Return to Chapter 3.3.1 - Income Statement Analysis
Return to Chapter 3.4.2 - Cash Flow Value
BAUMAN, WEISS & PALMITER - CHAPTER 9 (WEST GROUP 2003)
KAMIN V. AMERICAN EXPRESS CO.
86 Misc.2d 809, 383 N.Y.S.2d 807 (1976), aff’d on opinion below 54 A.D.2d 654, 387 N.Y.S.2d 993 (1st Dept.1976).
[In 1972, American Express purchased almost 2 million shares of stock in Donaldson, Lufkin & Jenrette, Inc. (DLJ), for $29.9 million. By 1975, the stock had declined in value to approximately $4 million. American Express announced that it would distribute the DLJ stock as a dividend. Two shareholders sued to enjoin distribution of the dividend. They argued that American Express would be better off selling the DLJ stock.
The shareholders pointed out that a distribution of the DLJ stock would not have any impact on American Express’s liability for income taxes. On the other hand, if American Express sold the DLJ stock, it could reduce otherwise taxable capital gains by an amount equal to its roughly $26 million loss on the DLJ stock and thus save approximately $8 million in taxes. In effect, the shareholders’ argument was that rather than distribute $4 million in DLJ stock as a dividend, American Express could sell the stock, save $8 million in taxes, and then (if it wished) distribute $12 million (the sale price plus the tax savings) as a dividend.
The American Express board of directors considered the shareholders’ argument at a meeting on October 17, 1975, and decided to proceed with the dividend. The board had previously been advised by its accountants that if the DLJ stock was distributed as a dividend, rather than sold, American Express would not have to reduce its reported income for 1975 to reflect its loss on its investment. Rather, it could bypass its income statement and simply reduce retained earnings by $29.9 million—the book value of the stock it would be distributing.]
Edward J. Greenfield, Justice.
Examination of the complaint reveals that there is no claim of fraud or self-dealing, and no contention that there was any bad faith or oppressive conduct. The law is quite clear as to what is necessary to ground a claim for actionable wrongdoing. * * *
More specifically, the question of whether or not a dividend is to be declared or a distribution of some kind should be made is exclusively a matter of business judgment for the Board of Directors.
* * * Courts will not interfere with such discretion unless it be first made to appear that the directors have acted or are about to act in bad faith and for a dishonest purpose. It is for the directors to say, acting in good faith of course, when and to what extent dividends shall be declared * * * The statute confers upon the directors this power, and the minority stockholders are not in a position to question this right, so long as the directors are acting in good faith * * *.
Thus, a complaint must be dismissed if all that is presented is a decision to pay dividends rather than pursuing some other course of conduct. * * * The directors’ room rather than the courtroom is the appropriate forum for thrashing out purely business questions which will have an impact on profits, market prices, competitive situations, or tax advantages. * * *
* * * The affidavits of the defendants and the exhibits annexed thereto demonstrate that the objections raised by the plaintiffs to the proposed dividend action were carefully considered and unanimously rejected by the Board at a special meeting called precisely for that purpose at the plaintiffs’ request. The minutes of the special meeting indicate that the defendants were fully aware that a sale rather than a distribution of the DLJ shares might result in the realization of a substantial income tax saving. Nevertheless, they concluded that there were countervailing considerations primarily with respect to the adverse effect such a sale, realizing a loss of $25 million, would have on the net income figures in the American Express financial statement. Such a reduction of net income would have a serious effect on the market value of the publicly traded American Express stock. This was not a situation in which the defendant directors totally overlooked facts called to their attention. They gave them consideration, and attempted to view the total picture in arriving at their decision. While plaintiffs contend that according to their accounting consultants the loss on the DLJ stock would still have to be charged against current earnings even if the stock were distributed, the defendants’ accounting experts assert that the loss would be a charge against earnings only in the event of a sale, whereas in the event of distribution of the stock as a dividend, the proper accounting treatment would be to charge the loss only against surplus. While the chief accountant for the SEC raised some question as to the appropriate accounting treatment of this transaction, there was no basis for any action to be taken by the SEC with respect to the American Express financial statement.
The only hint of self-interest which is raised, not in the complaint but in the papers on the motion, is that four of the twenty directors were officers and employees of American Express and members of its Executive Incentive Compensation Plan. Hence, it is suggested, by virtue of the action taken earnings may have been overstated and their compensation affected thereby. Such a claim is highly speculative and standing alone can hardly be regarded as sufficient to support an inference of self-dealing. There is no claim or showing that the four company directors dominated and controlled the sixteen outside members of the Board. * * *
Note: Accounting Versus Economic Results
To assess the merits of the American Express board’s decision to distribute the DLJ stock as a dividend requires consideration of two questions. First, was the board correct in its belief that stock market investors are more interested in the accounting treatment of American Express’s divestiture of its interest in DLJ than in that transaction’s financial impact on American Express? Second, even if the board’s assessment was correct, should the court have allowed the board to seek to increase the market price of American Express stock by abjuring a transaction (selling the DLJ stock and recording the loss) that would have produced a real economic benefit worth $8 million to the company?
Professor Henry Hu argues that managers’ fiduciary duty should be reformulated to require maximization of the “intrinsic value” (i.e., the discounted cash flow value) of a corporations’ stock, and that managers should disregard “evidence that stock market pricing of shares is, to a disturbing extent, ill-informed and irrational.” Henry T.C. Hu, Risk, Time and Fiduciary Principles in Corporate Investment, 38 U.C.L.A. L.Rev. 277, 281 (1990).
