Coldheart, Crafty and Robber* Loot Doomed inc
This post will not describe any actual non fictional events. My aim is to understand whether there are gaps in the law which can make bankruptcy profitable. I know virtually nothing about the law, so I am typing in almost complete ignorance. I do this, because I know nothing about CDS either and my effort to exploit this blog to learn about them was well received.
* The title is not meant to insinuate anything about any existing firm. This note explains why I did not go with my original running title “Bane Capital Loots Doomed Inc.”
Doomed Incorporated is an insolvent corporation whose CEO and board of directors won’t face facts enter Chapter 11 and let a bankruptcy court liquidate the firm (or is that chapter 7 ?). I will assume that the debt is in the form of bonds not bank loans. Coldheart, Crafty and Robber (hence CCR but not to be confused with any centers for constitutional rights) is a closely held private equity partnership dedicated to finding the outer limits of the law. Doomed is a profit opportunity, because its shares are very cheap. So CCR can buy the firm without issuing new debt.
CCR also sets up a firm controlled by CCR called “The Sack” and sells the assets of Doomed to The Sack for below market prices. Even at market prices, Doomed assets aren’t enough to pay interest and principle on its bonds, but even at these low prices, the proceeds of putting Doomed’s assets in The Sack are enough to pay coupons and pay off the face value of mature bonds for a while.
At the end of this while, CCR declares The Sack bankrupt and bond holders get roughly zero cents on the dollar. A huge amount of money has been made by taking money from bondholders by minimizing the recovery ratio (cents on the dollar).
Why is this illegal ? Managers of publicly traded firms have a fiduciary duty to shareholders, but Doomed is now privately held. Creditors can ask a bankruptcy court to protect them, but only once a firm is a dollar short or a day late (actually 60 days late I think, but I really know almost exactly nothing). GAAP accounts can’t report non arms length transactions at other than fair market prices, but Doomed accounts are private as it is closely held so who cares.
In my ignorance, I think there is a wholly owned subsidiaries are really the same firm rule somewhere. But CCR can also go to a pseudo partner The Beard Inc and give the pseudo partner 20% of the shares of the privately held Doomed 2 corporation. Those shares are worthless, but CCR doesn’t have to make The Beard inc pay anything for them. They don’t matter at all as the point is control of the firm not ownership of nonexistent equity.
I think this might be a real gap in corporate laws. As far as I know (in my ignorance) corporate codes and SEC regulations contain detailed protections for shareholders, but it is assumed that partners can take care of themselves.
Bond buying investors can use the data which is made public for shareholders (or really count on ratings agencies to use it). They are senior to shareholders, so if shareholders are protected, they are too. The shareholders are not organized enough to loot — a shareholders resolution which says “Let’s pay ourselves a huge dividend, then declare bankruptcy” is to blatant. But if a firm is taken private, the bondholders, who have been free riding on shareholder protections, can be almost legally robbed.
Publicly traded firms have been taken private only in the past 30 years. Has the law been changed to block the looting scheme which I describe ? Has the scheme been clearly banned for centuries ?
Note that the scheme works even if bondholders are fully rational. Doomed might be doomed because of bad luck. When the bonds were sold, the probability of bankruptcy might have been low. The existence of CCR means that recovery ratios will be low, but that doesn’t mean corporate bonds are worthless, since receipts in case of bankruptcy are a small, almost negligible and often completely neglected component of returns on bonds.
Note that I assume it is unwise to buy bonds from a privately held firm. I am so ignorant that I don’t know how many privately held firms issue bonds. Note that CCR will faithfully and creditably honor bonds which it issues.
OK a bit of reality. My story does not at all correspond to the case of Bain Capital and GS inc. In that case, bonds were sold after the firm was taken private. My view is that only a fool would buy such bonds. The outcome tends to correspond to my view. I do have a history question — how did the ratings agencies rate the bonds of a privately held firm ? It seems to me that, by their standard rules based on balance sheets and profit and loss statements, they must rate bonds issued by privately owned firms as of unknown risk, that is B or so. Were they a large part of the problem this time too.
In any case, in this post I assumed that looters can’t issue bonds, because I am an economist and I reflexively assume that investors aren’t total idiots.
