“Lending to the most highly indebted companies in the U.S. and Europe is surging.”— Wall Street Journal [Fn. 1]
When a large business files for bankruptcy, there is one group that almost always suffers. It is a group with little-to-no power. It is the unsecured trade creditors. It is those that supply the everyday goods and services that make a business run. The business cannot operate without them, but — individually — they are replaceable, expendable and at the mercy of bankruptcy processes.
Some trade creditors can be critical to a business debtor: e.g., a major supplier without which the debtor is incapable of operating and to which the debtor owes a great deal of money. Such creditors wield enormous power over the debtor. But these are the exception.
The vast majority of all trade creditors are small and powerless. They also bear the brunt of losses when a large business files bankruptcy. Because of their weak positions as small and unsecured creditors, they almost always get run over in the process.
Losses for trade creditors in a bankruptcy arise on several levels and are an accumulation of the following: (1) loss of the receivable that is on the books at the time of the bankruptcy filing; (2) loss of future business when the debtor fails or is sold to another business that has its own trade creditors; and (3) loss of preference liability–disgorging payments received from the debtor within 90 days before bankruptcy filing.
In combination, these are huge losses for any business, and especially for a small trade creditor that often experiences its own day-to-day business stress. Moreover, what’s particularly galling for trade creditors are instances where the debtor’s financial problems result from actions that benefit owners (or purchasers) of the business and shift risks of loss to trade creditors.
Business owners and purchasers, about to engage in egregious conduct, often do so after consulting professionals to assure that their actions have no negative consequences for themselves — never mind negative consequences for trade creditors.
Notably, the Bankruptcy Code places legal hurdles upon poor people, creating ineligibility for chapter 7 when they are able to pay even a tiny amount to creditors in a chapter 13. However, the Code does not prevent owners or purchasers of large businesses from investing huge sums and, in the process, shifting risks of loss from themselves to their trade creditors. This article discusses two examples of shifting loss risks to trade creditors and offers a solution for each.
Buying a Business and Encumbering It with Excessive Debt
Buying a house requires cash for a down payment plus a loan for the rest of the purchase price. Similarly, buying an ownership interest in Coca-Cola or Berkshire Hathaway requires a cash payment to purchase stock from a seller. The purchaser will use either cash-on-hand or a personal loan to cover the purchase price. But get this: What if you could buy stock in Coca-Cola by having Coca-Cola borrow the money to pay the purchase price? That would be cool!
That is what happens in a leveraged buyout (LBO). The acquired business borrows the money for its own purchase price, and there’s no significant down payment from the buyer — it’s a 100 percent loan. An LBO is a sweet deal for those directly involved: professionals get huge fees, lenders get high rates, taxes are minimized for sellers, buyers don’t tie up available cash, and high risks create possibilities for high rewards.
Unfortunately, the real losers in an LBO are trade creditors, who continue doing business as before. The closing of the LBO has no impact on their day-to-day activities or dealings with the business. The only change for trade creditors is the increased risk of the business failing (and of trade creditors incurring the aforementioned losses).
Trade creditors have a choice after an LBO happens: do they (1) continue with business as before, or (2) look for other/safer business partners? Invariably, they stick with what they have, which means that buyers of the business have achieved benefits for themselves and transferred away high levels of risk to trade creditors.
Remedies in bankruptcy for an LBO failure are under such laws as fraudulent transfer and director & officer liability. However, the levels of sophistication required to pull off an LBO also help to assure that the LBO defeats any claims under such laws. In addition, the passage of time and expiration of relatively short statutes of limitations also help the owners. Trade creditors have no such protections and are left vulnerable to future losses.
A proposed remedy: A simple way to protect trade creditors would be to amend § 510 of the Bankruptcy Code on equitable subordination to provide: “for any failure of the business within ten years after the LBO closes, all secured obligations used to buy the business will be subordinated to claims of trade creditors.” This change would tip the scales of justice back to a more-even level.
