Printer Friendly

The buddy system.

The 40-year relationship that Du Pont and GM enjoyed earlier this century this century suggests an enviable model for management-shareholder relations.

Thomas A. Murphy, the former chairman of General Motors, recently wrote to a friend describing "many so-called 'investors' [as] nothing more than predators, opportunists, speculators, traders, arbitragers, scavengers, even blackmailers, whose focus is on nothing more than trying to capitalize on the short-term ...profit to them, regardless of the consequences" to others. Not accepting the responsibilities of ownership, Murphy added, they do not deserve consideration as true owners of the enterprise. Being retired, Murphy could be blunt, but any CEO still in office probably has views that are not much different.

Let me suggest an improbable model for management-shareholder relations. I call it the buddy system, like the arrangement for protecting swimmers in deep water. The most celebrated example of it was the minority interest in General Motors that the Du Pont Co. first acquired in 1918 and retained for almost 40 years, until the federal government brought an antitrust suit and forced it to divest.

The GM-Du Pont relationship was unique in the annals of American industry. In many respects, it resembled more the ties we still see in Germany, where even at the largest companies substantial blocks of stock are held, for example, by one of the major banks. In the United States, we say, it is not possible to find investors of the same substantial and enduring quality as in Germany, investors willing and able to play a constructive, but still muted, role. Saddled with high costs and other perverse incentives, our banks have virtually abandoned their traditional ties to their largest and best industrial customers. (Outside of the banking system, the American attitude is that if it's worth owning a substantial part of another company, one should insist on owning all of it.)

But a least this once it did happen here. And it succeeded so brilliantly that it is a model for what might yet be and, more immediately, a mirror to illuminate our present deficiencies.

Ultimately, Du Pont profited enormously from its investment, but that was secondary to the enormous benefits to General Motors from which Du Pont's profits flowed. During the years after World War I, General Motors was saved from quite probable extinction by Du Pont's financial support and its credibility in financial markets. Du Pont brought help to GM internally, too, installing new and better financial controls, And during those formative years, when GM was face with a managerial crisis, Du Pont lent to GM for several years Pierre S. du Pont, the best it had, as president.

Du Pont first conceived of an investment in GM as an outlet for its accumulated wartime profits at a time when William C. Durant, the president of GM, was looking for a substantial financial partner. The investment was not an obvious one at all, because the automobile business was not yet generally accepted. There were dissenting votes on the Du Pont board, but the proposal had the energetic support of Pierre du Pont and Jacob J. Raskob, the company's treasurer.

The Initial Investment

The initial investment, made early in 1918, was $25 million. Raskob had written a memorandum for the Du Pont finance committee that showed an extraordinary insight into the future of the automobile industry. In Raskob's opinion, General Motors occupied a unique position in the industry and with proper management would eventually show results second to none. Du Pont's ability to sell paints and other products to GM was mentioned in the memo, but that was a minor factor.

Du Pont first acquired a 23.8% stake. By the end of 1919, Du Pont had increased its investment in GM to $49 million and a 28.7% interest. With Durant's concurrence, Du Pont promptly took control of GM's finance committee, and Raskob was installed as committee chairman.

At the end of World War I, Ford still dominated the automobile industry and it was not afraid to use its muscle when, in 1920, the industry fell on hard times. Faced with excess inventories, Ford slashed prices dramatically, as it could afford to do. Durant secretly tried to support the price of GM's stock by buying on margin and soon was over his head. With swollen inventories and short-term debt, GM was over its head, too. Ford's aggressive pricing tactics tightened its grip on market share, which rose from 45% in 1920 to 60% in 1921, while GM's market share fell from 17% to 12%.

Although Du Pont had not intended to invest anything more in GM, it came to the rescue. It brought in J.P. Morgan to refinance GM, and as part of the process, Du Pont increased its own holding to 36%, the highest level they would reach. Except for a minor interest, Durant was bought out. Pierre du Pont, who earlier had transformed Du Pont from an old-line cartel to a modern operating company, assumed the presidency of GM for more than two years. His reputation and leadership helped to stabilize the company. Among his many contributions was a recognition of the managerial and organizational genius of Alfred P. Sloan Jr., and it was Sloan who succeeded him as president. In time, the company prospered mightily.

What a "buddy" was du Pont. It is tempting to think about whether GM would have stumbled so badly in 1970s and 1980s if the Du Pont Co. had still been there. In the early 1920s, the GM management, with Pierre du Pont's participation, had carefully formulated a policy for creating several well-differentiated grades of cars, from Chevrolet to Cadillac. Sloan, who played a major role in the project, wrote that "each car in the line should properly be conceived in its relationship to the line as a whole." The concept of a complete line of cars, with carefully differentiated price and quality segments, something Ford had not achieved, was central to GM's strategy for half a century. It is difficult to imagine that the Du Pont Co., as principal shareholder, would not have rebelled against GM's decision in the 1980s to achieve production "economies" by policies that made it difficult for customers to distinguish a Chevrolet from a Cadillac except by the price tag.

