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Chapter Nine Mutual Funds as Institutional Investors 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 company's 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 LeBow's 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? 94 Chapter Nine Mutual Funds as Institutional Investors EXHIBIT 1 Ownership Information (February 6, 1996) Type of Shares Beneficial Ownership Officers & directors 0.45% Institutions 64.33% Wachovia Bank of North Carolina, N.A. 1.07% Votes per Share Shares Outstanding Common stock 1.00 272,807,942 Series C conversion preferred stock 0.20 26,675,000 ESOP convertible preferred stock 0.20 15,003,379 Source: Proxy Statement, CDA Investment Technologies. Note: The company has three types of voting stock. Each share of common stock entitles shareholders to one vote. Each share of Series C conversion preferred stock and ESOP convertible preferred stock entitles shareholders to one-fifth of a vote. RJRNabjsco Holdings Corp.* First Act Approval of the following shareholder resolutions submitted by Brooke Group, Ltd., a publicly traded company of the New York Stock Exchange, requires the written consent of a majority of RJR Nabisco Holdings Corp. common stock outstanding. Brooke Group has initiated a consent solicitation through which shareholders are being asked to approve two proposals. The first item seeks adoption of a nonbinding resolution requesting that the board spin off the remaining 80.5 percent of Nabisco common stock immediately. The second resolution is a binding bylaw amendment proposal in which shareholders will vote on whether to restore the right to call a special meeting by written request of holders of 25 percent of the common stock outstanding. Brooke Group, which is controlled by Chairman and CEO Bennett LeBow, owns approximately 4.8 percent of RJR's outstanding common stock. Item 1: Approve Resolution to Spin Off Nabisco This resolution is a nonbinding proposal through which shareholders would ask the board to spin off the remaining 80.5 percent share of Nabisco common stock in order to enhance the value of shareholders' investment by separating the company's food and tobacco businesses. RJR Management RJR's board opposes the proposal, arguing that while it sees value in ultimately spinning off the remaining Nabisco stock to shareholders, it believes that the timing is wrong. RJR argues that a negative environment from litigation against tobacco companies could attract further litigation claiming that the spin-off is a fraudulent conveyance, meaning that the spin-off is intended to frustrate potential creditors rather than to affect a valid business strategy. Moreover, if the spin-off is viewed as not having a valid business purpose, it might not be tax-free to shareholders. The company also claimed that an injunction against the spin-off could block further dividend increases and stock buyback programs that could otherwise enhance shareholder value. Another reason for delaying a spin-off was RJR's perceived commitment to security holders that a spin-off would be delayed for a period of time in order to ensure the company's investment-grade credit rating and overall financial integrity. RJR also questioned the integrity of proponents, Mr. LeBow * Reprinted with permission of the Institutional Shareholder Service. Copyright 1998. 95 Chapter Nine Mutual Funds as Institutional Investors and Carl Icahn, who are well known for their involvement in financing corporate takeovers and their association with companies that have filed for bankruptcy protection. Background RJR implemented a partial spin-off of Nabisco in 1994 and used the proceeds to reduce the substantial debt burden that was its legacy from its debt-financed takeover by Kravis, Kohlberg and Roberts (KKR) in the mid-1980s. Following the partial spin-off, RJR retained an 80.5 percent stake in Nabisco. A shareholder proposal submitted at the 1995 annual meeting by a religious organization requested that the company engage in a full spin-off in order to achieve a full separation of the food and tobacco businesses. The board opposed the proposal as not being in the best interest of shareholders and because it would violate a board resolution in which it committed to not engaging in any distributions of stock of subsidiary before December 31,1996and not before December 31,1998, if such a distribution would cause the company's senior debt rating to be downgraded. The company also argued that it was taking other steps that would benefit shareholders, including a one-for-five reverse stock dividend intended to improve the market for RJR common stock, the introduction of a $0.375 quarterly dividend, and an exchange offer involving debt securities of RJR and Nabisco, Inc. The spin-off proposal was defeated and received little support from RJR shareholders. Brooke Group approached RJR in May 1995 about a possible combination of its struggling Liggett tobacco business with RJR's tobacco operations in a merger that Brooke Group believed would permit RJR to spin off the remaining shares of Nabisco to RJR shareholders in a legally defensible transaction. Brooke Group reportedly asked for a 20 percent stake in the combined tobacco company and $350 million in preferred stock. RJR ultimately rejected the proposed transaction and may have also turned down a subsequent offer to buy Liggett from Brooke Group outright. In August 1995, after talks broke down between Brooke Group and RJR, Brooke Group's wholly owned subsidiary, New Valley Corp., made a Hart-Scott-Rodino Act (H-S-R) filing to buy 15 percent of the company's outstanding common stock. Later that month, the board amended the company's bylaws to eliminate the right of shareholders to call a special meeting in response to a perceived threat of a takeover by LeBow and Icahn. On October 30, 1995, LeBow sent a letter to RJR announcing Brooke Group's intent to conduct a consent solicitation in which shareholders would be asked to vote in favor of a nonbinding resolution to spin off the remainder of Nabisco immediately. On November 20, 1995, Brooke Group made the necessary filings to preserve its right to run a slate of directors at the company's spring annual meeting. RJR and Brooke Group Positions on a Spin-Off Brooke Group argues that the RJR board's fear of personal