THE GAMBLER WHO REFUSED $2 BILLION Pennzoil's J. Hugh Liedtke, fighting Texaco, made a historic bet. Initial effect: Everybody loses.
By Stratford P. Sherman REPORTER ASSOCIATES Rosalind Klein Berlin, Christopher Knowlton, Stephen Madden, Alison Bruce Rea, Julianne Slovak

(FORTUNE Magazine) – JUST THINK what they must be saying in Tokyo. Or Paris. Or Riyadh. 'Strange people, those Americans. Fighting for their competitive lives, they need strong companies. They also need oil, every drop they can drill. And yet they allow Texaco, their eighth-largest industrial company, their third- biggest oil producer, to enter bankruptcy, even though its operations are basically healthy. That may suit a few stubborn men obsessed with some very peculiar litigation. But America looks like the loser here.' Strange events indeed, and tragic. Not only does America lose, but so do Texaco's employees, suppliers, and stockholders -- at least temporarily. And so do the stockholders of Pennzoil, Texaco's adversary in the huge lawsuit that created the whole mess. Why must everybody lose? What constructive purpose is served? And what dreadful event may come next? The whole amazing story is beyond anyone's previous experience in business or law. Pennzoil's celebrated suit arose from Texaco's takeover of Getty Oil, which allegedly wrecked a planned Pennzoil-Getty deal. A Texas jury decided in November 1985 that Texaco owed Pennzoil $10.5 billion -- the largest award in history. A higher court later reduced it to $8.5 billion, but by mid-April interest and penalties had brought it up to $11 billion. Texaco offered to pay Pennzoil around $2 billion if Pennzoil would drop its claims. Pennzoil , Chairman J. (for John) Hugh Liedtke -- in what must be the biggest turndown of cash ever -- looked that ten-figure sum in the eye and said no. The next day Texaco filed for bankruptcy protection, the biggest company ever to do so. A quick settlement is the only sensible way to end this battle. When FORTUNE went to press in mid-April there was scant sign of one, though the situation could change rapidly. But in any case the negotiating failure that led Texaco to file under Chapter 11 -- shocking Liedtke -- left both sides worse off than if they had settled before the filing. Bankruptcy procedures are slow and uncertain. ''This is a typical degenerating negotiating situation, each side trying to be firmer than the other,'' says Gerard Nierenberg, a lawyer and president of Manhattan's Negotiation Institute. ''This is how we get into wars. This is how divorces occur. And it's simply how two giant corporations can go down the drain.'' Liedtke (pronounced LID-key), the man who turned down Texaco's $2-billion settlement offer, in mid-April still held out his hand for more. Asked by FORTUNE whether he is the greediest man in the world or simply in need of psychiatric help, Pennzoil's barrel-bellied chief executive chuckled and replied, in a voice so gravelly and deep you practically have to drill for it, ''Maybe both.'' Then he adds, ''I don't think 'greed' is fair, I really don't.'' Liedtke, 65, refuses to accept what he calls a ''shotgun settlement'' on Texaco's terms. ''Pennzoil is unmoved by Texaco's dramatic gesture,'' he says. ''Maybe now we should sit back awhile and see how they like bankruptcy -- the euphoria should wear off in about a week. We will not take an unreasonably low settlement, whether it takes six months or four years.'' This pugnacious gambler may never have expected to pocket the whole $11 billion, but Liedtke still insisted on a settlement in the $3-billion to $5- billion range -- roughly twice as much as Texaco's equally intransigent leaders would pay. The man who runs Texaco is adamant that his company has done nothing wrong. ''I am interested in settling this thing,'' says James W. Kinnear, 59, a trim, personable marketer who became Texaco's chief executive only last January. ''But I believe we are absolutely right under the law.'' THAT OBSTINATE ATTITUDE is reminiscent of John K. McKinley, 67, who was Kinnear's predecessor and got Texaco into this bind. Combined with the arrogance for which Texaco is famed in the oil patch, stubbornness contributed ) to the devastating series of setbacks the company has suffered in courts from Delaware to Texas to Washington, D.C. McKinley, an overbearing Alabamian who looks like Lyndon Johnson, failed to take Pennzoil's suit seriously enough at first and then lost big. He and Kinnear reluctantly tried to settle the case, but their efforts accomplished nothing. Now the company, long criticized for flat-footed management, will be run under the cumbersome rules of Chapter 11 bankruptcy, perhaps for years. Only three units, accounting for 4% of Texaco revenues, are in Chapter 11 (see diagram, left), but since they are the parent company and finance units, their uncertain prospects cast doubt on all Texaco operations. The inability of Liedtke and Kinnear to reach a compromise for so long proved horribly costly. The day after Texaco's bankruptcy filing, the market value of Pennzoil's stock dropped $631 million, prompting outraged shareholders to wake Liedtke in the middle of the night with angry phone calls to his home. Texaco's stock, already priced far below estimates of the company's intrinsic value, fell a bit further. Security analysts believe that if asset-rich Texaco had paid a settlement as high as $3 billion instead of going bankrupt, relieved investors would probably have pushed