border Takeover Activity 1999-2008

  SOURCE: Morgan Stanley;Thomson Financial 2008 figures as of April 30, 2008

  Absent a 1930s wave of recessionary protectionism, capital will continue to become increasingly global. Foreign investment will only increase and become a more significant source of investment. This is to the advantage of global investment banks, attorneys, and others who have a global presence. It will also make for new sources of capital, perhaps breaking traditional routes such as bank finance. The future depends upon America’s continued openness. The CFIUS process, as shrouded in mystery as it still is today, must come out into the open, making its process clear and transparent. In doing so, CFIUS can work to counteract prior U.S. actions that have put off foreigners on U.S. investment. In the end, the United States has a choice. It can be like France, which has protected its yogurt-maker Danone SA from outside takeover by designating it a national champion, or it can move toward a prudent, more welcoming stance.58

  The choice is driven by the growing globalization of the takeover market (see Figure 5.5). In 2008, European takeover activity at $1.3 trillion exceeded U.S. activity at $1.08 trillion. In that year, Asian take over activity was at $502 billion, only a 10 percent decrease over 2007.

  Meanwhile, cross-border takeovers continued to be an important part of the market. In 2004, cross-border takeovers amounted to $589 billion, and by 2008, the amount had risen to $1.14 trillion, a decline of 36.3 percent from 2007’s figure of $1.79 trillion.59 The continued, sustained worldwide rise of takeover activity will continue to drive cross-border activity toward and away from the United States.The global nature of the takeover will be a driving force in dealmaking in the coming decades, particularly when more stable economic times return. In these troubled times, this trend should be encouraged.

  Chapter 6

  Bear Stearns and the Moral Hazard Principle

  Into March 2008, the markets remained snarled in a credit crunch. In the period from December 2007 through February 2008, financial institutions had undertaken a massive recapitalization globally, raising $155.1 billion in new capital from investors.1 Sovereign wealth funds were the largest single type of investors, supplying $24 billion of total domestic investment.2 For a time, the stock market continued to trade near its fall 2007 highs. However, the relatively stable equity markets hid turmoil in the credit markets, as banks continued to struggle under the weight of the housing crisis and the mortgage-related assets on their balance sheets. Meanwhile, private equity firms remained hard-pressed to keep in place preagreed financing to complete their pending acquisitions.As credit remained scarce, the U.S. economy was undergoing something it had never experienced in modern times: a credit-driven rather than equity-driven market correction.

  It was amid this backdrop that Bear Stearns imploded the week of March 10. It would be a historic and important event with significant ramifications for deals and dealmaking. The saving of Bear Stearns would be a case study of how deal lawyers structure deals both within and up to the bounds of the law.

  Saving Bear Stearns

  In March 2007, the state of the investment bank Bear Stearns was best categorized as troubled. The battering was clear enough. In June 2007, two hedge funds advised by Bear Stearns and created to invest in subprime mortgage-related assets had become insolvent. Their failure had required Bear Stearns to commit approximately $3.2 billion to bail out one of the funds and had also made market participants particularly wary of the investment bank’s exposure to mortgage-related assets.3 Moreover, Bear Stearns was the most highly leveraged of the five large investment banks, with an approximate 33:1 debt to equity ratio.4 Bear Stearns was considered to have the largest exposure to mortgage-related assets. The bank had already taken $1.9 billion in write-downs related to its ownership of these types of assets in the fourth quarter of 2008.5 But the news was not all bad. At the beginning of March, Bear Stearns’s long-term debt, despite downgrades, was still rated investment grade by Standard and Poors.6 On Friday, March 7, 2008, its stock price closed at $70.08 per share—far down from its all-time high of $171.51 in January 2007, to be sure, but the market was not predicting Bear Stearns’s collapse.

  The week of March 10 changed all this. It was the week that Bear Stearns’s luck ran o
ut, but it was also an incredible illustration of the public trust necessary for any financial institution to survive. In that week, over the course of five days, a panic hit Wall Street. It would unfold around Bear Stearns, as rumors doubting the firm’s solvency began to spread. It would end with the sudden downfall of one of Wall Street’s bulge bracket banks. The failure would become almost commonplace by the next September, but at the time it was extraordinary.

  It began on Monday, when rumors began to spread in the market that a major investment bank had rejected a standard $2 billion repurchase loan request from Bear Stearns .7 From there, rumors increasingly spread that Bear Stearns was in financial difficulty. Counterparties become hesitant to trade with Bear Stearns and otherwise demanded collateral for their preexisting and future trades. Asset managers such as hedge funds began to move funds to other financial institutions.8 Bear Stearns was forced to put out a press release stating: “There is absolutely no truth to the rumors of liquidity problems that circulated today in the market.”9 Nonetheless, the market remained skeptical of Bear Stearns’s health, and credit default swaps for the company’s debt began to trade up sharply, going for more than $1 million for every $10 million piece of 10-year debt.10

  Rumors of Bear Stearns’s perilous state continued to spread on Tuesday. Market traders heard the scuttlebutt, and hedge funds and other institutional traders continued to withdraw their trades and assets from the firm. In an ominous sign, the credit default swap market for Bear Stearns shut down. No one was willing to insure against a Bear Stearns collapse.11 Bear Stearns management recognized the crisis and attempted to strike back. On Wednesday, Alan Schwartz, the recently appointed CEO of Bear Stearns, went on CNBC. The purpose of his appearance was to dampen rumors that Bear Stearns was suffering liquidity problems.