The Termination

In 1957 the Supreme Court forced Du Pont to dispose of its investment. The court did not find that du Pont had violated the law. Du Pont had not, for example, imposed on GM a requirements contract for Du Pont products, nor had it dictated GM's purchasing policies or practices. Indeed, the evidence was that GM retained its independence and that both parties had acted honorably and at arm's length. Instead, the decision relied on the potential for abuse, although the connection had already endured for decades. As Murphy, chairman of GM during much of the 1970s, would later recall, the Du Pont representatives on the GM board pursued only the interest of GM. Still, this remarkably useful and lengthy relationship was terminated.

In retrospect, there were several keys to the success of the Du Pont investment in GM. First, it was quite large - not just for GM but for Du Pont as well. Du Pont's stake in GM was not idle surplus; the company needed capital for its own postwar expansion. This was the only investment like it that the company would ever make, and the decision was important not just for the Du Pont Co. but in a personal sense for the Du Pont Family, too.

Second, Du Pont never contemplated owning more than a minority interest. Indeed, in 1923, not long after Sloan had become president, Du Pont used more than one-fourth of its own GM shares to fund a stock purchase plan for the GM senior management. Du Pont was intent "on creating a partnership relationship between General Motor's management and itself." Those words were not some self-serving statement by Du Pont; they were written years later by Sloan of GM.

Third, partly because it was so large, but for other reasons as well, the investment represented an ongoing, long-term commitment to GM. The rewards would be measured by the returns from the business itself, the dividends, rather than the stock market.

Fourth, it helped that Du Pont had the financial strength and credibility to provide additional funds, if needed, and to help raise them elsewhere.

And finally, it also helped that Du Pont, the investor, brought to GM something other than money - in this case, the experience and skills of a successful industrial enterprise and the wisdom and leadership of Pierre du Pont and others.

Alignment of Interests

Those are the defining elements. In combination they align the interest of those who manage a business and those who own it in ways that are wholly missing in the usual shareholder-management relationship. Du Pont's power at GM was impressive, but there was also a remarkable sense of its responsibilities. Unless GM grew and prospered, there would be no profit, except from the sale of paints and such, also a secondary consideration. There was no way to hedge, no puts or calls that would allow Du Pont's investment to be saved if GM failed. The very idea of hedging with derivative securities would have left Pierre du Pont incredulous. At times, the only sensible course, and the one Du Pont followed, was to commit further resources to GM.

Just as there would be today, Murphy notes, in the troubled days after Would War I there was pressure to dismember GM and to recoup Du Pont's investment, as part of what now would be called a "restructuring." Du Pont was able to extend itself, partly because it had the wherewithal to do so but more profoundly because from the outset, its decision about GM has been as particular and deliberate as it was significant. Du Pont understood why it invested in GM, and neither the dramatic downturn of 1920, the predatory pricing by Ford, not the failures of GM's management shook that faith. And somehow neither the initial losses nor the later profits ever blurred the separate identity of the two companies. Du Pont never contemplated a merger. But neither was GM just part of a portfolio that could be dumped at the first hint of a quarterly downturn.

Current-Day Example

The closest current-day example of the buddy system is Warren Buffett's Berkshire Hathaway, which has invested several hundred million dollars each in Capital Cities/ABC, Gillette, Coca-cola, and a handful of other companies. The dollars are large for Berkshire, and since Buffett, the chairman, owns 44% of Berkshire, they are large for him as well. The continuing relationship and the commitment that were so valuable to GM for 70 years are evidenced at Berkshire today by Buffett's dictum that his favorite holding period is "forever." (The author is a shareholder of Berkshire Hathaway.)

Buffett's business philosophy - that there are very few exceptionally good businesses and fewer still that are available at attractive prices - means that these investments will always be limited in number. And while Buffett's skills are quite different from those of Pierre du Pont, the now-retired CEO of Capital Cities - another Tom Murphy - Thomas S. Murphy, is fond of saying how much Buffett contributes.

Not everyone is a Pierre du Pont or a Warren Buffett, but in a sense, that is the point. There is a degree of distance and, therefore, balance of power inherent in a large but minority stock position. The balance is quite delicate, and that alone would discourage many. A 15% to 20% shareholder provides significant protection against hostile bids. It is not a perfect defense, but it does raise the ante for a putative raider, who is then likely to look elsewhere.

