CASE STUDY Fund Voting in a Proxy Fight Institutional activism takes many forms, as we have seen. In most situations, mutual funds are drawn into the fray by the actions of others. Company management may put forward a proposal or initiate a structural change, or an opposition group may propose to buy the company or change the companys business strategy. This case study presents such a situation where mutual funds and other institutional investors were drawn into a battle between an insurgent group and company management. This case study involves two related initiatives by an insurgent group in relation to RJR Nabisco. RJR Nabisco is a conglomerate with both a tobacco business (RJR) and a food business (Nabisco). The tobacco business was subject to a broad range of legal suits along with other tobacco companies. The insurgent group, led by Bennett LeBow and Carl Icahn, owned slightly less than 5 percent of the voting stock of RJR Nabisco. The remainder of the stock was heavily concentrated in the hands of mutual funds and other institutional investors. In the first initiative (First Act), the insurgent group put forth two shareholder proposals: to spin off the Nabisco food business from the tobacco business and to restore the right of shareholders to call a special shareholders meeting. Subsequently, in a second initiative (Second Act), the insurgent group proposed a slate of directors to replace the incumbent directors of RJR Nabisco. In reviewing this case study and Exhibit 3, What Burns Holes in LeBows Pockets? assume that you are the manager of two mutual fundsGrowth Fund and Environmental Growth Fundeach owning 1 percent of outstanding common stock of RJR Nabisco, which is trading at $30 per share. The Growth Fund is a $10 billion fund, and the Environmental Growth Fund is a $1 billion fund. The investment objective of the Growth Fund is to seek capital appreciation over the long term, and the investment objective of the Environmental Growth Fund is the same, while taking into account all aspects of environmental concerns. Discussion Questions You have been asked to vote shares of the two mutual funds on the above two shareholder resolutions and the election of directors. For each fund, please answer the following questions: 1. How will you vote? Will you vote the same for each fund? 2. What is the rationale for your vote? What is the difference between voting on shareholder resolutions and voting on director elections? 3. How would you evaluate the potential and probable benefits to your fund from engaging in shareholder activism on these votes? Quantify your answer to the extent feasible. 4. What strategies or tactics would you utilize in support of your position? Would you talk to the insurgents, company management and/or other institutional investors? Would you be prepared to solicit proxies or participate in any group actions? EXHIBIT 3 The voice crackles with excitement thats only accentuated by the scratchy connection from a car phone. Weve got a great message that institutional investors are really starting to turn on to, gushes Bennett S. LeBow, the one-time tanktown takeover artist whos now in the biggest battle of his life and clearly relishing it. Im an experienced fighter, and come April 17, I think a lot of people are going to get the surprise of their life. Thats the day, of course, he hopes to oust the board of giant RJR Nabisco Holdings at the companys annual meeting and install himself and his hand-picked slate of nine others as directors. LeBow is merely the latest barbarian at the gate of this once venerable tobacco and food concern. But his platform of breaking up the company to unlock value has seductive appeal to shareholders whove been saddled with years of disappointing earnings and slack stock performance following Kohlberg Kravis Roberts $29 billion leveraged buyout of the firm in 1989. LeBows plan calls for RJR to immediately spin off to current shareholders the 81 percent stake it still holds in Nabisco food operation. Then, LeBow figures, the food companys stock, freed of the immense litigation risks facing Reynolds and other tobacco companies, would bolt upward. But its difficult to imagine a more unlikely champion of shareholder value. Over the years, LeBow himself has proven a less-than-adept corporate manager. Two of his major corporation acquisitions of the mid-eighties, the computer concern MAI Systems and Western Union, ended up filing for Chapter Eleven bankruptcy protection in 1993 while still under his tutelage. Heavy losses were inflicted on shareholders. LeBow denies any responsibility for this sad pass. He claims both MAI and Western Union were in trouble, high-risk companies that he was, unfortunately, unable to save. His current publicly traded company, Brooke Croup Ltd., is hardly in the pink of health. This