Texaco's market value up by more than $3 billion. Kinnear does not think much of that argument, and he is sticking to his guns: ''Whatever we offer now will be less than our last settlement proposal.'' FOR ALL THE ALLURE of a timely settlement, none seemed likely as long as the leaders of the two companies refused to sit down and negotiate seriously. For months, backed up by squads of expensive lawyers and investment bankers, they did little more than lob unacceptable proposals at one another like hand grenades. When Liedtke and Kinnear individually discuss their negotiations, one likely reason for their lengthy impasse emerges: These men genuinely do not seem to understand or respect one another enough to communicate effectively. Both talk, neither listens. For 16 months Texaco threatened to file for bankruptcy if pushed too hard. Liedtke pushed anyway, and Texaco eventually made good its threat. Asked why he continued to push, Liedtke offers this story: ''When my daughter Kristie was a little girl, she'd threaten to hold her breath until she died if she couldn't have her way. She'd turn red and scare her mother and me half to death. On our pediatrician's advice, one time we just let her hold her breath till she keeled over. She never did it again. She has a very sweet disposition now.'' Counters the exasperated Kinnear: ''The truth is he was holding our head under water. You better hold your breath.'' Liedtke and Kinnear have almost nothing in common to help bridge the $2- billion-wide gulf that divided them. Liedtke is an entrepreneur and a rebel who named his first major company, Zapata Petroleum, after the famous Mexican revolutionary. Kinnear, by contrast, is an Annapolis-trained company man who toiled in Texaco's rigid bureaucracy for 33 years before winning his place atop it just six years before his mandatory retirement. Liedtke's suits don't always fit; Kinnear dresses for success, Texaco style, with French cuffs and a tie clip. Each man is convinced he is fighting for a principle and the other fellow is wrong. While the two men postured, the events leading to Texaco's bankruptcy filing chugged along. Under Texas law, Pennzoil could have secured that $11-billion judgment by seizing Texaco assets, or it could have filed liens -- legal claims -- on them while appeals were pending. Liens would have made Pennzoil a giant secured creditor of Texaco, upsetting Texaco's unsecured creditors, to whom it owes billions. Texaco could have prevented Pennzoil from going after its assets by posting a multibillion-dollar bond while the case was appealed. But the sums were so enormous that Texaco consistently said it would file for bankruptcy rather than post that bond. Texaco deferred the awful choice by maneuvering in court. After losing the original Texas trial, Texaco hired a new lawyer, David Boies of the New York firm Cravath Swaine & Moore. Boies had successfully defended CBS against General William Westmoreland's famous libel suit, among other high-visibility accomplishments. Attempting to sidestep the Texas courts, Boies turned to a federal court in White Plains, New York -- Texaco's hometown. There he won restraining orders that blocked Pennzoil from collecting its damages for as long as the appeals dragged on. But in early April the U.S. Supreme Court threw out that decision, stating that federal courts had no right to interfere until appeals on Pennzoil's security had been exhausted in Texas. TEXACO IS FAR from the most popular company in the Lone Star State and seems mighty uncomfortable in its courts. Some independent observers think Texas prejudice against Northeasterners is one reason the jury there slammed the company so hard. Apparently afraid to take its chances in Texas, Texaco filed for bankruptcy in White Plains the day before a Houston judge was scheduled to begin hearings on how Pennzoil's judgment was to be secured while Texaco pursued its appeal. The bankruptcy filing came on a Sunday, after days of intense settlement negotiations in Houston between Texaco and Pennzoil. Kinnear, whose earlier offers had reportedly been somewhere around $500 million, finally made his top offer of about $2 billion if Pennzoil would acknowledge that amount as full settlement of the court's award. ''Texaco was in a hostage situation,'' says Frank Barron, a Cravath partner. ''It's analogous to paying ransom to kidnappers. You don't do it because the kidnappers deserve the money but because you want the hostage back.'' Liedtke refused the offer, and Kinnear returned to White Plains for a Texaco board meeting on Saturday. That day Liedtke sent a counteroffer to Kinnear by corporate jet, using Pennzoil's pilot as courier. Liedtke says he offered to settle for something between $3 billion and $5 billion. The next day he flew to New York for meetings with Kinnear. But, relates Joseph Jamail, chief lawyer for Pennzoil in its suit against Texaco, ''They filed for bankruptcy while he was still in the air. It kind of made him wonder whether they were talking in good faith.'' Liedtke says he had to turn down Texaco's $2-billion offer. Having won $11 billion, he argues, he has a fiduciary duty to Pennzoil's stockholders to collect as much of that money as possible. His advisers told him that a settlement in the $3-billion to $5-billion range would be fair. If he were to accept a settlement much smaller than his advisers have suggested, says Liedtke, Pennzoil's shareholders might have grounds for a successful lawsuit.

