The Nestle crash

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The Nest16 crash

Claudio Loderer*, Andreas Jacobs

Institut ftir Finanzmanagement, Vniversitiit Bern, 3012 Bern, Switzerland (Received July 1992; final version received June 1994)

Abstract

On November 17, 1988, the board of directors of Nestli AG decided to allow foreign investors to hold NestK registered stock, reversing a longstanding practice. This decision had a tremendous impact on the prices of the firm’s three classes of common stock, as well as on the prices of several other corporations traded on the Ziirich stock exchange.

These price changes can be explained by the hypothesis that demand curves slope down.

Key words: Liquidity; Price elasticity of demand; Multiple stock classes; Crash; Antitake- over amendments

JEL classijcation: G15; G32; G34

1. Introduction

Many Swiss corporations have long been legally able to exclude certain groups from effective ownership of their registered shares. The first Swiss

*Corresponding author.

We are especially indebted to Daniel Regolatti (Senior Vice President Finance, Nest16 AG) for valuable information and detailed comments. We are also grateful to Michael Jensen, Christian Luhicz of Credit Suisse, Richard Ruback (the editor), Thomas Piper and Kenneth Froot (referees), and an anonymous referee for helpful suggestions and information. Moreover, we wish to thank Paul Malatesta, Nils Pallmann, Dennis Sheehan, Rent: Stulz, and participants in the ESSEC-AFFI International Conference in Finance and the 1992 European Finance Association Meetings, as well as participants in finance workshops at the University of Rochester, the Universitlt Basel, and the Universitt de Genkve, for their comments. We are grateful to Telekurs AG for providing the stock return data used in this study, and to Urs Altorfer, Ueli Fankhauser, Alain Jenny, Roland Kuhny, Stefan Rgbsamen, and Stefan Zumtaugwald for their research assistance. Earlier drafts of the paper carried the title ‘The Lure of Liquidity’.

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316 C. Loderer, A. Jacobs/Journal of Financial Economics 37 (1995) 315-339

corporate law, passed in 1881, provided for this possibility, leaving specific provisions to individual corporate charters. Investors are commonly required to be Swiss nationals. This paper investigates the market’s reaction when Nestle AG decided to relax its restriction against foreign investors.

Until 1988, Nestle’s registered stock (R stock) could be held only by domestic investors acceptable to management. Foreign investors could trade freely in the other two classes of stock, voting and nonvoting bearer shares (VB and NVB stock). Nestle’s voting bearer stock was selling for about twice the price of the registered shares when, on November 17, 1988, Nestle’s board decided to allow foreign investors to hold registered shares. At the same time, it announced plans to seek approval for a series of antitakeover amendments to the corporate charter limiting the fraction of R shares (and votes) that any single investor could control.

As Fig. 1 shows, these decisions had a dramatic impact on Nestle’s share prices. From the closing on November 15, 1988 (two trading days before the decisions were announced) to the closing on November 22 (two trading days after the announcement), the price of the VB stock dropped by 24%, the NVB stock price fell by 15%, and the price of the R stock surged by 33%. Nestle’s was not the only stock to react. The decisions also had a substantial impact on Ziirich’s stock exchange as a whole, which is why traders refer to the event as the Nestle crash: whereas R stock prices increased slightly, prices of VB and NVB

Swiss Francs

voting bearer stock price:

Nest14 registered stock price November 19.1988

1 I

Jan 5.1907 Jan 4.1988 Dee 29,1900 Jan 4.1990 Dee 28,199O

Fig. 1. Daily prices of NestlBs voting bearer stock and registered stock; sample period: January 5, 1987 to December 28, 1990.

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stock fell substantially. There were no contemporaneous changes in marketwide risk perceptions or in time and risk preferences (Jacobs and Loderer, 1993).

This paper examines the Nestle. decisions and their motivation. We also analyze the impact on Nestle’s share prices and on the Swiss equity market as a whole to gauge the costs and benefits for the affected shareholders. Although the price increase for the registered stock does not appear to have surprised anyone, the decline in the bearer stock price shocked most observers. Conse- quently, we focus on that decline, and consider four possible explanations. We also discuss the consistency of each explanation with the price increase in registered stock.

One explanation is that the market corrected Nestle’s and other firms’ VB stock prices in anticipation of antitakeover amendments which could have made a takeover of Nestle (and of any other firm that adopted them) more difficult, allowing management to entrench itself and heightening concerns about future dissipation of shareholder wealth. In such an event, the value of Nestle’s (and other firms’) bearer stock would have declined.

Alternatively, because Nestle’s decision to allow foreign ownership of registered stock made bearer and registered shares more fungible, the decision could have been seen as evidence that the firm intended to abolish its bearer shares, something Nestle actually did later, in 1993. If foreign shareholders held Nestle bearer stock to evade taxes or to conceal their wealth, these shares would have become much less attractive when Nestle signaled its intention to eliminate them.

A third possibility is that Nestle’s decision to make R stock more fungible with VB stock is equivalent to a sale of stock by insiders. Assuming that insiders held R stock, they could have forced the policy change when they realized that the VB stock was overvalued. A rational capital market would have understood this logic and slashed the VB stock price of Nestle and all firms in which corporate insiders had the option of following suit. According to this hypothesis, Nestle set an important precedent - that a firm could liberalize ownership and would presumably do so in a way that benefited insiders at the expense of outsiders.

Finally, the observed price reaction could have occurred because the demand function for individual stocks slopes downward (i.e., its price elasticity is finite).

Under this hypothesis, Nestle’s decision to allow foreigners to hold its registered stock essentially increased the number of VB shares in the international market;

a larger supply should depress the price. The price of NVB stock should have fallen for the same reason, since R stock represents a claim on future cash flows similar to that represented by NVB stock.

