Monday, January 9, 2012

How to Drive a Company Bankrupt for Fun and Profit

Mitt Romney with his campaign staff, at a recent press conference.  Whoops!  Wrong Caption!

In one of the episodes of The Sopranos, a local sporting-goods store owner gets into a gambling debt problem with Tony Soprano.  Tony realizes the fellow is getting in over his head, and lets him - knowing full well how the game will play out.

When the fellow can't pay off his debts, Tony and the gang take over his sporting goods store and then run it into the ground - a "bust out."  It is a fairly simple formula, and it happens all the time in American Business, particularly the retail and restaurant businesses.

Tony and the boys make money by not paying any of the businesses' bills - the rent, the light, the suppliers, the payroll, the withholding, etc.  But they keep selling inventory - and ordering more, using the store's credit - and then pocketing the cash, tax-free.  Any business that is tax-free ends up being pretty profitable, which is probably the only reason drug-dealing has any profit at all - no overhead, no taxes.   

But since they are basically selling off the inventory at 100% profit, they can take hundreds of thousands of dollars out of the business, before the suppliers get wise and start cutting off shipments to the company.  Eventually, they have run the business into the ground, walked away with all the money, and left the owner a bitter and broken man.

And to the outside world, it appears just as another "small businessman gone bust!" and everyone shakes their head at how poorly managed the place must have been.

Restaurants work the same way, and I recounted before the tale of the young fellow (a cook) who used his inheritance to start a restaurant with his "connected" Uncle from Utica.  The Uncle had run a number of  restaurants, many of which mysteriously caught fire.  All went out of business - and yet the Uncle was quite wealthy.  Suppliers went unpaid, tax withholding payments never got to the IRS, and paychecks started to bounce.  Yet the Uncle had a new Cadillac.

Needless to say, the Old Tyme Gaslight Restaurant went the same way as the other restaurants the Uncle had a hand in, and the young cook, distraught over his failure, shot himself one night in the kitchen.  As dishwasher, my last task was to mop up the floor, before I clocked out for the last time.   I never got my last paycheck. 

Personable Presidential Candidate Mitt Romney has made recent news for his connection to Bain Capital, an investment firm that, among other things, did what Tony Soprano did, only, of course, perfectly legally.  Many companies are often offered for sale at prices that are very low - often less than the liquidation value.  Such companies are viewed as "dogs" as the equipment may be old and worn out and, in order to be competitive again, they would need to invest millions, if not billions, in new equipment and technology.  And they may also have unfunded pension and health care liabilities for the current and retired workers.  And they may have years of Hazmat cleanup issues.  No one wants such money-losing propositions, and they are often sold for cheap.

A rusty old steel mill is a case in point.  This sort of technology - rolling steel one slab at a time - dates back to the early part of the last Century.  And indeed, many of these mills have equipment that predated World War II.  I interviewed for a job at one such mill.  They used a room full of clattering relay logic to run the mill, which had dirt floors and ancient rolling equipment.  Management had ill-advisedly bought out the company from the owners, using highly leveraged junk bonds (this was, after all, the 1980's).  They were struggling to make the payments on the debt from the income of the place.  Since then, they have reorganized, yet again, and are still in business, mostly because they make specialty steels - high-tech and high-priced steels that the foreign market has yet to tap into.

Other mills are not so lucky.  High-volume steel production has largely shifted overseas.  Instead of dirt-floored environmental nightmares, where the same bar of steel is heated, reheated, and then rolled, rolled, rolled, over and over again (with the impurities being ground off between rollings), modern antiseptic factories in Japan and elsewhere use "continuous mills" which intake raw materials at one end and turn out neat shiny rolls of sheet steel at the other, in a machine that looks like a big brother to the newspaper press.  The bulk market for sheet metal, for appliances, cars, and the like, is met by these new, modern plants.

And the old plants can't compete.  They will go under, eventually, without huge investments in materials and equipment - investments that no sane investor would make, as they would still be marginally competitive with overseas plants.  You'd be smarter to just start fresh and build a new mill and a new company, than to pay good money for an old rolling mill.

But, there might be money still to be made running the existing place into the ground, particularly during an economic boom time, where some small profits may yet be made.  You can sell the steel, take out cash, and continue to under-fund the place, spending nothing on infrastructure, repair, or anything else.  Sort of like, well, what Sears is doing.

Since you didn't pay a lot for the place, every nickel you take out of it is pretty much profit.  So you make a nice pile of money, in the short-term, running the place into the ground.  When the end comes, you throw up your hands and say, "Gee, it didn't work out - the equipment was too old, and the foreign competition was murder!  And those unfunded pension liabilities!  We never did get around to making that up!"

So another company goes under - a company that arguably would have gone under anyway, and perhaps should have shuttered its doors years earlier and taken the cash to fund the pension fund.  But the Pension Benefit Guaranty Corporation takes up the slack, slashing the retiree's pensions and making up the difference from its own assets.

Is this legal?  Yes.  Going out of business has never been against the law, in the United States.  However, I suppose you might be able to make out a conspiracy or fraud charge, if you could prove it was their intent to gut the company and leave the government on the hook for the pension liabilities (and screw the pensioners).  But it would be a hard case to prove.

This is not to say, of course, that a political case or a moral case can't be made.

Because, just like the Sopranos example above, when you go out of business, it ain't against the law.  And unless you can prove intentional malfeasance, it is a hard case to make.   And in many cases, the same scenario plays out with a number of companies you might be invested in.