Kinnear and his fellow Texaco board members -- who include such business heavyweights as former IBM chairman Frank Cary and Capital Cities/ABC Chairman Thomas Murphy -- have a similar problem. Texaco shareholders have already filed 15 suits against them, arguing that the directors should be liable for an act -- the Getty takeover -- that resulted in an $11-billion judgment against the company. A settlement with Pennzoil could give those suits extra power by appearing to be an admission of wrongdoing by directors, and the dollar amount of the settlement might be seen as a measure of the damage done to Texaco's shareholders. Says Frank Barron: ''That possibility never entered / into the board's deliberations.'' EVEN WITH TEXACO in bankruptcy, the two companies could still settle. In a way the bankruptcy filing could make settling easier for Texaco. So long as the company remains in Chapter 11, any deal it agrees to with Pennzoil must be approved by federal bankruptcy judge Howard Schwartzberg as well as by Texaco's creditors. That ratification could insulate Texaco's directors from charges of wrongdoing even if they paid the enormous sums Liedtke was demanding. ''Look,'' they could say, ''we did our best to avoid it, but the bankruptcy judge said the settlement was OK.'' But the filing could also reduce Texaco's incentive to settle. Bankruptcy law effectively blocks Pennzoil from securing the $11-billion judgment. Until Liedtke can grab Texaco's assets, he can't bully Kinnear into quickly settling on Pennzoil's terms. So long as the original jury verdict stands, Texaco has no great leverage over Pennzoil either. Bankruptcy raises a host of other complicated issues. As Texaco's largest creditor, Pennzoil could gain enormous influence over Texaco's affairs. This will be one of Pennzoil's strongest weapons. ''Texaco may have shot themselves in the foot,'' says lawyer Jamail. ''They can't get out of bankruptcy unless we agree.'' Texaco may try to exploit a provision of bankruptcy law to reduce the damage award by as much as $7 billion. Bankrupt companies are not required to pay ''unmatured'' interest, which is interest that has not yet come due. Texaco may argue that most of the damages it owes represent just that. In addition to punitive damages, the original jury award included actual damages of $7.5 billion. Texaco may say that figure represents what Pennzoil would have had to spend over the next 25 years to find as much oil as it would have received with Getty. Although Texaco failed to make this point in the original trial, it now argues that the value in today's dollars of those 25 years of spending is much less than the jury figured. The reasoning: Through compound interest, the $7.5 billion can be created from a far smaller amount invested for 25 years. Pennzoil rejects Texaco's premise, asserting that the damage award represents what all that lost oil would have cost to find at the time of the verdict. Pennzoil will probably also counter that a federal bankruptcy judge has no authority to fool around with the elements of a decision by a state court -- just as that federal judge in White Plains could not. Argues Laurence H. Tribe, a law professor at Harvard Law School who has represented Pennzoil: ''This is an attempt to take a second bite out of a fruit that the higher federal courts have already said is a forbidden fruit.'' Kinnear and Liedtke disagree about whether the Chapter 11 filing was an economic necessity or a negotiating stunt. ''This is not a ploy,'' asserts Kinnear. ''It was done to stay alive.'' That seems a considerable overstatement. With assets of $34 billion and a book value of $18.3 billion -- which is surely much less than its true net worth -- Texaco certainly could have paid a $3-billion settlement or posted a multibillion-dollar bond and survived. According to Liedtke, Texaco could even afford to pay all of the original Texas judgment and still have enough left over to pay off every other creditor in full. LIEDTKE ADMITTED that Texaco could win its case as it proceeded up the ladder of appeals, leaving Pennzoil with nothing to show for its victories to date but millions in lawyers' bills. That prospect, which Liedtke naturally regarded as unlikely, would be a sad denouement to an otherwise brilliant career. A sophisticated financier as well as a wildcatter, Liedtke has needed no windfall from Texaco to enrich his shareholders (see chart opposite). The returns to an investor who bought into Pennzoil in 1963, soon after Liedtke took over, would have averaged 21.5%, compounded annually. Liedtke's business