Corporate Kleptocracy at RJR Nabisco

Of the many worries facing shareholders, the potential for destruction by incompetent or irresponsible management is a big one. A CEO can hurt a company in various ways, by steering it the wrong way, diversifying too much or too little, or expanding at the wrong times. Occasionally, the damage is intentional and wanton. The case of RJR Nabisco is a prime example of corporate kleptocracy from the 1980s.

The behind-the-scenes drama was retold in a now-classic business book, Barbarians at the Gate: The Fall of RJR Nabisco, by Brian Burrough and John Helyar.

The Doldrums

In the 1980s, tobacco giant R.J. Reynolds was in despair about its future. It was a one-product company, and the product was cigarettes.

Public attention to the health risks associated with tobacco use was increasing. Litigation was getting costly and smokers were quitting. CEO J. Tylee Wilson decided to search for another business to merge with—ideally, a company that offered an upside to counteract the expected declines in his company's core business.

Why Nabisco

The best candidate, according to Wall Street advisors, was Nabisco Brands. Nabisco Brands was already a merged company. It had been created in 1981 by combining two food companies, Standard Brands and Nabisco. The CEO of the original Standard Brands, F. Ross Johnson, had managed to stay on through the merger and wrest control of the new entity.

Johnson had established a clear modus operandi despite holding the CEO post at only two companies. His first moves after taking charge at Standard Brands and, later, Nabisco Brands was to ingratiate himself with the board of directors, increase management compensation, and pile on the management perks.

The CEO's compensation at Standard Brands tripled when he took over, and company jets and Jaguars soon followed. The same thing happened with Nabisco Brands, with Johnson seizing the reins within three years of the merger.

A Record-Breaking Merger 

In the spring of 1985, Wilson and Johnson met to discuss a friendly merger in which Wilson would become chair of the new company. Johnson disliked the vice-chair title he was offered and asked for the post of president and chief operating officer. Wilson countered by suggesting Johnson could have the top post when Wilson retired two years later.

In the end, Wilson was more desperate for the deal than Johnson. Wilson had to pay a high premium for Nabisco, and Johnson pushed through demands for various perks and the two posts in a sweetheart deal that saw R.J. Reynolds finally acquire Nabisco Brands for $4.9 billion.

The creation of RJR Nabisco was at the time a record-setting merger for non-oil companies.

The Insider-Trading Angle

The cost of the merger increased when stock trader Ivan Boesky bought Nabisco stock prior to the merger, signaling the takeover to the market and making a tidy sum in the process. It was one of the trades that fueled an investigation into Boesky's activities and resulted in his eventual conviction for insider trading.

As for the newly christened RJR Nabisco, the two CEOs soon found that they had very different views on management. Wilson was cost-conscious; Johnson spent freely. Johnson got close to the board of directors and managed to open a rift between the board and Wilson.

It took him less than a year to wrest the top post from Wilson.

The Party Begins and Ends 

With RJR Nabisco, Johnson had a much bigger larder to raid. Management salaries and perks quickly grew to outsized proportions. Johnson reportedly billed two dozen country club memberships and a fleet of 10 private planes to the company. His annual salary was about $1.7 million, a tidy sum at the time.

When Johnson ran into trouble with the new board chair for his growing expense, he managed to replace the chair with someone more sympathetic and began filling other key positions with friends.

In the meantime, RJR Nabisco was in the doldrums. It took a huge hit in the 1987 crash, dipping from around $70 per share to the low $40s.

The LBO Option

Johnson believed that the bad publicity surrounding tobacco products was holding back the less controversial and more profitable foods division of the company.

He started putting out feelers for merger candidates and asking investment bankers for ideas. Several suggested a leveraged buyout (LBO) with shareholders taking the tobacco business and Johnson and his management taking Nabisco private.

Johnson initially didn't like this idea because owing money to a bank would bring significant management oversight, thus forcing him to restrain his spending.

About the Leveraged Buyout

The leveraged buyout was a relatively new idea at this time. It grew out of a single sensational deal in 1982, when several investors put up $1 million, borrowed $79 million, and bought Gibson Greetings for $79 million. Eighteen months later they sold the company for $290 million, a profit that caught the attention of would-be corporate raiders everywhere.

Later on, there was an unholy alliance of the leveraged buyout and so-called junk bonds. These bonds, whose nickname reflects the level of risk they represent to their investors, became a new way to fund buyouts.

Meeting With Raiders 

In 1988, Johnson met informally with Kohlberg Kravis & Roberts, better known as KKR. Henry Kravis of KKR talked about the benefits of LBOs, including the tightening of management and improved efficiency.