Overall, the evidence is inconsistent with explanations that focus on agency problems, tax evasion and wealth concealment, and signaling. Of the four interpretations of the Nestle crash considered here, the only one broadly consistent with the evidence relies on the notion of finite price elasticities of

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318 C. Loderer. A. JacohsJJoumal @Financial Economics 37 (199.5) 31.5339

demand for VB stock. Since Nestle had a market capitalization of almost SFr 21 billion in equity alone at the time in question ($14 billion at an exchange rate of SFr 1.45 to the dollar), the phenomenon documented here has more than local relevance.

The paper is organized as follows. Since much of the discussion revolves around institutional characteristics specific to Swiss corporations, the next section briefly discusses those peculiarities and then summarizes the relevant aspects of Nestle’s decisions. The third section documents the price reactions to Nestle’s decisions, and Section 4 interprets those reactions. The last section draws conclusions.

2. Institutional details 2. I. General considerations

Most publicly traded corporations in Switzerland have up to three classes of common stock outstanding: voting bearer stock, nonvoting bearer stock, and registered stock. Nonvoting bearer stock may or may not have a par value. The most popular kind has a par value and is called a participation certificate. Some privately held corporations also have nonvoting registered stock outstanding.

Only voting bearer stock and registered stock possess voting rights (generally one vote per share). All three classes, however, represent financial claims that are proportional to their par values. For example, if R shares have a par value of SFr 50 and VB shares a par value of SFr 100, VB shares are entitled to twice the dividend payout of R shares. The same logic applies to any other distribution.

If they have the same par value and if we ignore voting rights and differential liquidity, the three classes of stock should sell for the same price. As it turns out, the par value of R stock is never higher but is often lower than that of VB stock, which is one reason R shares tend to sell at a discount to VB shares. In such cases, more votes can be controlled with the same capital by buying R stock rather than VB stock. Even correcting for different par values, however, VB stock generally sells at a premium to R stock. In our sample, as explained below, the average premium is 26%.

The main difference between VB and R stock is that VB shares can be traded without restriction, whereas new buyers of R stock must be registered by the corporation to claim the rights vested in the stock. Criteria for acceptability for registration are laid out in the corporate charter. (The new corporate law, which took effect in the summer of 1992, significantly curtails discrimination against unwanted buyers of R stock; what follows, unless explicitly stated, refers to the situation before 1992.) Historically, one criterion was that shareholders be Swiss nationals. Corporate charters can also authorize the board to reject prospective shareholders without providing specific reasons. Most firms seem to prefer this generic authorization to a detailed list of acceptability criteria (Kaufmann and

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Kunz, 1991, p. 12). We do not know of any arbitrage attempts (short of a takeover) to benefit from the price differences among the different classes of stock in any one firm. Conceivably, an investor could attempt to arbitrage a positive price differential between VB and R stock by buying R shares and selling, for a higher price, homemade bearer shares that promise the same payoffs. The board would probably refuse to register such an investor, however.

Investors who fail to be registered are in principle entitled to any cash distribution, but have no voting rights. In Switzerland, however, trading on the stock exchanges is carried out by banks, and banks have an agreement with listed corporations to help them enforce the restrictions on registered stock.

Consequently, the possibility of owning shares of registered stock without actually being registered is slight.

The main reason to restrict registration of new shareholders would seem to be to give the controlling majority or management a shield against undesirable shifts in ownership and unsolicited takeover attempts. (Nestle has never had a controlling majority except in the very early stages of its existence, 1867-1905.) Consistent with this conjecture, R shares control a median 71% of all votes in our sample corporations and claim an absolute majority in more than 75% of the firms, while making up only 48% of the market value of equity (Table 1).

The third major class of stock, nonvoting bearer stock, typically has a lower par value (when specified) than either registered or voting bearer stock. Since payouts are proportional to par value, NVB shares tend to sell at a discount to VB shares. But NVB shares sell at a discount even when par values are the same;

in the sample of firms analyzed here, the discount is 32%, possibly because NVB shares lack voting rights or perhaps because NVB stock is not even mentioned in the corporate law (the 1992 revision has changed that). As a consequence, the legal rights of NVB stockholders are ill-defined. Among other things, the acquiring party in a corporate takeover has no obligation to buy out the owners of NVB shares or to extend them an offer commensurate with that made to the holders of voting shares. The Swiss takeover code, an agreement reached in 1991 by the association of Swiss stock exchanges after the events we are examining here, requires the acquirer to extend the same offer to all stock classes in a firm if the takeover leads to control of more than 50% of the votes outstanding, but does not specify the penalty for noncompliance. NVB stock also appears to trade in a thinner market than VB or R stock (Loderer and Zimmermann, 1988).

The ill-defined legal status of NVB stock and the fact that it represents only 11%

of the average capital structure (Table 1) are the reasons for focusing mainly on VB and R stock.

2.2. Nestlk ‘s decisions

On November 17,1988, Nestle’s board of directors decided to lift the prohibi- tion against foreign buyers of its registered stock. The announcement was made

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Table 1

Capital structure of Swiss corporations: Descriptive statistics

The variables shown are based on a comprehensive sample of42 firms with the necessary data. All computations are as of November 151988, two trading % 9 days before Nestlt’s decision to accept foreign investors as registered shareholders. Definitions of variables are as follows: # R = aggregate shares of a registered stock, # VB = aggregate shares of voting bearer stock, RM = aggregate market value of registered stock, VBM = aggregate market value of b

voting bearer stock, NVBM = aggregate market value of nonvoting bearer stock. 8

P Number of

firms Minimum Maximum

25th

percentile Median”

75th Standard 2 2

Average percentile deviation 2

E.

#R 42 0.333 0.960 0.600 0.712 0.700 0.806 0.138 : -.

