Study Case from Modern Banking by Shelagh Heffernan
- Kidder Peabody Group –
‘‘But Leo’’, said Alan Horrvich, a third-year financial analyst at General Electric Capital
Corporation (GECC) in September 1987: ‘‘I don’t know anything about investment banking. If I walk in there with a lot of amateurish ideas for what he ought to do with Kidder, Cathart will rip me apart. OK, you’re the boss, but why me?’’
‘‘Look Alan’’, replied Mr Leo Halaran, Senior Vice-President, Finance of GECC: ‘‘we’ve got ten thousand things going on here right now and Cathart calls up and says, very politely, that he wants somebody very bright to work with him on a strategic review of Kidder Peabody. You’re bright, you spent a semester in the specialised finance MBA programme at City University Business School in London, you earned that fancy MBA from New York University down there in Wall Street, and you are available right now, so you’re our man. Relax, Si isn’t all that tough. If you make it through the first few weeks without getting sent back, you’ve got a friend for life. . .’’, he ended with a grin. ‘‘Me.’’
Mr Silas S. Cathart, 61, had retired as Chairman and CEO of Illinois Tool Works in 1986. He had been a director of the General Electric Company for many years and was much admired as a first-rate, tough though diplomatic results-oriented man- ager. After the resignation of Mr Ralph DeNunzio as Chairman and CEO of
Kidder Peabody following the management shake-up in May 1987, Mr Cathart had been asked by Mr Jack
Welch, GE’s hard-driving, young CEO, to set aside his retirement for a while and take over as CEO of
Kidder Peabody, to give it the firm leadership it needed, particularly now. Cathart had not been able to say no. His first few months were spent trying to get a grip on the situation at Kidder, which had been traumatised by the insider trading problems, and by management uncertainty as to what GE and its outside CEO were going to do to Kidder next. After reporting substantial earn- ings of nearly $100 million in 1986,
Kidder was expected to incur a significant loss in 1987.
Technically, Cathart and Kidder reported to Mr Gary Wendt, President and Chief Operating Officer of
General Electric Financial Services (GEFC) and CEO of GECC, but Alan understood everyone believed that old Si reported only to himself and Mr Welch. Mr Cathart wasn’t going to be in the job for that long and could not care less about company politics. All he had to do was return Kidder to profitability, and set it on the right strategic course – one that made sense to both the Kidder shareholders and the GE crowd. After that, he could go back to his retirement and let someone else take over.
Everyone Alan had talked to at GECC felt that the job would be very tough, and that Cathart might be at a big disadvantage because he did not have prior experience in the securities industry.
Alan’s plan was to play it dead straight with Mr Cathart, to work most of the night getting the basics under his belt, and to consider Kidder’s strategic position, and how to implement any proposed changes. If asked something he did not know, he would simply say he did not know but would try to find out. A chronology of significant events is summarised below.
Chronology of Significant Events, 1986–87
April 1986
General Electric Financial Services agreed to pay $600 million for an 80% interest in Kidder Peabody and
Company, leaving the remaining 20% in the hands of the firm’s management. GEFS is a wholly owned subsidiary of General Electric Company. The price paid was about three times the book value – each shareholder was to receive a cash payment equal to 50% of the shares being sold, the remainder being paid out over three years. GEFS was to replace the shareholder capital with an initial infusion of $300 million, with more to follow. When the transaction closed in June 1986, GE and Kidder shareholders had invested more equity in the firm than previously announced – Kidder’s total capital was boosted to $700 million.
Mr Robert C. Wright, head of GEFS, claimed the expansion of investment banking activities would mean
GEFS’s sophisticated financial products in leasing and lending could be combined with corporate financing, advisory services and trading capability at Kidders. There was no plan to institute any management changes.
Kidder ranked 15th among investment banks in terms of capital, and had 2000 retail brokers in 68 offices.
The view was that it was too small to compete with the giants, but too large to be a niche player, making it an awkward size. Among analysts, it was generally accepted that Kidder had not been purchased for its retail network, but rather, for its institutional and investment banking capabilities.
Kidder initiated the talks with GE. It was believed the firm agreed to give up its independence as a means of using a more aggressive strategy to achieve a better image – there was a general perception that it was being left behind.October 1986
Mr Ivan Boesky was arrested for insider trading. He implicated Mr Martin A. Siegel, a managing director of
Drexel Burnham Lambert, who had been head of Kidder Peabody’s merger and acquisition department until his departure in February 1986 to join Drexel.
December 1986
Kidder reorganised its investment banking division. Eighty-five professionals were trans- ferred to the merchant banking division, 45 of whom were placed in acquisition advisory, and another 40 in the highyield junk bond department. The group was headed by Mr Peter Goodson, a Kidder managing director, who at the time noted the move was a fundamental change in management structure. Mr Goodson did not anticipate any long-term effects from the insider trading scandal.
