Учебный год 2023 / Bhandari_J__Weiss_L_Corporate_Bankruptcy_Economic_and_Legal_Perspectives_1996

The costs of conflict resolution and financial distress

of Pennzoil, with the judgment for $7.53 billion in actual damages, $3 billion in punitive damages, and $1.5 billion in accrued interest.

The jury's decision was widely decried in the press. Commentators uniformly attacked the size of the judgment because it was based on the replacement cost of the oil that Pennzoil would have obtained from Getty, not on the damages that Pennzoil suffered by failing to acquire Getty at the agreed-on price. There was a widespread expectation that the judge would either overturn the judgment or reduce the damages substantially. Notwithstanding these predictions, on December 10, 1985 (event 2), the Texas judge denied Texaco's request to overrule the jury, and affirmed its award.

Under Texas law, Texaco was required to post a bond in the full amount of the judgment to appeal the case. Texaco objected to the requirement and appealed the issue to the Federal Court in New York. On December 18, 1985 (event 3), Texaco received a Temporary Restraining Order prohibiting Pennzoil from attaching liens to Texaco's assets until the bond matter could be decided. A hearing on the requirement was held in early January 1986, and on January 10, 1986 (event 4), the Federal judge ruled that Texaco had to post only a $1 billion bond to appeal the case. A federal Court of Appeals upheld this ruling on February 20, 1986 (event 5).

After the Appeals Court ruling, both companies appealed the decisions favorable to the other side. Texaco obtained a hearing on the original case in the Texas Court of Appeals, and on February 12, 1987 (event 6) that Court upheld all but $2 billion of the judgment for Pennzoil. On April 6, 1987 (event 7), the Supreme Court vacated the Federal Court ruling. Faced with liens being placed on its assets, on April 12, 1987 (event 8), Texaco filed for bankruptcy. Although Texaco was in bankruptcy, it continued its appeal of the case. In June an appeal was filed with the Texas State Supreme Court. Pennzoil, meanwhile, appealed the bond reduction to the United States Supreme Court. On November 2, 1987 (event 9), the Texas State Supreme Court declined to review the case and left standing the Appeals Court judgment.

After the Texas Supreme Court decision, Texaco and Pennzoil held a final round of settlement negotiations. From November 19 to December 10, 1987, the companies negotiated a "base-cap" settlement, which would have limited overall liability ("the cap") in exchange for a nonrefundable "base" payment. Despite Texaco's announcement to the Bankruptcy Court that the companies had made great progress (December 2, 1987), they were unable to reach an agreement. Independently, on December 11, 1987, Texaco's shareholders' committee, in conjunction with Carl Icahn, reached a $3 billion settlement with Pennzoil. On December 18, the two companies formally agreed to this amount.

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III. The Effects of the Conflict on Shareholder Wealth

A. Methodology

To measure the impact of the conflict on the two companies, we examine the abnormal changes in equity values induced by news bearing on the litigation. We use the market model to measure abnormal returns:3

Rit = at + $iRmt + e/r,

where Rit and Rmt are the return to stock i and the market at time t. The abnormal return is measured as the residual, e£> We multiply the abnormal returns by the value of the outstanding equity of each company to estimate the changes in wealth caused by the litigation.4

B. Market response

As a first test of the impact of the dispute on equity values, we examine the correlation between the stocks' abnormal returns. If litigation news was frequent and had large effects, the two returns should show a lower correlation than would otherwise be expected. This appears to be the case. For seven oil companies not involved in the litigation,5 the average pairwise correlation of abnormal returns is .249, with a standard deviation of .171. For Texaco and Pennzoil, the correlation is 016.6 Thus, the litigation appears to account for a large fraction of the return variance of both companies.7

The most natural measure of total litigation costs is the change in value of the two companies in reaction to important events. Tables 17.1 and 17.2 show the effects of each of the events described in section 2 on the market value of the two companies and on the combined equity values.8

Fama, Fisher, Jensen, and Roll (1969) and Schwert (1981) discuss the methodology more fully.

We use return data from January 1984 to January 1988. The data were adjusted for dividend payments and stock splits. We used the return on the Standard and Poor's Composite Stock Index as a proxy for the market return. The results are invariant to the time period used for the estimation.

