Kaist Informaiton&Media MBA 20093988 Hahm, Seung-wan 20093837 Yeo ju 20093998 Hwang, do-won The costs of conflict resolution and financial distress: Evidence from the Texaco-Pennzoil litigation

Table of Contents Introduction 2. The conflict 3. The effects of the conflict on shareholder wealth 4. The effects on other claimants 5. Where did the value go? 6. Conclusions and implications

I. Introduction

Reducing the combined equity value 1. Introduction Case : The litigation between Texaco and Pennzoil over the Getty oil takeover (1984~1988) Large fluctuation in value During the litigation Reducing the combined equity value Asymmetric returns Texaco’s shareholders Pennzoil’s owners Texaco value leakages $ 1 Lose $3.4 billion (over 30 %) $ 0.4Gain Pennzoil value Joint value Before dispute ongoing dispute

II. History of conflict

Texas state supreme court Federal court of appeals 2. History of conflict U.S court structure [ Texas State ] [ Federal] Texas state supreme court Texas court of appeals Texas state court supreme court Federal court of appeals Federal court History of conflict Date Court Event Additional information 1985, 11/19 Texas state court In favor of Pennzoil Total $12.03 billions(B) - result : jury are decried $7.53B in actual damage $3B in punitive damage $1.5B in accrued interest 12/10 Texas jury denied Texaco’s request to overrule the jury Award($12.03B) is affirmed

2. History of conflict (cont) Date Court Event Additional information 1985, 12/18 Federal Texaco received a temporary Restraining order It’s temporary until bond matter could be decided 1986, 1/10 court Texaco bond requirement is reduced Only $ 1 billion bond 2/20 Federal court of appeals Uphold bond reduction original case and bond case were appealed 1987, 2/12 Texas court of appeals Uphold $2 billion of the judgment for Pennzoil <= original case’s award 4/6 Supreme Vacated the federal court ruling <= bond case 4/12 - Texaco filed for bankruptcy After bankruptcy, Texaco appealed the case to upper court 11/2 Texas state supreme court Declined to review the case 1987 , 12/11 $3 billion settlement in Texaco’s shareholders’ committee (& Carl Icahn) Trial court : 사실심 법정

III. The Effects of the Conflict on Shareholder Wealth

3. The Effects of the Conflict on Shareholder Wealth Measures market value of both companies. Examines the correlation between the stocks’ abnormal value. F-1. Litigation News and Change in Value F-2. Settlement News and Change in Value (million) (million) - Frequent news: lower correlation. Litigation costs: change in value of the two companies. Penzoil’s gain = 6X Texaco’s loss - After settlement, the value was recovered.

3. The Effects of the Conflict on Shareholder Wealth Nov 1985 → Oct 1987 = $3.7B↓ After settlement: combined value = $2.6B↑ Change Value =-$1.1B Shareholders Cost Billions Of Dollars Time 1986 1987 6 4 8 1) $3.7B 2) $2.6B Figure-3. Combined Value of Texaco & Pennzoil

IV. The Effect on Other Claimants -Texaco’s Bondholders

4. The Effect on Other Claimants 1) Texaco’s Bondholders Reorganization : Claims can be reduced or eliminated entirely. Liquidation(청산) : Redemption of outstanding debt at par value, not market value. T-1. Change in Value of Texaco Debt The return to bondholders mirrored that to stockholders. Dramatic increase in value → due to the resolution of the dispute. After settlement, debt value increased. Total value -$986B

4.The Effect on Other Claimants 2) The Government -Federal law of Damage Payment Taxable or Deductible F-3. Tax flow Damage Payment Tax Deduction Tax Liability

4.The Effect on Other Claimants – The Government 3 considerations suggest that the litigation could have tax consequences, however.. 3 considerations 1. The Texaco couldn’t use all of tax losses generated by a payment to Pennzoil. 2. Distinction between “ordinary income” and “capital gains” lowered tax liability of Pennzoil. 3. Capital gain is not liable in case of “Involuntary Conversion” within 2 years. Claims of these creditors do not counter the loss or increase in value. The effects on no equity claims cannot explain the equity losses and the fluctuations in value did not reflect transfers among claimants.

V. Where did the value go?

Free cash flow may be invested at below the market return 5. Where did the value go? 1) Legal payment 2) Fail to manage fund Settlement Total legal payment Pennzoil would not use any funds it received from Texaco so efficiently 14% of the resulting increase in value to Pennzoil Free cash flow may be invested at below the market return Texaco Pennzoil $250M $400M After tax joint total $ 525M 15% loss of Joint value Lowering the value of the pennzoil

The large fluctuations 5. Where did the value go? 3) Secondary Costs 4) Responsibility of take over Suppliers The large fluctuations Favorable litigation announcement Negative litigation announcement Make operating hard Value up Value down Bank Stock market After initiate litigation decisions the possibility decreased 1 Make financing hard Give negative view Carl Icahn tried to acquire the companies in hostile takeovers 2 Texaco’s credit & financial condition had been declined 3 After settlement

5) Inefficient valuation 5. Where did the value go? 5) Inefficient valuation The market in efficiently valued the claims of two company 1 The hypothesis of market error in valuing two companies is attractive - But there must be strong general grounds for doubting the rationality of market valuation 2

VI. Conclusion 5. Where did the value go? 5) Inefficient valuation The market inefficiently valued the claims of two companies The hypothesis of market error in valuing two companies is attractive In this case, - matters of public records are involved. - they were widely followed and actively traded throughout the period. - the valuation pattern persisted over two years, and was noted on several occasions in the financial press. VI. Conclusion

6. Conclusions Total cost Different Expectations Market expect that it will be $2billion Direct Expenses Indirect Expenses Legal fee - $525million Interfered with firm’s abilities to obtain working capital and make them less profitable- not measurable but greater than direct expenses

Total joint loss -$1.1billion 6. Conclusions History about total loss Litigation Settlement $3.7 billion $2.6 billion $10.5 billion $9.4 billion Total joint loss -$1.1billion The best way to avoid the litigation A bargain should be stuck immediately A bargain costs should not be incurred There would not be third party Value Both parties must be fully informed

Thank you ! 5. Where did the value go? 5) Inefficient valuation The market inefficiently valued the claims of two companies The hypothesis of market error in valuing two companies is attractive In this case, - matters of public records are involved. - they were widely followed and actively traded throughout the period. - the valuation pattern persisted over two years, and was noted on several occasions in the financial press. Thank you !