A Terrible Argument By The American Express Board of Directors In 1976

In 1959, William Donaldson, Dan Lufkin, and Richard Jenrette started an investment bank that they named after themselves–Donaldson, Lufkin, and Jenrette, Inc. (usually called “DLJ”). It immediately went public, and employed thousands of people in its budding trading, underwriting, and research divisions. The odds seemed fair that it would emerge to occupy a dominant place on Wall Street, and it drew the attention of the American Express Board of Directors as a fast-growing firm worthy of acquiring.

The American Express Board of Directors couldn’t agree with the DLJ Board on the right price for an acquisition, so American Express just began acquiring shares of DLJ on the open market in 1972. If even a 70% premium wasn’t enough to convince the DLJ Board to sell, American Express was happy to flood the market with buy orders for 1,954,418 shares of DLJ stock. By the end of 1972, American Express had spent $29.9 million gobbling up these DLJ shares.

When the bear market of 1973 and 1974 arrived, no rich investors were really interested in making deals that involved a mid-tier investment bank, and even fewer were interested in purchasing DLJ’s research. The trading division, a casualty of the rapid declines in the market, began operating at a loss.

This turn in operations, coupled with the fear of bear market, dragged the price of DLJ stock down from $15.29 to $2.04 per share. That $29.9 million investment had fallen in value to $4.0 million within three years. In 1975, the American Express Board of Directors decided that they wanted to shed the DLJ investment during the bear market low.

They had a choice of how to dispose of this nearly two million share DLJ position.

They could sell the stock outright, collect what was left of the $4.0 million remainder to use for general corporate purposes, and also create a right to $8 million in tax deductions that could be used to offset the expected capital gains taxes from the sale of other profitable investments over time.

Or, they could spin off the DLJ investment to existing shareholders, and while this wouldn’t incur the 1% to 2% frictional costs associated with unloading the position as well as the potential additional price drop over the stock unloading period, it also wouldn’t provide an $8 million tax benefit.

On July 28, 1975, the American Express Board of Directors elected to spin-off the DLJ investment to AXP shareholders as a special in-kind dividend. This rightfully infuriated many of the American Express shareholders, and prompted Howard Kamin to lead a lawsuit against the American Express Board of Directors for violating the fiduciary duty of reasonable care owed to the shareholders.

The advantages of the $8 million tax benefit to AXP was so substantial that it was foolish to hand over the position to stockholders. Even if American Express assumed the risk of a faltering price while discarding the stock, it would only add to the capital loss tax savings. At worst, American Express could lose another $4 million if the company went bankrupt before it unloaded any of the shares. Meanwhile, the stock would need to at least double to equal the tax savings that would have been immediately available through capital loss savings. Given that DLJ was flirting with bankruptcy at the time–that was not a bet you would want to make.

In response to the allegation that it violated the reasonable care requirement of the fiduciary duties owed to shareholders, American Express made one of the worst arguments I’ve ever seen by a corporate law firm. Carter, Ledyard, & Milburn, a New York law firm that was founded and still exists to this day, defended American Express and argued that it opted for the stock spin-off due to the following:

“The minutes of the July 1975 meeting indicate that the defendants [American Express] were fully aware that a sale rather a distribution of the DLJ shares might result in the realization of a substantial income tax saving. Nevertheless, they concluded that there were countervailing considerations primarily with respect to the adverse effect such a sale, realizing a loss of $25 million, would have on the net income figures in the American Express financial statement. Such a reduction of net income would have a serious effect on the market value of the publicly traded American Express stock.”

If Warren Buffett got hit by a bus tonight, when do you think the trading would reflect that information?

The answer is nearly instantaneously. The absolute first trade tomorrow morning would show a sharp decline in the price of Berkshire’s stock. American Express is arguing, effectively, that it’s not the news of Warren Buffett getting hit by a bus that would cause the price to tank, but rather, the price would be affected when Berkshire Hathaway disclosed that fact in its formal filings with the SEC.