despite the fact that Brookes stock rocketed from $4 a share to $14 in a matter of weeks last fall after LeBow first announced his campaign to bust up RJR. The stock currently trades at around $9. Brookes major operating unit, Liggett, is in free fall as a result of its shrinking share of the U.S. cigarette business. Liggett now holds about 2 percent of the market, and it is plagued by declining volume, poor distribution, a loss of pricing power for its important discount brands, and antiquated plants and equipment. Meanwhile, the parent company Brooke is asphyxiating on some $400 million in consolidated debt that recently had to be restructured. As of last September 30 [1995], Brooke boasted a negative net worth of more than $325 million. And that number is likely to grow. In a notification of late filing last week, Brooke reported that it expects to post a net loss of $32 million for 1995. With performance like this, Brooke has another shot at being Fortune magazines Least Admired company in the U.S., an accolade it last won in 1994. The deplorable operating results of LeBow-controlled companies never stopped him from enriching himself at the expense of fellow investors. Over the years he has feasted royally even as his companies hemorrhaged red ink. His combined annual compensation at Brooke at its various units exceeds $2 million. He also has never been averse to making sweetheart deals between his public companies and the private entities he controls. Brooke, for example, spent some $10 million in 1992 to buy LeBows management company, which benefited from having Brooke buy back shares from him in a deal that was not offered to other shareholders. In a sense, LeBow green-mailed his own company. And, when it comes to maneuvering in bankruptcy court, few financiers shake and bake with the agility of LeBow. Though a minority shareholder of Western Union, or New Valley, as the company was renamed in 1991, LeBow wound up maintaining control of the company when it shocked the investment world by emerging from bankruptcy in 1995 with a cash kitty of $300 million after paying off all its creditors. An unexpected windfall from the sale of New Valleys funds-transfer business had made a minor bonanza out of what was expected to be a lugubrious court-ordered liquidation in which creditors and shareholders would be hosed. Chapter Nine Mutual Funds as Institutional Investors 100 Other equity holders cried foul and sued, charging that LeBow and Brooke had manipulated the bankruptcy process to their own benefit. But to no avail. Today, LeBow uses New Valley as his personal investment arm despite the fact that Brooke owns but 42 percent of the companys common. Lavish Lifestyle Lastly, LeBow has few qualms about using his debt-laden companies as personal banks for streams of loans to finance his lavish lifestyle of multiple homes and occasional hijinks. He outdid himself in 1989 when he chartered a plane to fly 150 friends to a $3 million party in London to christen his private yacht, which was modeled on one built for Queen Victoria. LeBows guests reportedly were put up at Claridges Hotel and were met at the harbor by a uniformed marching band. At one point, LeBows borrowing got so out of control that Brooke shareholders successfully sued to force LeBow to pay back some $16 million in outstanding loans, waive his right to $6.25 million in preferred dividends and limit increases on his annual salary for the next four years. LeBow remains unrepentant. As he told Barrons last week, the point to remember is that I would have paid every dime of the loans with contracted interest anyway. The lawsuit just accelerated the payback. Look, those were the swinging Eighties when everybody was living high. And by the way, you should know that RJR Chairman Mike Harper took some $40 million from the company last year, if you add up his salary, incentive compensation, bonuses, and other benefits. Well fax you the numbers. Of course, LeBow was stretching the truth a tad in his spirited rejoinder. The loans he was forced to repay all occurred in the Calvinist Nineties rather than the spendthrift Eighties. And the proffered fax on Harpers compensation got the magic $40 million level only by lumping together two and a half years of Harpers salary, bonuses, option awards, insurance benefits, and perks. Clearly, all is fair in love and takeover battles. LeBows career of self-dealing has clearly paid off. His nearly 60 percent interest in Brooke alone has a current market value of more than $90 million. Characteristically, hes mounting his epic proxy battle for control of multibillion-dollar RJR on the cheap. His partner in the effort, long-time raider Carl Icahn, put up some $350 million of the $500 million the pair used to accumulate its 18 million-share, or 6.6 percent, position in