Up to a point:
“CCR also sets up a firm controlled by CCR called “The Sack” and sells the assets of Doomed to The Sack for below market prices. Even at market prices, Doomed assets aren’t enough to pay interest and principle on its bonds, but even at these low prices, the proceeds of putting Doomed’s assets in The Sack are enough to pay coupons and pay off the face value of mature bonds for a while.”
And that is the point. If Doomed doesn’t have enough to pay its debts (all of them, trade creditors, bond holders, the taxman, everyone, and yes, of course we do some peering into the future about future sales and profits etc) then it is insolvent.
And the law is really rather harsh on people who loot insolvent companies. The law’s actually pretty harsh on people who know their company is insolvent and yet they allow it to continue to trade.
Further, allowing a company to trade while insolvent (the US phrase might be slightly different but there will be a law or more that says this) is a criminal act. Making any such switches of assets etc, the money earned from them, the proceeds of crime. Which can be and are hoicked back from their recipients.
So, yes it’s something that it is right to ponder upon, but something that is already dealt with in the current law.
” I do have a history question — how did the ratings agencies rate the bonds of a privately held firm ?”
Privately held companies can and do issue bonds. The first one that came to mind was Cargill. Private (family owned) company that issues bonds all the time.
True, they don’t have to lay out their accounts publicly like a publicly traded company has to. But they most certainly have to let the guys from the ratings agencies in to see their internal accounting etc, just as other issuers of bonds do. No one’s bond ratings (well, maybe sovereigns) depend purely upon public information.
Nice shot Robert, but I am guessing you skipped both business law and accounting as an undergrad. Could this scenario happen? Given the MBA grads these days anything is possible I guess. There is no clean way to liquidate an insolvent company, usually quick and dirty is the best way to end the misery and minimize professional fees. This differs from a Chapter 11 reorganization.
(For the record, about 100% of accounting and business majors study economics, but apparently one can get a PhD in economics without studying accounting or business or business law or finance.)
In any bankruptcy scenario the shareholders get $0 because they get nothing until all creditors are paid in full, which usually cannot happen in a bankruptcy.
Bond holders take haircuts, but they knew that risk when they bought the bonds. Actually, many of the bondholders probably dumped their bonds on scavengers early on (despite the image of an old lady with a box full of bonds, very few investors I know hold bonds as a long term investment),
Liquidation is Chapter 7.
Bond buyers can be just plain nuts, but usually not fully wildly nuts. Many are traders and not investors anyway.
Question. Is it not the case, that under the 2007 Consumer Bankruptcy Protection Act, we now have one set of rules for corporate persons, and another set for living, breathing human persons? If so, doesn’t this raise Constitutional issues regarding equal protection?
Maybe Underbelly can help? Seems he has taught BK law.
I meant to ask about US law. Also I really meant to/should have asked if the general principle that one should not loot can, in fact, be enforced.
On rating bonds, note that “I don’t know how many” does not imply “I don’t know if any.” GS industries is an example of a privately held firm issuing bonds which I mentioned recently at this blog. My question is why people buy them. I sure seems to me that the rate of default on debt of private equity firm controlled firms (note again not the parent) is huge. For Bain 22% of firms were in bankruptcy court within 8 years. As a general principle, if a firm is controlled by Bain, I’d rate its debt C.
I know that Bain and, say S&P can share data. The problem is that the ratings can’t be explained to the public, nor can third parties detect uh special consideration. What if, like the whole CDO of RMBS business, private equity depends on supportive ratings agencies ? Here the ratings agency has a clear interest in new approaches in finance which give them more things to rate, hence a conflict between their interests and the interests of those
who use the ratings. I think we now know that their integrity was grossly overestimated.
Importantly LBOs imply a fairly new asset (also created with 80s type takeovers) that is, debt of highly leveraged firms which didn’t become highly leveraged because of decline in equity. If Bain is in charge, thes assets are highly risky. Is this risk approximately correctly priced. Being an economist, I looked for an undesireable Nash equilibrium, but I would guess that the true main sorce of returns for private equity firms is separating fools and their money.