DLJ was a publicly held investment by American Express. DLJ had its own stock quote. The daily quotes in the newspaper would have told you that the value of the DLJ stock had fallen 86% between 1972 and 1975. American Express argued their stock price would never be affected until they formally acknowledged it in their SEC filings.

I used Warren Buffett as an example because he’s been a clear advocate of “economic reality” over “accounting reality”, and he is a sizable shareholder in a company that forty years ago declined to take advantage of an $8 million tax credit because it would rather cater to accounting reality than do what’s best for economic reality.

It’s the equivalent of weighing yourself on February 1st and seeing 170 pounds on the scale. Then, you eat 5,000 calories per day with a sedentary lifestyle, and weigh in on March 1st to see 200 pounds. American Express is arguing that March 1st would be the moment you suddenly gained 30 pounds. That’s not how it works–the people that interacted with you would have seen the 180 pound you on February 9th, the 190 pound you on February 18th, and the 200 pound you on the first of March. Your increasing obesity was something that was occurring gradually over time just as the declining price of the American Express investment in DLJ was something that was gradually occurring over a three-year period. Reality updates itself in real time; not just when you choose to formally measure it.

Despite this terrible argument, American Express still won their case. The term fiduciary duty seems vague and amorphous, but it is a term with some specific.

First, the Board has a fiduciary duty of loyalty to the shareholders. This has three prongs. As a director, (1) you cannot engage in self-dealing; (2) you cannot have a conflict of interest; and (3) you must act in good faith. There are some exceptions to numbers 1 and 2.

Secondly, the Board has a fiduciary duty of reasonable care to shareholders. This has two prongs–you must make decisions that are substantively reasonable, and you must make decisions that are procedurally reasonable (you must inform yourself of all reasonably available information before making a corporate decision).

Howard Kamin was arguing that American Express violated its duty of care to make a substantively reasonable decision when it decided not to collect the $8 million tax credit and instead spin off the DLJ stock to shareholders. The New York Court ruled, however, that the business judgment rule provides protection against the duty to make substantively reasonable decisions as long as the duty of loyalty and duty of procedural due care were followed.

In other words, because American Express considered the implications of the $8 million tax credit, and made a poor decision anyway, they were protected by the business judgment rule that protects you against monetary damages for boneheaded decisions so long as you are acting in good faith, don’t have a conflict of interest, aren’t engaged in self-dealing, and comply with the procedural prong of reasonable care.

The only way a shareholder can successfully launch a suit against a corporation that fulfills the duty of loyalty requirements and also complies with the procedural prong of the duty of care requirement is through an allegation of “corporate waste of assets.” That’s a long-shot legal claim because the hurdle is so high–you must prove that the corporate decision was so stupid that it was an effective “gifting away” of corporate assets. There’s a sense of outrageousness, rather than terribleness, that needs to be present in such a case and it’s terribly hard to prove.

American Express is lucky that they acknowledged fully considering the effects of the $8 million tax savings at the board meeting. If they tried to play it sly, and act aloof about that alternative, then they wouldn’t have complied with the procedural requirement of the duty of care, and Howard Kamin would’ve won his lawsuit for saying that a fiduciary duty had been violated in a way that didn’t afford business judgment rule protection. But they did consider all reasonable alternatives, and as long as the fact-gathering process is complete, corporate actors have a lot of leeway to make poor corporate decisions without facing a backlash that will result in a successful legal claim.

Sources Consulted: Kamin v. American Express Company, 86 Misc.2d 809, 383 N.Y.S.2d 807, affirmed, 54 A.D.2d 654, 387 N.Y.S.2d 993 (1st Dept.1976).

Notice: This article, which I believe may be of interest to readers, is for general information and entertainment purposes only. It only reflects my best understanding of the topic at hand and should not be relied upon as legal or investment advice.