#R+ #VB $

#VB

#R+ #VB 42 0.040 0.667 0.194 0.288 0.300 0.400

RM 42

RM+VBM+NVBM

VBM 42

RM + VBM + NVBM NVBM

RM + VBM + NVBM 33

0.128 3.826 0.294 0.482 0.457 0.587

0.043 0.405 0.072 0.136 0.113 0.198

0.418 0.426 0.518

Y

0.183 2

5’

0.189 e

2

“Not all firms in the sample have NVB shares outstanding, which explains why the median fractional values of capital structure do not add up to 100%. h ‘c

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after the closing of the Swiss stock exchanges (Zurich is the main exchange). At the same time, the board announced it would ask stockholders to approve the following corporate charter amendments (Blrtschi and Gerber, 1991):

l To limit the fraction of R shares controlled directly or indirectly (through contractual agreements) by any natural or legal person to 3%. The board can make exceptions, but it can also retroactively deny registration of shareholders not meeting those ceilings.

l To limit the fraction of votes directly or indirectly controlled by any one stockholder to 3% of all votes outstanding, although the board can make exceptions.

l To require a three-fourths majority of voting shareholders for corporate charter amendments, including the amendment of this provision itself. The minimum quorum needed for such meetings is two-thirds of the shares outstanding. The intention was to require an absolute majority of the shares outstanding to approve major amendments ($ of 4 is 50%).

On November 15, two trading days before the decisions, Nestle’s capital structure was as given in Table 2. Although R shares had the same par value as VB shares, R stockholders controlled 67.5% of the votes outstanding while contributing only 47% to Nestle’s aggregate equity value. At the time it was announced, the proposed 3% limit on R stockholdings corresponded to a SFr 300 million investment ($207 million at an exchange rate of SFr 1.45 to the dollar).

In a press release and a letter to stockholders, Nestle’s board cited three reasons for its decision and the proposed amendments. First, it was concerned about the company’s international image, since only 2% of Nestle’s sales originate in the domestic market. Nestle’s takeover practices had been some- what controversial. Critics pointed out that Nestle was going after recalcitrant

Table 2

Nestli’s capital structure on November 15, 1988 Voting bearer shares

Nonvoting bearer shares

Registered shares Number of shares

Par value per share Percentage of votes Price per share Percentage of total

market value of equity

1,073,000 SFr 100 32.5%

SFr 8,790 46%

1,150,OOO SFr 20

0%

SFr 1,280 7%

2,227,OOO SFr 100

67.5%

SFr 4,310 47%

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322 C. Loderer. A. Jacobs/Journal of Financial Economics 37 (1995) 315-339

targets (such as the British firm Rowntree) while shielding itself from unwanted suitors with restrictions incompatible with free markets. Politicians and regula- tors in other countries could have used these arguments as an excuse to constrain Nestle’s activities.

Second, lifting the restriction on foreign ownership of R stock would reduce Nestle’s cost of capital. The firm had previously raised equity by issuing all three classes of stock, a costly practice since R shares sold for half the price of VB shares while being entitled to the same distributions. The firm hoped that lifting the restriction against foreign shareholders would bring the price of R stock more in line with that of VB stock, which would reduce the cost of capital. The obvious alternative would have been to raise equity by issuing only VB stock.

The third reason given was that it would be in shareholders’ interests to adopt amendments guaranteeing the firm’s independence. The board’s concern about independence is easy to see. The price differential between Nestle VB shares and R shares could have been viewed as a golden takeover opportunity. Technically, a raider would have needed only 10% of the votes (obtained by purchasing VB stock) to call an extraordinary shareholder meeting to abolish all the restrictions against registration of new shareholders. The raider could have simultaneously extended a tender offer for 69.4% of the R shares, conditional on approval of the amendment, to obtain control of the corporation (69.4% of the R shares plus 10% of the VB shares represented 50.1% of the votes outstanding). In principle, since unrestricted R shares should have sold for the same price as VB shares, a raider could have extended an all-or-nothing offer at a price below the market price of VB stock (and above the price of R stock) in the hope of clearing the difference. In this situation, the board may have felt that the amendments were necessary to shore up Nestle’s antitakeover defenses. Her- mann and Santoni (1989) suggest that Nestle’s decision to allow foreign investors opened the gates for potential takeovers from abroad, although the boards simultaneous request for approval of the antitakeover amendments makes it unclear whether Nestle’s policy changes, taken together, increased the probability of takeover.

On May 25, 1989, the proposed amendments were approved by the vast majority of the votes cast (48% of the votes outstanding were represented at the meeting). Since R shares were trading at half the price of the VB shares, it is reasonable to assume that the holders of R shares, most of them domestic investors, favored and possibly even lobbied for the registration policy change.

The change was also made easier by the belief that a small price decline in VB stock would suffice to entice international investors to hold Nestle’s R shares, now that they were almost fully fungible with VB shares. As Nestle insiders have confirmed, the firm thought that SFr 50 million of its own and an additional SFr 100 million through Credit Suisse would stem any temporary VB stock price decline. As it turns out, the decline was SFr 2.3 billion.

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3. Empirical results

3. I. Ned stock price behavior

As Fig. 1 shows, NestlC’s decisions had a dramatic impact on its share prices.

According to panel A of Table 3, from the closing on November 15, 1988 (two trading days before the closing on November 17, when the decisions were announced) to the closing on November 22 (two trading days after November 18, the day on which the Swiss financial markets were able to react to the announcements), the VB stock dropped by 24%, the NVB stock fell by 15%, and the R stock surged by 33%. All of these changes are statistically significant.

Registered shareholders as a group gained SFr 3.2 billion, while holders of voting and nonvoting bearer shares lost SFr 2.5 billion (panel B). Overall, aggregate equity value increased by SFr 661 million.

