Over the next few years we will place special emphasis on enhancing our strong customer preference, increasing operating cash flow and reducing debt.
— Chairman’s letter to shareholders, Marriott Corporation 1990 Annual Report, p. 3 Priorities for the next few years: Reduce our long-term debt to about $2 billion by the end of 1994, by maximizing cash flow and selling assets.
— Chairman’s letter to shareholders, Marriott Corporation 1991 Annual Report, p. 5 [Third in a list of four priorities.] J.W. Marriott, Jr., chairman of the board and president of Marriott Corporation (MC), had weathered difficult times in the last few years. The company his father had founded in 1927 had grown explosively during the 1980s, developing hotel properties around the world and selling them to outside investors while retaining lucrative long-term management contracts. However, the economic slowdown in the late 1980s and the 1990 real estate market crash left MC owning many newly developed properties for which there were no buyers, together with a massive burden of debt. As Marriott had promised in successive annual reports over the last few years, the company was working to sell properties and reduce that burden, but progress was slow.
Looking ahead to the end of 1992, three months away, financial results promised to be only slightly better than for 1991, although still a significant improvement over the low point reached in 1990. For the foreseeable future, MC’s ability to raise funds in the capital markets would be severely limited. But Marriott now faced a decision that had the potential to change this situation completely. He was considering a radical restructuring of the company proposed by Stephen Bollenbach, the new chief financial officer, under which the bulk of MC’s service businesses would be split off from its property holdings—and debt. A new company would be created for the service businesses, with existing shareowners of MC receiving a share of stock in the new company to match each share they owned in the old one. The new company would have the financial strength to raise capital to take advantage of investment opportunities. The old one, valued for the chance of appreciation in its property holdings when the real estate market recovered, and not on the basis of earnings, would be under less pressure to sell properties at depressed prices.
Bollenbach had served as treasurer of MC in the early 1980s at the beginning of its period of rapid growth. After leaving in the middle of the decade, he had built a reputation for creating innovative financial structures in the hotel industry with the 1987 recapitalization of Holiday Corporation (later named Promus Companies, Inc.), and then with his rescue of Donald Trump’s heavily indebted real Professor Lynn Sharp Paine and Research Associate Charles A. Nichols III prepared this case. HBS cases are developed solely as the basis for class discussion. Cases are not intended to serve as endorsements, sources of primary data, or illustrations of effective or ineffective management.
Copyright © 1993 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685, write Harvard Business School Publishing, Boston, MA 02163, or go to http://www.hbsp.harvard.edu. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of Harvard Business School.
Bollenbach returned to MC as CFO in February 1992. His proposed restructuring, called “Project Chariot,” reflected the imaginative and innovative thinking characteristic of the financial advisors who had contributed so much to MC’s growth in the 1980s. Project Chariot seemed like the perfect solution to the company’s problems. Was it the right step to take now? MC’s board of directors would be meeting soon, and Marriott needed to decide what to recommend.
Founding and early years With 202,000 employees at the end of 1991, MC was ranked as the 12th largest employer in the United States.2 The company traced its beginnings to 1927, when J.W. Marriott, Sr., opened a small root beer stand in Washington, D.C. The business soon began to sell food and was renamed the Hot Shoppe restaurant. Working with his wife Alice, Marriott, Sr., saw the business grow throughout the 1930s and 1940s to a family-owned chain of 45 restaurants in nine states. The Marriotts also acquired contracts to run cafeterias and company kitchens, as well as to supply food to the airline industry. Growth and success were based upon a policy of careful attention to details and centralized and standardized operating procedures. Initial public offering MC went public in 1953, selling one-third of its shares. Although the company continued to sell stock to the public over the years, in 1992 the Marriott family still owned 25% of the company. In the first five years after the initial stock offering, it had doubled in size.
In 1956 it opened its first hotel, in Washington, and in the next eight years had grown to 120 Hot Shoppes and 12 hotels. J.W. Marriott, Sr., resigned the position of president in 1964, passing it to his son J.W. Marriott, Jr., then only 32. Under the son’s leadership MC abandoned the father’s conservative financial policies. It turned to major borrowing to finance expansion that would maintain its historical 20% annual revenue growth rate. In the 1970s MC began to use bank credit and unsecured debt instead of mortgages to finance development. According to new financial thinking developing in the company, borrowing was acceptable so long as cash flow was maintained at a sufficient multiple of interest charges. The company acquired restaurant chains and entered new businesses, such as theme park development and operation.