RJRs common. LeBows contribution consists of $80 million supplied by New Valley seemingly his sole remaining source of corporate liquidityleveraged with some $70 million in margin debt. Both Icahn and LeBow are slightly underwater on their positions, based on RJRs recent trading level of around $31. Yet the proxy fight being mounted by LeBow and Brooke cant be dismissed out of hand. Certainly RJR is taking the effort seriously, firing volley after volley of full-page ads in the New York Times and The Wall Street Journal trumpeting various claimed depredations of LeBow LeBogus or LeBowLeBankrupt and carpet-bombing its shareholders with all manner of anti-LeBow propaganda. In February, the LeBow team shocked RJR by winning a consent solicitation of the companys shareholders in which more than half of RJRs outstanding shares voted in favor of a nonbinding resolution that the food unit should be immediately spun off. Its the first time any Fortune 1000 company has ever lost such a solicitation, LeBow crowed to Barrons. Perhaps even more worrisome from RJRs standpoint, Brooke also won a binding bylaw change that would allow any RJR shareholder to call a special shareholder meeting with the backing of just 25 percent of RJRs outstanding shares. This means that LeBow and Brooke can continue to push for changes in the composition of the RJR board and the like, even if they lose the proxy fight at the April 17 annual meeting. And they would no longer need a majority of the shares outstanding to pass new resolutions, as is needed in consent solicitations. Just a majority of the shares present and voting would suffice. Moreover, last month LeBow thought hed pulled off a considerable coup that would virtually insure a Brooke victory in the proxy battle. Breaking with previously sacrosanct Chapter Nine Mutual Funds as Institutional Investors 101 tobacco-industry practice, LeBows Liggett settled a clutch of major outstanding tobacco liability suits. The Bucks involved were small, some 12 percent a year of Liggetts anemic pretax income, but the symbolism of the act was huge. LeBow, of course, extracted a key concession from the plaintiffs lawyers. They agreed that if LeBow were to win the proxy fight, they would allow the bust-up of RJR and the spin-off of the food unit to proceed without tying the deal up in court. Thus, RJR could no longer claim that any spin-off would automatically trigger suits from plaintiffs lawyers. LeBow badly miscalculated, however. News of the Liggett settlement sent RJR and the other tobacco stocks careening lower. Industry giant Philip Morris slipped more than 10 percent in a matter of days, helping vaporize more than $10 billion in the tobacco industrys stock value. Investors panicked at the thought that Liggetts deal would, in the words of leading cigarette analyst Gary Black of Sanford Bernstein, unleash a new flood of litigation. And who knew what damaging industry memos would surface now that Liggett was consorting with the enemy? As a result, LeBow has likely cost Brooke victory in the proxy fight by alienating a number of large institutional shareholders in RJR who had backed Brookes February consent solicitation. At least thats what Black and other analysts are hearing in their independent soundings of institutions. The doors at Fidelity and other major institutions are no longer open to LeBow, though he denies this is the case. Its doubtful that LeBow would win the proxy fight anyway. For its one thing to use LeBow to send a message to RJR management and quite another to actually hand over control of a major company to someone with as tainted a reputation as his. RJRs huge cash flow might prove too tempting. RJR officials argue persuasively that LeBow has a hidden agenda in trying to take over RJR. They say his real intent is to unload the ailing Liggett on RJR at a fancy price. Theres plenty of evidence to back this contention. LeBow concedes that he began his saber rattling at RJR only late last summer after the company spurned his proposal to merge Liggett into RJRs tobacco company for a price nearly four times what RJR considered Liggetts fair market value. So much for boosting RJRs shareholder value. Likewise, the briefing books that various Brooke nominees for RJR directorships received last December included financial tables assuming the two tobacco operations would be merged. If Brooke fails in its effort to dump Liggett on RJR, which now seems likely, its business could continue to deteriorate and it, too, could someday join that long list of companies that LeBow has driven into bankruptcy court. Thats what several sophisticated short-sellers are betting. But any setback for LeBow would only be temporary, one suspects. For in bankruptcy court he would have his fellow Brooke investors and creditors just where he wants them.