These companies were Ashland Oil, Arco, Chevron, Exxon, Mobil, Occidental, and Unocal. The data were from January 1985 to December 1987.

6 One possible explanation for the small correlation is that periods of nontrading result in noncontemporaneous reactions to the same news. If this were true, the one-period lead or lag returns should be correlated positively. Leading and lagging Texaco's return by one period, however, yields correlations of-.107 and .031. We thus reject this explanation.

7This test actually understates the significance of the dispute because some events, such as the bankruptcy filing by Texaco and the settlement talks the two companies held, caused the two stock prices to move together.

8The standard errors for the change in combined value were computed from a portfolio containing a weighted average of Texaco and Pennzoil shares, where the weights were the market value of the companies at the end of the previous day.

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Table 17.1. Litigation news and changes in value"

a Table shows change in value of Texaco, Pennzoil, and combined equity. The change in combined value is compared from a value-weighted portfolio of Texaco and Pennzoil shares. Numbers in parentheses are the standard errors expressed as changes in value by multiplying by the market value of the firm or portfolio.

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Table 17.2. Settlement news and changes in value"

a Table shows change in value of Texaco, Pennzoil, and combined equity. The change in combined value is computed from a value-weighted portfolio of Texaco and Pennzoil shares. Numbers in parentheses are the standard errors expressed as changes in value by multiplying by the market value of the firm or portfolio.

Table 17.1, which focuses on the effects of litigation news, provides strong evidence that the market associated large costs with the Texaco-Pennzoil dispute. While Texaco's and Pennzoil's share prices almost always moved in opposite directions, Texaco's change in value was much larger than Pennzoil's. In the six events decided against Texaco (events 1, 2, 6, 7, 8, and 9), Texaco's one-day loss was 5.1 times greater than Pennzoil's gain. In only one case did Pennzoil gain even half as much as Texaco lost. While the results are weaker for the decisions favoring Texaco (events 3, 4, and 5), they nonetheless support the view that the costs of the conflict are large. With the exception of the Federal Court bond reduction,9 Texaco seems to benefit greatly; the return to

The New York Times commented that the returns on this day were partly a reaction to the court ruling and partly a reaction to a fall in oil prices. As Table 17.nl shows, Texaco lost much less value in relation to the Oil Index in this week.

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Pennzoil is less clear. Both the individual changes in value and the change in combined value are statistically significant at conventional levels.

The combined loss to shareholders from these nine events is striking. Using single-day returns, we find that Texaco's value fell a total of $4.1 billion, Pennzoil's rose only $682 million. Pennzoil gained only 17 percent of what Texaco lost. Before the litigation was filed, Texaco's value was about $8.5 billion, while Pennzoil's was about $2 billion. The loss thus represents over 32 percent of the prelitigation joint value.

Table 17.1 also shows that the two stock prices moved together after the bankruptcy filing of Texaco. On the day after the filing, joint value fell by over $1.2 billion. It was widely reported that the losses were caused by disappointment on the part of shareholders over the failure to settle the case the week before. The implication is that events that were expected to prolong the dispute or to magnify what was at stake led to large losses in joint value.

In contrast to the news about the magnitude or duration of the litigation, Table 17.2 shows that the events associated with the resolution of the dispute resulted in large increases in combined value. Using single-day returns, we find that joint value increased by $2.3 billion after the four settlement announcements in November and December 1987. This rise in value is 65 percent of the loss from the

a Table shows change in value of Texaco debt. Average excess return is found as a weighted average of excess returns for individual issues. Change in market value is the book value of longterm debt at the end of the previous quarter times the average price-to-book value ratio, times the average excess return on the debt.

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STATE JUDGE

AFFIRMS AWARD

U S SUPREMF COURT

REINSTATES 8OND

REQUIREMENT

1985

Figure 17.1. Combined value of Texaco and Pennzoil.

litigation events, although the prolonged negotiations make it more difficult to identify all days on which expectations of a settlement changed.

Unfortunately, the magnitude of the gain is also obscured by the involvement of Carl Icahn in the settlement process. The threat of a takeover by Icahn potentially induced a premium in Texaco's value. While we discuss this aspect of the case more fully in a later section, we note here that on several days when the news was almost exclusively about the negotiated settlement - the days reported in Table 17.2 - joint value rose substantially. Settlement announcements appeared to increase the value of both companies.