Joint ventures In 1978 MC embarked upon its first joint venture, constructing a group of hotels and then selling them to the Equitable Life Assurance Society, a major insurance company. Thus began a powerful growth strategy in which the company would plan and develop hotels, sell the properties to investors, and retain long-term management contracts. By 1980, following a fiveyear period of 30% annual growth, 70% of MC’s hotel rooms were owned by outside investors. MC possessed an enviable reputation for quality and reliability in service, and together with careful site selection procedures and hotel sizing, this reputation translated into occupancy rates 4%-6% above industry averages. This gap had widened to more than 10% by 1992; when the industry average was only around 65%, MC’s rate was 76%–80%.3
The Economic Recovery Tax Act of 1981 created new incentives for the ownership of real estate, which further fueled MC’s hotel-developing activities. Its first real estate limited partnership, offered 1Much of the material in this section is based upon Keith F. Girard’s, “What the Hell Happened to Marriott?,” in that year, gave investors $9 in tax writeoffs for every $1 invested. Beginning in 1983, MC also branched out into the mid-price lodging market with “Courtyard” hotels, which were bundled into groups of 50 or more for limited partnership offerings. In 1985, scaled-down but full-service “compact hotels” for smaller city markets, as well as all-suite hotels and longer-term residence inns were introduced; MC entered the budget hotel market with “Fairfield Inns” in 1987. MC also continued to acquire restaurant chains, including Gino’s in 1982 and Howard Johnson’s in 1985, although its success in establishing a national business in this area was limited. In 1984 the company discontinued its theme park operations.
End of the boom In 1986, the Tax Reform Act ended most of the tax incentives for real estate investment, but MC, relying on the strong economy and its own reputation, continued its high-paced development activities. However, the market for its limited partnerships was drying up, and in 1989 the company experienced a sharp drop in income. It froze capital expenditures, which had increased threefold over the previous six years, sold off its airline in-flight catering business, and discontinued its restaurant operations. In 1990 the real estate market collapsed. MC’s income plummeted and its year-end stock price fell by more than two-thirds—a drop of over $2 billion in market capitalization. For the first time, investor-owned Marriott hotels went bankrupt.
MC was saddled with large interest payments on properties it was unable to sell. Industry excess capacity led to low occupancy rates and deep discounting on room rates, resulting in large losses for many of MC’s competitors and even bankruptcies in some cases. In 1991 MC intensified its focus on contract and management opportunities that required less capital outlay. These included captive food service markets such as hospitals, office buildings, and turnpike service plazas, as well as management of golf courses. The development and management of “life-care” community facilities for senior citizens was also a high-growth market that MC had entered, but capital constraints forced it to cut back on planned new construction.
Thus, the MC of September 1992 was a far cry from the real estate development engine of the 1980s. Capital spending had been reduced to an annual level of $350 million—only the amount necessary to maintain and refurbish the existing properties. While the company had improved its position from the low point in 1990, investors still regarded it at best as a company beset by the problems of a severely depressed industry, with several years of slow recovery ahead before it could begin to grow again. (See Table A for market statistics on MC.)
Corporate culture However, MC remained a company with many strengths, not least of which was a unique corporate culture built around the personality and values of the Marriott family, and especially of J.W. Marriott, Sr., the founder. In every Marriott hotel lobby hung a painting of the two J.W. Marriotts; every Marriott hotel room contained a Gideon Bible, the Book of Mormon, and an authorized biography of J.W. Marriott, Sr.—a book commissioned and written in the 1970s and published in 1977.4 The biography detailed the life of the founder, beginning with his roots in the Mormon frontier communities in Utah, his childhood and early struggles in difficult economic circumstances, and his work for several years as a missionary for his church.
