Should Congress Stem the Rising Tide...

While I am not a tax expert, I do understand the energy industry, in which a portion of recent takeover activity has taken place. Accordingly, I know what has--and what has not--been the primary motivation behind the recent surge in merger activity in that industry.

I urge the subcommittee to move cautiously in considering the pending legislative proposals. It should reject misguided proposals that, in my view, reflect a basic misunderstanding of the realities of the marketplace, in general, and what is now occurring in the energy industry, in particular.

The proposed tax legislation designed largely to discourage takeovers implicitly assumes, against the great weight of evidence, that mergers are somehow bad per se, and that it is appropriate to add provisions to the tax code specifically to discourage hostile takeovers. The proposed legislation overlooks the overwhelming benefits of mergers that accrue to the economy and to its key participant, the American shareholder. These bills serve only to protect incumbent management, often to the detriment of shareholders. They are simplistically drawn and do not address at all the true cause of corporate mergers. The primary reason mergers are good is that they provide shareholders a means for calling corporate management into account.

Industry in Transition

Mergers among energy companies are motivated by the market realities of an industry in transition. Recent acquisitions are driven primarily by the need of companies to replace diminishing reserves in the most economic fashion.

The industry today is in the midst of an internal restructuring, which represents a response to existing market forces. Recent cutbacks in drilling simply reflect the realities of exploration economics: a scarcity of good drilling prospects, high finding costs and stable energy prices. There is a serious question whether current energy prices afford sufficient economic incentive to explore in frontier areas.

Mergers are recognized by authorities in government and industry not to be primarily tax motivated. Testimony before a Senate Finance subcommittee last year on oil company mergers, the assistant secretary of the treasury for tax policy stated that the current tax rules are not propelling the recent flurry of oil company acquisitions, and that Congress should not amend the tax laws for the purpose of discouraging these mergers. In addition, George Keller, chairman of Chevron, also stated before the Senate Finance Committee last year that the Chevron-Gulf merger was not made for tax purposes and that the idea of gaining tax benefits from the merger played absolutely no part in the company’s thinking. Finally, I told the Senate Judiciary Committee last year that tax considerations were not major factors in Mesa’s bid for Gulf.

A basic underlying cause of corporate mergers today is management inefficiency. As this year’s Economic Report of the President pointed out, the American economy’s success depends on competition. Competition should also play a significant role in what is a healthy market for corporate control. An active merger market is a healthy threat to incompetent management. It is good for the economy because it shifts corporate assets from poor managers to more efficient ones.

Proposed tax legislation will adversely affect shareholders. The key point is that companies involved in mergers are not owned by managements, but by shareholders. It is their interest that should be paramount. There are 42 million shareholders who own stock in publicly traded companies. This represents one out of six Americans. Stockholders place their investments in the hands of management and expect management will do its best to keep the market value of their investments as close as possible to its true value.

If investors are dissatisfied with management performance, they will serve notice on management to improve the return on assets left under their control. Too often unresponsive managements give the small investor little choice but to sell. Restrictions on legitimate tender offers would deprive these investors of that basic property right--the right to sell. Mesa would not invest if we did not believe that management would respond in a positive way to our ownership. The small investor can have a tough time getting management’s attention.

Benefit From Premium

A number of studies have pointed out that target company shareholders who tender their shares benefit from a premium over the market price which averages in a range of 30% to 35%. For the bidder, the average gain is 3% to 4%. Legislative restrictions on mergers would deny to shareholders this premium and thus in effect would impose a new restraint on shareholder value.

Proposed tax legislation will adversely affect capital markets and the economy. The effect of tax legislation that impedes corporate acquisitions could be severe. Corporate acquisitions are an important goal of entrepreneurial activity in our economy. Private entrepreneurs, financed by venture capitalists, are the primary creators of new jobs and new businesses.

Mergers create wealth. They are a natural product of the economy’s need to allocate capital efficiency. They operate to free investment capital from inefficient usage and permit it to flow to the innovative and efficient, thereby enhancing the creation of wealth. To establish prohibitive tax barriers to this type of activity would be to harden the arteries that carry the life blood of our economic system--investment capital.

