The Costs of Conflict Resolution and Financial Distress: Evidence from the
Texaco-Pennzoil Litigation
David M. Cutler; Lawrence H. Summers
The RAND Journal of Economics, Vol. 19, No. 2. (Summer, 1988), pp. 157-172.
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RAND Journal of Economics Vol. 19, No. 2, Summer 1988 The costs of conflict resolution and
financial distress: evidence from the
Texaco-Pennzoil litigation
David M. Cutler*
and
Lawrence H. Summers**
This article demonstrates that the dispute between Texaco and Pennzoil over the Getty Oil
takeover reduced the combined wealth of the claimants on the two companies by over
$3 billion. During the course of the litigation, Pennzoil's shareholders gained only one-sixth
as much as Texaco's shareholders lost. When the litigation was settled, about two-thirds of
the loss in wealth was regained. These fluctuations in value exceed most estimates of the
direct costs of carrying on the litigation, and may reflect the disruption in the operations of
Texaco caused by the dispute.
1. Introduction
From 1984 to 1988 Texaco and Pennzoil were engaged in a legal battle over Texaco's
usurpation of Pennzoil in the takeover of the Getty Oil Company. The stakes were huge:
the original jury award called for a payment of more than $10 billion; the companies ultimately settled for $3 billion. The Texaco-Pennzoil case presents a unique experiment for
studying debt burdens and bargaining costs. Market assessments of the prospects of both
parties in a prolonged dispute are rarely as observable as they are in the Texaco-Pennzoil
case. Further, unlike in most other litigation settings and in almost all bankruptcy cases,
the burden imposed on Texaco did not have a collateral effect on furture cash flows.
This article examines the abnormal returns earned by the shareholders of Texaco and
Pennzoil over the course of the dispute.' A clear pattern emerges. Events affecting the size
* Massachusetts Institute of Technology. ** Haward University and National Bureau of Economic Research. We are grateful to Gordon Cutler, Lany Katz, Greg Mankiw, Jim Poterba, Myron Scholes, Andrei Shleifer, Vicki Summers, A1 Warren, and two anonymous referees for comments on an earlier draft. Becky Boman, Steve
Coll, Alan Edgar, Andrew Grey, Gary Hindes, Allanna Sullivan, Tom Petzinger, and Dan Wilhelm provided
valuable information on different aspects of the case. This research was supported by the National Science Foundation
and the Sloan Foundation. A data appendix has been deposited at the University of Michigan archive.
After circulating an early draft of this article, we became aware of work by Engelmann and Cornell (1988)
on the wealth effects of several large corporate disputes, including the Texaco-Pennzoil case. They note the asymmetric
returns as well, but concentrate on events at the beginning of the case. Bhagat, Brickley, and Coles (1987) examine
stock price movements to news in a large number of corporate legal cases and obtain similar results. Mnookin
(1987) discusses the reasons Texaco and Pennzoil failed to settle the litigation earlier. Baldwin and Mason (1983)
in related work examine the market reaction to the Massey Ferguson bankruptcy case and find that the resolution
of the bankruptcy resulted in a substantial increase in the value of the company.
'
158
/ THE RAND JOURNAL OF ECONOMICS
of the transfer resulted in opposite but asymmetric returns to the two companies: when its
obligation to Pennzoil was increased, Texaco's value fell by far more than Pennzoil's rose;
the opposite reaction occurred for events reducing the expected transfer. These "leakages"
in value were enormous: each dollar of value lost by Texaco's shareholders was matched
by only about 40 cents' gain to the owners of Pennzoil. The ongoing dispute reduced the
combined equity value of the two companies by $3.4 billion, over 30% of the joint value
of the two companies before the dispute arose. A large fraction of the losses in combined
value was restored when the case was settled. The precise impact of the settlement is difficult
to gauge, however, because of the coincidence between the case's settlement and takeover
threats to Texaco.
After documenting these large fluctuations in joint value, we seek to identify their
causes. One explanation is the fees that both companies paid to the many lawyers, investment
bankers, and advisors that were retained. These costs seem too small to account for the
large swings in joint value, however. A second explanation is that a settlement would have
been wasted by Pennzoil and thus was discounted by the market. This explanation seems
inconsistent with the large increase in value after the resolution of the dispute, however. It
appears either that there were additional costs to Texaco's shareholders that were relieved
by the settlement, or that the claims on the two companies were valued inefficiently during
the litigation.
We conclude by discussing a number of implications for economic analysis. First, the
large losses illustrate that efficient bargains will not always be struck, even when neither
side possesses much relevant private information. Second, the losses suggest that financial
conflict can have substantial effects on productivity. This has implications for bankruptcycost explanations of firms' debt-equity choices, macroeconomic theories that stress credit
disruptions as an important element in business-cycle fluctuations, and arguments that debt
relief for major debtor nations would make all parties to the LDC debt crisis better off.
The article is organized as follows. Section 2 briefly recounts the history of the dispute
and describes the event-study methodology we use. Sections 3 and 4 document the large
changes in joint value during the litigation. We focus first on the equity claimants, and then
on other claimants-bondholders and the Federal government. Section 5 examines potential
causes of the fluctuations in joint value. Section 6 concludes with some implications of our
findings.
2. The Texaco-Pennzoil conflict
The Texaco-Pennzoil dispute arose from the bids both companies made to acquire
Getty
On January 2, 1984, Pennzoil reached what it felt was a binding agreement with
the directors of Getty Oil to acquire 3/7 of Getty. Within a week of the Pennzoil-Getty
proposed sale, however, Texaco purchased all of the Getty stock at a higher price per share.
As a condition of the sale, Texaco indemnified Getty and its largest shareholders against
any possible litigation. Thus, when Pennzoil sued for breach of contract, Texaco became
liable for damages.
