Where’s the Limit? Ross Johnson and the RJR Nabisco Takeover Battle

The date was portentous: on Oct. 19, precisely one year after the stock market crashed, the chief executive of RJR Nabisco was the host of a lavish meal at Atlanta’s Waverly Hotel. Ross Johnson’s guests had come to expect such treatment. A brash and hard-driving manager with a fondness for fine living, he liked to treat RJR Nabisco’s board members to an elegant evening out before the next day’s regular meeting.

On this night, however, Johnson’s purpose was not just to be convivial. Declaring that he had tried everything he could during the past two years to boost RJR Nabisco’s stock price, Johnson said he had found a solution: he and his fellow top managers would take complete control of the company in a leveraged buyout (LBO). Johnson would then sell off some of the company’s food brands and run the remaining divisions as a private company. Surprised that a chief executive would initiate a raid on his own company, the directors nonetheless allowed him to mount what would be the largest takeover ever.

But the directors — and much of the public as well — were soon shocked to read news accounts reporting that Johnson’s plan would enrich him and seven of his top executives beyond the dreams of Midas. In exchange for $20 million they would put up for an 8.5% stake in the new company, Johnson and the seven other executives would see the value of their investment jump to $200 million when the sale was completed. That was only the beginning. By doing some simple arithmetic, critics of the plan calculated that the eight men’s holdings, which were scheduled to grow to 18.5%, could be worth $2.6 billion within five years if they turned RJR Nabisco into a leaner and more profitable enterprise. Johnson’s share alone would have been worth $1 billion.

Swamped by a wave of resentment, Johnson rushed last week to reassure the RJR board that he had intended all along to share the newly created wealth with the 15,000 employees who would remain after the breakup. “I wasn’t going to take 18% of this company for seven people,” Johnson told TIME in his first interview since the buyout offer. “If I’d known it was going to be in the newspapers, I would have said, ‘Look, there’s going to be 15,000.’ “

Even as Johnson backed away from his huge initial stake, rival bidders rushed in to get theirs. The competing offers turned the fight for RJR Nabisco, whose brands range from Animals Crackers to Winston cigarettes, into the brassiest and potentially most damaging brawl in Wall Street history. By last week three groups were locked in a titanic struggle for the company (1987 revenues: $15.8 billion), and the offering price has climbed above $26 billion — more than the gross national product of Peru or Portugal and twice the sum that Chevron paid for Gulf Oil in 1984 in the largest previous merger. The ordeal turned into a feeding frenzy for hangers-on as well: hundreds of lawyers and investment bankers involved in the bidding stand to earn a total of as much as $1 billion for their expertise.

The sums are so vast, and so apparently out of line with any foreseeable benefits that the deal might bring to American industry, that they raise deep and disturbing doubts about the direction of U.S. business at a time when many firms lag badly in foreign competition. Seldom since the age of the 19th century robber barons has corporate behavior been so open to question. The battle for RJR Nabisco seems to have crossed an invisible line that separates reasonable conduct from anarchy.

Except for its scale, the proposed RJR breakup was like many of the fruitless paper-shuffling deals that have proliferated in the past decade. The management group is planning to take apart a merger, between RJR and Nabisco, that they hailed only three years ago as a brilliant strategic move. “What is being done threatens the very basis of our capitalist system,” said John Creedon, president of Metropolitan Life Insurance company, which is suing RJR because the potential buyout has undermined the value of all bonds that the food and tobacco company sold before the announcement. Not everyone was alarmed. Said Harry D’Angelo, a finance professor at the University of Michigan: “I don’t see any major social dangers. The real challenges have been to the conventional wisdom that large numbers of shareholders provided the best means of financing industry.”

The RJR battle has brought several U.S. business trends of the past decade under greater scrutiny in Washington. Among the political concerns:

— The relentless focus on dealmaking rather than on long-term investment.

— The apparent disregard for company employees and the communities in which firms are located.

— The rapid pileup of debt that has alarmed everyone from small investors to Federal Reserve chairman Alan Greenspan, who recently called for measures to curb borrowing.

— The cost to American taxpayers, who wind up underwriting the buyouts to the tune of billions of dollars because interest payments on the giant borrowings are deductible as a business expense.