Immediate responses to dispute events thus indicate that news that increased either the expected transfer from Texaco to Pennzoil or the expected duration of the dispute greatly reduced the combined value of the two companies. Not all information bearing on the ultimate resolution of the case came out in discrete events, however. To assess the full effect of the dispute on the two companies, Figure 17.1 plots the cumulate changes in the abnormal returns of Texaco and Pennzoil over the course of the dispute. We present excess monthly returns for the two companies in Table 17.3.

It is apparent from Figure 17.1 that most of the movements in the combined value of the companies were associated with the major events highlighted in Tables 17.1 and 17.2. The total decline in value between the initial verdict in November 1985 and October 1987 was $3.7 billion, about the same as the sum of the losses in value during the case. Settlement of the dispute in November and December 1987 was associated with a gain of $2.6 billion in combined

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Table 17.3. Monthly excess returnsa

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Table 17.3. Monthly excess returns'1 (cont.)

a Table shows sum of abnormal returns for each week in the month. Abnormal returns are relative to the Standard and Poor's Composite Oil Index. Numbers in parentheses are standard errors expressed as changes in value by multiplying by the market value of the firm or portfolio.

value. These totals suggest that the conflict between Texaco and Pennzoil cost their equity holders about $1 billion.

IV. The Effects on Other Claimants

There are two principal claimants, in addition to Pennzoil, that stand to be affected by the litigation: the holders of Texaco debt and the Federal government, through its tax claim on the two companies,10 We examine the impact on these claimants in turn.

The effect on Pennzoil's bondholders is not included since the value of these claims was never in doubt. The price of Pennzoil debt moved very little over the period and showed no exceptional movements in response to any of the litigation events.

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Texaco's bondholders. Litigation and bankruptcy pose two problems for bondholders. First, under the terms of the reorganization, their claims can he reduced or eliminated entirely, Second, in the event of liquidation, bondholders can suffer (or gain) from redemption of the outstanding debt at par value, not market value.

Exclusive of Pennzoil, Texaco's bondholders were its largest claimants throughout the litigation period.11 We, therefore, focus on the induced change in the value of Texaco's bonds. To determine these changes we used the following procedure. For each issue listed on the event day, we computed the abnormal return relative to a long-term oil company bond.12

Using book value weights, we then computed a weighted-average debt return. In addition, we computed a weighted-average price-to-book-value ratio on the day before the event. To find the change in debt value we multiplied the book value of long-term debt as of the end of the previous quarter by the price- to-book-value ratio (to find the market value of debt) and by the abnormal return on the debt.

Table 17.4 shows the changes in debt value on each of the important events.13 The return to bondholders mirrored that to stockholders. Adverse events in the litigation proceedings (events 1, 2, 6, 7, 8, and 9) reduced the value of the debt; favorable announcements generally increased the value. The aggregate effect of the nine litigation events is a fall of $1.5 billion in debt value. This figure obtains despite the fact that debt selling below face value fell by much less than higher yield debt. When Texaco filed for bankruptcy, for example, its average debt value fell by almost 12 percent, while the value of some of its low-yield debt fell by only 2 percent.

As with the equity claims, settlement induced large increases in debt value. After the four settlement events, Texaco's debt increased in value by $488 million. Since takeovers should not affect debt payments, the magnitude of this increase suggests that the cause of the dramatic increase in value, for the bondholders and potentially for the stockholders, was primarily the resolution of the underlying dispute.

The government. Under Federal law, damage payments are both taxable on receipt and deductible on payment. Thus, one might expect that the litigation would not affect government tax collections. Three considerations suggest that the litigation could have tax consequences, however.

First, it seems unlikely that Texaco could use all of the tax losses generated by a payment to Pennzoil. Between 1982 and 1986 Texaco received tax re-

11At the time of bankruptcy Texaco had $8.4 billion in bonds outstanding, of which $6.8 billion were long term.

12We used a 6 percent coupon rate, 1997 expiration Exxon bond.

13Because Texaco's bond prices are not carried on any financial databases, we were unable to calculate standard errors for the changes in bond value.

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Table 17.4. Returns relative to composite oil price indexa

1 Standard errors in parentheses.

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