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Publisher : Elsevier - Science Direct (الزویر - ساینس دایرکت)
Journal : Journal of Corporate Finance, Volume 9, Issue 3, June 2003, Pages 271–294
We examine value creation and destruction in the tobacco industry due to the radical litigation strategy of Brooke Group CEO Bennett LeBow. Brooke Group had tiny market share, low margins, high leverage and highly concentrated management ownership. Beginning in 1996, the firm reached settlements in lawsuits brought against all cigarette companies by class action plaintiffs and US state governments. Brooke Group's actions, which included promises to cooperate in litigation against its rivals, spurred other companies to reach settlements on less favorable terms. These events led to massive wealth destruction within the industry but impressive returns for shareholders of Brooke Group.
On March 13, 1996, Bennett LeBow, Chairman, CEO and controlling shareholder of Brooke Group, announced that his firm had agreed to settle Castano vs. American Tobacco, 84 F 3d 734 (1996), a class action lawsuit filed by cigarette smokers against the major US tobacco companies. Within 2 days, LeBow also reached settlements with five US states that had sued cigarette manufacturers to recover the cost of tobacco-related Medicaid and Medicare expenses. A more comprehensive settlement between LeBow's company and 22 plaintiff states followed in March 1997. By breaking ranks with industry counterparts who had steadfastly maintained no responsibility for health hazards of smoking, LeBow set the stage for the larger settlement that the industry reached with 46 state governments in November 1998. Brooke Group (since renamed Vector Group) owned a controlling interest in Liggett, the fifth largest cigarette maker in the US. Liggett had a tiny market share, and Brooke Group's capital structure and ownership pattern differed significantly from those of other tobacco companies. Brooke Group's settlements of smoking lawsuits had a dramatic impact on share prices throughout the industry: over the 2 days following the initial March 1996 announcements, more than US$7 billion disappeared from the market capitalization of other tobacco companies, while Brooke Group's equity value rose by US$30 million, a net-of-market gain of nearly 20%. Similar patterns of returns occurred over the subsequent 3 years as the tobacco industry's litigation strategy evolved from defiance toward conciliation. Brooke Group shareholders earned returns that were modest in dollar value but enormous in percentage terms, as LeBow repeatedly obtained lenient settlements for his company while agreeing to assist plaintiffs and regulators in their efforts against his far larger rivals. In contrast, other tobacco investors lost billions as the legal environment's deterioration—abetted by LeBow's cooperation with outsiders—motivated companies to settle litigation on terms they had once viewed as inconceivable. This paper follows LeBow's management of Liggett beginning in 1986, when he purchased its tobacco operations from Grand Metropolitan in a highly leveraged transaction. In many ways, Liggett and LeBow epitomized the move towards debt financing and concentrated ownership in corporate America during the 1980s. In a series of mostly unsuccessful investments, LeBow pursued a strategy of buying financially troubled companies with junk bond financing, raising their value through asset sales and operational improvements and recouping his investment by selling a minority stake in an initial public offering. This approach was designed to give LeBow handsome profits on his initial investment while allowing him to retain residual control of the firm. His performance as a creator of shareholder value was at best mixed. Business Week, in a 1996 profile, described LeBow as a “minor-league bottom-fisher” and “third-tier wheeler-dealer” (Lesly, 1996), and several of his investments led to bankruptcies and shareholder lawsuits. Table 1 gives a chronology of LeBow's major ventures apart from Liggett. Table 1. Major investment proposals by Bennett LeBow Date Firm Transaction Outcome 1967 DSI Systems Company started by LeBow Major restructuring in 1969; sold in 1971 1980 Information Displays Majority equity investment Sold in 1984; Buyer files Chapter 11, sues LeBow 1985 ShowBiz Pizza Time Purchases 6.4% and launches proxy fight Loses shareholder vote 1985 MAI Basic Four Information Systems Acquired in US$105 million LBO Files Chapter 11 in 1993 1986 Northwestern Steel and Wire US$165 million acquisition proposal Rejected by shareholders 1986 Brigham's Ice cream chain acquired for US$17 million Divested in 1991 1987 Western Union (renamed New Valley) LeBow acquires control during restructuring Files Chapter 11 in 1993 1988 Allegheny International Suggests alternative reorganization plan Rejected by shareholders 1988 Prime Computer US$970 million hostile bid Rejected by management 1988 American Brands Obtains regulatory clearance for bid Rejected by management 1989 SkyBox International Trading card business started by Brooke Group Divested in 1995 for US$165 million Major investment proposals by Bennett LeBow, whether successful or unsuccessful, apart from his involvement with Liggett. Information was obtained from news reports and company filings. In addition to those ventures listed, LeBow at various times owned interests in the jewelry, photostatic copying, shipbuilding and real estate industries. Table options Stock return data indicate that LeBow's Brooke Group shareholders earned handsome returns while other tobacco company stocks performed poorly amid the turmoil