These price changes altered the price differentials between the various stock categories. As illustrated in Fig. 2 and detailed in panel C of Table 2, the price differential between VB and R stock, defined as the ratio of the respective adjusted prices, was almost erased, dropping from 2.0 to 1.1. Similarly, the differential between VB and NVB stock fell from 1.3 to 1.1. All of these changes are statistically significant with confidence well in excess of 99%. (Since price differentials are nonnormally distributed, the significance test is nonparametric.)

The NestlC stock price changes do not appear to be short-run. We estimate the market model from January 1, 1990 through December 31, 1990 with the Swiss Performance Index’s (SPI) stock market index, a value-weighted index covering 98% of the market capitalization, and use the parameter estimates to compute cumulative abnormal returns (CAR) for VB stock. CARS are estimated over the first 50 trading days following the (- 2, + 2) event-time window analyzed so far (time 0 is November 18, the first trading day after Nest& decision announcement, which came after the closing on November 17). The market model is estimated with post-event data out of a concern that the change in registration policy could have changed the risk characteristics of Nestli’s VB stock; using pre-event market model parameters could bias the results (as it turns out, it does not). The results are summarized (event time intervals in top row and CARS below) as:

ET1 CAR ,,;;3;3) h; +4) f.“,; +5) (+3, +6) (+3, +7) (+3, +13) (+3, +23) (+3, +33) (+3, +53)

0 0 0 1.6% 1.3% -0.5% 0.5% -0.9% - 1.9%

The CARS are very small. More importantly, they provide no evidence of a rebound in the price of VB stock.

NestlC’s VB shareholders, particularly the French nationals who held about 30% of this stock, reacted vehemently to these developments. Some wrote and threatened to sue, although nobody actually did sue, possibly because the board had not overstepped its authority or possibly because the VB stock price rose

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Table 3

Announcement effect of Nestle’s policy changes

Price changes are computed from November 15 to 22,1988. Price differentials are computed as equally weighted averages of firm-specific ratios of the stock prices of the categories in question during the 30-day period preceding and including November 15 and during the 30-day period from November 22 on. Two price differentials are shown: between voting bearer and registered stock and between voting bearer and nonvoting bearer stock. Prices are adjusted to reflect equal par values. Definitions of variables am as follows: VE = voting bearer stock, N VE = nonvoting bearer stock, R = registered stock.

Panel A: Price changes Prices on November 15, 1988 Prices on November 22, 1988 Change

Daily-return standard deviation t-statistic

Probability value

Panel B: Changes in equity value Aggregate change

Change in total equity value

VB stock

SFr 8,190 6,650 - 24.35%

0.52%

- 20.94

< 0.001

SFr - 2,300 million

R stock

SFr 4,310 5,740 33.18%

0.47%

31.57

< 0.001

SFr 3,180 million

NVB stock

SFr 1,280 1,090 - 14.84%

1.09%

- 6.09

< 0.001

SFr ~ 219 million SFr 661 million

Panel C: Changes in price differentials

Median relative price differential VB/R stock, 30-day period ending November 15, 1988 2.020

Median relative price differential VB/R stock, 30-day period starting November 22, 1988 1.120

Wilcoxon-Mann-Whitney rank test, z-value ~ 6.653

Probability value < 0.001

Median relative price differential VB/NVB stock, 30-day period ending November 15, 1988 Median relative price differential VB/NVB stock, 30-day period starting November 22, 1988

Wilcoxon-Mann-Whitney rank test, z-value Probability value

1.346 1.133 - 6.653

< 0.001

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1.6

1.4

1.2

1

0.8

NestI& ratio of voting bearer share price to registered share price

NestI& ratio of voting bearer share price to nonvoting bearer

share price November 18.1988

+--

Jan 5,1987 Jan 4.1988 Dee 29.1988 Jan 4.1990 Dee 28.1990

Fig. 2. Daily adjusted price differentials of Nest16 stock; sample period: January 5, 1987 to Decem- ber 28, 1990. Since payouts are proportional to par values, the price of nonvoting bearer stock is adjusted by multiplying it by five to obtain the same par value as that of the other two classes.

with the rest of the market and recovered fully within a few months of the decisions. According to Nestle insiders, however, there was no dumping of bearer stock by foreign investors as a group. Even though Swiss firms do not know their VB shareholders by name, a rough estimate of their nationality is possible from information gathered at the stockholders’ meetings and from information provided by the financial intermediaries, usually banks, that handle dividend collection for shareholders. Foreign ownership of Nestle VB stock was about 85% before the Nestle crash and remained at that level thereafter. Moreover, foreign ownership of Nestle R stock actually increased: it quickly rose from about 15% before the decisions (which shows that the restriction against foreign ownership of registered stock was not airtight) to 45% thereafter.

Interestingly, the board committee charged with examining the issue of allowing foreigners to hold registered shares had originally thought of asking for shareholder approval. This idea was dropped when some members voiced concerns about how the market would react; if the reaction penalized VB shareholders, the argument went, they would oppose the change in registration policy. For the same reason, various schemes to compensate VB and NVB shareholders for any losses they would incur were rejected. All compensation plans would have called for a preferential treatment of bearer stock and, under the law, would have therefore required the approval of all stockholders, something unlikely to happen.

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3.2. Partial anticipation

Nestle’s decisions seem to have caught the market unprepared. According to press accounts, it was in September 1988 that the board committee started considering management’s proposal to allow foreigners to hold registered shares; management itself had been toying with the idea for two years. No outside consultants were hired, although the committee included the two directors representing Credit Suisse and Swiss Bank Corporation. In the end, about 25 persons knew about the upcoming decisions. Yet there is only minor evidence that any insiders traded on or before November 17, 1988, when the decisions were formally made. Since the decisions were announced only after the closing of the Swiss exchanges, the earliest the Swiss financial markets could have reacted, in the absence of any information leaks, was November 18, although London traders reacted on the evening of the 17th. There is no evidence of abnormal stock price performance before November 18, and, as argued below, trading volume changed little, if any.

