Kamin v. American Express(accounting vs. investment value)

Law & Valuation

Spring 2005

Valuation in corporate decision-making

• Board decision on “maximizing shareholder value”– Board choice in Kamin v. American Express– Accounting treatment of DLJ disposition – Accounting value vs. economic value

• Judicial response– Business judgment rule– Deference to market irrationality

Kamin v. American Express

Management wants to dump bad DLJ investment. Why? Presents options to board:

Option 1: Declare special dividend of DLJ stock to AmEx shareholders.

Option 2: Sell DLJ stock at corporate level, sustaining capital loss but realizing tax savings.

How account?

Purchase of DLJ stock (1972)

Debit Credit

Investment 29.9

Cash 29.9

Balance sheet

Assets Liabilities Cash (29.9)

Investment 29.9

Equity

Option 1: Dividend distribution

Debit Credit

Dividend paid 4.0

Retained earnings 25.9

Investment 29.9

Balance sheet

Assets Liabilities Investment (29.9)

Equity Retained earnings (29.9)

Option 1: Dividend distribution

Income StatementRevenue --

Expense --

Gain / Loss --

Tax --

Net income --

Option 2: Sell DLJ stock

Debit Credit

Cash 4.0

Other income (loss) 25.9

Investment 29.9

Debit Credit

Income tax payable 8.0

Income tax expense 8.0

Option 2: Sell DLJ stock

Balance Sheet

Assets LiabilitiesCash 4.0

Investment (29.9) Tax liability (8.0)

Equity

Retained Earnings (17.9)

Option 2: Sell DLJ stock

Income statementRevenue

--

Expense --

Gain / Loss (25.9)

Tax (31%) 8.0

Net income (17.9)

Cash flow statement Inflow from sale 4.0

Tax savings 8.0

Net cash flow 12.0

Kamin v. American Express

Compare Option 1 and Option 2Option 1: Distribute DLJ stock and avoid

$17.9 million reduction in net incomeOption 2: Sell DLJ stock and reduce taxes

by $8.0 million

Why did board choose Option 1 – the economically inefficient, but market-friendly distribution of DLJ stock?

Kamin v. American Express

Team 2: “Board’s attempt to smooth earnings by avoiding a short-term hit seems to be an attempt to protect shareholder value.”

Team 6: “Courts will not interfere unless [board] powers have been illegally or unconscientiously executed … or fraudulent or collusive and destructive of the rights of the stockholders.”

Team 9: “In today’s dollars, AmEX could be subjecting the company to a potential shareholder value loss of $344.2 million. … If Kamin disagrees he should sell.

Team 12: “More likely AmEx did not have capital gains sufficient to absorbed the entire $25.9 million in long-term capital losses … would have been carried back to tax years 1972-1974. Total $12 million in savings may have actually been less in PV terms. In 1975.

Kamin v. American Express

American Express EPS '74-'78 (NB)

0

1

2

3

4

5

1974 1975 1976 1977 1978

Years

EP

S

EPS

Kamin v. American Express

Did the reviewing court, which deferred to the board, make the right decision?

Kamin v. American ExpressTeam 2: “The board seems justified in its decision to focus

on the market value of AMEX stock.”Team 6: “The board exchanged sound business judgment

[creating positive cash flows of $12 million] for short term accounting solution.”

Team 9: “Managers use accounting tricks to “smooth earnings” and add value to a firm, increasing shareholder wealth. Until the manipulation is unveiled, the company enjoy rewards from the market with steady earnings and meeting estimates.

Team 12: “Under current accounting rules, AmEx would have had to show the dividend transaction in footnotes to its financial statements and accrued depreciation on the investment as a loss. … 1975 accounting seems to have been designed to defraud both current and potential investors.”

Kamin v. American Express

Any suggestions to make markets more rational, efficient?

Kamin v. American Express

Kamin v. American Express

VJG: “… maybe regulation by the SEC or federal law could replicate institutional investors valuing companies not based on accounting tricks”

BH: “AmEx could have avoided dispute had accountants properly “marked to market” DLJ stock .. Loss can’t be changed by magic in accounting”

FG: “ We would have sent case to trial, not decide on SJ, to get more information on board decision”

NB: “Buffet has lost confidence in EPS: “primary test of managerial performance is high earnings rate on equity capital employed … and not EPS.”

JM: “Shareholders pay the board … and must life with the decisions … or take action”

Kamin v. American Express

In the end, who should decide value?