On the other hand, while a buddy shareholder with that significant a stake is not in a position to give strict orders to management, it is very likely that the CEO will, in exchange for this more stable, less distracted working environment, pick up the telephone when the buddy calls - and likely, too, that he or she will consult on major transactions. This delicate balance would be shattered if the affiliate so much as suspects that its powerful shareholder might someday press for full working control.

White-Squire Money

Looking over the landscape of American industry, one struggles to find anything else quite like Du Pont. Corporate Partners, an affiliate of Lazard Freres, and other funds have created so-called white-squire pools of money that take significant, but still friendly, positions in public companies. The fund managers, however, are almost never ready to eat their own lunch by investing a permanent part of their capital, apart from whatever fees they receive. The attraction for the fund managers is the rich stream of income, plus the prospect of a relatively early payoff and the recycling of the dollars into the next pool. "Forever" is not in their lexicon.

There is missing at investment banks the permanent alignment of interests, of risks and rewards, that existed for GM and Du Pont and was so vividly reflected in the Du Pont decision to use its own GM shares as a fund for building a partner's relationship with the GM management group. And while other, more entrepreneurial investors are around, generally they are not credibly content to own only a minority interest. However much they protest, in the end they turn out to be potential raiders.

We have yet to see anything like the buddy system among institutional investors. Because they own so many stocks, no particular one is all that important. Knowing that, as managers, they will be judged by their quarterly or annual performance, they tend to watch the behavior of stocks, and other stock players, as much as or more that the behavior of individual companies.

However attractive it may be, the buddy system will remain a rarity. For some investors, the system raises significant tax and accounting questions. Most of the legal concerns are manageable, such as whether a large minority shareholder might be deemed a "control" person under the federal securities laws. But the tax burdens can be quite serious. If a Du Pont Co. does not own the 80% of a GM necessary to file consolidated tax returns, there is an extra layer of taxation, the effect of which is to produce a below-market rate of return, unless GM, the operating company, is in the star class.

The accounting results may also be dreadful. If the investment does not satisfy the requirements for equity-method treatment, a Du Pont cannot include in its own earnings, its proportionate share of the GM earnings, except to the extent of dividends. If the shareholding company believes that it depends on earnings that are reportable, its inability to show any meaningful income from, say, a 16% stake in another company could be a serious drawback.

Too Individualistic?

It would take a radical tinkering with our laws and industrial culture to have anything much in the U.S. that resembles the buddy system, and it may be that American society is too individualistic for it. Sharing power does not come easily. American manufacturing companies are trying to emulate the Japanese, but it has been difficult, for example, to achieve stable long-term relationships of collaboration and trust with suppliers in which ideas and money are permitted to flow freely. In short, if we are at GM, we want to remain fully independent and to run our own show. If we are at Du Pont, we want to own enough of GM to make "sure" that things go right. By contrast, the lines of authority in the buddy system are inherently ambiguous.

There is a price for this individualism. At least the GM-Du Pont experience tells us what we are missing. Of course, if by chance a company finds a buddy somewhere, one willing to play Du Pont to its GM, one with a deep pocket, reservoir of patience, and no cannibalistic tendencies, it should recognize just how valuable that can be.

Louis Lowenstein is Simon H. Rifkind Professor of Finance and law at Columbia University where he directs the Institutional Investor Project. A corporate lawyer for over 20 years, he has also been President of Supermarkets General Corp. This article is an excerpt from his recent book, Sense and Nonsense in Corporate Finance, Copyright [C] 1991 by Louis Lowenstein. Reprinted by permission of Addison-Wesley Publishing Co.
COPYRIGHT 1992 Directors and Boards
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1992 Gale, Cengage Learning. All rights reserved.

Article Details
Printer friendly Cite/link Email Feedback
Title Annotation:Chairman's Agenda: Governing for Shareholder Prosperity; new model for management-shareholder relations
Author:Lowenstein, Louis
Publication:Directors & Boards
Date:Mar 22, 1992
Previous Article:The high cost of confrontation.
Next Article:A tool to be best-in-class.

Related Articles
A 'blue-collar approach' to board effectiveness.
Court Rejects Demands of Dissident Shareholders; Removes a Cloud Over Company's Future.
Babcock Relents on Wyser-Pratte Demand for Shareholders Meeting; Wyser-Pratte to Nominate Mr. Werner Engelhardt as Supervisory Board Chairman.
Independent directors are a good thing: a financial advisory firm CEO argues that smart companies are treating Sarbanes-Oxley requirements as an...
Broadband Wireless International Corporation Announces Election of the Board of Directors.
The chairman's job description: time for a change in your governance leadership? In the post-SOX era, there is a new interest in separating the top...
To the Shareholders of AB LINDEX (publ).
All you need to know to be prepared for the AGM.

Terms of use | Copyright © 2016 Farlex, Inc. | Feedback | For webmasters