Since trading volume on the Zurich stock exchange was a well-guarded secret until recently, it is difficult to tell conclusively whether traders shorted Nestle VB stock and bought R stock before the decisions became public. A gauge of that activity can be obtained by looking at the number of daily transactions in Nestle stock. That statistic, displayed in Fig. 3, provides no evidence that insiders capitalized on their knowledge. The number of trades in both VB and R stock increased dramatically but only after the decisions. During the first week following the decisions, the average number of daily transactions in VB stock more than tripled (82 versus 26). Yet the number of transactions on November 17 (28) is only slightly above the average number (27) a week before. It is possible, however, for insiders to trade large blocks off the exchange.

Another place to look for clues to insider trading is the options market.

Market participants may have attempted to benefit from or at least to hedge against a likely decline in the price of VB stock by buying put options on Nestle VB stock on the Swiss Options and Financial Futures Exchange. In the 35 trading days preceding November 18, the number of open put contracts reaches a maximum on November 17. An abnormal increase cannot be excluded. There are 128 more contracts outstanding on November 17 than on November 16.

Even if this increase is significant, however, the dollar amount involved is relatively modest, since there are only five shares in any one option contract.

3.3. Reactions by otherjirms

3.3. I. The sample of firms considered

Nestle’s decisions affected the market as a whole. To document this reaction and to examine the stock price changes of corporations that subsequently imitated Nestle and relaxed their restrictions against foreign investors, we study

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Number of Trades

Novemhcr 18.1988 --

7

0‘3 3.19RR ocll7 OCt 31 Nov 14 NW 2X Ike I? 1xX 27 Jan 12.19x9

Fig. 3. Number of daily trades in Nest16 shares on the .&rich stock exchange

all firms with at least two classes of stock (R and VB) traded on the Zurich stock exchange starting on January 1, 1987 and with no discontinuities in the corresponding daily-price time series. Forty-two firms meet these requirements:

there are 42 R stocks, 42 VB stocks, and 27 NVB stocks. Stock prices are last- trade-of-the-day prices.

Data on par value and number of shares outstanding are from various issues of Union Bank of Switzerland’s Swiss Stock Guide. Since payouts (including any liquidating dividend) are proportional to par values, all prices are corrected to reflect the same par value and therefore the same claim to future cash distributions. For instance, the par value of Union Bank of Switzerland’s (UBS) R shares is SFr 100, that of its VB shares is SFr 500, and that of its NVB shares is SFr 20;

comparability therefore requires that the price of R shares be multiplied by 5 and the price of NVB stock by 25.

One problem with our procedure for making the different stock classes comparable is that it ignores voting rights. In the numerical example above, a portfolio of five registered UBS shares has five votes compared with only one for the UBS voting bearer share. If the marginal value of a vote is positive, the five R shares should be more valuable than one VB share. Alternative adjustment procedures have their own problems, however; more importantly, they do not seem to yield different results. Stulz and Wasserfallen (1993), for instance, attempt to make VB shares equivalent to R shares by adding

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(F(R) - F(I/B))/F(NL’B) of NVB shares to one VB share, where F( .) indicates face value. This adjustment modifies the financial claim (par value) of one VB share without changing its voting rights: one adjusted VB share has the same voting rights (one vote) and the same claim to future dividends as one R share.

The problem with this adjustment is the assumption that, except for voting rights, VB and NVB shares are equivalent. Given the ill-defined legal status of NVB shares, this assumption is troublesome.

3.3.2. Market reaction to Nestl4’s decisions

Nestlt’s decisions liad a significant effect on the other sample firms, none of which formally allowed foreign ownership of its R stock at the time. From the evidence, it appears the market concluded that many of them would follow Nestlt’s lead. Consistent with the Nestlt pattern, VB and NVB stock prices fell substantially: the median price decline for VB stock was 3.6% and that for NVB stock was 5.2% (Table 4, panel A). Both changes are statistically significant with 99% confidence. Surprisingly, however, fewer than 60% of the R stocks rose in price, for a median increase of less than 0.7% (not significant). Overall, aggregate equity values fell by a median SFr 3.8 million, and only 24% of the firms ended up with higher values (Table 4, panel B).

As with Nestlt, these price changes had a significant effect on the price differentials between the stock categories (Table 4, panel C). The differential between VB and R shares (defined as the ratio of their adjusted prices) fell from 1.2 to 1.1 and that between VB and NVB shares dropped from 1.5 to 1.4. Both changes are significant with better than 99% confidence according to a Wilcoxon-Mann-Whitney rank test.

As a comparison, we computed the contemporaneous VB stock returns for a separate sample of firms without any registered stock outstanding. This sample includes 29 firms, most of them very small. The VB stock prices of these firms changed little if any over the five trading days from the closing on November 15 to the closing on November 22: their return was less than - 1.1%

with a t-statistic of - 1.1.

As noted earlier, the results in this section could be different with an adjustment procedure that took voting rights into consideration. To shed light on this possibility, we repeat the investigation of Table 4 with a sample of 15 firms whose VB and R shares have the same nominal value. Contrary to the claim that voting rights are driving the results, voting bearer shares drop a median 7.6%

and registered shares rise a median 3.2%; by comparison, in the complementary sample (firms in which VB shares have a higher nominal value than R shares), VB shares fall a median 2.6% and R shares increase a median 1.0%. All changes are significant with 99% confidence. If the adjustment procedure were driving the results, the price decline of VB shares would be confined to the complementary sample.

