Bankruptcy Can Be Profitable… For Corporations
For an individual or small business, the entire process of bankruptcy can be pretty horrific. You must deal with the shame, the harassing letters and phone calls, and the final court proceedings.
This is clearly not true for certain investors and for large corporations…
1) They can use bankruptcy to escape lawsuits
Bankruptcy has become a powerful weapon in the arsenal of corporate defendants.
Bankruptcy offers companies facing legal liability an escape hatch that puts them beyond the reach of lawsuits. Bankruptcy can let companies emerge from their own scandalous misconduct unscathed.
Bankruptcy was never intended to protect bad actors from liabilities that they knowingly created through their own bad actions. However, once an entity files for Chapter 11 bankruptcy, it benefits from an “automatic stay” on assets, which immediately pauses all creditor action to collect debts, including lawsuits.
For example: U.S.A Gymnastics filed for bankruptcy in 2018, after gymnasts sued the organization for failing to protect them from Larry Nassar’s sexual abuse.
Boy Scouts of America, confronted with hundreds of sex abuse lawsuits from thousands of alleged victims, declared bankruptcy in 2020.
Pharmaceutical giants Purdue Pharma and Mallinckrodt filed for bankruptcy in 2019 and 2020, respectively, in the face of a wave of lawsuits for fueling the opioid epidemic.
Johnson & Johnson created a subsidiary to hold all the legal liability arising from its talc baby powder—which allegedly causes ovarian cancer—just so the subsidiary could declare bankruptcy three days later.
Claimants are often lucky if they get to recover anything at all.
2) “Private equity” investors can strip corporate assets so thoroughly that bankruptcy is virtually inevitable
The ugly ‘leveraged buyout’ process works like this:
Step One: Private equity investors buy out the target company, with at least 80-90% borrowed money.
Step Two: The new debt is secured by the assets and cash flow of the target company.
(Executives of the target companies usually go along, because they expect to get rich themselves. Typically they have no sympathy for workers, pensioners, or customers.)
Step Three: Within a year or less, the purchased company pays the buyer an enormous dividend.
The private equity firm uses the dividend to recover their relatively modest investment. The target company may have to borrow even more money.
Step Four: These special dividends – plus other large “management fees” – put the target company further into debt. Eventually they may default on the debt and declare bankruptcy.
For the investors, it’s like getting to use somebody else’s credit card to pay yourself. If the target company later goes bankrupt, the private equity firm will not have to pay any of that money back.
For example: Golden Gate Capital and Blum Capital, the two firms behind footwear chain Payless, paid themselves $700 million in dividends in 2012 and 2013, all on the back of the company. Payless filed for bankruptcy soon after, closing 400 stores.
Toys“R”Us filed for bankruptcy in September, unable to sustain annual interest payments on $5.2 billion in long-term debt. Buyout managers, including Bain Capital and Kohlberg Kravis Roberts, had stripped out close to $2 billion in cash overall.
Toys “R” Us had steady sales and decent market share….but almost all of its operating income was going to service the interest payments on its debt (to say nothing of the extortionate management fees). The company went from having $2 billion in cash when it was acquired to having no money to s\maintain its stores.
Simmons Bedding was sold and resold six different times, accumulating $1.6 billion in debt when it first entered bankruptcy. Its succession of short-term financial-firm owners removed close to $1 billion out of the company in dividends, ‘management fees’, and uninvested profits.
The Carlyle Group bought ManorCare for $6 billion, which, by the magic of creative accounting, ManorCare had to pay back.
The Carlyle Group wanted to pay itself a billion-dollar dividend, so it essentially pawned the real estate holdings of the nursing home chain, (called a “sales-leaseback” maneuver), which then required a half-billion-dollar yearly rent payment. This was managed through savage staffing cuts that clearly harmed the elderly residents.
3) Investors can use bankruptcy to “re-structure” the companies they buy – but often with lower salaries, no unions, and no pension plans.
The fastest way to improve the financial condition of a company is to take it out on the workers.
Companies use the bankruptcy process to break union contracts, and often close locations, leading to layoffs.
Investors have the ability to slough off any pension obligations. Retirees must then rely on the Pension Benefit Guarantee Corporation, often getting much lower payouts.
Corporate lenders can then become the owners of a new unencumbered company with a much higher profit margin. Hostess Bakeries is a good example of this.
Here Are The Reforms That Need To Take Place
In 2019, Sen. Elizabeth Warren introduced The Stop Wall Street Looting Act. Its proposed reforms are still valid, including:
● If in a bankruptcy, the workers’ pensions are not fully funded, then all monies that have been paid to the equity/hedge owners can be clawed back to the date of acquisition — until the workers’ pensions are fully funded.
● The same provision applies to workers’ severance pay.
Warren proposes additional reforms to discourage leveraged buyouts.
Under her law, the equity/hedge funds could not make an acquired corporation assume the debt incurred to buy the shares of that corporation.
The hedge fund will have to repay those debts out of its own earnings, as with every other type of investment.
The law would also prohibit dividend payments in the first two years post-acquisition.
An excellent summary of the worst corporate practices — plus possible reforms — is in the book Plunder: Private Equity’s Plan to Pillage America. by Brendan Ballou.