As evidence that allowing managers to focus on accounting results, rather than economic realities, may produce economic costs far greater than those involved in Kamin, consider that the risk management manual of Enron Corporation, which for years used “aggressive” accounting to create the appearance of increasing profitability, provided the following guidance:Reported earnings follow the rules and principles of accounting. The results do not always create measures consistent with underlying economics. However, corporate management’s performance is generally measured by accounting income, not underlying economics. Risk management strategies are therefore directed at accounting rather than economic performance.Enron Corp., Risk Management, Derivatives I: Applied Energy Derivatives 20 (1999) (emphasis added.)
Note: Financing Choices
As Kamin illustrates, courts exhibit a strong propensity to extend the protection of the business judgment rule to dividend decisions by the boards of public corporations. As the court pithily observes, the prevailing rule is that the appropriate battleground for such decisions is the boardroom, not the courtroom.
Decisions on whether to distribute funds to shareholders are closely related to decisions concerning investment and capital structure. Professors Merton Miller and Franco Modigliani, two Nobel laureates, have pointed out that in a perfect capital market, it makes no difference whether a corporation finances its investments internally or distributes all the cash it lawfully can and then finances its investments by borrowing the funds it needs or selling new equity. The choices a firm makes should not affect either the value of the firm or the value of its shareholders’ interests.
Nonetheless, boards’ decisions concerning what distributions to make and how to finance new investments generally are viewed as important. In large part, that is not because people reject the Miller-Modigliani insight but because the markets in which corporations operate are far from perfect. At least three real world factors make financing choices important: taxes; differences in the information available to those who run the firm and those being asked to invest in it; and the possibility those who run the firm make financing decisions designed to promote their own interests rather than the interests of the firm or those who have invested in it.
These factors have led financial economists to develop three theories directed at explaining corporations’ financing choices: a tradeoff theory, which focuses on the impact of taxes; a pecking order theory, which focuses on information differences; and agency cost theory, which focuses on self dealing. Research on corporations’ financing choices suggests that all of these theories have some merit, but that none provides a complete explanation. As one recent survey points out, “Debt ratios [and distribution practices] of established U.S. public corporations vary within apparently homogenous industries. There is also variation over time, even when taxation, information differences and agency problems are apparently constant.” Stewart C. Myers, Corporate Structure, 15 J. Econ. Perspectives 81, 82 (2001).
The tradeoff theory builds on the current tax code’s different treatment of interest and dividends, described above in connection with our discussion of leverage. Because interest is tax deductible and dividends are not, it might seem that every firm will try to borrow to finance virtually all of the investments it plans to make. However, as the risk of default increases, so does the interest demanded by prospective lenders. Moreover, default or prospective default generates additional costs for a borrower firm. Consequently, the tradeoff theory suggests only moderate debt to equity ratios. More specifically, it suggests that firms will borrow up to the point at which the marginal value of the tax benefits from additional debt will be offset by the increased possibility that incurring additional debt will lead to financial distress. This suggestion comports with common sense. It also is consistent with studies finding that companies with relatively safe, tangible assets tend to have higher debt-equity ratios than firms with risky, intangible assets. But other studies find that the most profitable firms in many industries—i.e., the firms best situated to take on additional debt—often borrow the least. Thus, while the tradeoff theory has considerable explanatory power, some other theory must explain at least some firms’ financing choices. See id. at 88-91.
The pecking order theory assumes that managers know the true value of a corporation’s existing assets and investment opportunities but that investors do not. It further assumes that managers, acting in the interest of existing shareholders, will not issue new equity at a price below the present value of the firm’s existing assets and investment opportunities and that investors, aware of this tendency, therefore will assume that any new equity offering is overpriced and will further mark-down the price they are prepared to pay. This makes it attractive to managers to finance new investments internally if they can, because internal financing does not bring informational differences into play, and to avoid initiating or increasing dividends if they anticipate that the firm will need internally generated funds for future investments. However, managers will avoid cutting dividends to finance new investment opportunities because investors generally interpret dividend cuts as a signal of adverse business developments. When managers need to resort to external financing, they will try to issue the safest security they can to finance new investments, beginning with safe debt (which involves fewer informational asymmetries than equity) and then proceeding to higher risk debt, convertible debt or preferred stock, and selling equity, which involves the greatest informational asymmetries, as a last resort. See id. at 91-93.
The pecking order theory illustrates how informational asymmetries may affect managers’ financing decisions. It also is consistent with many corporations’ financing decisions, but it fails to explain other patterns of corporate financial behavior. That may be because the theory assumes managers always act in shareholders’ best interest but a good deal of theory and real world evidence suggests they do not. (Recall the discussion of agency cost in Chapter 2.) This has given rise to the agency cost theory of corporate finance, propounded most vigorously by Professor Michael Jensen. Jensen set forth his views at the end of the 1980s, a decade in which many public corporations became the targets of hostile takeovers financed by high-yield debt and many others, perhaps to fend off takeover bids, adopted highly leveraged capital structures. He directed his critique primarily at public corporations “in industries where long-term growth is slow, where internally generated funds outstrip the opportunities to invest them profitably, or where downsizing is the most productive long-term strategy.”
Return to Chapter 3.3.1 - Income Statement Analysis
Return to Chapter 3.4.2 - Cash Flow Value