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Table 4

Announcement effect of Nestfir’s policy changes on other firms’ prices

Price changes are computed from November 15 to 22, 1988. Price differentials are computed as equally weighted averages of firm-specific ratios of the stock prices of the categories in question during the 30-day period preceding and including November 15 and during the 30-day period from November 22 on. Two price differentials are shown: between voting bearer and registered stock and between voting bearer and nonvoting bearer stock. Prices are adjusted to reflect equal par values.

Definitions of variables are as follows: VB = voting bearer stock, NVB = nonvoting bearer stock.

R = registered stock.

VB stock R stock NVB stock

- Panel A: Individual stock price changes

Number of observations Minimum

25th percentile Median Average 75th percentile Standard deviation

Proportion of positive changes Sign test, z-value

41 - 19.69%

- 1.33%

- 3.55%

- 4.58%

0%

6.09%

17%

- 4.23

41 - 6.30%

0%

0.68%

1.40%

3.22%

3.05%

59%

1.15

27 - 17.28%

- 9.51%

- 5.20%

- 5.95%

- 1.90%

5.10%

3.7%

- 4.82 Panel B: Aggregate equity changes

Minimum 25th percentile Median Average 75th percentile Standard deviation

Total equity change

- 6.81%

- 4.59%

- 1.63%

- 1.69%

- 0.04%

3.14%

SFr - 680 million SFr - 84 million SFr - 3.75 million SFr - 88.12 million SFr - 0.09 million SFr 175 million 24.4%

- 3.28 SFr - 3,613 million Panel C: Changes in price differentials

Median relative price differential VB/R stock, 30-day period ending November 15, 1988 1.245 Median relative price differential VB/R stock, 30-day period starting November 22, 1988 1.103

Wilcoxon-Mann-Whitney rank test, z-value - 6.653

Median relative price differential VB/NVB stock, 30-day period ending November 15,

1988 1.468

Median relative price differential VB/NVB stock, 30-day period starting November 22,

1988 1.369

Wilcoxon-Mann-Whitney rank test, z-value - 6.387

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330 C. Loderer, A. Jacobs/Journal of Financial Economics 37 (1995) 315-339 Table 5

Nestle-type events, November 1988 to June 1992

Firm name Event date

Excess return

VB stock t-stat.

Excess return

R stock t-stat.

Jacobs Suchard AG June 21, 1989 - 3.1% - 2.28 8.0% 2.94

Ciba-Geigy AG February 21, 1990 - 6.8% - 4.13 5.4% 2.19

BBC Brown Boveri AG March 22, 1990 - 3.9% - 1.78 6.5% 1.69

Forbo AG April 2, 1990 3.8% 1.09 - 2.2% - 0.47

Mikron Holding AG June 19, 1990 2.1% 0.48 - 1.5% - 0.52

Holvis AG June 25, 1990 - 8.4% - 1.60 1.8% 1.78

Alusuisse March 5, 1991 1.6% 0.66 3.8% 1.02

3.3.3. Reactions to Nestlhype decisions

We also examine what happened when firms followed Nestle’s lead and allowed foreigners to own their R stock. The problem with this analysis is partial anticipation. The uncertainty about both the occurrence of these decisions and their timing is likely to decrease after a few firms have imitated Nestle. With this caveat, we perform an event study for all the Nestle-type decisions by our sample firms from November 1988 to June 1992. There are 22 Nestle-type events during that interval. Excess returns and associated statistical tests are computed with the method illustrated in Brown and Warner (1985). For each firm, market model parameters are estimated with daily raw returns from the 100~trading- day interval preceding day -5, where day 0 is the day the press reports the decisions (using a 100~trading-day interval after day + 5 yields the same conclusions). We use the Swiss Performance Index’s (SPI) stock market index. The market’s reaction to the disclosure of Nestle-type decisions is measured with a 5-day excess return defined over the same interval analyzed above, i.e., (-2, + 2). The results for the first 7 of the 22 events are shown in Table 5.

The first three events prompt returns that are statistically significant and replicate the pattern observed in reaction to the original Nestle decisions:

R stock prices rise and VB stock prices fall. As expected, the price reactions taper off in time, and, after the third event in the table, stock prices fail to change significantly. No pattern is discernible in the remaining 15 events (not reported):

VB stock falls in only 7 cases and R stock increases in only 8.

4. Interpretation of the Nestk crash

4.1. An explanation based on agency costs

The decision to accept foreign holders of registered stock was not the only policy change adopted or proposed by Nestle’s board. Along with that decision,

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the board announced that it would ask for approval of a series of antitakeover charter amendments. Any market corrections of Nestle’s and other firms’ stock prices could have been in anticipation of these and similar amendments rather than solely in response to the decision to allow foreigners to hold registered stock.

As Nestle’s board explained, the amendments were intended to make a takeover of the firm more difficult. However, the amendments could also have allowed Nestle’s management (and the management of any other firm that adopted the same amendments) to entrench itself, heightening concerns about future dissipation of shareholder wealth. In this event, the value of Nestle’s (and other firms’) various classes of stock would have declined.

Several considerations undermine this entrenchment hypothesis. First, it cannot by itself explain the increase (rather than the predicted decrease) in the price of Nestle R stock and the unchanged (on average) R stock price of other corporations. Second, a lower probability of takeover would not necessarily hurt shareholders. In fact, antitakeover amendments may benefit diffuse and noncooperating shareholders by transferring bargaining power to management (De Angelo and Rice, 1983).

Third, a direct test of the hypothesis rejects it. Two sample firms, Ciba-Geigy and Sandoz, introduced antitakeover amendments before November 18, 1988.

Sandoz limited the ownership of R shares by domestic investors to 3%.