The case was ultimately brought before the Texas State Court and was tried in mid1985. A decision was reached on November 19, 1985 (event 1) in favor of Pennzoil, with
the judgment for $7.53 billion in actual damages, $3.0 billion in punitive damages, and
$1.5 billion in accrued interest. The jury's decision was widely decried in the press. Commentators uniformly attacked the size of the judgment because it was based on the replacement cost of the oil that Pennzoil would have obtained from Getty, not on the damages
The description of the dispute here is necessarily brief. Entertaining narrative histories of the Getty case
may be found in Petzinger (1987) and Coll (1987). We have also drawn heavily on the ongoing reporting of the
Wall Street Journal and New York Times.
CUTLER AND SUMMERS /
159
that Pennzoil suffered by failing to acquire Getty at the agreed-on price. There was a widespread expectation that the judge would either overturn the judgment or reduce the damages
substantially. Notwithstanding these predictions, on December 10, 1985 (event 2), the Texas
judge denied Texaco's request to overrule the jury, and affirmed its award.
Under Texas law Texaco was required to post a bond in the full amount of the judgment
to appeal the case. Texaco objected to the requirement and appealed the issue to the Federal
Court in New York. On December 18, 1985 (event 3), Texaco received a Temporary Restraining Order prohibiting Pennzoil from attaching liens to Texaco's assets until the bond
matter could be decided. A hearing on the requirement was held in early January 1986,
and on January 10, 1986 (event 4), the Federal judge ruled that Texaco had to post only a
$1 billion bond to appeal the case. A Federal Court of Appeals upheld this ruling on February 20, 1986 (event 5).
After the Appeals Court ruling, both companies appealed the decisions favorable to
the other side. Texaco obtained a hearing on the original case in the Texas Court of Appeals,
and on February 12, 1987 (event 6) that Court upheld all but $2 billion of the judgment
for Pennzoil. On April 6, 1987 (event 7), the Supreme Court vacated the Federal Court
ruling. Faced with liens being placed on its assets, on April 12, 1987 (event 8), Texaco filed
for bankruptcy.
Although Texaco was in bankruptcy, it continued its appeal of the case. In June an
appeal was filed with the Texas State Supreme Court. Pennzoil, meanwhile, appealed the
bond reduction to the United States Supreme Court. On November 2, 1987 (event 9), the
Texas State Supreme Court declined to review the case and left standing the Appeals Court
judgment.
After the Texas Supreme Court decision, Texaco and Pennzoil held a final round of
settlement negotiations. From November 19to December 10, 1987,the companies negotiated
a "base-cap" settlement, which would have limited overall liability ("the cap") in exchange
for a nonrefundable "base" payment. Despite Texaco's announcement to the Bankruptcy
Court that the companies had made great progress (December 2, 1987), they were unable
to reach an agreement. Independently, on December 11, 1987, Texaco's shareholders' committee, in conjunction with Carl Icahn, reached a $3 billion settlement with Pennzoil. On
December 18 the two companies formally agreed to this amount.
3. The effects of the conflict on shareholder wealth
Methodology. To measure the impact of the conflict on the two companies, we examine
the abnormal changes in equity values induced by news bearing on the litigation. We use
the market model to measure abnormal return^:^
+
+
Rit = a, P,R,,
€it,
(1)
where R,, and R,, are the return to stock i and the market at time t. The abnormal return
is measured as the residual, ei,. We multiply the abnormal returns by the value of the
outstanding equity of each company to estimate the changes in wealth caused by the litigati~n.~
Market response. As a first test of the impact of the dispute on equity values, we
examine the correlation between the stocks' abnormal returns. If litigation news was frequent
and had large effects, the two returns should show a lower correlation than would otherwise
Fama, Fisher, Jensen, and Roll (1969) and Schwert (1981) discuss the methodology more fully.
We use return data from January 1984 to January 1988. The data were adjusted for dividend payments
and stock splits. We used the return on the Standard and Poor's Composite Stock Index as a proxy for the market
return. The results are invariant to the time period used for the estimation.
160
/ THE RAND JOURNAL OF ECONOMICS
be expected. This appears to be the case. For seven oil companies not involved in the
litigation,' the average painvise correlation of abnormal returns is .249, with a standard
deviation of .17 1. For Texaco and Pennzoil, the correlation is .0 16.'j Thus, the litigation
appears to account for a large fraction of the return variance of both c ~ m p a n i e s . ~
The most natural measure of total litigation costs is the change in value of the two
companies in reaction to important events. Tables 1 and 2 show the effects of each of the
events described in Section 2 on the market value of the two companies and on the combined
equity values8
Table 1, which focuses on the effects of litigation news, provides strong evidence that
the market associated large costs with the Texaco-Pennzoil dispute. While Texaco's and
Pennzoil's share prices almost always moved in opposite directions, Texaco's change in
value was much larger than Pennzoil's. In the six events decided against Texaco (events 1,
2, 6, 7, 8, and 9), Texaco's one-day loss was 5.1 times greater than Pennzoil's gain. In only
one case did Pennzoil gain even half as much as Texaco lost. While the results are weaker
for the decisions favoring Texaco (events 3, 4, and 5), they nonetheless support the view
that the costs of the conflict are large. With the exception of the Federal Court bond reseems to benefit greatly; the return to Pennzoil is less clear. Both the
d u ~ t i o n Texaco
,~
individual changes in value and the change in combined value are statistically significant
at conventional levels.