It described the source of his life-long aversion to borrowing: the burden of debt on his family’s sheep farm in Utah and the resulting foreclosure during the depression following World War I. The book closed with the picture of a wealthy and respected man, a leader in his church, and active in politics and philanthropy. In describing the growth of the MC, the book stressed the themes of careful attention to detail and organization, and above all of service to customers. But the organization itself was focused on the employees. On his retirement in 1964, in a letter to his son and successor, number of “guideposts” in his management philosophy, including the principle that “People are No. 1—their development, loyalty, interest, team spirit.”5 And nine years later, in introducing J.W. Marriott, Sr., as a speaker to the employees at the opening of the Los Angeles Marriott, a company senior executive remarked, “Marriott believes that the customer is great, but you come first. Mr. Marriott knows that if he takes care of his employees, they’ll take care of the customers.”6 Table AxxxMarket Statistics on Marriott Corporation (September 1992) Recent market price
Estimated earnings per share
S&P 500 Industrials (close of 3Q1992)
S&P Hotel/Motel (close of 3Q1992)
Value Line reports (September 4, 1992), MC annual statement, S&P Analysts’ Handbook.
Under Project Chariot, MC would become two separate companies. The division would be effected by a special stock dividend, giving stockholders of MC a share of stock in the new company to match each share they held of MC. The new company, to be called Marriott International, Incorporated (MII) would comprise MC’s lodging, food and facilities management businesses, as well as the management of its life-care facilities. Food management had become a major segment of MC’s business. With nearly 3,000 accounts, it included as clients some of the largest corporations and educational institutions in the United States. The existing company, to be renamed Host Marriott Corporation (HMC) would retain MC’s real estate holdings and its concessions on tollroads and in airports (see Exhibit 1 for details). The transaction would be conditioned upon a ruling from the Internal Revenue Service that the special dividend would be tax-free to shareholders, and upon ratification by a majority of MC stockholders. The plan called for the distribution of the dividend by mid-1993.
Under the plan, MII and HMC would have separate management teams. J.W. Marriott, Jr., would be chairman, president, and chief executive officer of MII, while his brother Richard Marriott (currently vice chairman of MC) would be chairman of HMC, and Stephen Bollenbach (the current MC chief financial officer) would be HMC’s president and chief executive officer. The two companies would also have separate boards of directors, except that the two brothers would each serve on both boards. MII would have an ongoing contractual relationship with HMC similar to the current relationship between MC and owners of hotel properties managed by MC. Such contracts typically involved the payment by the property owners of an annual management fee of 2%-3% of revenues. Similarly, MII would have the right to lease and operate the senior living facilities owned by HMC. Under the spin-off, MII would have the right to purchase up to 20% of HMC’s voting stock at market value in the event of a change in control of HMC. MII would also have right of first refusal if HMC offered its tollroad and airport concessions for sale.
In the past several years MC had reduced its work force significantly in response to its difficult economic situation. It was not expected that Project Chariot would lead to further cuts in the work force. After the division, MII would have 182,000 employees and in 1992, on a projected pro forma basis, would have had $7.9 billion in sales and operating cash flow before corporate expenses, interest expense, and taxes of $408 million. HMC would have 23,000 employees and 1992 projected pro forma sales of $1.8 billion with operating cash flow before corporate expenses, interest expense, and taxes of $363 million. Under the plan, HMC would retain nearly all of MC’s long-term debt of nearly $3 billion, although it would have access through December 1997 to a revolving line of credit of $600 million from MII. However, MII itself would have very little long-term debt (see Exhibit 1).
Pure plays Dividing MC into two companies was consistent with the company’s general strategy of separating property ownership from management operations. The theory was that added value came from finding investment opportunities and developing and managing hotels, not from the ownership of real estate. MC management had long felt that the financial markets undervalued the company’s stock because of the difficulty investors had in distinguishing and separately valuing property ownership and management. Project Chariot offered investors the opportunity to participate in “pure plays” in the hotel management business and in hotel real estate investment business for longer-term appreciation.
Career opportunities In many ways, Project Chariot would offer attractive possibilities to Marriott’s management. In the downsizing of the previous few years many executive positions had been lost. MC had also seen the departure of “fast-track” executives who decided that their chances of rapid ascent in the organization and wealth accumulation were not as good as elsewhere. With two separate companies there would now be twice as many top-level positions, and with MII poised for rapid growth, ambitious managers would be more likely to stay. Managers with stock holdings and options would also benefit personally from the expected increase in the value of the company’s stock after the Project Chariot restructuring.8
Opportunities for HMC and MII Because HMC would be valued more on the basis of the chance of appreciation in its property holdings than on expected income, the company would be under less pressure from investors to sell off hotels at distress prices. To the extent that HMC operated at a loss, the combined after-tax earnings of the two separate companies would be smaller than that of MC as a single entity, for HMC’s losses would no longer offset MII’s positive earnings. On the other hand, unburdened by debt, MII would have the ability to raise additional capital to finance growth, perhaps to participate in the consolidation of the hotel industry by purchasing the
8According to the MC March 1992 proxy statement, the Marriott family was deemed to control 25.75% (approximately 25.6 million shares) of common stock of MC. The holdings of all other directors, nominees, and executive officers amounted to approximately 300,000 shares. An additional 800,000 shares were set aside for executive officers under a restricted stock plan and deferred stock agreements, as well as approximately 2.8 million stock options (of which 1.1 million were currently exercisable) under a stock option plan.