Ciba-Geigy introduced a similar limit and put a 5% cap on the votes any shareholder could cast. Contrary to what the entrenchment hypothesis would predict, the stock prices of these two firms barely moved when the amendments were disclosed. Of course, if the firms’ managers were already entrenched, the lack of price movement is not very surprising. However, their prices moved substantially when Nestle announced its new registration policy. Nestle’s decisions should have had a comparatively small impact, since any potential increase in future entrenchment should already have been anticipated when the antitakeover amendments were introduced. Yet the price of Ciba-Geigy VB stock dropped 15%. Only four other sample firms experienced a larger price decline. Similarly, Sandoz VB stock fell by 17%; only three firms fared worse.

Fourth, Ciba-Geigy and Sandoz later imitated Nestle by allowing foreigners to hold registered stock. Unlike Nestle, however, they did not simultaneously cap their shareholders’ voting power. Contrary to the entrenchment hypothesis, prices reacted as they did to Nestle’s announcement: VB and NVB stock prices fell while R stock prices increased.

Finally, an alternative test with a larger sample also contradicts the entrenchment hypothesis. According to the hypothesis, adoption of antitakeover amendments should be especially bad news for shareholders of firms in which the threat of a takeover better aligns managers’ and shareholders’ interests. It is reasonable to assume that this threat can materialize in firms whose boards cannot ward off takeovers by preventing registration of new shareholders. In

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332 C. Loderer, A. Jacobs/Journal qf Financial Economics 37 (1995) 315-339

such firms, R shares control only a small fraction of the votes outstanding. One can therefore examine whether a larger fraction of votes controlled by R shares (FRACTION) is associated with a more moderate VB stock price decline at the time of Nestle’s decisions (this test assumes that the anticipation of Nestle-type antitakeover announcements occurs at the time of Nestle’s decision). As it turns out, there is no such relation. Regressing the VB stock price change, measured over the same (-2, + 2) event time window as before, against the variable FRACTION yields a coefficient of -0.06 with a r-statistic of -0.82. One could argue that if antitakeover amendments are increasingly likely to be adopted when R shares control more votes, any inverse relation between the fraction of votes controlled by R shares and the absolute VB stock price decline could be obscured. The probability that Nestle-type antitakeover amendments will be adopted, however, is unrelated to the fraction of votes controlled by R shares (details of this investigation are not shown here).

4.2. Tax evasion and wealth concealment

An alternative interpretation of the Nestle crash is that when market participants learned of the decision to register foreign shareholders, they concluded that firms would soon do away with bearer stock. Under this interpretation, bearer stock generally sold at a premium to registered stock because investors were willing to pay to conceal their investment from the tax authorities, the police, or the media. Nestle’s decision to register foreign stockholders could have drastically reduced this premium and thereby depressed the price of bearer stocks. The price of R stocks should not have changed. As it turns out, Nestle did swap all its VB and NVB stock for R stock, as did four other firms in the sample by the end of June 1993.

However, this explanation is not consistent with the evidence either. First, it cannot explain the increase in the price of R stock. Second, although VB and NVB stocks generally sold at a premium to R stocks, there were fairly frequent exceptions. Between May 1,1987 and November 15,1988, for instance, VB stock sold at a discount to R stock in 36% of the sample firms for at least 23 trading days; in 33% of the firms, it did so for at least 46 trading days; and in 7 firms, it did so for more than half the period. This seems to contradict the notion of an unconditional premium for anonymity. Third, the adjusted ratio of VB to R stock prices differed widely across firms, even for large firms. On November 15, 1988, for instance, the ratio exceeded 1.9 for Nestle, Schweizerische Riickver- sicherung, and Sandoz, but was only 1.13 for Brown Boveri and 1.07 for Union Bank of Switzerland (the largest Swiss bank). Even if anonymity was the reason to buy bearer stock, investors would not pay widely different prices for that privilege because arbitrage would have guaranteed the law of one price.

Overall, there is little evidence to support the notion that the Nestle crash is related to foreign stockholders’ fear of losing a valuable vehicle for tax evasion

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and wealth concealment. If anonymity was demanded by investors, firms would be unlikely to eliminate bearer stock in the first place. As it turns out, firms tried to accommodate stockholders who did not want to register and reveal their identity. In Nestle’s case, for instance, about 25% of its VB stockholders refused (or failed) to be registered. These stockholders can claim their dividends but have no voting rights, a condition unlikely to bother them since stockholders who want to be anonymous are hardly the active stockholder type. Moreover, the firm gave VB stockholders the option to register under their names or under a fiduciary’s name; in the latter case, they would forgo their voting rights. Other firms allowed stockholders to keep their voting rights even if they registered under a fiduciary’s name.

A variation of the investor anonymity explanation is that Nestle’s decisions coincided with a market reassessment of the probability that Switzerland would eventually join the European Community (EC). If Switzerland ever joined the EC, it would probably share information with the tax authorities of other EC countries. In this event, bearer stock might lose some of its attraction, which could explain the decline in the value of VB and NVB shares. This alternative version of the anonymity hypothesis is questionable for some of the same reasons the main version is implausible. In particular, it is inconsistent with VB/R stock price differentials smaller than one, and it cannot explain the cross-sectional differences in those differentials.

4.3. Signaling

A third explanation of the Nestle crash is that the decision to make R stock more fungible with VB stock can be interpreted as the sale of stock by insiders.

Accordingly, Nestle insiders prompted the decision when they realized that the VB stock was overvalued. Investors realized that these insiders had superior information, and the price of Nestle VB stock fell. Since other firms with VB and R stock could do the same under the appropriate circumstances, the market lowered the price of VB stocks in general. This hypothesis has a clear tie to the economics literature on adverse selection; for a review, see Rasmusen (1989, pp. 181-203).