The combined loss to shareholders from these nine events is striking. Using single-day
returns, we find that Texaco's value fell a total of $4.1 billion; Pennzoil's rose only $682
million. Pennzoil gained only 17% of what Texaco lost. Before the litigation was filed,
Texaco's value was about $8.5 billion, while Pennzoil's was about $2 billion. The loss thus
represents over 32% of the prelitigation joint value.
Table 1 also shows that the two stock prices moved together after the bankruptcy filing
of Texaco. On the day after the filing, joint value fell by over $1.2 billion. It was widely
reported that the losses were caused by disappointment on the part of shareholders over the
failure to settle the case the week before.'' The implication is that events that were expected
to prolong the dispute or to magnify what was at stake led to large losses in joint value.
In contrast to the news about the magnitude or duration of the litigation, Table 2 shows
that the events associated with the resolution of the dispute resulted in large increases in
combined value. Using single-day returns, we find that joint value increased by $2.3 billion
after the four settlement announcements in November and December 1987. This rise in
value is 65% of the loss from the litigation events, although the prolonged negotiations
make it more difficult to identify all days on which expectations of a settlement changed.
These companies were Ashland Oil, Arco, Chevron, Exxon, Mobil, Occidental, and Unocal. The data were
from January 1985 to December 1987.
One possible explanation for the small correlation is that periods of nontrading result in noncontemporaneous
reactions to the same news. If this were true, the one-period lead or lag returns should be positively correlated.
Leading and lagging Texaco's return by one period, however, yields correlations of -. 107 and .03 1. We thus reject
this explanation.
This test actually understates the significance of the dispute because some events, such as the bankruptcy
filing by Texaco and the settlement talks the two companies held, caused the two stock prices to move together.
The standard errors for the change in combined value were computed from a portfolio containing a weighted
average of Texaco and Pennzoil shares, where the weights were the market value of the companies at the end of
the previous day. Appendix Table A1 repeats the analysis by using the return on the Standard and Poor's Composite
Oil Index as a proxy for the market return. The results are similar to those in Table 1.
The New York Times commented that the returns on this day were partly a reaction to the court ruling and
partly a reaction to a fall in oil prices. As Table A1 shows, Texaco lost much less value in relation to the Oil Index
in this week.
' O The New York Times, for example, speculated that the inability of Texaco and Pennzoil to settle before
the bankruptcy filing probably added four years to the projected length of the dispute.
CUTLER AND SUMMERS /
TABLE 1
161
Litigation News and Changes in Value*
One Day after Announcement
Change in Value
($ million)
No.
Event
1
November 19, 1985:
Texas jury rules for
Pennzoil
2
Pennzoil
Combined
Pennzoil
Combined
-$646.3
(164.3)
$295.7
(44.8)
-$350.6
(166.4)
-$1,124.3
(336.7)
$483.3
(1 15.7)
-$731.0
(366.7)
December 10, 1985:
Texas state judge
affirms jury
award
-$580.8
(128.7)
$18.9
(60.1)
-$561.9
(147.7)
-$806.6
(273.9)
-$137.5
(134.5)
-$946.1
(3 18.8)
3
December 18, 1985:
Texaco obtains
Temporary
Restraining Order
$445.8
(1 15.6)
-$126.6
(58.5)
$3 19.2
(135.8)
$686.2
(276.7)
$77.9
(128.4)
$764.1
(3 16.9)
4
January 10, 1986:
Bond requirement
reduced
-$125.2
(13 1.9)
-$88.3
(64.6)
-$213.5
(153.4)
-$407.1
(286.5)
-$88.7
(143.1)
-$495.8
(335.1)
5
February 20, 1986:
Federal Court
upholds bond
reduction
$6.7
(124.7)
$23.7
(51.5)
$30.4
(138.4)
$161.7
(280.2)
-$14.6
(1 17.0)
$147.1
(3 11.9)
6
February 12, 1987:
Court of Appeals
upholds
judgment
-$8 18.7
(18 1.0)
$378.6
(66.9)
-$440.1
(195.5)
-$1,092.0
(370.3)
$200.6
(163.6)
-$89 1.4
(4 18.0)
7
April 6, 1987:
Supreme Court
vacates bond
rulings
-$l,O00.l
(176.9)
$267.2
(80.0)
-$732.9
(199.4)
-$1,257.4
(360.5)
$498.6
(183.5)
-$758.8
(423.8)
8
April 12, 1987:
Texaco files for
bankruptcy
-$697.5
(149.8)
-$56 1.5
(87.6)
-$1,259.0
(184.1)
-$308.4
(302.6)
-$645.9
(175.2)
-$954.3
(382.2)
9
November 3, 1987:
Texas Supreme
Court denies
appeal
-$681.5
(161.0)
$474.7
(52.8)
-$206.8
(169.2)
-$989.2
(329.9)
$563.9
(143.1)
-$425.3
(370.2)
-$4,097.6
(453.6)
$682.4
(192.8)
-$3,415.2
(501.1)
-$5,137.1
(945.0)
$937.8
(439.9)
-$4,199.5
(1,087.9)
Total Litigation
Events
Texaco
Five Days after Announcement Change in Value ($ million) Texaco
* Table shows change in value of Texaco, Pennzoil, and combined equity. The change in combined value is
computed from a value-weighted portfolio of Texaco and Pennzoil shares. Numbers in parentheses are the standard
errors expressed as changes in value by multiplying by the market value of the firm or portfolio.
Unfortunately, the magnitude of the gain is also obscured by the involvement of Carl
Icahn in the settlement process. The threat of a takeover by Icahn potentially induced a
premium in Texaco's value. While we discuss this aspect of the case more fully in a later
section, we note here that on several days when the news was almost exclusively about the
negotiated settlement-the days reported in Table 2-joint value rose substantially. Settlement announcements appeared to increase the value of both companies.
