Monday, March 24, 2008 4 comments ++[ CLICK TO COMMENT ]++

The Downside of Being an OPMI: The Bear Stearns Case



Bear Stearns provides a good illustration on the shortcomings of being an OPMI (outside passive minority investor). The fact that Bear Stearns is being "saved" is probably good for the markets but the same cannot be said for the shareholders. Who knows what the facts are in this case but here is what has transpired.

Bear Stearns, one of the top 5 independent investment banks, collapsed under the most murky of circumstances in many decades. It has a book value of $84/share but was offered a price of $2/share by JP Morgan Chase & Co. The deal disallowed the board of directors or other key employees from soliciting other bids (this apprently didn't stop James Cayne, one of the biggest holders and current chairperson, from soliciting others).

Imagine if you were a shareholder. What seems like take-under deal was signed by the board of directors (who are supposed to represent the shareholders) at the last minute. Most shareholders would have taken a loss of around 90% so it is highly probable that a shareholder vote would have rejected the deal (I will note that BSC has high employee ownership so some may vote in favour of the deal to save jobs, but given that JPM says it will cut around 50% of the workforce, even this support was never clear.)

Given that the takeover was likely not going to get the shareholder vote, JPM now increased its offer to $10/share. The interesting thing is that the board of directors somehow managed to issue shares and give away 40% of Bear Stearns to JPM without a shareholder vote. Not that too many other parties would have been interested in BSC but this pretty much locks up the deal for JPM. It's quite scary to think about how management and board of directors can issue shares and offer them to a preferred party (JPM in this case) without any shareholder approval. BSC board even side-stepped NYSE rules to offer the shares to JPM. Needless to say, Jamie Dimon of JPM has significantly increased compensation (one analyst called it bribes in a Bloomberg article) to senior executives, who also sit on the board.

The Bear Stearns deal goes to show how a lot of shady deals are done behind closed doors by insiders. The public and the media always criticize board of directors for their questionable compensation packages for executives, but these closed-door "smoky room" deals are even worse. The WSJ Deal Journal blog also shares similar views as me, questioning who the BSC board is representing.

The Bear Stearns situation is important in that it pitted shareholders against other interests (such as government, other banks, and bondholders). Shareholders likely wouldn't care if they get offered 10% or zero (bankruptcy) but it certainly affects bondholers, customers, and others. The fact that the Federal Reserve was also made to guarantee up to $30 billion of questionable assets is a plus for those attempting to profit from the BSC takeover.

The monoline insurers also face a similar situation, where the shareholders have divergent interests from municipalities, politicians, and others. Shareholders of monolines don't care about ratings if the business can't write any new business; but buyers of insurance, as well as some politicians, do care. I really feel that the management of Ambac fleeced their sharehodlers due to pressure from the government. The Ambac situation isn't as bad as BSC because there is some benefit from retaining the AAA rating.

Another deal where insiders favoured select parties, which led to a company being fleeced is Borders (BGP). Borders borrowed money from its main shareholder, William Ackman, at exorbitant interest rate (secured loan at 12.5%--unsecured wouldn't be bad but secured at that rate?) and issued a lot of warrants. Borders was desperate no doubt but couldn't they have made a public offer or attempted to raise funding from other parties?

The key point is that OPMI didn't have a say in any of this. If you are a small investor--or even a large investor in the case of BSC--it's very hard to avoid massive losses due to dilution when the board of directors do something. Warren Buffett says that management is very important but I would say that the board of directors are a far greater importance these days!

(I don't have a position in any company that I discussed except Ambac, a monoline insurer).

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4 Response to The Downside of Being an OPMI: The Bear Stearns Case

Anonymous
March 24, 2008 at 10:55 PM

What I don't understand is why go through JP Morgan at all? The central component of the deal is the 30 billion "option" from the Fed. Why didn't the Fed just give that to Bear directly to keep it solvent, rather than going through JP Morgan? The general result would have been the same.

I realize there are additional considerations (for instance, the purchase increases JP Morgan's solvency and reduces its need to free up cash since contracts between the two get cancelled), but none of them seem enough to explain the sweet deal JP Morgan got.

tc
March 25, 2008 at 4:12 AM

According to WSJ reporting, BSC told the Fed that they would have to file for bankruptcy by Friday. So at that point in time, management seemed to believe that shareholders were already getting 0. Of course, they might have been saying that to get the Fed to provide an emergency loan. Which they did, through JPM on Friday. They went through JPM because the Fed was only supposed to lend to banks (of course, they dispensed with that restriction a couple of days later).

March 25, 2008 at 10:36 AM

As anonymous points out, why give a preferential offer to JPM? John Hussman also wonders how the Federal Reserve was made to bail out an investment bank. John Hussman's concern seems to be with the Federal Reserve's bailout of BSC bondholders. He feels that the shareholders and bondholders should take a loss rather than the Federal Reserve/taxpayers.

The ironic thing is that if the FedRes window, which was made available to investment banks later, was present, the BSC probably wouldn't even need any of this.

March 25, 2008 at 10:40 AM

TC,

It would seem bizarre that the management thought the business was worth zero, when JPM ends up offering a few billion (with the $10/share offer). Granted that BSC's value is mostly in intellectual property (i.e. its bankers) so the business is close to zero if employees flee.

There is something shady going on behind the scenes.

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