The RJR buyout aroused anxieties even in the investment community, where some executives feared that the Johnson-initiated scramble would swallow up too much of the available money for deals and, moreover, give mergers and LBOs a bad name. “This is the sort of excess that investment bankers have worried about for years,” said economist Robert Reich of Harvard’s John F. Kennedy School of Government, “because it so clearly exposes the greed and rapaciousness of so many of these takeovers.” Martin Weinstein, managing director of Kubera, a Wall Street arbitrage firm, concurred: “Do I sense fear? Yes. At some point there is going to be a rebellion against greed.”

The first sign of revolt, interestingly, came from the outside directors who had come to dinner at the Waverly Hotel. Appalled by the gall shown by Johnson, whom one director called a “raider from the inside,” a committee of five directors three weeks ago opened the bidding to all comers. First to accept the invitation were the most aggressive LBO artists of all, the Wall Street firm of Kohlberg Kravis Roberts. Headed by Henry Kravis, 44, and George Roberts, 45, KKR pioneered the leveraged buyout in the 1970s and nurtured it into one of the best-paying financial arrangements of the decade.

Many Wall Street insiders thought the KKR bid was as self-serving and hasty as Johnson’s offer had been. “They broke the golden rule by injecting their egos into a business decision,” said one financier who knows KKR well. “They went after RJR Nabisco to protect their franchise as the largest dealmaker.”

The directors’ invitation attracted a third and scrappy new bidder who helped turn the fight into a virtual Who’s Who of finance and industry. Assembled by the First Boston investment firm, the group of newcomers included Jay Pritzker, the Chicago-based chairman of Hyatt Corp., his wealthy family and Philip Anschutz, a Denver oil billionaire. First Boston also wooed Harry Gray, the retired chairman of United Technologies, and several other high- rolling investors. The group came into the bidding with a show-stopping but tentative offer of cash and securities worth up to $26.8 billion, or $118 a share, for RJR stock that traded for $56 a share in mid-October.

That bid, quickly dubbed a “Chicago submarine” because it would torpedo the competition, easily surpassed both rival offers. The Johnson team had bid $23 billion, or $100 a share, while KKR had proposed a package worth $21.6 billion, or $94 a share. Board members extended the deadline until Tuesday, Nov. 29, to take any counteroffers and allow time to study each proposal. If none is accepted, the directors could supervise an RJR restructuring themselves.

The donnybrook was only the most colossal of the deals that persisted last week in rearranging the U.S. corporate landscape. Hospital Corporation of America, the nation’s largest hospital chain, ended more than a month of dickering and agreed to be acquired for $3.6 billion in an LBO put together by the company’s management. Triangle Industries, which just two years ago acquired the packaging division of American Can in an LBO, agreed to be bought for $1.3 billion by Pechiney, the state-owned French metals firm.

Leveraged buyouts seemed like a small-time, unglamorous financial gimmick when KKR began hawking them on Wall Street in the mid-1970s. But the arrangements were an immediate hit with managers who saw the wisdom of taking their companies private to escape corporate raiders. LBOs were also a boon to promising firms that wanted to grow outside Wall Street’s harsh spotlight.

Perhaps the most attractive feature of LBOs is that they give managers a sizable chunk of equity in newly structured companies. By using borrowed money to buy out the stockholders, executives can cash in their old shares at a profit even as they become owners of their firms. The managers are then free to sell parts of the business at a handsome profit. The ultimate payoff comes when they put their companies back on the market. The sale of well-run corporations can return up to 100 times the amount of a manager’s original investment. With investors lured by such prospects, the value of completed LBOs soared from just $13.4 billion in 1984 to $76.8 billion so far this year. Since 1985, four of the ten largest LBO acquisitions have been made by KKR.

Some deals have fallen short of their fanfare. KKR hailed the purchase of Beatrice as the “deal of the century,” but wound up getting stuck with businesses that have not yet found buyers. “Beatrice was overadvertised as a spectacular deal when it was really just a good one,” said one investor. “Everybody’s making money; they’re just not making as much money as they thought they would, or as fast as they could.”