As an undergraguate, I majored in biology. I was not taught accounting or business law. As a graduate student, I took few courses, none of which had anything to do with accounting or law.
I am an extreme case, but I don’t know of a PhD economist wholy trained in the USA who was taught both. You will have noticed that PhD economists don’t seem to ever say much about the nitty gritty of business.
On the other hand, I seem to hàve given you an impression that I am more ignorant than I am, since, of course I know that shareholders get zero in bankruptcy.
In my scenario, the invention of LBOs means that bond holders face a risk that they didn’t know about when they bought the bonds, since they thought that laws which protect shareholders who by shares on exchanges would protect them too.
But also, even if the risk of looting is known, and priced in, it doesn’t mean it should be legal.
“I know that Bain and, say S&P can share data. The problem is that the ratings can’t be explained to the public, nor can third parties detect uh special consideration.”
Quite true. Which is why the probity and reputation of the ratings agency is even more important in rating private company bonds than it is in rating any other type. The agency has access to a lot of information that no one else outside the firm does.
Whether that comforts you or not is another matter of course…..
In my scenario, the invention of LBOs means that bond holders face a risk that they didn’t know about when they bought the bonds,
I think you’re getting a little confused here. An LBO means purchasing a company through the issuance of new bonds. So the risks of an LBO are spelt out in the issuance docs for the new bonds.
It does. It means that back when the ratings agencies had good reputations and credibilty, they could (and did) enable Bain to profit from having a subsidiary sell bonds, pay a huge dividend to Bain ( e.g. Over 4.5 times Bains investment made one year earlier) and later go bankrupt costing Bain only the valuelessness of the stock of GS (plus the 16,000,000 in good money Bain sent after the original 8,000,000 of very bad).
Now that investors have learned not to trust ratings agencies, such problems with privately held firms selling bonds have been eliminated. Of course this creates trouble for Bechtel not to mention KKR which is nothng like CCR. It is really to bad as there is evidence (link lost) that privately held firms invest more. It’s too bad that it is just impossibe to set up SUC (securities unexchanged commission) regulations forcing them to publish their books.
Yes, but that doesn’t mean that there aren’t also old bonds which lose value due to the LBO. I mean really you can’t actually think that just because bonds are issued now other bonds can’t have been issued in the past. The buyers of the bonds used to fund the LBO know that they are buying bonds in a highly leveraged firm, so, if they ate rational will get pay only a low price and get expected returns which compensate for the risk(including the risk of looting). Not so for people who bought bonds issued by the corporation ng before when it was publicly traded.
Also, even if it is known(but not provable in court) that CCR is a gang of looters, they can still finance LBOs by issuing bonds on the full faith and credit of CCR not the ff and c of doomed inc. In the looting scheme doomed is declared bankrupt but CCR isn’t. Rational inestors will pay high prices for the bonds used to finance the looting so long as CCR backs them. I am ignorant and I don’t know if LBO firms do this, but they can.
I believe those in the know refer to this as “financial innovation.”
Verizon Conned Fairpoint, Creditors Claim
Creditor Trust Sues Verizon for $2 Billion
“In 2008 Verizon offloaded their New Hampshire, Maine and Vermont DSL and landline networks to Fairpoint Communications for $2.7 billion. The deal was a crafty and complicated one for Verizon, company lawyers using a Reverse Morris Trust to not only offload networks they had no interest in upgrading — but to saddle Fairpoint with $1.7 billion in Verizon debt while netting a nifty $600 million tax write off.
Not too surprisingly, the added debt and obligations layered on a tiny telco (whose eyes were bigger than its stomach) resulted in Fairpoint’s implosion and subsequent bankruptcy.
Several years later, the creditors left holding the bag are trying to recoup their losses. A trust set up to benefit creditors in the FairPoint bankruptcy case is suing Verizon Communications for $2 billion, claiming Verizon was effectively running a giant con. “
Precedence. That’s the point here, precedence of creditors. I’m not entirely sure that you can actually issue bonds which gain precedence over previously issued ones. I’m heading into hte wilderness of not knowing myself here. But I have a feeling that the LBO bonds would be behind previously issued bonds in the creditors queue.
If they weren’t, then the old issue must be refinanced or at least compensated. I think.