February 1987
The 1986 Kidder Annual Report emphasised the importance of synergies apparent in the combination of
Kidder Peabody and GEFS – it was believed the synergies far exceeded the firm’s expectations. A source of new business at Kidder was existing customer rela- tionships with hundreds of middle-sized American firms at GEF. Additional capital from GEFC allowed Kidder to provide direct financing, picking up a sizeable number of new clients.
The Kidder Annual Report also revealed Kidder’s core business had been reorganised to reinforce competitive strengths and facilitate future growth. A global capital markets group was formed under Mr Max
C. Chapman Jr (President of Kidder, Peabody and Co., Incorporated), to direct the investment banking, merchant banking, asset finance, fixed income and financial futures operations on a world-wide basis. Mr
John T. Roche, President and Chief Operating Officer, Kidder Peabody Group Inc., established an equity group. Mr William Ferrell headed up a municipal securities group, formed from the merger of the public finance and municipal securities groups. The CEO, Mr Ralph DeNunzio, claimed these changes were made to ensure the firm was in a position to compete effectively in the global market place.
February 1987
Mr Richard B. Wigton, Managing Director, was arrested in his office by federal marshalls on charges of insider trading. A former employee, Mr Timothy Tabor, was also arrested. Both arrests were the result of allegations made against them and Mr Robert Freedman of Goldman Sachs and Company by Martin Siegel, who, next day, pleaded guilty to insider trading and other charges brought against him. Kidder’s accountants,
Deloitte, Haskin and Sells, qualified Kidder’s 1986 financial statements because they were unable to evaluate the impact of insider trading charges. Kidder reported earnings of $90 million (compared to $47 million earned in 1985); ROE was 27%.
The New York Stock Exchange fined Kidder Peabody $300 000 for alleged violations of capital and other rules. Two senior officials, including the President, Mr Roche, were fined $25 000 each for their role in these violations.
The Wall Street Journal reported that Mr DeNunzio had instructed Martin Siegel to help start a takeover arbitrage department in March 1984; Mr DeNunzio had indicated that the role played by Mr Siegel should not be disclosed publicly – there were inherent conflicts in having the head of mergers and acquisitions directly involved in trading on takeover rumours. A Kidder spokesman said the report was a
‘‘misstatement’’, and denied that Mr DeNunzio had ordered the formation of such a unit.
May 1987
Mr Lawrence Bossidy, Vice-Chairman of GE and head of all financial services, announced a management shake-up at Kidder Peabody: Mr DeNunzio, Mr Roche and Kidder’s General Counsel, Mr Krantz, would be replaced. Following the arrests, GE sent in a team to assess Kidder. The internal investigation revealed the need for improved procedures and controls. Mr Cathart was to take over as Kidder’s CEO. GE men were also brought in to fill the positions of chief financial and chief operating officers, and a senior vicepresident’s position for business development. The board of directors was also restructured, to ensure GE had a majority of seats on the Kidder board. In the same month, charges against Messrs Wigton, Tabor and
Freedman were dismissed without prejudice, though it was expected they would be charged at some future date. June 1987
GE required Kidder to settle matters with the Federal Prosecutor and the SEC. In exchange for a $25 million payment and other concessions, including giving up the takeover arbitrage business, the US Attorney agreed not to indict Kidder Peabody on criminal charges related to insider trading. Civil litigation against Kidder was still possible, though it would not have the same stigma as criminal charges and conviction. GEFS also agreed to provide an additional $100 million of subordinated debt capital to Kidder Peabody.July 1987
GE announced its first half results. At the time, GE said its financial services were ahead of a year ago because of the strong performance at GECC (GE Capital Corporation) and ERC (Employers Reinsurance
Corporation), which more than offset the effects of special provisions at Kidder Peabody for settlements reached with the government. It was estimated that Kidder had lost about $18 million in the second quarter.
September 1987
Mr DeNunzio retired from Kidder Peabody after 34 years of service. For 20 of these years, he had been
Kidder’s principal executive officer. The Wall Street Journal reported that morale at Kidder Peabody was improving, with GE and Kidder officials conducting a full strategic review of the firm. It was also announced that Kidder planned to establish a full service foreign exchange operation and would operate trading desks in London and the Far East.
1989 – 94
Mr Michael Carpenter joined Kidder as ‘‘head’’ in 1989, just as the bank was reeling from the insider trading scandal. In a deal negotiated with the SEC, Kidder was required to close down its successful risk arbitrage department. This was quite a blow to Kidder because its other businesses were only mediocre.
Kidder had an excellent reputation, but was saddled with high expenses and many unproductive brokers.
Half of the firm’s retail offices produced no profit at all. In 1989, a number of the productive brokers left
Kidder because of dissatisfaction with the level of bonuses. These departures, together with the closure of the risk arbitrage department, resulted in a net $53 million loss in 1989, and a loss of $54 million in 1990.