Immediate responses to dispute events thus indicate that news that increased either the
expected transfer from Texaco to Pennzoil or the expected duration of the dispute greatly
reduced the combined value of the two companies. Not all information bearing on the
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/ THE RAND JOURNAL OF ECONOMICS
TABLE 2
Settlement News and Changes in Value*
One Day after Announcement
Change in Value
($ million)
No.
Event
Texaco
1
November 19, 1987:
Pennzoil proposes
base-cap
settlement
2
December 2, 1987:
Texaco reports
progress in
negotiations
3
December 11, 1987:
Shareholders'
Committee and
Pennzoil agree to
settlement
4
December 18, 1987:
Texaco and
Pennzoil agree to
settlement
Pennzoil
Combined
Five Days after Announcement
Change in Value
($ million)
Texaco
Pennzoil
Combined
Total Settlement
Events
* Table shows change in value of Texaco, Pennzoil, and combined equity. The change in combined value is
computed from a value-weightedportfolio of Texaco and Pennzoil shares. Numbers in parentheses are the standard
errors expressed as changes in value by multiplying by the market value of the firm or portfolio.
TABLE 3
Monthly Excess Returns*
Change in Value ($ million)
Month
November 1985
December 1985
January 1986
February 1986
March 1986
April 1986
May 1986
June 1986
July 1986
August 1986
Texaco
Pennzoil
Combined
CUTLER AND SUMMERS /
163
Continued
TABLE 3
Change in Value ($ million)
Month
Texaco
Pennzoil
Combined
September 1986
October 1986
November 1986
December 1986
January 1987
February 1987
March 1987
April 1987
May 1987
June 1987
July 1987
August 1987
September 1987
October 1987
November 1987
December 1987
January 1988
Totals
November 1985-October 1987
November 1987-December 1987
* Table shows sum of abnormal returns for each week in the month. Abnormal returns are
relative to the Standard and Poor's Composite Oil Index. Numbers in parentheses are standard
errors expressed as changes in value by multiplying by the market value of the firm or portfolio.
ultimate resolution of the case came out in discrete events, however. To assess the full effect
of the dispute on the two companies, Figure 1 plots the cumulate changes in the abnormal
returns of Texaco and Pennzoil over the course of the dispute. We present excess monthly
returns for the two companies in Table 3.
164 /
THE RAND JOURNAL OF ECONOMICS
FIGURE 1
COMBINED V A L U E OF TEXACO A N D PENNZOIL
It is apparent from Figure 1 that most of the movements in the combined value of the
companies were associated with the major events highlighted in Tables 1 and 2. The total
decline in value between the initial verdict in November 1985 and October 1987 was $3.7
billion, about the same as the sum of the losses in value during the case. Settlement of the
dispute in November and December 1987 was associated with a gain of $2.6 billion in
combined value. These totals suggest that the conflict between Texaco and Pennzoil cost
their equity holders about $1 billion.
4. The effects on other claimants
There are two principal claimants, in addition to Pennzoil, that stand to be affected by
the litigation: the holders of Texaco debt and the Federal government, through its tax claim
on the two companies." We examine the impact on these claimants in turn.
W
Texaco's bondholders. Litigation and bankruptcy pose two problems for bondholders.
First, under the terms of the reorganization, their claims can be reduced or eliminated
entirely. Second, in the event of liquidation, bondholderscan suffer (or gain)from redemption
of the outstanding debt at par value, not market value.
Exclusive of Pennzoil, Texaco's bondholders were its largest claimants throughout the
litigation period.'' We therefore focus on the induced change in the value of Texaco's bonds.
To determine these changes we used the following procedure. For each issue listed on the
event day, we computed the abnormal return relative to a long-term oil company bond.I3
I ' The effect on Pennzoil's bondholders is not included since the value of these claims was never in doubt.
The price of Pennzoil debt moved very little over the period and showed no exceptional movements in response
to any of the litigation events.
l 2 At the time of bankruptcy Texaco had $8.4 billion in bonds outstanding, of which $6.8 billion were
long-term.
"We used a 6% coupon rate, 1997 expiration Exxon bond.
CUTLER AND SUMMERS /
TABLE 4
Number
165
Change in Value of Texaco Debt*
Date
Average
Excess Return
Change in
Market Value
($ million)
Litigation Events
November 19, 1985
December 10, 1985
December 18, 1985
January 10, 1986
February 20, 1986
February 12, 1987
April 6, 1987
April 12, 1987
November 3, 1987
Total Litigation Even
Settlement Events
1
2
3
4
November 19, 1987
December 2, 1987
December 11, 1987
December 18, 1987
Total Settlement Events
8.1%
$488.4
* Table shows change in value of Texaco debt. Average excess return is found as a
weighted average of excess returns for individual issues. Change in market value is the
book value of long-term debt at the end of the previous quarter times the average priceto-book value ratio, times the average excess return on the debt.
Using book value weights, we then computed a weighted-average debt return. In addition,
we computed a weighted-average price-to-book-value ratio on the day before the event. To
find the change in debt value we multiplied the book value of long-term debt as of the end
of the previous quarter by the price-to-book-value ratio (to find the market value of debt)
and by the abnormal return on the debt.
Table 4 shows the changes in debt value on each of the important events.14The return
to bondholders mirrored that to stockholders. Adverse events in the litigation proceedings
(events 1 , 2 , 6 , 7 , 8 and 9) reduced the value of the debt; favorable announcements generally
increased the value. The aggregate effect of the nine litigation events is a fall of $1.5 billion
in debt value. This figure obtains despite the fact that debt selling below face value fell by
much less than higher yield debt. When Texaco filed for bankruptcy, for example, its average
debt value fell by almost 12%,while the value of some of its low-yield debt fell by only 2%.