liability from litigation surrounding a potential spin-off is keeping Nabisco from being spun off and that the failure to carry out a separation of the food company is hurting the overall company's earnings and stock performance. Brooke notes that since RJR's initial public offering (February 1, 1991) through the date of the New Valley H-S-R filing, the company has had meager total returns of -0.5 percent, compared to 9.8 percent for the S&P Tobacco index and 9.8 percent for fellow food and tobacco products company Philip Morris. For the one-year period through the H-S-R filing RJR suffered a loss of 12 percent, while the S&P Tobacco index returned 28.6 percent and Philip Morris generated a 32.8 percent return for its shareholders. LeBow has stated that Brooke Group only wants to see RJR spin off Nabisco to increase his estimated $150 million investment in the company's stock and is not seeking to take control of RJR. Brooke Group cites recent studies and statistics demonstrating the apparent benefits of corporate spin-offs to shareholders. Brooke Group also expresses considerable doubt as to predictions of an improving litigation environment that will produce a more favorable time for a spin-off. RJR does not refute Brooke Group's criticism of the company's past performance, but asserts that the litigation environment makes an immediate spin-off too risky. The company notes that the industry is currently faced with several lawsuits (Castano, Engle, and Broin) in which courts have upheld class certifications that could result in massive class action lawsuits against the 96 Chapter Nine Mutual Funds as Institutional Investors industry, as well as a handful of state attorneys general cases in which states (including Florida, Mississippi, Minnesota, Maryland, and West Virginia) are seeking reimbursements for Medicaid expenses arising from alleged injuries and deaths due to smoking. The company believes that in the current environment, a spin-off would attract protracted litigation to prevent RJR from shielding Nabisco from a potential mega-verdict arising from any of these cases. RJR CEO Steven Goldstone has publicly stated that he thinks that the company may make sufficient progress in these cases by mid-1998 that will make a spin-off less risky at that time. RJR cautions shareholders not to throw their support behind Messrs. LeBow and Icahn given their reputation as corporate raiders and their involvement in certain companies which ended up in bankruptcy at some point, including SkyBox International Inc. (LeBow), MAI Systems Inc. (LeBow), and TWA (Icahn). RJR asserts that Brooke Group was forced by the company to disclose its attempts to work a deal to combine Liggett with RJR Tobacco and efforts by LeBow to form a consortium to take a controlling interest in RJR. . . . Amendment of the Bylaw and RJR's Corporate Governance RJR Management Mr. Goldstone acknowledged that the elimination of shareholders' right to call a special meeting is an unpopular move with many of the company's institutional shareholders. However, he claims that most shareholders RJR has contacted do not intend to support the LeBow bylaw amendment, given the concerns expressed by the company that the dissidents' agenda is really to take over RJR and not to improve the company's corporate governance. Goldstone said the board believed that this one potential defense against Mr. LeBow and Mr. Icahn is necessary, given that relative to other S&P 500 companies, RJR has erected relatively few antitakeover defenses. He noted that the company does not maintain a poison pill, maintains cumulative voting in the election of directors, allows shareholders to act by written consent with a vote representing a majority of shares outstanding, and elects its board annually. RJR argues that the move to restrict the right to call a special meeting is aimed solely at the LeBow/Icahn solicitation and prevents the possibility of the dissidents calling a special meeting to vote on a takeover of RJR with support as low as 25.1 percent of shares outstanding. RJR also asserts that Brooke Group's corporate governance profile contains similar voting requirements to those adopted by RJR. EXHIBIT 2 Ownership Information (April 8, 1996) Type of Shares Beneficial Ownership Officers & directors Institutions Wachovia Bank of North Carolina, N.A. 0.46% 70.71% 1.07% Votes per Share Shares Outstanding Common stock 1.00 272,987,782 Series C conversion preferred stock 0.20 26,675,000 ESOP convertible preferred stock 0.20 15,003,379 Source: Proxy Statement, CDA Investment Technologies. Note: The company has three types of voting stock: common stock entitles its holder to one stock, and ESOP convertible preferred stock. Each share of common stock entitles its holder to one vote. Each share of Series C conversion preferred stock and ESOP convertible preferred stock entitles its holder to one-fifth of a vote. Wachovia Bank of North Carolina, N.A. beneficially owns 100 percent of the company's ESOP convertible preferred stock. Bennett LeBow and Carl Icahn together own approximately 6.6 percent of the outstanding stock. Brooke Group complains that the bylaw amendment removing the right of shareholders, but not the board's right, to call special meetings was done in secrecy after Brooke Group met with RJR management and made known its intention to increase its stake in RJR. Brooke Group 97 Chapter Nine Mutual Funds as Institutional Investors believes institutional shareholders will support its effort to restore their previous right to call a special meeting. Second Act Item 1: Elect Directors Mr. LeBow's Brooke Group has nominated a 10-member slate to replace the current board of RJR. The LeBow slate has a three-prong platform: Effect an immediate spin-off of Nabisco. Increase the company's 1996 annual tobacco dividend from $1.50 to $2.00 per share and maintain a payout ratio of 60 percent of net cash flow. Revitalize the tobacco company under Ronald Fulford, former executive chairman of Imperial Tobacco, a subsidiary of Hanson PLC. In addition, as a result of the terms of the recent Liggett Group Inc. tobacco litigation settlement of the Castano class action lawsuit and the settlement of a number of state attorneys' general suits against the industry to recover expenses of treating Medicaid patients, Mr. LeBow would offer RJR