Taking Extraordinary Dividends and Encumbering the Business with Excessive Debt
The second example also has a name: “leveraged dividend recapitalization” (a.k.a. “dividend recap”). “Dividend recap” is a fancy name for this sentiment: “We’ll probably rip off everyone that deals with us, if business goes bad.”
A common reason for doing a dividend recap is that owners see business risks on the horizon and want to get their money out while the getting is good — and it happens a lot. One online source, Stout, describes a spike in volume of dividend recap activity (back in 2009-10) like this: “[A]pproximately $8.8 billion of debt was issued to pay dividends in the first quarter 2010, compared with $7.9 billion in all of 2009.”[Fn. 2]
The comparison of all of 2009 with the first quarter of 2010 is significant because the economy took a dive in 2009. So, in 2010, owners were getting their money out of their businesses before things really turned bad: they were shifting risks of losses from themselves to others — while they still could. It worked well, paying off handsomely for owners when those risks-on-the-horizon proved later to be real — and the business went under. Trade creditors did not fare so well.
Here is how a leveraged dividend recapitalization works:
A business has substantial equity, i.e., its debt is relatively low compared to its value. So, the business declares a huge dividend to its owners (e.g., an amount equal to one-third of its entire equity). The business borrows money to pay the dividend. Once the dividend is paid: (i) the business has an unhealthy debt load, and (ii) it’s risk of failure is dramatically increased.
By doing a dividend recap, owners of the business are “(i) protecting their own interests by taking out cash with borrowed money, and (ii) transferring their future risks of loss to others, including their trade creditors.” This is unjust.
Below are excerpts from Stout, providing advice on risks of a dividend recap and on how businesses might get away with it — when the business subsequently tanks.
–“[D]ebt-funded dividends that are too large may leave a company too thinly capitalized to adequately fund day-to-day working capital needs. Even moderately-sized leveraged dividends can hinder a company’s future growth opportunities.”
–“If a company’s performance deteriorates post-transaction to the point of insolvency, the dividend recap could be ‘set aside’ under fraudulent conveyance laws.”
Getting Away With It
–“[A] key question for private equity firms considering a dividend recap is how to best effectuate the transaction while shielding themselves and their company’s directors from liability.”
–Although “dividend recaps are fraught with risks,” participants “may significantly reduce the risk of liability by making use of best practices – which includes obtaining a solvency opinion from an independent financial advisor – before consenting to a dividend recap.”
Despite the risks, many business owners want the benefits of a dividend recap and work diligently to get away with it. Many of them do get away with it when the business fails, leaving trade creditors and others holding the losses. Solvency opinions and expirations of statutes of limitations are key elements in getting off scot-free. Again, this is unjust.
A Proposed Remedy: A simple remedy would be to amend § 548 of the Bankruptcy Code to provide a constructive fraudulent transfer claim as follows: “if the business becomes insolvent within six years, all leveraged dividend recapitalization payments to owners could be recovered as fraudulent transfers.” This change would tip the scales of justice back to a more even level.
Trade creditors tend to be small players in the day-to-day activities of large businesses. Collectively, trade creditors are critical to the large business, for it cannot operate without them. Individually, however, trade creditors have little-to-no power in the relationship and are often the first-and-worst casualties of the bankruptcy process.
Actions by owners or purchasers of large businesses to take benefits for themselves and shift business risks to trade vendors are unjust. Two examples of this risk-shifting are leveraged buyouts and leveraged dividend recapitalizations.
New remedies are needed to protect trade creditors from such self-centered actions of business owners. Two such alternatives involve the aforementioned amendments to §§ 510 and 548. Such amendments are needed immediately.
Footnote 1. Christopher Whittall, “Leveraged Loans Are Back and on Pace to Top Pre-Financial Crisis Records,” Wall Street Journal (Sept. 24, 2017) (log-in required to read article).
Footnote 2. Aziz El-Tahch, “Dividend Recaps: Trends and the Importance of Solvency Opinions,” Stout (Sept. 1, 2010).
Note: This article was originally published in the Legislation Committee Newsletter of the American Bankruptcy Institute on November 29, 2017,
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