As with the equity claims, settlement induced large increases in debt value. After the
four settlement events, Texaco's debt increased in value by $488 million. Since takeovers
should not affect debt payments, the magnitude of this increase suggests that the cause of
the dramatic increase in value, for the bondholders and potentially for the stockholders,
was primarily the resolution of the underlying dispute.
The government. Under Federal law, damage payments are both taxable on receipt and
deductible on payment. Thus, one might expect that the litigation would not affect government tax collections. Three considerations suggest that the litigation could have tax consequences, however.
--
- -
Because Texaco's bond prices are not carried on any financial databases, we were unable to calculate
standard errors for the changes in bond value.
l4
166
/ THE RAND JOURNAL OF ECONOMICS
First, it seems unlikely that Texaco could use all of the tax losses generated by a payment
to Pennzoil. Between 1982 and 1986 Texaco received tax refunds four times; earnings and
previous taxes were thus clearly inadequate to offset the losses immediately.'5 At year-end
1987 the company reported $4.9 billion in losses and write-offs.
Second, the distinction in the tax law between ordinary income and capital gains could
have lowered the tax liability of Pennzoil upon any receipt in 1986 or 1987. By purchasing
assets from Texaco at a below-market price, Pennzoil could have avoided all but capital
gains taxes on the step-up in basis of the assets. Since a settlement of this type was considered
the most likely source of payment in that period, the implied tax liability may have been
based on the capital gains rate.I6
Third, Federal law stipulates that in cases of "involuntary conversion" of property into
similar property or cash used to purchase similar property within two years, the recipient
of the resulting capital gain is not liable for tax on the gain." It is possible that Texaco's
payments to Pennzoil would qualify as an involuntary conversion of Getty assets and so
would be untaxed. Pennzoil has stated that it intends to file such a claim. It is not clear
whether an involuntary conversion claim would be accepted by the IRS, however.
The tax consequences of a settlement are thus uncertain, both for the liability upon
receipt and for the deduction upon payment. A consideration of debt and taxes together,
however, makes it clear that the claims of these creditors do not counter the large initial
loss in value or the subsequent increase. Even if the market had anticipated that Texaco
could not use any tax deductions, that the payment to Pennzoil would have been taxed at
a 28% capital gains tax rate, and that the payment from Texaco to Pennzoil would have
equalled Texaco's loss in value, not Pennzoil's gain in value, the tax liability in the presettlement stock prices would have come to only $950 million, which is less than the $1.5
billion loss suffered by Texaco's bondholders. l8 Further, the settlement substantially increased
debt value, although the agreement on a cash transfer might have implied a higher overall
tax payment.19 We thus conclude that the effects on nonequity claimants cannot explain
the equity losses, and that the fluctuations in equity value did not reflect transfers among
claimants.
5. Where did the value go?
One explanation for the large swings in value is that the money would have been paid
to the bankruptcy lawyers, trustees, and other litigation participants that both companies
hired, and that these costs were saved by the settlement. Certainly, lawyers on both sides
were numerous, and legal fees were large.
It is difficult to believe that the market had expected future fees for the case to be as
large as $2 billion, however. On August 27, 1987, Texaco announced that its legal fees since
I S Texaco's financial statements do not report the amount of tax loss canyforwards the company has accumulated, but did indicate that Texaco had some loss carryforwards.
l6 There was also some discussion about ways of structuring transfers to make them entirely tax free. Generally,
these involved taking assets from both companies and putting them in a potentially tax-free third company, which
would be jointly owned by the two groups of shareholders. Such transfers, however, were noted to be difficult to
structure, and there was no guarantee that the transfer would be tax free. Much more journalistic attention was
paid to schemes to "transform" receipts from ordinary income to capital gains. We thus focus on this more narrow
tax consequence.
l 7 An involuntary conversion is defined as: "(1) destruction of property in whole or in part; or (2) theft; or
(3) actual seizure; or (4) requisition or condemnation or threat or imminence of requisition or condemnation."
l 8 Indeed, even if the loss in value were the result of expected taxes or payments to the litigation participants,
it is still a puzzle why the companies did not regain this value by negotiating an agreement sooner.
l 9 If the market was expecting a 2890 rate before the settlement, a $3 billion payment taxed at the 34% rate
would be an increase in expected tax payments of $180 million.
CUTLER AND SUMMERS /
167
the original jury decision had been $55 million. Texaco also had to pay an estimated $3.5
million each month for the bankruptcy expenses of the company and of the creditor committees. Over a five-year period the present value of a continuation of these payments is
about $250 million. Since legal fees are deductible from taxable income, the after-tax cost
would have been only $165 million.
It is unclear how much the market had expected Pennzoil to pay in total legal fees.
Pennzoil's lead attorney, Joe Jamail, handled most cases on a contingency-fee basis. When
asked about his fees, he was known to joke that the only math he knew was how to "divide
by thirds" (Petzinger, p. 20). Jamail, however, insisted that he had no set fee for the case,
and claimed that he took the case to help his friends at Pennzoil. Estimates of fees could
thus have varied widely.20
Future market reactions, however, suggest that Pennzoil's expected legal fees were not
large relative to the loss. After the settlement Pennzoil announced on December 29, 1987,
that its costs for the case were $400 million, $200-$300 million of which was estimated to
go to Jamail. The abnormal return for Pennzoil on that day was -$I1 3.4 million, which
suggests an expected fee of at most $200 million. Thus, even if Pennzoil had additional
future and past fees equal to Texaco's, the after-tax legal payment for both companies would
be only $525 million, or 15% of the loss in joint value. Further, the reduction in fees from
the settlement would explain only 14% of the resulting increase in value.