Mr Carpenter’s arrival resulted in millions of dollars and a great deal of management time had been spent nursing Kidder back to health. The bank was also building up its investment banking operations. Profits rose in 1991; in 1992 they peaked at $258 million.
Most of Kidder’s profits came from its fixed income securities operations, the one area where it had managed to establish a lead over other investment houses. Underwriting and trading mortgage backed securities (MBSs) pushed Kidder up the underwriting league tables. During this time, the profits from mortgage backed securities were said to have accounted for about 70% of total profits.
Unfortunately, the sharp rise in interest rates at the start of 1994 hurt the mortgage backed business. The consequences of the ‘‘go for it strategy’’ with MBSs was seen in the first quarter of 1994 – Kidder lost more than $25 million.
The same year, Kidder took a loss of around $25 million on margin trades entered into with Askin Capital
Management, a hedge fund group which had to seek protection from its creditors, because of trading losses.
Mr Carpenter’s attempts to build Kidder’s other businesses produced mixed results. By reducing costs and firing unproductive brokers, Carpenter succeeded in turning round the retail brokerage business – it was the most profitable business, after the fixed income department. But Carpenter’s objective of achieving synergy between GE Capital and Kidder Peabody had been far from successful. There was a great degree of animosity between Mr Carpenter and Mr Gary Wendt, the CEO of GE Capital. It was reported that when clients wanted GE Capital to put up money for a deal, they would avoid using Kidder as their investment banker. Mr Welch was reported as saying, ‘‘The only synergies that exist between Kidder and GE Capital are Capital’s AAA credit rating’’.
In April 1994 it was revealed that Kidder had reported $350 million in fictitious profits because of an alleged phantom trading scheme. Kidder blamed Mr Joseph Jett, who had been accused of creating the fictitious profits between November 1991 and March 1994. Kidder had to take a $210 million charge against its first quarter earn- ings in 1994. There was also the question of how a person with so little experience could have been appointed to a position bearing so much responsibility. This fiasco was reminiscent of a deal that went sour for Kidder in autumn 1993, which cost Kidder $1.7 million. The deal was headed by Mr Kaplan, who like Mr Jett, had insuf- ficient experience.
Both the SEC and the New York Stock Exchange (NYSE) launched enquiries into the Jett affair. In a report prepared by Gary Lynch (who is a lawyer with the law firm that represented Kidder in an arbitration case against Joseph Jett), it was concluded that there was lax oversight and poor judgement by Mr Jett’s superiors, including Mr Cerrullo (former fixed income head) and Mr Mullin (former derivatives boss). The report suspiciously supports Kidder’s claim that no other person knowingly acted with Mr Jett. Kidder’s top managers should have been suspicious because Mr Jett was producing high profits in government bond trading – never a Kidder strength. Some of the blame can be attributed to the aggressive corporate culture of
Kidder. At an internal Kidder conference, Jett was reported to have told 130 of the firm’s senior executives
‘‘you make money at all costs’’.
However, from details that have been revealed in the prepared reports, it is evident that there were problems at Kidder long before the Jett affair, indeed, even before Jett arrived. For example, in December 1993 Kidder had the highest gearing ratio of any bank on Wall Street, at 100 to 1. Mr Jack Welch of GE attempted to restore the reputation of GE by disciplining or dismissing those responsible. Mr Michael Carpenter was pressurised into resigning; both Mr Mullin and Mr Cerrullo were fired.On 17 October 1994, GE announced GE Capital was to sell Kidder Peabody to Paine Webber, another investment bank. The sale included the parts of Kidder that Paine Webber wished to purchase. GE Capital also transferred $580 million in liquid securities to Paine Webber, part of Kidder’s inventory. In return GE
Capital received shares in Paine Webber worth $670 million. Thus GE received a net of $90 million for a firm that it had purchased for $600 million in 1986, though GE also obtained a 25% stake in Paine Webber.
Questions
1. How might a conglomerate go about assessing the real worth of an investment bank when so many of the assets are intangible?
2. Identify the areas of potential ‘‘synergy’’ for Kidder and GEFS. In this context, explain the differences between synergy and economies of scale/scope.
3. Was the emphasis on developing investment banking and corporate finance rather than the use of Kidder’s retail outlets a wise decision?
4. Given Mr Cathart’s mission of restoring Kidder to profitability, what advice might Alan Horrvich give?
What are the implications for each strategic alternative?
5. What in fact happened after 1987?
6. Summarise the various scandals associated with Kidder Peabody. What factors made this firm prone to scandals? 7. In 1994, GE divested itself of Kidder Peabody. The extent of the failure of this ‘‘match’’ is illustrated by the sale of Kidder to Paine Webber for a net of $90 million, compared to the $600 million price tag for
Kidder in 1986.
(a) Did GE pay too much for Kidder in 1986? Why?
(b) How much is GE to blame for the subsequent problems at Kidder? Could these problems have been avoided?
8. Was GE wise to take a 25% stake in Paine Webber?