Implications for Bondholders
While Project Chariot would very likely benefit stockholders in MC, the situation was quite different for bondholders. (See Exhibit 2 for a summary of MC’s long-term debt.) Although MC management was confident that HMC would have the financial strength to make all payments of interest and principal on long-term obligations when due, the separation of the two companies would affect the security of MC debt holders. Bond rating agencies such as Moody’s Investors Services (Moody’s) and Standard and Poor’s Corporation (S&P) were likely to lower the ratings on MC’s longterm bonds to a level below investment grade. (See Appendix A for a discussion of bond ratings.) This development could force some institutional holders of MC debt to sell their holdings, since banks, insurance companies and pension funds often operated under legal restrictions that limited the amount of noninvestment grade securities they could own. Fiduciaries managing such funds were also typically required by law to follow the “prudent person” rule in making investment decisions.
Covenants MC’s debt indentures contained the usual provisions, but lacked so called “event risk” covenants that would have blocked the Project Chariot restructuring or required any measures to protect bondholders from its potentially adverse effects. Event-risk covenants had emerged in the 1980s when transactions such as leveraged buy-outs (LBOs) had provided stockholders with large profits from tender offers at premium prices while creating large losses for bondholders in the reduced market value of their newly speculative investments. In response, bondholders began to insist on new covenants to protect them against the risk of the occurrence of such transactions.
These covenants provided that, on the occurrence of certain “triggering events,” such as a merger or consolidation, a change in ownership, or a major distribution of cash or securities, the company might be required to redeem immediately all or a specified proportion of the debt, provide collateral, or increase the interest rate to market levels. Research revealed that in 1989 30% of bonds issued included such covenants, with the securities of companies expected to be targets of takeovers more likely to be so protected.9
While event-risk covenants protected bondholders, they often did so at the cost of lower interest rates. With the collapse of the junk bond market in the early 1990s and the slowing of takeover and LBO activity, the use of such covenants decreased. None of MC’s long-term debt indentures contained event-risk covenants, including the indentures under which MC issued $400 million of long-term bonds in April and May of 1992 (see Exhibit 2). These were now selling at 110, reflecting a general decline in market interest rates during 1992.
Several LBOs that became insolvent were attacked by creditors using the legal theory of “fraudulent conveyance.” The doctrine of fraudulent conveyance, which dated to a sixteenth-century English statute, protected creditors from debtors who tried to shelter 9Kenneth Lehn and Annette B. Poulsen, “Contractual Resolution of Bondholder-Stockholder Conflicts in Leveraged Buyouts,” Journal of Law and Economics, Vol. 24, October 1991, pp. 645–673. 10Material in this paragraph is taken from their wealth or avoid their debts by conveying their property to others.
In some cases of failed LBOs, unsecured creditors attempted to recover funds from those benefiting from the LBO transaction, such as shareholders or advisors to the transaction. Because it was often difficult to prove intentional fraud by these parties, most LBO-related fraudulent conveyance actions were brought under the constructive fraud provisions of statutes such as the Federal Bankruptcy Code, the Uniform Fraudulent Conveyance Act, or the Uniform Fraudulent Transfers Act. According to section 548(a)(2) of the Bankruptcy Code, constructive fraud could be established when the debtor: 1. received less than reasonably equivalent value for the property transferred; and 2. either
a) was insolvent or became insolvent as a result of the transfer, b) retained unreasonably small capital after the transfer, or c) made the transfer with the intent or belief that it would incur debts beyond its ability to pay.