shareholders a first opportunity to consider a merger between Liggett and RJR that purportedly would extend the settlement to RJR and free the company from all current and future addiction-based liability claims. The Brooke Group slate comprises 10 nominees, 5 of whom (Bennett LeBow, Rouben Chakalian, Richard Lampen, Arnold Burns, and Barry Ridings) are employees or directors of Brooke Group or some affiliated organization. Mr. Chakalian has been president and CEO of Liggett since June 1994. Liggett is the manufacturer of Chesterfields and Eve cigarettes. Also providing the slate with tobacco industry experience is Peter Strauss, who was for three years (through December 1994) senior vice president, trade marketing (domestic) and international operations for the American Tobacco Co., which was merged into Brown & Williamson, a subsidiary of B.A.T. Industries, in 1994. In addition to Mr. Strauss, the outside directors include shareholder advocate and former California Public Employees' Retirement System (CalPERS) CEO Dale Hanson, attorney Robert Frome, investment banker Barry Ridings, business professor William Starbuck, and Frederick Zuckerman, a former senior executive of IBM, RJR Nabisco, and Chrysler. Cognizant that RJR and some shareholders are suspicious of Mr. LeBow's motives, Brooke Group's nominees have pledged that if they have not declared a spin-off of the remaining Nabisco shares held by the company within six months of their election, they will call a special meeting for the election of new directors. Brooke Group has also stated that it will not participate in the management of RJR Nabisco. In addition, Brooke Group's slate has also pledged to adhere to a number of corporate governance policies, including the following: Any corporate transaction between RJR Tobacco and its subsidiaries and Brooke Group or its affiliates valued at more than $2 million (i.e., a Liggett/RJR merger) would require approval by a special committee of independent directors and RJR shareholders. No adoption of a staggered board or poison pill. Adoption of confidential voting for future stockholder votes. . . . EXHIBIT 3 What Burns Holes in Lebow's Pockets?* Jonathan R. Laing 98 Chapter Nine Mutual Funds as Institutional Investors The voice crackles with excitement that's only accentuated by the scratchy connection from a car phone. We've got a great message that institutional investors are really starting to turn on to, gushes Bennett S. LeBow, the one-time tanktown takeover artist who's now in the biggest battle of his life and clearly relishing it. I'm an experienced fighter, and come April 17, I think a lot of people are going to get the surprise of their life. That's the day, of course, he hopes to oust the board of giant RJR Nabisco Holdings at the company's 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 who've been saddled with years of disappointing earnings and slack stock performance following Kohlberg Kravis Roberts' $29 billion leveraged buyout of the firm in 1989. LeBow's 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 company's stock, freed of the immense litigation risks facing Reynolds and other tobacco companies, would bolt upward. But it's 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 Brooke's 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. Brooke's 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 magazine's 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 LeBow's 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 Valley's 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. 99 Chapter Nine Mutual Funds as Institutional Investors 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 company's 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. LeBow's guests reportedly were put up at Claridge's Hotel and were met at the harbor by a uniformed marching band. At one point, LeBow's 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 Barron's 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. We'll 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 Harper's compensation got the magic $40 million level only by lumping together two and a half years of Harper's salary, bonuses, option awards, insurance benefits, and perks. Clearly, all is fair in love and takeover battles. LeBow's 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, he's 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 RJR's common. LeBow's 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 RJR's recent trading level of around $31. Yet the proxy fight being mounted by LeBow and Brooke can't 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 company's shareholders in which more than half of RJR's outstanding shares voted in favor of a nonbinding resolution that the food unit should be immediately spun off. It's the first time any Fortune 1000 company has ever lost such a solicitation, LeBow crowed to Barron's. Perhaps even more worrisome from RJR's 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 RJR's 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 he'd pulled off a considerable coup that would virtually insure a Brooke victory in the proxy battle. Breaking with previously sacrosanct 100 Chapter Nine Mutual Funds as Institutional Investors tobacco-industry practice, LeBow's Liggett settled a clutch of major outstanding tobacco liability suits. The Bucks involved were small, some 12 percent a year of Liggett's 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 industry's stock value. Investors panicked at the thought that Liggett's 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 Brooke's February consent solicitation. At least that's 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. It's doubtful that LeBow would win the proxy fight anyway. For it's 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. RJR's 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. There's 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 RJR's tobacco company for a price nearly four times what RJR considered Liggett's fair market value. So much for boosting RJR's 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. That's 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. *Reprinted with permission of Dow Jones, from Barron's, April 8, 1996; permission conveyed through Copyright Clearance Center, Inc. 101