Commentary: Why Madrid Shot Down Telefonica's Ace

Telefonica CEO Juan Villalonga resigned on July 26, the loser in a high-stakes battle with Spanish Prime Minister Jose Maria Aznar that raged for six months. In Madrid, the bitter conflict took on the dimensions of a real-life soap opera as cocktail parties and office hallways buzzed with tales of various acts of betrayal.

In this fiasco, there's plenty of blame to go around. First, the clubby ties between government and business in Spain that helped bring Villalonga down do little honor to a country that aspires to be Europe's new economic star. Aznar's vendetta against Villalonga translated into a government campaign of behind-the-scenes manipulation of Telefonica board members that undercut Villalonga's ability to manage the company. Government officials deny that they engineered Villalonga's downfall. But top executives in Spain affirm that board members at many large companies are highly susceptible to government pressure, and Telefonica was a case in point. "Villalonga is a brilliant manager," says one Telefonica board member and ally of the embattled CEO. "But he didn't keep good relations with the government, and that is absolutely essential."

POWERHOUSE. Villalonga enraged Aznar in February by announcing a $500 million stock option plan for Telefonica executives a month before general elections. Aznar, worried about voter reaction, panicked and tried to persuade Villalonga to renounce the plan. He refused. Aznar retaliated by hiking taxes on options.

At the same time, Villalonga made himself a target through behavior that wouldn't pass muster in U.S. or British boardrooms. His excesses and arrogance made him vulnerable, overshadowing his successes and putting his credibility in doubt. In June, the 47-year-old CEO was placed under investigation for possible insider-trading violations in 1998 while negotiating an alliance with MCI WorldCom. "In the U.S. and Britain, if you give stock options to top management and don't report them at a general shareholders' meeting, you would go to jail," says one Madrid investment banker. What Villalonga did appears to have been legal at the time, which is one reason the initial investigation was dropped two years ago. And the reopening of that probe in June may be politically motivated. But his actions undercut his self-proclaimed standing as a champion of shareholder value.

No question, Villalonga has vision. Under his six-year stewardship, Telefonica went from provincial weakling to global powerhouse with a market capitalization of $90 billion. Telefonica is the No. 1 telecom player in Latin America. Its Internet subsidiary, Terra Networks, is merging with U.S. portal Lycos Inc. In March, Telefonica boosted its muscle into media with the acquisition of Dutch giant Endomol Entertainment Holding for $5.4 billion. But Villalonga's domineering personality and clashes with management became a liability.

In the long run, Telefonica may well be better off without Villalonga. Yet Spain's industry would also be better off if politicians broke the direct ties to industry that give them too much economic power. On the heels of a resounding reelection victory, Aznar made it a priority to bring Spanish capitalism rapidly into the 21st century. If he means what he says, then overhauling the relationship between government and business should be a top priority.

INFLUENCE. That includes a reassessment of the "golden share" that the government still holds in Telefonica and other privatized companies. In April, the government sharply opposed Villalonga's plan to merge Telefonica and Dutch telecommunications giant Royal KPN on the grounds that KPN is still partly owned by the Dutch government. While never executed officially, the government's golden share clearly influenced the decision of core shareholders to vote down the KPN deal.

Despite his flaws, Villalonga helped jump-start Spain's New Economy. "He was the first to realize what the markets wanted and break with old Corporate Spain," says Pepe Cervera, a consultant at in Madrid. In the end, he lost the battle. The worst thing Aznar could do now is glory in that defeat.

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