Einhorn vs Apple: Can management be permitted to hoard cash?

Mr. David Einhorn, founder and president of Greenlight Capital, challenged the decision of Apple management to present a bundle of three resolutions to the annual shareholder meeting for approval. It brings forth many interesting issues in corporate governance. A manufacturing corporation faces many choices that parallel what most households face. Exploiting the similarities provides an easy pathway to understanding the complexities of corporate finance. Both need to manage the cash flows. Consider a household where earning members receive wages or salaries at periodic intervals. Less frequently they receive interest on their savings and dividends on their stock. Even less common is cash received from sale of assets like an old car or some property they own. The temporal flow of routine expenses of the household in purchasing food, drinks, travel etc. will not coincide with the inflow of cash. The gap has to be bridged either by drawing on the balance in the bank or use of a credit card. A financially successful household will be able to keep the expenses over a period month or year below its income and add the difference to its savings. In addition, the household occasionally incurs large expenses on purchase of cars or a house. Such expenses cannot be financed by current savings and the household takes a loan.1 For purchase a house, the family has to put a down payment and the family waits till it has enough savings to do so. In contrast, a manufacturing firm has to start with a substantial expense upfront as it builds or acquires a manufacturing facility. Once that is done, it has to hire employees who need to paid salaries periodically. It incurs expenses in building a stock of inventory. The revenue from the sale of its revenue will begin flowing months and even years later. The financing of fixed investment in building and machinery is financed by issuing stock which shareholders purchase with their savings. The return they get is the dividends that the firm declares or the appreciation of the stock. In an abstract sense they are equivalent as the shareholder can sell the appreciated stocks to obtain a return on his or her investment. Another source of funds for the firm is bonds. Unlike stocks, the bond commits the firm to pay out interest regularly. In times when sales revenue is below expectation, the firm may not have funds to pay the interest on bonds and may be forced to declare bankruptcy. Legally the shareholders are the owners of the firm and have the right to direct the management in the decisions they make. In practice, there are few shareholders pension funds, rich individuals and some financial institutions that own large block of shares and a large number of shareholders who own a few shares. The shareholders are dispersed and are not in continuous

contact with the management and they are less well informed than the management. This informational asymmetry makes it difficult for shareholders, nominal owners, to exercise control over the upper management.2. Given the limited supervision, the management can fall to the temptation to make decisions that benefit it even if it is not in the best interest of the shareholders. This is another example of the agency problem.3. In a perfect financial market, the firm can raise funds as and when it needs funds for capital expenses but transactions in the market have costs. The firm has to use investment banks and their costs and commission have to be paid. The complex procedure of issuing bonds and stocks can be avoided if the firm has a cash reserve. Given the limitations in monitoring the management, the concern is that the management will be tempted to make investments to expand production, develop new products or acquire another firm even if such actions are not in the interest of the shareholders. Synergy is an excuse to diversify and expand but many times the acquisitions do not add to the value of the firm. A glaring example is Hewlett-Packard acquisition of the British soft-ware maker Autonomy for $11.1 billion resulted in a loss of $8.8 billion.4. Apple has a cash holding of $137 billion. The question is why is it is hoarding such a large amount instead of distributing it to the shareholders. An equivalent to dividend, as mentioned earlier, stock appreciation, is stock appreciation but Apple stocks have recently depreciated. This provides the background for the challenge made by Mr.Einhorn who wants the funds to be returned to the shareholders. He proposed that Apple issue preferred stocks which is a hybrid instrument that gives its owners preference over ordinary shares on dividends but is subordinate to bond holders in right to assets in case of liquidation. If the company did not declare dividend one year, it has to provide it in future before dividend to those who hold ordinary shares are declared. As long as the company is solvent, preferred shareholders are assured a dividend. 5. Apple management proposed a bundle of three resolutions to change its articles of incorporation. The first is about the election of directors, the second is setting a minimum value of Apple shares and the third requires a shareholder vote before issuing preferred shares. In principle all three strengthens the shareholders voice in management. But, given the dispersal of voting rights, the last one makes it harder to press the management to issue preferred shares and transfer some of the funds to the shareholders. Mr. Einhorn objected to the bundling of the three and asked that they voted separately, hoping to defeat the one on preferred shares. Apple management objected but on Firday 22 nd of February, U.S. District Court of Manhattan issued an injection against holding the shareholder meeting till there is an agreement between parties or a judgment on the appropriateness of bundling the three resolutions. Here is the dilemma. In principle, each resolution is shareholder friendly but bundling is a form of disenfranchisement.

Footnotes:
1.

Even if the household is able to do so, it may not want to do so as they are not easily convertible the investments to cash. They are less liquid assets.
2.

On evaluation of new project by shareholders and other governance issues, see Opportunities and choices: understanding our economic decisions, http://www.scribd.com/doc/49513234/Opportunities-and-Choices, pp. 209218.
3.

For an explanation of agency problem, see Opportunities and choices: understanding our economic decisions, http://www.scribd.com/doc/49513234/Opportunities-and-Choices, pp.195-197.
4.

http://www.nytimes.com/2012/12/01/business/hps-autonomy-blunder-might-be-one-for-the-recordbooks.html?pagewanted=all&_r=0.
5.

(1) http://online.wsj.com/article/SB10001424127887324048904578320492287826864.html; (2) http://online.wsj.com/article/SB10001424127887324048904578320492287826864.html; and (3) http://blogs.wsj.com/deals/2013/02/22/einhorns-apple-victory-seen-as-legal-precedent-in-corporate-governance/.

Rama V. Ramachandran
http://www.visualeconomicanalysis.info/index.html Facebook: Ramanomics
Copyright 2012 Rama V. Ramachandran