Who protects the shareholders?

These days, financial executives wear plenty of different hats: manager, director, employee, shareholder. And most of the time, you can wear them all at once. But what happens when your company is the subject of a hostile takeover, and each role pulls you in a different direction? In the fourth of a series of case studies in ethics, two financial executives and an ethicist help a hypothetical CFO clear a path through an ethical jungle of conflicting responsibilities.

THE QUANDARY

"Off the record, Wally, what do you think we ought to do?" asked Joe as he and Wally drank coffee in a quiet comer. Both Joe and Wally were directors on the board of durable goods manufacturer ARS, Inc. Wally was CFO of the company, while Joe was an outside director who owned his own firm. They were talking before a meeting on the company's response to yesterday's hostile takeover announcement from The Harris Group, a holding company through which C. Max Harris had led several takeovers in recent years.

ARS was widely considered to be a well-run company, but a series of setbacks beyond management's control - slow recovery from a local recession, the failure of a long-time major customer and residual impact from earlier management problems that the current team was turning around - had led to six quarters of disappointing results. Harris believed ARS would be worth more if it abandoned its long-term business strategy. A typical Harris takeover involved acquiring a vulnerable company; slashing costs in the short term; selling assets for cash in the medium term, which increased share price; and then selling the stock at a substantial gain.

Wally struggled to respond to Joe's question. "Look, the stock price has already jumped 15 percent on his announcement and will increase substantially more if he succeeds. The people we directors represent, the shareholders, are bound to make a lot of money. Not that I like the situation, though. I know as well as anyone we've got an excellent team here with a strong business plan. If we had more time, we'd raise the stock price without cutting jobs or selling businesses. I know that legally it's gray enough that the decision is up to us. I just don't know which decision to make."

Joe mentioned various defenses the company could pursue, such as a poison-pill resolution, a proxy fight or even greenmail. "But," he acknowledged, "I'm a shareholder, too, and maybe we should just bargain for the best price and be done with it." Wally questioned whether he should mention golden parachutes if no one else did. His biggest concern, though, was how to sort his multiple roles: manager, director, employee, shareholder and local citizen.

How should Wally balance his conflicting responsibilities? What should he say in the meeting, if anything? How should he vote? Would your answers to these questions be the same if C. Max Harris were already a minority director and attended the upcoming meeting? If not, how would your answers differ? Assuming that the shareholders come first, what course of action is truly in their best interest?

THE COURAGE OF YOUR CONVICTIONS

by Gene Kaplan Managing director, secretary and treasurer Seawoulfe Partners Princeton, N.J.

I firmly believe that in this case, there should be no difference in how Wally responds to Joe, whether as a manager, director or employee. In each of those roles, he represents multiple constituencies: the shareholders, employees, customers and suppliers.

If ARS has a strategic plan, it should be based on proper research, coupled with empirical knowledge of the company and its industry. That business plan should have already considered what jobs can be eliminated, what expenses can be cut and what businesses might be sold off to improve the operating results, the cash flow and the value of the shareholders' investment. Why should Harris, an outsider, be presumed more able to bring good long-term shareholder returns than "an excellent team with a strong business plan"? Harris' solution provides short-term solutions for the shareholders, rather than "staying the course" to achieve greater long-term return for all consitutencies. If Wally believes in himself and his management team, his only real choice is to pursue his business plan and fight the takeover.

The answer wouldn't be any different if Harris were already a minority director and attended the board meeting. Opposing Harris at the board meeting might not be the best career move for Wally, but not opposing Harris would be ignoring what Wally strongly believes is best for the company and its shareholders. Wally should make his case clearly, describing the total returns the company can expect in the long run. He knows the company and its industry far better than Harris, who's focused on creating potential short-term profit without concern for long-term effects on any constituency other than the shareholder.

Rejecting Harris' offer is in the best interests of the shareholders. Most shareholders, while sensitive to short-term change, invest in companies for the long-term benefit, and in this case, the long-term prospects of ARS outweigh the short-term benefits to be gained by a takeover. The share price coming from its nadir would appear to have much potential to grow beyond the short-term blips, as the turnaround program is put into place. If Wally truly believes in the company, he should have the courage to support it. There's always an ongoing need for efficiency to enable a company to compete effectively. This effort should be part of a studied, long-term plan, not of a "quick fix," which an ARS takeover represents.

THE DIRECTOR AS FIDUCIARY 

by Arthur Neis CFO and treasurer Life Care Services Corp. Des Moines, Iowa 

This case illustrates a common conflict of interest between the process of corporate governance by directors, who are elected by shareholders, and the exercise of corporate control by managers, who are selected by directors. The conflict arises because ownership of the company is separate from control of the company.