At RJR Nabisco, the benefits of LBOs were hardly lost on Johnson. Born in Winnipeg, Man., he had parlayed a keen eye for a deal and the nerves of a gunslinger into the top job at three major corporations. He was president of Standard Brands, the producer of Planters nuts and Baby Ruth candy bars, when it merged with Nabisco in 1981. Four years later, as Nabisco’s president, Johnson sold out to RJR Reynolds for $4.9 billion and soon became president of the merged company. After adding the title of chief executive officer in 1987, he swiftly moved RJR Nabisco headquarters from Winston-Salem to Atlanta, sold the Heublein liquor business and slashed the corporate staff from 1,000 to 400. The dapper Johnson, a friend of such sports figures as hockey star Bobby Orr and broadcaster Frank Gifford, is described as a “charmer” by one associate. Another warned that when the boss was displeased, “swift as a sword, he would chop your head off.”

Amid the brawl for his company, Johnson has remained aloof from most outsiders and workers at RJR Nabisco headquarters in the elegant Galleria complex north of Atlanta. “We don’t know what is going on,” says an employee. “Some of us are going to lose our jobs, but we don’t know who, or where.” Feelings of helplessness were hardly confined to the South. Said a 15-year employee at an RJR Nabisco cookie plant in Fair Lawn, N.J.: “When you’re at the bottom of the ladder and you got money men at the top, you take it one day at a time.”

Whoever wins the grab for RJR, a highly leveraged takeover could add more debt to the U.S. economy than any previous business deal. All told, corporate debt has climbed from some $965 billion in 1982 to $1.8 trillion this year, a rise from 32% to 37% of U.S. gross national product. LBOs can be especially worrisome of borrowing, because they replace virtually all of a company’s equity with IOUs that must be repaid. A sudden downturn can thus put a firm heavily in hock out of business. “High leverage is unsafe, not just for a company but for the entire economy,” says M.I.T. economist Franco Modigliani, a Nobel laureate. Modigliani adds that while the debt mountain has not yet grown perilously high, “LBOs are reducing the safety. Management loses the power to do many things. It has no margin for error and less margin for additional risk.”

A company mired in debt can ill afford to build new plants or develop new products, since most of its earnings go to pay off borrowings. The shortage of investment can then dampen U.S. growth and damage the ability of American firms to compete abroad. In a slump, the impact can be dramatic. A study by the Washington-based Brookings Institution, a liberal think tank, estimated that a new recession could jolt 10% of major U.S. companies into bankruptcy.

Bankers, too, are taking a harder look at the risks, and some junk-bond buyers are becoming picky. While cash has poured in from such staid investors as the Harvard and Yale endowment funds and many state pension plans, other money managers are refusing to play. Says New York City comptroller Harrison Goldin, who oversees the investment of some $30 billion in pension funds: “I cannot condone activities that divert so much time and energy from investments that create new jobs and opportunities to those that reshuffle chairs. Pension-fund managers are supposed to invest in the American economy.”

While that may be true, even the U.S. tax code is a strong ally of LBO artists. Since the interest on junk bonds and bank loans is tax deductible, companies like RJR Nabisco can borrow at Government expense. Some — but not all — of the Treasury’s loss can be recouped from capital-gains taxes on the profits of shareholders who sell their stock.

The way the tax code treats stock profits is another plus for LBOs. Corporate earnings are taxed twice: they are first paid to stockholders out of a company’s after-tax profits, and the shareholder then pays taxes on the dividends. “There is no question that our tax laws have a bias toward debt that must be rectified,” says a top congressional aide.

The buyout binge produces some big-time losers as well, particularly investors who owned a company’s top-quality bonds when the same firm’s junk bonds hit the market. Since the new IOUs would saddle the company with a riskier load of debt, the old bonds get clobbered. No sooner had Johnson disclosed that he wanted to buy RJR Nabisco, for example, than the company’s $5 billion of outstanding bonds lost 20% of their value. Furious bondholders, including Metropolitan Life and ITT, immediately sued for damages. Declared Metropolitan Life chairman Creedon: “No one in his right mind wants to invest in corporate bonds anymore.” In fact, the LBO binge has created a financial innovation called the “poison put,” which guarantees bondholders against the risk of buyouts and other unexpected deals that might depress their holdings.

Shareholders can lose out in LBOs even when they sell their stock for a profit. That is because stockholders usually receive far less than executives make when they break up a company and then put it back on the market. LBO critics argue that managers who fatten their wallets in this way are really profiting at the expense of other stockholders. So far, shareholders have brought eleven class-action suits against RJR Nabisco charging executives with acts ranging from “unfair self-dealing” to “not acting in the best interests of the stockholders.”