That wasn't necessarily what Johnson wanted. However, after talking with KKR, Johnson was convinced by some of the benefits of an LBO, namely an additional influx of money.

When RJR Nabisco's price continued to languish, Johnson began buying back shares to try and force up the price—spending $1.1 billion in the process—but the price dropped back down again.

Johnson feared the low stock price would attract corporate raiders, so he began building defenses.

In the meantime, Kravis started to wonder about Johnson's lack of follow-up on his proposal. Kravis started to run numbers on taking over RJR Nabisco.

In Play 

Johnson was in fact working with Shearson Lehman Hutton to bring a completed LBO to the meeting to avoid bringing the company into play, where it could be auctioned to the highest bidder.

Johnson's terms for the LBO were control of the board and 20% of the stock for himself and seven managers—stock that was projected to be worth billions in five years—without putting up any of his own money.

Johnson's terms stunned everyone involved, including the investment banking team that was working with him. Johnson offered a buyout at $75 a share or about $17 billion.

The board refused outright. Its members were shocked to find a black knight on their own payroll. The board issued a press release, putting the company into play while they considered their options.

And that is where Barbarians at the Gate gets its name. Once made public, the offer created a bidding war that would eventually push the price for RJR Nabisco to $25 billion.

Battling for Oreos and Camels 

KKR swooped in and offered the board $90 a share, touching off a bidding war. KKR wanted the company, but they didn't want Johnson anymore.

Johnson's team upped its bid to $92. The board decided that the company would sell itself to the highest bidder.

KKR raised its bid to $94, including $75 in cash and $19 in other securities, including Drexel junk bonds. Johnson's team bid $100 a share, including $90 in cash and $10 in other securities.

At the last minute, First Boston came in as a gray knight with a bid of $118, causing the board to extend its deadline for a deal. But the First Boston bid turned out to be poorly financed.

Upping the Ante

Johnson upped his bid to $101, and KKR bid $109. Board members and many shareholders had turned against Johnson by this time. Johnson tried $112, with $84 in cash and the rest in securities.

Ultimately, KKR's deal was chosen at $3 less.

The justification was that the superior financing of the KKR bid would require less gutting of the company to pay off debts. However, many saw it as a final snub of Johnson.

The $25 billion deal set yet another record non-oil takeover and the biggest LBO ever. Johnson was fired by KKR but still got his record-making $23 million golden parachute.

And RJR Nabisco was saddled with a crushing $25 billion in debt.

Nabisco Lives on 

For years after the deal, RJR Nabisco continued to get juggled about. KKR cut jobs and divisions, spinning the international tobacco business off to Japan Tobacco. The domestic parts, both tobacco and food, were separated and recombined in a shuffle involving almost as many players as the original dance—even Carl Icahn was in there.

In June 2000, Philip Morris (PM) purchased Nabisco for $14.9 billion, as reported by the BBC. Nabisco was integrated into Kraft General Foods by Philip Morris. Kraft Foods was spun off as a separate company in 2007, and eventually, the company split into two with Nabisco becoming part of the newly formed Mondelez International Inc. (MDLZ) in 2012.

As it turned out, RJR Nabisco represented the height of the LBO craze even as it highlighted corporate excesses. It was the last big LBO of the decade, and that kind of corporate restructuring has largely fallen out of favor since.

The Fallout

The RJR Nabisco story started a debate over the ethics of Wall Street and the outsized greed of some of its participants.

In particular, the leveraged buyout were examined. The LBO was an opportunity to create a huge profit for a few by sucking a massive amount of value out of a company, leaving an outsized debt behind.

Leveraged buyouts still occur, although not perhaps with the bald-faced motive of plundering a company that motivated the early examples, Today's LBOs may involve buying a company that is underperforming in order to take it private and restore it to health.

The Bottom Line

Corporate kleptocracy refers to the use of underhanded tactics by corporate executives to siphon off wealth at the expense of shareholders. The scandal at RJR Nabisco is a good example of corporate kleptocracy in the 1980s. When F. Ross Johnson became CEO of Nabisco Brands in 1986, he increased management's compensation and perks, used the company's accounts for his own personal spending, and installed friends on the board of directors. These actions led to high expenses and a declining stock performance and price.

In 1988 the firm KKR acquired RJR Nabisco for $25 billion, in one the largest leveraged buyouts in U.S. history. Johnson was fired as CEO after he had essentially exhausted the company's funds.

The case of RJR Nabisco started a debate over the ethics of Wall Street and the outsized greed of some of its members.