In the LBO situation, the tests of solvency and capitalization were the critical factors in determining constructive fraud.11 Since courts excluded from consideration both intangible value created by a transaction and tangible value received by anyone other than the debtor (the corporation), LBOs failed the “reasonably equivalent value test” by their very nature. LBO lawsuits were rarely successful. In large cases plaintiffs almost always agreed to settlements averaging less than 10 cents for each dollar of their claims.12 A review of two dozen decisions found only five with a verdict for the plaintiffs, and federal appeals courts ruled for the defendants in virtually every key case considered between 1986 and 1992. Among the most favored defendants were “public shareholders who received most of the funds, but did not control the deal.”13
Duties to bondholders U.S. courts had held that corporations have no responsibilities to safeguard the interests of bondholders other than those spelled out by the terms of the bond indenture. For example, in 1986, the Delaware Court of Chancery stated in Katz v. Oak Industries: Arrangements among a corporation, the underwriters of its debt, trustees under its indentures, and sometimes ultimate investors, are typically thoroughly negotiated and massively documented. The rights and obligations of the various parties are, or should be, spelled out in that documentation. The terms of the contractual relationship agreed to, and not broad concepts such as fairness, define the corporation’s duty to bondholders.
However, a more recent Delaware Chancery Court decision took the position that the duties of corporate boards of directors toward holders of corporate debt could be more extensive than simply to observe indenture provisions, particularly when the corporation was facing serious economic difficulties or bankruptcy. In such cases very risky courses of action could be beneficial to stockholders, yet injurious to the interests of debt holders. In Credit Lyonnais Bank N.V. v. Pathe Communications (1991 WL 277613), the court imposed a duty on the board to respect “the community of interest that sustained the corporation, to exercise judgment in an informed, good faith effort to maximize the corporation’s long-term wealth creating capacity.”
A commentator noted that this decision altered the traditional approach in which “the board’s duties to the company ran primarily to the stockholders, unless the company became insolvent, in which case the board’s duty in some sense ‘flipped’ to creditors.” In contrast, the new decision “. . . recognizes that there is no magic point at which duties should shift from stockholders to creditors. Instead, there is a continuum approaching insolvency in which the board’s incentives become increasingly distorted and the creditor-stockholder conflict increases.”16
The Delaware Chancery Court’s decision in the Credit Lyonnais case was not based upon completely novel ideas about the legal responsibility of corporate leaders. As far back as 1932, E. Merrick Dodd, Jr., in an article in the Harvard Law Review noted that “despite many attempts to dissolve the corporation into an aggregate of stockholders, our legal tradition is rather in favor of treating it as an institution directed by persons who are primarily fiduciaries for the institution rather than for its members.”17 However, Professor Dodd’s view was far from the orthodox position of most financial economists and lawyers in 1990, who regarded managers as agents for the shareholders with responsibility primarily to protect and promote shareholders’ interests.
Social and Economic Climate
As the junk bond market collapsed and many of its high-risk issues headed toward bankruptcy or renegotiation, public opinion regarding the acceptability of massive-wealth transfers through financial “engineering” shifted. Although there were still defenders of such transactions, they were viewed with suspicion by large segments of the public who condemned them as “paper” transactions contributing no real value to the economy. Junk bonds and real estate investments had left many financial intermediaries such as commercial banks, pension funds, and life insurance companies in financially shaky positions. Although commercial bank profits were starting to improve, the real estate market continued to languish as financial institutions shed nonperforming real estate loans, and residual fears dampened the enthusiasm of potential investors.
Marriott wondered what he should recommend to the board of directors regarding Project Chariot. (See Exhibits 3-7 for relevant financial data.) He had been assured by legal counsel that the corporation was within its rights as a debtor to restructure itself in this way. Investment advisors had given him an opinion that the transaction was in the best interests of shareholders. His CFO, Bollenbach, was convinced that cash flows for HMC were more than adequate to cover debt service requirements. And surely, if public reaction were extremely negative, or if other difficulties arose, Project Chariot could be abandoned without significant loss. But with this transaction the company was entering new territory.
The board would be meeting soon, and Marriott needed to decide.
15Richard P. Swanson, Esq., “Directors’ Duties to Creditors,” p. 16. 16Ibid., p. 16.
17E. Merrick Dodd, Jr., “For Whom are Corporate Managers Trustees?” Harvard Law Review, XLV, No. 7 (May 8, 1932), pp.