strategy is simple. Like T. Boone Pickens and others, he buys assets for less than he thinks they are worth and repackages them to make them more attractive to investors. Tulsa-born Liedtke, a big friendly galoot with a face as droopy as a basset hound's, definitely does not look or talk like a wizard of high finance. But be warned: The blood in his veins is Prussian, and this good old boy is a graduate of Amherst, where he majored in philosophy, and of Harvard Business School and the University of Texas Law School. He is smart, tough, unconventional, and lucky -- a combination that makes him a fearsome adversary. Liedtke got lucky early in life. After Navy service on an aircraft carrier during World War II, he settled down to practice law in Midland, Texas, which sits atop one of the biggest pools of oil in the continental U.S. According to Robert Green of Merrill Lynch, who had been Liedtke's Amherst roommate and is now Pennzoil's lead investment banker, Liedtke quickly tired of the divorces, estate cases, and wills that constituted the bulk of his practice. So Liedtke teamed with his younger brother, William, also a Midland lawyer, to invest modest sums in oil exploration. In 1953 they joined with George Bush -- now Vice President of the U.S. -- to form the exploration company called Zapata. They invested $2,500 each, raised $1 million, and had the good fortune to drill one successful well after another, amassing Texas-size fortunes while still in their early 30s. Though they severed their business ties in 1955, Liedtke and Bush remain good friends. ''George isn't a wimp, I can tell you that,'' says Liedtke. ''I think he'd make a whale of a President.'' Liedtke was a corporate raider and bust-up artist decades before those terms were invented. His first big move was a friendly takeover of South Penn Oil Co. in the early 1960s. Once part of the Standard Oil trust, South Penn made the popular lubricating oils sold under the Pennzoil brand name. The company owned plenty of valuable assets but produced paltry profits. The brash young Liedtke figured South Penn would do better if he were running it. When Liedtke arrived on the scene, the company was controlled by J. Paul Getty, the oilman then called the richest American. Getty installed Liedtke as chief executive, and a few years later Getty sold out to him. Liedtke merged the exploration business into South Penn and renamed the company Pennzoil. His fascination with hidden asset values led Liedtke into the fight with Texaco. In late 1983 he noticed that shares of Getty Oil Co. were selling for considerably less than the per-share value of Getty's vast reserves of oil and gas. Liedtke started buying. Soon he formed an alliance with Gordon Getty, one of the late J. Paul's sons. A gifted musician and an amateur businessman, Gordon headed a family trust that owned 40% of Getty Oil. HE AND LIEDTKE cooked up a deal that would greatly increase Getty's market value. Early in 1984, Pennzoil and Getty Oil announced a detailed agreement in principle for Pennzoil to buy three-sevenths of Getty's shares for $3.9 billion, or $112.50 per share, $40 more than the market price of a month before. Several days later, however, Getty accepted a Texaco offer to buy all of its shares for $125 each, a price later raised to $128. The total came to more than $10 billion, a record at the time. Pennzoil sued, arguing that Texaco had illegally interfered with a binding contract between it and the ! Getty interests. Far from being intimidated by the lawsuit, Texaco's McKinley went ahead with the purchase. In retrospect he should have been much more cautious. Martin Lipton, the renowned takeover lawyer who represented the Getty Museum -- a principal owner of Getty Oil -- had insisted that Texaco indemnify the Getty interests against lawsuits arising from the deal. Texaco management considered the risks and agreed, scarcely imagining how vast the consequence would be. When the Texas jury ruled in Pennzoil's favor to the tune of $10.5 billion, Texaco had no one with whom to split the bill. And while Texaco, along with many objective observers, regards that damage award as absurdly high, the company did not present its own theory of damages during the original trial. To advocate a different way of figuring damages, the company's lawyers reasoned, would only dignify Pennzoil's claim. The Texas appellate court that reduced the damage award nevertheless sustained the jury's verdict. As of mid-April, Texaco still intended to appeal to the Texas Supreme Court and then, if necessary, the U.S. Supreme Court. But