Can We Avoid Another Cataclysmic Meltdown Of The Global Financial System?

Chapter 4 Barbarians at the Gate

Chapter 4 takes a hard look at how activist investors, (a.k.a., ”barbarians” or “corporate raiders”), have taken control of some of the country’s most successful corporations and are driving them to pursue strategies for maximizing shareholder value, while curtailing  investment in innovation and job creation. Discussed in some detail is the story of Apple’s recent experiences in dealing with Carl Icahn, who is allegedly the  world’s most feared corporate raider of all time.

Corporate Raider Strategies

Normally, shareholder activists such as Mr. Icahn, target cash-rich companies whose shares they believe are undervalued. Once the shareholder activists acquire enough stock to force target company boards to pay dividends and issue them stock options that are required to be re-purchased  by the target company at higher values.

Managements of these target companies naturally resist these hostile takeovers because they believe these take-overs  could undermine other corporate objectives. But when they are forced to make such distributions and stock buybacks, they often refer to these shareholder activists as “corporate raiders” or “barbarians at the gate”.

The Apple Story 

By the 1990’s Apple Inc. (Apple”) had already become one the most innovative and profitable companies in history, and it no longer needed to issue additional shares to raise investment capital to grow. It also no longer made sense for Apple to increase its real investment in its core businesses as it could focus on increasing shareholder value by employing investment banking strategies such as in acquiring companies, in lending money to other companies, in backing new debt offerings and in trading in its own stock.

By 2011, Apple’s  worldwide undistributed profits had reached $212 billion, forcing it to hoard its cash in overseas banks, in order to avoid being taxed on profits it has earned as an US corporation both here in the US and abroad. Apple’s CEO, Tim Cook, sought to use some of this cash in Apple’s financialization activities without paying a substantial percentage of these distributions to the US Treasury in corporate income taxes.

Mr. Icahn saw a way for Apple to avoid this tax burden. He convinced Mr.Cook to create significant increases in  the market  value of Apple’s stock while avoiding tax payments by sheltering its retained earnings and getting an additional  tax deduction for using debt versus after tax income in its financialization activities. What was entailed was having Apple make distributions to its shareholders (including Messrs. Icahn and Cook)  by issuance of stock options and re-purchasing of these options at increased valuations that would ensue. The buyback of stock by Apple was to be paid for by using bond proceeds that Apple was able to obtain by selling its corporate bonds that would be backed by Apple’s hoard its cash in overseas banks. In addition, the tax write-off on interest paid to bondholders could be used to offset Apple’s bond interest incurred. Cook agreed to implement Mr. Icahn’s plan and it proved to be short-term win-win for Cook, Icahn, and other Apple shareholders, but not the US taxpayer. How it has impacted longer term viability of Apple, is  still open to question.

“Goosing Market Value” Using Financialization Strategies

The take-aways from the Apple story are many. We know from this case study and the many cases like this  one, that financialization of corporate America  has now reached a point where the dominant corporate model is no longer “retain-and-reinvest” as it has becoming one of “downsize-and-distribute”.

In the ‘70s, companies invested about 40% of each additional earned or borrowed dollar into the real economy. Since the ‘80’s companies  have funded the stock market rather than the stock market financing companies. Over the last 30 years, corporate stock buybacks have been touted as a sure way to inflate stock prices and they have become the main corporate strategy for achieving increased shareholder value. This alchemy has become so pervasive that as late as 2015, publicly traded American companies have expended over 115% of their average annual corporate net earnings on buybacks and dividends.

We now see financial markets become insular as corporations are no longer reinvesting in themselves but are either retaining their earnings or distributing them to shareholders. At the same time, they are downsizing the number of people they employ, curtailing R&D and other growth enhancing capital investments, and avoiding payment of their fair share of taxes. Some believe that this is leading us toward a national economy characterized by greater economic inequity and diminished innovative capability. Not good!.

This chapter then concludes that this use of buybacks and other  financialization strategies to “goose markets” will continue to increase in order to compensate for expected declines in corporate earnings and stock prices. But we are cautioned that financialization strategies may have to be modified and the tactics of the stock activist may change, as it is expected that the Fed will in all likelihood have to increase interest rates and the IRS will continue to try to close tax loopholes.