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.