Although appealing, the signaling hypothesis is questionable for a variety of reasons. First, it is not clear who the group of insiders could have been. Nestle’s ownership structure is fairly diffuse. In particular, management and the board were far from having majority control. It is difficult to imagine any atomistic R shareholder willing to organize a coalition to do away with ownership restrictions.

Second, nothing prevented insiders from trading in VB shares before the Nestle event. If they thought Nestle VB stock was overpriced, they could have shorted the stock or written forward contracts on it on the Zurich stock exchange. Either action would have been much easier and faster than passing a

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resolution at the board level relaxing ownership restrictions on R stock. Third, and for the same reasons, it is doubtful that it took the liberalization of ownership to caution VB shareholders that they might be dealing with insiders, especially at a time when legislation against insider trading was gaining ground.

Fourth, the hypothesis predicts (all else being equal) an across-the-board drop in VB stock prices. That insiders had the opportunity to liberalize ownership at a time when it would presumably benefit them and hurt prospective buyers of VB stock is a concept that should have applied in principle to all firms with R and VB stock. However, the evidence contradicts this prediction. Table 6 sorts the sample by the adjusted ratio of VB to R stock prices. As shown in panel A, firms with a large VB/R stock price differential before the NestlC: decision experience the largest and most significant price adjustments: VB stock falls by 8.1% whereas R stock increases by 2.8% (all average values). Both returns are statistically significant. In contrast, firms with a small VB/R stock price differential experience largely negligible price changes: VB stock falls by 0.9% and R stock by 0.1% (all average values; see panel B of the table). Neither price change is statistically significant with 95% confidence.

Finally, the very notion that liberalization signals overpricing is shaky.

Assume for the sake of the argument that ‘insiders’ are R stockholders-at-large.

Table 6

Announcement effect of Nest& policy changes on other firms’ prices by size of the VB/R stock price differential

Price changes are computed from November 15 to 22, 1988. Price differentials are computed as of November 15 and with prices adjusted to reflect equal par values. Definitions of variables are as follows: VE = voting bearer stock, NVB = nonvoting bearer stock, R = registered stock.

VB stock R stock NVB stock

Panel A: Stock price changes ofjirms with a VBJR stock price ratio above the sample median

Number of observations 21 21 18

Median - 6.54% 2.56% - 7.40

Average - 8.07% 2.82% - 8.01%

Sample standard deviation 6.22% 3.07% 4.24%

t-statistic - 5.947 4.201 - 8.010

Proportion of positive changes 9.52% 90.48% 100.0%

Sign test, z-value - 3.714 3.714 - 4.241

Panel B: Stock price changes of firms with a VBfR stock price ratio below the sample median Number of observations

Median Average

Sample standard deviation f-statistic

20 20 14

- 1.48% 0.0% - 1.0%

- 0.91% - 0.08% - 2.03

3.11% 2.27% 3.71%

- 1.302 - 0.166 - 2.045

45.0% 70.0% 42.9%

- 0.446 1.786 - 0.530

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When managers decide to liberalize ownership, they essentially exercise an option to convert R stock to VB stock. If managers maximize insiders’ wealth, they will follow a conversion strategy that maximizes the value of R stock, with the crucial assumption that some insiders may want to liquidate their holdings and will therefore benefit from a higher stock price. The optimal conversion policy is as follows. If the price of VB stock falls below the price of R stock, it does not pay to convert. In contrast, as soon as the price of VB stock rises above the price of R stock, the conversion option should be exercised, or R shareholders who are selling will have passed up an opportunity for higher revenue. This policy does not change if managers can tell whether the firm’s VB stock is mispriced. As long as R stock sells at a discount to VB stock and insiders want to liquidate their holdings, it always pays them to convert before selling, regardless of any VB stock mispricing. In contrast, no conversion is meaningful when R stock sells at a premium to VB stock.’ Consequently, since conversion depends only on the VB/R stock price differential and not on the mispricing of VB stock, the decision to convert cannot convey any signal about the intrinsic value of VB stock.

4.4. Price pressure

The last hypothesis is that the Nestle crash is the result of downward-sloping demand curves for individual financial assets (see also Stulz and Wasserfallen, 1993).2 Nestle’s decision to allow foreign investors to hold its registered shares made its R stock significantly more fungible with its VB stock, essentially increasing the number of VB shares in the international market. In a world of downward-sloping demand curves, this increase should have depressed the price not only of Nestle VB stock but also that of other firms with VB and R stock, due to a reduction in investors’ reservation prices for VB stock in anticipation of a Nestle-type decision. The price of NVB stock should also have fallen, since

‘These conclusions hold even if the mispricing of VB and R stock is in different directions (for instance, an overpriced VB stock could sell at a premium to an underpriced R stock). Of course, since the two stocks can be compared only if they are adjusted to represent the same claim against future cash flows, they have an identical true value; this means that there cannot be an underpriced

VB stock selling at a premium to an overpriced R stock. The proof is best shown by investigating the conversion policy with two contingency tables, depending on whether VB stock sells at a premium

or a discount to R stock. Each table has three rows (underpriced, overpriced, and correctly priced VB stock) and three columns (underpriced, overpriced, and correctly priced R stock).

‘For a discussion of this hypothesis and a survey of the literature, see Loderer, Cooney, and Van Drunen (1991). Evidence consistent with finite price elasticities of demand can be found in, among others, Bagwell (1991a), Barclay and Litzenberger (1988) Eades, Hess, and Kim (1991), Harris and Gurel (1986), Lakonishok and Vermaelen (1986), Loderer, Sheehan, and Kadlec (1991) Ogden (1990) Ritter (1988), Rozeff (1986), and Shleifer (1986). Theoretical work allowing for finite price elasticities of demand includes, among others, Mayshar (1978), Parsons and Raviv (1985), Merton (1987) Bagwell (1991 b), and Lakonishok, Shleifer, and Vishny (1992).