A second explanation for the fluctuations in value is that Pennzoil would not use any
funds it received from Texaco so efficiently as Texaco would. Such explanations are consistent
with the findings of Jensen (1986) that free cash flow may be invested at below the market
return, thus lowering the value of the company. We find it difficult to believe that this
explanation can account for the large value fluctuations, however. Throughout the litigation
the most commonly discussed settlement was a transfer of oil and gas properties. There
would thus be no cash for Pennzoil to misuse. Further, Texaco has historically had among
the highest finding costs in the oil industry, and has certainly been much less efficient than
the settlement between the companies called for a payment in cash, not
~ e n n z o i l .Finally,
~'
property. If the loss were due to potential wastefulness on the part of Pennzoil, the settlement
should have been associated with a further reduction in joint value.
A third explanation for the large loss is the secondary costs of the dispute on Texaco's
profitability. By creating uncertainty about Texaco's long-term viability, making it difficult
for Texaco to obtain credit, and distracting Texaco's management, the litigation may have
reduced Texaco's value by more than the expected value of the transfers it would have to
make to Pennzoil. Effects of this kind have been stressed in discussions of credit constraints
(Greenwald and Stiglitz, 1987) and of the burdens associated with LDC debt obligations
(Sachs and Huizinga, 1987).
The most important evidence for the adverse effects of the dispute is an affidavit Texaco
submitted with its bankruptcy filing that described the effect of the week-old Supreme Court
decision on its operations. The affidavit asserted that some suppliers had demanded cash
payments before performance or insisted on secured forms of repayment. Others halted
20 Most discussions of Jamail's fees indicated that Pennzoil and Jamail had yet to agree on a dollar amount,
although it was certain to be less than Jamail's usual award. There was occasional speculation that his fees would
be rather large. The Wall Street Journal reported that "[slome well placed Wall Street sources say they understood
Mr. Jamail stands to collect 20% of the jury's award, which, if upheld, would result in a mind-boggling $2.4 billion
for him" (November 21, 1985, sec. I, p. 2, col. 3). This was the only estimate this large, however, and the amount
was never repeated. Given the future stock market reaction, it seems reasonable to conclude that this figure was
an overestimate of market expectations.
From 1983 to 1985 Texaco averaged $27.6 per barrel of oil and natural gas found, while Pennzoil averaged
$16.3. The industry average for the 1984 to 1985 period was $10.9.
168 /
THE RAND JOURNAL OF ECONOMICS
crude shipments temporarily or cancelled them entirely. A number of banks had also refused
to enter into, or placed restrictions on, Texaco's use of exchange-rate futures contracts. The
affidavit concluded:
The increasing deterioration of Texaco's credit and financial condition has made it more and more difficult, with
each passing day, for Texaco to continue to finance and operate its business. . . . As normal supply sources become
inaccessible and other financing is unavailable, Texaco's operations will begin to grind to a halt. In fact, Texaco is
already having to consider the prospect of shutting down one of its largest domestic refineries because of its growing
inability to acquire crude and feedstock.
This sentiment was echoed by journalistic accounts of Texaco's actions. The New York
Times, for example, noted that "Texaco has been under extreme financial pressure to resolve
the case because of nervousness among its lenders, suppliers, and business partners about
its future" (December 21, 1985, sec. I, p. 37, col. 5). Some analysts even attributed the stock
market reaction to these costs. The Wall Street Journal reported:
One analyst says he believes the market is assuming that Texaco will have to pay roughly $5 billion in cash to
Pennzoil. But the market has discounted Texaco's stock even further because, he says, the company already has
been damaged by the litigation. "They've been unable to refinance debt, they've missed opportunities in the oil
patch, and the diversion of management has to cost something" (April 8, 1987, sec. I, p. 3, col. 5).
Unfortunately, no direct evidence exists on whether these operational problems were
really of major importance.22 Indeed, the day after the affidavit was filed, some of the
suppliers mentioned specifically disputed Texaco's assertions. The principal evidence of
their importance is the observation that most reasonable measures of conventional litigation
costs are far below the observed fluctuations in joint value.
A fourth explanation for the large fluctuations in value is that the market response
reflected changing probabilities of a takeover of either Texaco or Pennzoil. If the market
associated favorable litigation announcements with increased takeover probabilities and
adverse litigation announcements with less likely probabilities, the resulting fluctuations in
takeover premiums would mirror the observed changes in joint value.
Changing takeover probabilities seem implausible as an explanation of the reduction
in combined value during the litigation period. After the initial litigation decisions, it was
widely commented that the losses increased, rather than decreased, the likelihood that Texaco
would be taken over. The New York Times, for example, reported that "[tlhe damage to
Texaco could spread far beyond the verdict. . . . The decline [in Texaco's stock price] was
so dramatic that Texaco prepared a poison pill that would make a takeover prohibitively
costly." It further noted that "analysts said the ruling could send Texaco's stock price down
further and perhaps attract a hostile bid from a company hoping to buy Texaco at a bargain
price" (December 11, 1985, sec. IV, p. 4, col. 4).
It is much more likely, however, that a takeover premium was responsible for a large
part of the increase in value at the conclusion of the dispute. The news media widely noted
Carl Icahn's history of acquiring companies in hostile takeovers. Indeed, on the day that
Icahn's first purchases of Texaco's shares were announced, the abnormal returns were $556
million for Texaco's equity and $182 million for ~ e n n z o i l ' s After
. ~ ~ the settlement was
announced the following month, the New York Times indicated that many takeover specialists saw Texaco as undervalued and were thinking about investing in it.