LeBow helped create. Fig. 1 shows the value over time of a US$1.00 investment in the four public US tobacco stocks on August 1, 1995, the approximate beginning of LeBow's restructuring activities. The graph extends to September 30, 1999, soon after the announcement of the US federal government's lawsuit against the industry. For comparison purposes, the results of a US$1.00 investment in the S&P 500 Index are also shown. A US$1.00 investment in Brooke Group would have grown in value to US$4.35 during the time studied, compared to an outcome of US$2.28 from investing in the market index. All three of the other tobacco stocks—Philip Morris, RJR-Nabisco2 and Loews—trailed the market during this period, yielding US$1.71, US$1.28 and US$1.22, respectively, from a hypothetical US$1.00 investment. Since the other firms were far larger than Brooke Group, their loss in market capitalization represented a small transfer of value to Brooke Group, and a much larger transfer to legal claimants, principally state governments. Full-size image (13 K) Fig. 1. Performance of US tobacco stocks (August 1, 1995–September 30, 1999). Value of a US$1.00 investment in the stocks of the four public US tobacco manufacturers between August 1, 1995 and September 30, 1999. For comparison purposes, the dark line represents the value of a US$1.00 investment in the S&P 500 Index. Dates are chosen to coincide with Brooke Group's active efforts to resolve private and government litigation against the tobacco industry. The stock of R.J. Reynolds is represented by RJR-Nabisco prior to its June 15, 1999 spinoff. Stock return information was obtained from the CRSP database. Figure options Within the tobacco industry, LeBow's efforts to create value differed markedly from the strategies of his rivals. While other companies were preoccupied with overseas expansion and cutthroat domestic battles for market share, LeBow paid little attention to the product markets and instead focused on changing the financial structure of Liggett. His initiatives involved a series of attempts to limit legal liabilities associated with tobacco-related illnesses. Although these liabilities were hypothetical at the time that LeBow acquired Liggett, we argue that he viewed them as an enormous contingent claim against his firm's assets and a significant part of Brooke Group's capital structure. Accordingly, LeBow sought to raise the value of his equity investment by taking actions that he hoped would reduce expected litigation damage payments. Our paper contributes to the literature on how the incentive effects of debt impact corporate strategy and the value of the firm. The example of Brooke Group suggests that these effects are intensified by the presence of potential legal liabilities which can be viewed as a form of pseudo-debt. While tobacco companies have operated within a unique regulatory and political environment, our findings also have relevance for other types of firms that face large hypothetical liabilities, such as those in the handgun, chemical or nuclear power industries. The analysis also has implications for issues such as financial market and product market interaction and the costs and benefits of concentrated ownership. Fig. 2 provides a schematic of Brooke Group's capital structure using actual 1995 values of long-term debt (book value) and equity (market value). In addition to these traditional components of capital structure, the figure includes a third piece, the expected value of future legal liabilities. Among investors and analysts, these potential damage payments were widely viewed as a drag on firms' equity values. Securities analysts often cited legal liability concerns as the reason that tobacco stocks did not trade at the same multiples as equities in comparable industries like food and agricultural products. LeBow's strategy amounted to reducing or eliminating the value of these claims, hoping to transfer the asset value shown on the left side of Fig. 2 from legal claimants to equity investors. Full-size image (15 K) Fig. 2. Brooke Group's hypothetical asset value and capital structure. All dollar amounts are in millions. Figure options LeBow's strategy to reduce litigation exposure evolved through three distinct phases. First, in conjunction with raider Carl Icahn, LeBow attempted to merge Liggett's tobacco operations with those of RJR-Nabisco and engineer a spinoff of RJR's nontobacco assets, in order to isolate those assets from the reach of potential jury verdicts. Second, in the midst of his battle for RJR, LeBow settled the Castano and state lawsuits, hoping that RJR shareholders would view the settlement terms favorably and, therefore, support his bid for control. However, RJR shareholders repudiated this strategy and backed management in an April 1996 proxy vote. Finally, faced with objections within the industry over his attempts to reduce litigation exposure, LeBow turned against his competitors, settled lawsuits on his own and began cooperating with government regulatory and litigation efforts. LeBow's strategic perspective differed wildly from the publicly announced beliefs of other companies in the industry, who disingenuously insisted they faced zero potential legal liability and buttressed this position with aggressive publicity campaigns, litigation defense and contributions to public officials.3 For this strategy to succeed, the industry required unanimous participation from its members, given that all companies had similar access to potentially damaging legal materials. However, the incentives for LeBow to participate in this scheme were not clear-cut. LeBow realized only a tiny share of the