The RJR deal also raises the salary competition among executives to absurd levels. Says John Swearingen, former chairman of Standard Oil of Indiana: “There is a limit to what managers ought to be paid for managing other people’s money.” Adds a top executive involved in a current takeover: “The yardstick for compensation has just gotten twelve inches longer. The chief executive who’s doing a first-class job running a major U.S. corporation for $890,000 a year is going to start thinking he’s some kind of a fool.”

Washington lawmakers readily recognize the populist sentiments aroused by the spectacle. “What’s going on is corporate cannibalism,” says Congressman Edward Markey. “We have to ask whether it is in the national interest to allow companies to go so heavily into debt.” As chairman of a House subcommittee that covers finance, the Massachusetts Democrat will play a key role in drafting any legislation to curb LBO excesses when Congress reconvenes next year. But lawmakers are uncertain how to limit buyouts, or even if they should.

Washington’s reformers concede that the stock market is still edgy after its collapse. Wall Street showed just how nervous it was when stocks dropped nearly 79 points in the week that George Bush was elected President. “Nobody wants to be blamed for setting off another stock market crash,” says a brokerage-house lobbyist. Legislators are still haunted by charges that proposals to restrain takeovers last year helped cause Black Monday. Many Wall Street insiders are now convinced that buyouts and mergers are among the market’s few remaining props.

Yet Congress cannot ignore growing public fears that greed, debt and buyouts are all spiraling out of control. “The dealmakers have gone too far,” says Samuel Hayes, professor of finance at Harvard Business School. “They have defied that tolerance that allowed them their freedom.” Federal Reserve chairman Greenspan urged the Senate in October to consider tax-law changes to curb the debt buildup. Said he: “The laws still provide substantial incentives to borrow.”

House Speaker Jim Wright last week urged steps to slow the pace of buyouts, which he said were having a damaging “psychological and economic impact.” Meanwhile, members of the Senate Finance Committee have been quietly pondering measures that would reduce the tax loopholes for interest payments and give a break to dividends. To cushion the Wall Street impact of such provisions, they might be included as part of a general tax bill that would seek to narrow the budget deficit.

LBOs do have some strong defenders, and not just among the executives who grow rich from them. Some financiers and economists argue that increased leverage can be a benefit to companies, especially those in mature industries like tobacco. Reason: these businesses produce a lot of cash but call for relatively little research or development. For them, one efficient way to distribute profits to shareholders is simply by buying up stock.

Proponents say many companies have become stronger than ever after being taken over and reorganized. The point is driven home in a study by Abbie Smith, a University of Chicago economist who surveyed 58 acquired companies — among them, R.H. Macy, Mary Kay Cosmetics and Uniroyal — most of which had been bought out since 1984. The findings indicated that the firms were generally more profitable and productive after they were bought.

Even so, the results underscored a common criticism of the motives for buyouts. Richard Thevenet, vice president of Stern Stewart & Co., a Manhattan- based management efficiency consultant, put it bluntly: “Managers have an incentive to underperform before a buyout. Records of dramatic turnarounds after an LBO raise a troubling question. Why were these managers unable to accomplish these feats before the LBO? Shareholders bear all the costs, but not the rewards of the turnaround.”

American business is built on a rock of lawfulness and trust between companies and those who hold a stake in them. But when avarice grows out of proportion, cracks start to appear in the foundation. “Greed can be good,” says M.I.T.’s Modigliani, when it spurs profitable and productive growth. “But it can also be bad,” he warns, when it outpaces all other considerations.

In the fight for RJR Nabisco, that seems to have happened in spectacular fashion. No matter how the battle turns out, the unseemly scramble for riches has, for the moment at least, given overreaching a bad name. In the end, the RJR brouhaha may turn out to be a useful testing of the limits: of greed, of debt, of dealmaking. The resulting outcry may prove an effective regulating device. “In its own way, the deal has been typically American, where nothing is in moderation, including the enormous selfishness of management,” notes James Bere, chairman of Borg-Warner. “It’s touched a nerve. Sometimes we have to do things in extremes before we can put the total in perspective.” Without that perspective, the wages of greed may be a less productive and ever more debt-ridden economy.

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CREDIT: TIME Chart by Nigel Holmes

CAPTION: A Leveraged Buyout in Action

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CREDIT: TIME Chart by Cynthia Davis

CAPTION: CORPORATE DEBT