neither tribunal was obliged to hear the case. G. Irvin Terrell, an attorney with Baker & Botts, one of Pennzoil's law firms in Houston, estimated that exhausting the appeal process could take as little as nine months if neither court accepts the case, or as long as 18 months if both do. Some independent lawyers and security analysts think presenting appeals to both courts could take much longer, perhaps three or four years. The only way Texaco could escape the judgment entirely would be to win on appeal -- possible but unlikely. At worst, if Texaco refused to settle it could end up having to pay Pennzoil the whole $11 billion it owed the day it went into bankruptcy -- also unlikely. But as of mid-April each of those extremes represented a serious risk for one of the two warring C.E.O.s, and an opportunity for the other. Since neither man had won a decisive advantage, settlement still seemed in the interest of both. And although the sum of roughly $2 billion that divided them seemed impossibly large, the financial risks each man faced if he did not settle were even larger. Splitting the difference -- arriving somewhere between $2.5 billion and $3.5 billion, say -- might have made sense for everyone concerned. Liedtke expects Pennzoil to wind up with some of Texaco's money, and he is already thinking about what to do with it. True to form, he is considering spinoffs, one of his favorite techniques. In a spinoff, a parent company takes some of its own assets and creates a new company out of them. The ownership of those assets does not change at first, since the shareholders of the parent receive all the stock in the new company. But henceforth the two companies' shares trade independently -- and as Liedtke has often demonstrated, investors frequently pay more for the same assets when they are separated into comprehensible pieces in this way. In 1985, for example, Pennzoil spun off most of its gold-mining operations, whose success had done little for Pennzoil's stock. Reconstituted as Battle Mountain Gold Co., this company's shares have since tripled in price.

Liedtke plans to retire once the case is resolved, and he has no heir apparent. Instead, he expects to execute his ultimate spinoff, breaking up Pennzoil into four pieces and in effect liquidating the company. He has already set up the pieces: the parent company, which owns most of the oil and gas reserves and carries most of the debt; the eponymous lube-oil business; a sulfur-mining operation; and a grab-bag assembly of everything else Pennzoil owns, from Houston real estate to gold properties in Indonesia. Depending on whether Texaco pays in cash or another form, Liedtke plans to pop the payment into the right Pennzoil unit and then push the button on his spinoff plan.

Bad management by both Texaco and Pennzoil transformed an awkward dispute into a disaster of historic proportions. Managers hoping to avoid making epic messes of their own are finding this miserable saga a rich source of lessons. Lesson No. 1 is that even the most learned and famous lawyers and investment bankers that money can buy may give imperfect advice. No. 2: Before you agree to indemnify people, ask yourself why they need indemnity in the first place. Marty Lipton's request that Texaco indemnify the Getty interests could have alerted Texaco's McKinley to the considerable risk he faced. No. 3: Never engage in a jury trial if you can avoid it. If you can't avoid it, treat even the silliest-seeming jury trial with life-and-death seriousness. No one knows what a jury will do. No. 4: Corporate shareholders do not require their fiduciaries to fight for matters of principle, but they get very testy when their financial interest is threatened. It is often wiser to settle, even if you are right. No. 5: If you're going to negotiate at all, you must be prepared to respect your opponent's position. As of mid-April, that was a lesson that Hugh Liedtke and James Kinnear apparently still had not learned.

CHART: NOT AVAILABLE CREDIT: ILLUSTRATION BY RENEE KLEIN CAPTION: TEXACO'S EMPIRE Pennzoil's huge claim is against Texaco Inc. Figures are 1986 revenues; the three units that entered bankruptcy produced little. DESCRIPTION: Chart shows Texaco companies that have and have not filed for bankruptcy, with 1986 revenues for each.

CHART: NOT AVAILABLE CREDIT: NO CREDIT CAPTION: Liedtke's gambles have usually paid off. The chart assumes that shares of spun-off companies are kept and dividends reinvested. DESCRIPTION: Chart shows value of $1,000 investment in Pennzoil stock since J. Hugh Liedtke became chairman in 1962.