benefits from the industry's coordinated defiance, given his firm's negligible market share, and its high leverage meant that any costs of deviating from the group strategy would have fallen largely on LeBow's debtholders (and his rivals). If regulators or litigators secured LeBow's cooperation, they could extract enormous economic rents from other, larger tobacco companies and potentially share this value with LeBow, leaving him with far more than he was earning from the operation of Liggett. We are surprised that other tobacco firms did not pay greater heed to the possibility that LeBow would adopt this viewpoint and break ranks. Given Brooke Group's capital structure, LeBow's maverick actions seem to fit squarely with Jensen and Meckling's (1976) predictions about the owner–manager of an extremely levered firm, who should be expected to pursue risky strategies with high possible payoffs but low probabilities of success. LeBow's litigation settlements were risky because they involved admissions of liability that made his firm vulnerable to increased damages in numerous other actions still pending or not yet filed, and they also increased the likelihood of stringent government regulation that could have reduced cash flow throughout the industry. Risk-shifting incentives arising from the conflicts of interest between equity and risky debt have been discussed extensively in the finance literature (see Green, 1984 and John, 1987). Additionally, our paper highlights the less documented conflicts of interest between security holders (debt, equity) and other claimants against the firm (employees, suppliers, consumers and society at large). This issue is addressed by Shleifer and Summers (1988), who argue that the financial gains from takeovers may partly represent wealth transfers from employees and communities. In the tobacco industry, the struggle over assets between equity holders and litigation claimants has resembled similar conflicts in such industries as asbestos (Johns Manville), birth control devices (A.H. Robins) and silicone breast implants (Dow Corning). In addition to its implications for the incentive properties of debt, our paper has relevance for legal theories of plea bargaining in which the first mover obtains more lenient treatment by agreeing to cooperate with authorities. Kobayashi (1992) provides a model in which a prosecutor uses plea bargaining as a device to “buy” information from malfeasors. Bebchuk (1984) and Reinganum (1988) are related works. An excellent recent example of the value consequences in sequential plea bargaining occurred in the US vitamin industry, when five companies agreed to pay fines of US$1.1 billion to settle price-fixing charges but a sixth industry leader, Rhone-Poulenc, avoided a fine by cooperating with the US Justice Department and helping it build the case against its rivals Segal, 1999a and Segal, 1999b. The paper is organized as follows. Section 2 describes the background of Liggett and LeBow and the financial strategy LeBow used to acquire Liggett through his Brooke Group investment vehicle. Section 3 provides background information on tobacco litigation. Section 4 examines the creation and destruction of value at Brooke Group and other firms due to strategic actions taken by LeBow. Section 5 concludes.
نتیجه گیری انگلیسی
The tobacco industry in the mid-1990s faced a variety of litigation claims from consumers and government authorities. Bennett LeBow, CEO of cigarette manufacturer Brooke Group, created enormous value for shareholders by adopting a litigation strategy different from that of his industry rivals. While other tobacco companies steadfastly refused to settle lawsuits or cooperate with regulatory authorities, LeBow pursued a strategy of accommodation. By being the first firm in the industry to reach agreements with plaintiffs, LeBow's company secured lenient settlement terms in exchange for cooperating in lawsuits against others. Though LeBow's actions contributed to massive destruction of wealth within the tobacco industry, his own small firm increased in value substantially as regulators implicitly allowed Brooke Group to obtain a portion of the economic rents extracted from his competitors. Our paper extends the literature on how debt affects managerial behavior by highlighting the connection between financial leverage and hypothetical legal liabilities. LeBow's apparent insight was to recognize that large contingent legal claims from tobacco lawsuits represented pseudo-debt on Brooke Group's balance sheet. Under these conditions, LeBow rationally pursued a high-risk strategy of attempting to increase equity value by reducing the value of other claims against his firm's assets. LeBow's actions seem entirely predictable to us, given his firm's tiny market share, negligible cash flow, levered capital structure (even in the absence of litigation), and high ownership concentration. Indeed, an unexplained puzzle of this story is why Philip Morris and the other tobacco companies did not recognize this possibility and buy out Liggett from LeBow years earlier, especially given his reputation as an unorthodox manager with little regard for financial convention. Our study also illustrates opportunities for value creation for both regulators and defendant corporations during legal plea bargaining. In our example, government authorities extended generous financial terms to a small player, and by doing so gained cooperation that facilitated value extraction from other, larger firms. This dramatic outcome of this strategy in the case of tobacco may influence product liability litigation in other industries such as handguns.