It is unclear how much of the settlement revaluation should be attributed to takeover
premiums, however. Although Icahn's initial purchases of Texaco's stock resulted in large
22 Attempts to analyze Texaco's financial statements for evidence on the effects of the litigation were complicated
by the large gyrations in oil prices that occurred over the period.
23 It was mentioned in the press that Icahn had purchased about 2% of Pennzoil's shares in addition to his
Texaco purchases, although analysts noted that the large amount of Pennzoil's stock held by the Chairman of the
company made a takeover of Pennzoil unlikely.
CUTLER AND SUMMERS /
169
increases in value, his subsequent actions had little effect on market values. When Icahn
filed a notice with the SEC stating his intentions to increase his shares in the company, for
example, Texaco's value rose by only $38.5 million. Two weeks later, when Icahn first
threatened to file his own reorganization plan, Texaco's value fell by $18.5 million. These
small revaluations suggest that, at least as of the time of the settlement, the involvement of
Icahn in the dispute may have signalled only that a resolution of the dispute was forthcoming.
A final explanation for the large fluctuations is that the market inefficiently valued the
claims of the two companies, perhaps because many investors were unwilling to hold stock
in a potentially or actually bankrupt company like Texaco, and other investors did not step
in to fill the gap.24Consistent with this view, there is evidence that news provided by the
companies resulted in asymmetric returns to the two stocks. On October 8,1987, for example,
Pennzoil's value rose by $170.2 million and Texaco's fell by $42.0 million because "the
company impressed industry analysts in New York with a presentation explaining its position
in its protracted legal dispute with Texaco" (New York Times, October 9, 1987, sec. IV,
p. 3, col. 1).
The hypothesis of market error in valuing Texaco and Pennzoil is attractive, given our
inability to locate large costs of the ongoing struggle. If Texaco and Pennzoil were valued
inefficiently, however, there must be strong general grounds for doubting the rationality of
market valuations. Unlike many important events, the principal uncertainty in the TexacoPennzoil case involved matters of public record. Further, both Texaco and Pennzoil were
widely followed and actively traded throughout the period. Finally, the valuation pattern
persisted over two years, and was noted on several occasions in the financial press.
6. Conclusions and implications
Our results suggest that the Texaco-Pennzoil dispute reduced the combined wealth of
the claimants on the two companies by about $2 billion. These costs seem much larger than
reasonable estimates of the transfers the case was likely to generate. Given these large costs,
it is natural to wonder why a bargain was not struck sooner. Theories of bargaining under
complete information such as Rubinstein's (1982) work usually imply that if both parties
are fully informed, bargains should be struck immediately and bargaining costs should not
be incurred. Settlement did not take place in the Texaco-Pennzoil conflict, however, until
four years after the dispute arose.
The most commonly advanced explanations for failure to come to immediate agreement
are differing expectations about the ultimate outcome, delaying settlement as a means of
signalling private information, and committing to an inefficient outcome to influence the
range of potential solutions (Crawford, 1982; Farber and Bazerman, 1987). These arguments
seem like weak reeds in the Texaco-Pennzoil case. The principal uncertainties revolved
around likely legal judgments that both parties had equivalent capacities to predict. Further,
we have seen no indication that the parties had private information about their own financial
condition. Finally, commitment does not seem credible when the case will be decided by a
third party.
Journalistic accounts typically explain why no bargain was struck by pointing to the
mutual antipathy between the executives of the two companies. Two billion dollars, however,
seem like a lot to pay to engage in pique. In the end it seems that something other than
asymmetric expectations or information lay behind the inability of Texaco and Pennzoil
to settle the case, or alternatively, that if the amount of asymmetry in this case is enough
24 The argument that the combined value of the two companies was depressed because of risk aversion
founders on the observation that investors could purchase shares of both companies and thus profit from the
settlement revaluation.
170
/ THE RAND JOURNAL OF ECONOMICS
to explain why almost $2 billion were nearly sacrificed in bargaining costs, that asymmetry
must be present in almost every bargaining ~ituation.'~
The costs of Texaco's financial distress also shed light on several aspects of corporate
financing and macroeconomic policy. American firms rely heavily on equity despite the
substantial incentive to debt finance provided by the deductibility of interest but not dividends. This is often attributed to bankruptcy costs, or more generally to the costs of financial
distress (Gordon and Malkiel, 1981). Yet empirical evidence demonstrating that bankruptcy
expenses are substantial has been lacking (Warner, 1977; White, 1983; Jensen and Meckling,
1976). The Texaco-Pennzoil case indicates that legal disputes can impose large costs on a
firm, and that the indirect effects of conflict on profitability can be substantially greater
than the direct expenses of the litigation (Altman, 1984).We suspect that if market valuations
of the participants in other large disputes, such as the asbestos claimants and companies,
could be found, they would show similar losses in joint value. The evidence suggests that
this is almost certainly the case for intercorporate disputes (Engelmann and Cornell, 1988;
Bhagat, Brickley, and Coles, 1988; Baldwin and Mason, 1983).
Greenwald and Stiglitz (1987) have argued that monetary contractions have substantial
supply-side effects. By raising the debt burdens of firms, they interfere with firms' ability to
obtain working capital and so make them less profitable. This is quite distinct from any
adverse effects that contractionary monetary policies and high interest rates may have on
the demand for investment goods. The idea that contractionary monetary policies adversely
affect productivity can explain why real wages often fall rather than rise during recessions,
and why firms postpone production by liquidating inventories rather than building up stocks
during recessions. The Texaco-Pennzoil evidence supports the contention that financial
distress can interfere with firms' ability to produce efficiently.