Wally's and Joe's individual responses are perfect examples. Wally, an employee, manager and inside director, thinks of his own self-interest and economic well-being - that is, golden parachutes. This is a natural response. He's also concerned, however, about his responsibilities as a director.

When presented with the hostile takeover bid, Joe, an outside director who owns his own firm and is also an ARS shareholder, defines two alternatives - defend the company (perhaps defending the results of his years of service as a director?) or bargain for the best price for shareholders.

So who represents the shareholders? Shareholders have a simple objective - return on their investment. The return is measured by both dividends and appreciation in share value over time. When shareholders elect directors as their representatives, the directors' objective should be the highest possible return for those they represent. Therefore, directors have a fiduciary obligation to the shareholders.

The real conflict of interest in this instance lies with the inside directors. Is an inside directorship another form of golden parachute? Does it confuse the issue of fiduciary responsibility to shareholders with the issue of day-to-day control? If so, it begs the question of whether inside directors can ever effectively represent shareholders in the event of a takeover bid. To avoid the conflict of interest, perhaps they should consider resigning.

The burden of proof to show there's no conflict of interest is clearly on the shoulders of the inside directors. And any expenditures to "defend" the company from a hostile takeover need to be ultimately justified by enhanced shareholder value.

Another dilemma that deserves more careful review is management owning a substantial number of the outstanding shares. In that instance, how does the company respect the fiduciary responsibility to truly minority shareholders?

Turning to other issues, directors should be concerned when management engages in the "blame game" - saying their failure to deliver acceptable returns to shareholders stems from "setbacks beyond management control." None of the setbacks mentioned are "acts of God." But the specifics aren't as important as management's plan to mitigate the impact on the company's future. If management has successfully presented its vision of the future and explanation of the present to its shareholders, it should welcome a shareholders' vote.

Also, directors should be alert to timing issues in selling the company. The carefully determined moment to sell is as important a part of a director's fiduciary responsibility to shareholders as monitoring current results.

THE WRAP

by David C. Smith President Council for Ethics in Economics Columbus, Ohio 

Tugged in different directions by diverse role obligations, Wally searches for a responsible solution. Should he strike a "balance" that acknowledges his various corporate and community roles? Should his decision boldly affirm that one particular obligation presents an ethical claim that outweighs all the others?

The board's fiduciary responsibility to all shareholders is an important ethical consideration, but that alone probably isn't enough to chart a course of action. We can predict both the bidder and the defense will appeal to the shareholder value.

Wally should ask himself, as dispassionately as he can, whether present management is indeed building good long-term return for the shareholders. If he's honestly convinced of that, he shouldn't capitulate at the mere announcement of a hostile bid.

Mature and self-aware ethical decisionmaking requires that we imagine the potential consequences of our choices on others before embarking on a course of action. If Wally's vote represents a clear choice between a likely win-win-win result for shareholders, employees and community, and a probable win-lose-lose outcome for the respective stakeholder groups, then the best ethical choice is easy.

Of course, the actual situation is murkier. The directors and management must weigh long-term vs. short-term consequences. Further, like it or not, the company is now in play, and its strategic options may be narrowed. Even so, the priorities of the simplified case hold. The shareholders' interest takes priority, but that interest isn't equivalent to their potential for short-term gain, nor is it the sole legitimate consideration in Wally's decision.

While it's acceptable for Wally to "balance" the short-term interests of shareholders with the real stakes employees and the community have in the outcome, his concerns about what Mad Max may do to the current management team shouldn't factor into his decision. As a director, Wally's responsibility is to the shareholders as a class, not just to the insiders.

If C. Max Harris is already a minority board member, the upcoming meeting will be stressful. It may fall to Wally to make the case that there's more at stake than quick profit. Is he up to defending that view to a skeptical and hostile audience? In this situation, ethics may require some real courage, not just good intentions.

Our executives stress Wally must take a long-term view of the best interests of shareholders. They don't mention tactics sometimes invoked by management on the defense - poison pills or staggered terms for directors. While in this instance such mechanisms might protect "good" management from a ruthless plunderer, the very same devices can be used by weak and ineffective managers to escape legitimate accountability to shareholders and market forces. How would ARS like it if companies it wanted to acquire adopted such strategies? Wally and his colleagues would do well to recall the Golden Rule as they prepare their defensive strategies. The best course is to beat Max fairly through effective communication with shareholders.