Arbitrary tax rules could also weaken our securities markets. They could adversely affect the willingness of investors to put their savings into corporate equities and thus impair the ability of corporations to raise capital. If the shareholder’s right to sell is restricted, equity securities would no longer be as attractive for investment purposes. This would aggravate the existing bias in the tax law in favor of debt as compared to equity financing--ironically, the very condition that some proponents advance in support of anti-merger tax legislation. Once investor confidence is weakened, equity markets will deteriorate to the detriment of capital formation.

Could Curb Exploration

Proposed tax legislation designed to thwart mergers in the petroleum industry might adversely affect energy exploration and drilling by inhibiting the most efficient combination of resources and expertise. Congress should not approve anti-merger tax legislation on the misbegotten notion that it would cause the energy industry management to drill more domestic wells. There is plenty of money in the industry today to drill all the economically feasible prospects that are available. Rigs aren’t drilling because the economics are bad. The number of rigs working in the United States today is less than half the number that were working in December, 1981. Tampering with the tax laws would only reduce the rig count further.

Mergers increase federal revenues substantially, and adoption of anti-merger tax proposals could result in the loss of these revenues. For example, premiums paid in merger transactions have been a major generator of capital gains tax revenues, and any specific tax restraint on mergers would result in a decline in portfolio values for shareholders, resulting in smaller gains or perhaps capital losses.

Testimony before the Senate last year on the tax aspects of oil company mergers suggested that tax revenues from the Chevron-Gulf merger alone were estimated to be $2 billion. In the three takeover attempts in which Mesa Petroleum has been involved recently, 750,000 shareholders have made a pretax profit of roughly $13 billion, and federal coffers have been enriched by about $3 billion in taxes.

Pending tax bills aimed to deter mergers are inherently flawed. The most simplistic proposal would deny the deductibility of interest on debt incurred to acquire another company, on the premise that current law represents a “tax subsidy” in favor of mergers. This is simply an incorrect characterization of the facts.

Would Discriminate

Our tax laws have always permitted corporations to deduct interest for funds borrowed, whether to purchase stock or real assets, to build a plant or equipment, to develop new products or for general operating purposes. There is no reason to view the acquisition of a company through a merger as any different than we would view the acquisition of these other properties. I see little basis to discriminate against mergers in general as opposed to other types of capital transactions.

The borrowing of funds does not create interest deductions for the borrower without creating corresponding interest income for the lenders, which is subject to tax. Denying the interest deduction would also prevent the most efficient allocation of capital in our economy. This requires mechanisms to match willing buyers and sellers and the freedom of sellers to sell to the highest bidder. Income tax rules should not attempt to dictate credit allocation in this free market, because it would remove the highest bidders in the targeted industry from the market. This would be bad tax policy and would create a dangerous legislative precedent.

Other tax bills would determine tax consequences of a proposed acquisition on the approval or disapproval of the target company’s board of directors. This represents questionable tax policy because it is contrary to the determinations of the free marketplace. It would shift the balance between the bidder and target in favor of the management of the targets, although not necessarily in favor of the shareholders. And it could create a situation in which directors would be offered payoffs in return for approving a deal.

Let me add a word about provisions in certain tax bills that are designed to curb “greenmail.” Greenmail is properly defined as the repurchase of a corporation’s stock by the corporation from a large, relatively new shareholder where the same offer to repurchase is not made to all shareholders. I have always been an outspoken opponent of greenmail because by its very definition it discriminates among shareholders, and is thus anti-shareholder. While legislation designed to curb this practice may be well intentioned, these anti-merger tax bills miss the mark. I question whether use of the tax code is the best method to adopt to correct what is essentially a securities law matter. But the larger point is that greenmail is a trademark of weak management. The way to end it is not to penalize the shareholder who receives it, but the managements who pay it.

Response to Changes

Mergers are not motivated by the tax laws or by some kind of quick-profit scheme. They reflect the response of sensible shareholders alert to market changes and problems with management. Mergers are a means by which shareholders exercise the right to run the corporations they rightfully own.

Proposed tax law changes would be pointlessly punitive. Arbitrary legislation of this type can only send a chilling message to the private sector--that the government has lost its sense of cause and effect in the economy and has determined that it can better provide for the economic health of the nation than can the private sector.

The greatest defense against a takeover is for management to utilize corporate assets efficiently to maximize the return for its shareholders. It is not by legislative tampering through the tax code, which may appear to have superficial appeal, but which would result in serious harm to shareholders and the economy as a whole.