Finally, there are important parallels between the Texaco-Pennzoil conflict and the
Latin American debt crisis. In both cases, there was an ongoing struggle over a large sum
of money. Just as most observers thought it was almost inconceivable that Texaco would
pay Pennzoil the full $12 billion jury award, most observers doubt that Latin America will
ever pay back the face value of its debt. Just as Texaco's ability to operate efficiently and
to undertake profitable investments was impaired by the overhang of its debt to Pennzoil,
so too investment in Latin America today is crippled by overhanging debt and the need to
meet interest obligations. Just as a negotiated settlement of the Texaco-Pennzoil case raised
the market value of both companies, so too an appropriately negotiated writedown of Latin
America's debt might benefit both the creditors and the debtor nations.
Appendix
Table A1 reports the returns of Texaco and Pennzoil and their combined return relative to the Standard and
Poor's Composite Oil Price Index.
TABLE A1
Returns Relative to Composite Oil Price Index*
Change in Market Value ($ million)
No.
Date
Texaco
Pennzoil
Combined
$427.8
(104.7)
-$382.9
(293.0)
Litigation Events
1
November 19, 1985
-$810.7
(286.3)
25 One possible resolution of the failure of bargaining is the agency problem associated with shareholder
lawsuits. Since Texaco's managers may be personally liable for damages the company pays, they might not have
an interest in specifying a damage amount (Mnookin, 1987). The proposed settlement, however, indemnified
Texaco's directors from any personal liability, and it is not clear why such an indemnification could not have been
proposed earlier.
CUTLER AND SUMMERS /
TABLE A1
171
Continued
Change in Market Value ($ million)
No.
Date
Texaco
Pennzoil
Combined
Litigation Events
December 10, 1985
December 18, 1985
January 10, 1986
February 20, 1986
February 12, 1987
April 6, 1987
April 12, 1987
November 3, 1987
Total Litigation Events
Settlement Events November 19, 1987 December 2. 1987 December 1 1. 1987 December 18. 1987 Total Settlement Events * Standard errors in parentheses.
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You have printed the following article:
The Costs of Conflict Resolution and Financial Distress: Evidence from the Texaco-Pennzoil
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David M. Cutler; Lawrence H. Summers
The RAND Journal of Economics, Vol. 19, No. 2. (Summer, 1988), pp. 157-172.
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1
Measuring the Cost of Corporate Litigation: Five Case Studies
Kathleen Engelmann; Bradford Cornell
The Journal of Legal Studies, Vol. 17, No. 2. (Jun., 1988), pp. 377-399.
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1
The Resolution of Claims in Financial Distress the Case of Massey Ferguson
Carliss Y. Baldwin; Scott P. Mason
The Journal of Finance, Vol. 38, No. 2, Papers and Proceedings Forty-First Annual Meeting
American Finance Association New York, N.Y. December 28-30, 1982. (May, 1983), pp. 505-516.
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3
The Adjustment of Stock Prices to New Information
Eugene F. Fama; Lawrence Fisher; Michael C. Jensen; Richard Roll
International Economic Review, Vol. 10, No. 1. (Feb., 1969), pp. 1-21.
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Using Financial Data to Measure Effects of Regulation
G. William Schwert
Journal of Law and Economics, Vol. 24, No. 1. (Apr., 1981), pp. 121-158.
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References
A Further Empirical Investigation of the Bankruptcy Cost Question
Edward I. Altman
The Journal of Finance, Vol. 39, No. 4. (Sep., 1984), pp. 1067-1089.
Stable URL:
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The Resolution of Claims in Financial Distress the Case of Massey Ferguson
Carliss Y. Baldwin; Scott P. Mason
The Journal of Finance, Vol. 38, No. 2, Papers and Proceedings Forty-First Annual Meeting
American Finance Association New York, N.Y. December 28-30, 1982. (May, 1983), pp. 505-516.
Stable URL:
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A Theory of Disagreement in Bargaining
Vincent P. Crawford
Econometrica, Vol. 50, No. 3. (May, 1982), pp. 607-637.
Stable URL:
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Measuring the Cost of Corporate Litigation: Five Case Studies
Kathleen Engelmann; Bradford Cornell
The Journal of Legal Studies, Vol. 17, No. 2. (Jun., 1988), pp. 377-399.
Stable URL:
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The Adjustment of Stock Prices to New Information
Eugene F. Fama; Lawrence Fisher; Michael C. Jensen; Richard Roll
International Economic Review, Vol. 10, No. 1. (Feb., 1969), pp. 1-21.
Stable URL:
http://links.jstor.org/sici?sici=0020-6598%28196902%2910%3A1%3C1%3ATAOSPT%3E2.0.CO%3B2-P
Why is there Disagreement in Bargaining?
Henry S. Farber; Max H. Bazerman
The American Economic Review, Vol. 77, No. 2, Papers and Proceedings of the Ninety-Ninth
Annual Meeting of the American Economic Association. (May, 1987), pp. 347-352.
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Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers
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The American Economic Review, Vol. 76, No. 2, Papers and Proceedings of the Ninety-Eighth
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Perfect Equilibrium in a Bargaining Model
Ariel Rubinstein
Econometrica, Vol. 50, No. 1. (Jan., 1982), pp. 97-109.
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U.S. Commercial Banks and the Developing-Country Debt Crisis
Jeffrey Sachs; Harry Huizinga; John B. Shoven
Brookings Papers on Economic Activity, Vol. 1987, No. 2. (1987), pp. 555-606.
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Using Financial Data to Measure Effects of Regulation
G. William Schwert
Journal of Law and Economics, Vol. 24, No. 1. (Apr., 1981), pp. 121-158.
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Bankruptcy Costs: Some Evidence
Jerold B. Warner
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Michelle J. White
The Journal of Finance, Vol. 38, No. 2, Papers and Proceedings Forty-First Annual Meeting
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