Posts this month
A blog on financial markets and their regulation
Earlier this month, the UK Financial Services Authority bowed to public pressure and published a massive (452 page) report on the failure of the Royal Bank of Scotland. This report has been much commented upon in the press and the blogospherre (yes, I am rather late to this party!), but I do wish to comment on what the report says about the due diligence involved in the ABN Amro acquisition:
Many readers of the Report will be startled to read that the information made available to RBS by ABN AMRO in April 2007 amounted to ‘two lever arch folders and a CD’; and that RBS was largely unsuccessful in its attempts to obtain further non-publicly available information. (Chairman’s Foreword, page 9)
The RBS Board was unanimous in its support for the acquisition. The RBS Board’s decision to launch a bid of this scale on the basis of due diligence which was insufficient in scope and depth for the major risks involved entailed a degree of risk-taking that can reasonably be criticised as a gamble. The Review Team reached this conclusion in the knowledge that had a fully adequate due diligence process been possible, the RBS Board might still have been satisfied with the outcome and decided to proceed. (Para 415)
In contested takeovers only very limited due diligence is possible. Management and boards have to decide whether the potential benefits of proceeding on the basis of limited due diligence outweigh the risks involved. Institutional investors are well aware of the limited nature of the due diligence possible in these circumstances, and have the ability to vote against approval of the acquisition if they consider the risks are too great. If the acquisition turns out to be unsuccessful, they can dismiss the board and management. (Para 441)
In most sectors of the economy, this market discipline approach remains appropriate because the downside risks affect only the equity shareholders. Banks, however, are different because, if a major takeover goes wrong, it can have wider financial stability and macroeconomic effects. The potential downside is social, not just private. (Para 442)
As a result, further public policy responses to the lessons of the ABN AMRO acquisition need to be considered. … Establishing within this formal approval regime a strong presumption that major contested takeovers would not be approved, or would only be approved if supported by exceptionally strong capital backing, given that specific risks are created by an inability to conduct adequate due diligence. (Para 443)
I think this whole idea is misguided. Absent outright fraud, there is in fact not much that can be gained from invasive due diligence of a large public company. The FSA report itself admits that all the major risks of the acquisition were crystal clear without any due diligence. RBS made a conscious strategic decision to buy the ABN Amro business. They thought that the assets were of great strategic value, when in fact they were toxic. The problem was not one of lack of information; it was simply a wrong macro view of this business. A million lever arch folders and CDs would not have cured this problem.
If FSA thinks that an investment decision based on ‘two lever arch folders and a CD’ worth of due diligence is a gamble, then they must also argue that Warren Buffet’s bail out of General Electric and Goldman Sachs in 2008 (and of Bank of America this year) were gambles. I think this is wrong. Absent outright fraud, buying a large listed company after analysing only the public filings is perfectly prudent and legitimate. And, if the FSA thinks that banking is a sector where there is a preponderance of outright frauds, then that is an admission of total and complete regulatory failure – the regulators surely have access to all the lever arch files and CDs in the bank.
Only a check box ticking regulatory mindset can lead somebody to the silly idea that the quality of decision making can be measured by the volume of data that was processed. I am reminded of the great chess player Jose R. Capablanca who when asked how many moves he analysed before making his move replied “I see only one move ahead, but it is always the correct one.” When RBS looked at ABN Amro, they were fixated on one big move and that was a horribly wrong one. For that, they do deserve all the blame in the world, but let us not get unduly fixated about the ‘two lever arch folders and a CD’.