Are you a culpable as Tony Soprano or Mitt Romney, because you bought stock in GM?  GM paid out dividends, even as it was losing market share.  They rode the company "all the way down" and then refinanced it, in bankruptcy, courtesy of a government bailout.  Who suffered?  Well, some employees who are now getting paid a lot loss, and some retirees, whose pensions are going to be funded from a lump sum which is now in the hands of the Union (that won't end well, I promise you that!).

And some economists might argue, rationally, that when you strip away all the emotional baggage about the workers (a favorite phrase of both Karl Marx and NPR) that what companies like Bain Capital were doing, was in fact, an economically useful function. 

Sharks and other predators are feared - and rightly so.  And they usually pick off the lame, crippled, and elderly prey - which are easiest to catch.  But predators are necessary to any ecosystem, as we've discovered in environments where we've wiped out the predator class of species.  Without predators, the prey species often overpopulates - often becomes weaker as a result - and is prone to diseases and sudden die-offs.

Creaky old steel mills and lame and ailing gazelles have one thing in common - they need to be taken down.  You can wait for the inevitable disease and decay to set in, or finish them off in one bloody flash of violence.  And no, Darwinism isn't pretty nor neat.  And many folks don't have the stomach to witness this process.  And perhaps that is one reason why the folks who specialize in shutting down companies and laying everyone off are so highly paid in our society - few people have the stomach for this sort of thing.

But that is harsh reality, and not many folks like to live in reality - but instead prefer a fantasy world, where the lion lays down with the lamb, and hopelessly outdated an inefficient businesses are kept alive by government subsidy, forever.  But neither is a realistic option.  The lion eventually gets hungry, and you can't keep money-losing businesses afloat forever - in denial of economic reality.  Great Britain tried that, and it didn't work.

But even in these sorts of scenarios, where the "worker" feels pushed about by greater powers than himself, one does have choices to make in life.   And while you can argue all day long about the "unfairness" of the closing of the steel mill, it won't reopen it - ever, ever - nor will it get you any satisfaction, either emotionally or fiscally.

The main problem "the workers" face in a situation like this is that their defined benefit pensions are based on promises made by the management, and often the union as well, and thus are little more than paper promises that cannot be enforced, if the money is not there.  A full retirement from GM back in 1980 was a good deal, as the company was still solvent.   But you have to hope the company stays solvent for your pension checks to keep coming.

As many Eastern Airlines Pilots discovered, even pushing your employer to fund the pension plan is no real solution.  They accepted a cut in pay in return for full-funding of their pensions, only to have the money taken away during bankruptcy proceedings and pooled with the underfunded pensions of the other unions.  United Airlines employees fared little better.

For most of us in the younger generation, this is not even an issue.  Defined-Benefits Pension Plans are a fairy-tale.  We have to fund our own retirements, which may turn out to be a better deal.  If properly funded, you may end up better off than with a Defined-Benefit Pension Plan that ends up being taken over by the Government.

Incidentally, it is amazing to me how so many people are fiscally illiterate on this subject.  The other day, I was discussing Defined-Benefit Pension Plans with a retiree (who is receiving such a pension, from a company that is teetering on the verge of bankruptcy) and they asked, "What is a Defined-Benefit Pension Plan?" - they had no clue.  And unfortunately, they have no clue how their lifestyle will be affected once the company supporting the plan goes belly-up and their pension check is cut by more than half.   Only three more years on their new car loan, too.  Ouch.

And that right there is where you can take action in your own life.  Live on less, spend less, save more.  Just because ACME corporation promises you 75% of your last year's pay in perpetuity as a pension, don't count on it as your sole source of retirement income.  Because there is a very real and finite possibility that it won't be there for you - or that at least part of it will go into the ether, if the company becomes insolvent.

And in retirement, it pays to keep an eye on your pension - if you have one - and understand the finances of the company supporting it, and whether they will be there to pay it, down the road.  If you are offered a lump sum payout, it might be an option worth exploring, as you at least have that money in your hands, and are not counting on the whims of future management, future markets, and other uncertainties in operating a business.

Of course, one question a lot of people have is, "Why do they let these companies underfund their pensions?" and the answers are very complex.   Pension liabilities are always the last thing to be paid, just as many people, individually, fail to fund their own 401(k).   It always seems there is something more pressing to be paid now, and that retirement can be funded later.  And many executives make the same argument - we need to fund new products to keep the company in business, so we can fund the pension plan down the road.

But like the failing restaurant scenario (where the restaurateur stops paying withholding in order to buy meat), the lack of funding for the pension is like the miner's canary, and should be a wake-up call to management that perhaps they would be better off just shuttering the place, paying everyone off, funding the pension plan, and calling it a day.  Because that is what ends up happening, anyway.  Knowing when to quit, is key.

After 9/11, laws were passed relaxing the already relaxed standards for pension funding.  Airline and Steel industries were targeted as being particularly vulnerable to bankruptcy, and it was thought that relieving these businesses of some of their pension liabilities would help them stay solvent. 

Of course, it didn't work, did it?  The companies went bankrupt anyway, a few years later, and since the pensions were even more underfunded than before, the "workers" were screwed even worse.  You have to wonder - if you believed in conspiracy theories - whether it was all a set-up from the get-go, and that these Bain Capital people didn't actually push for the more relaxed pension-funding standards (or knew they were on the horizon) and realized there would be cash to be extracted from a failing business.

Like Tony Soprano, they let the "mark" gamble more, knowing full well the end result would be a "bust out".

The only way to avoid this scenario, is to simply not play the game.  Save money, spend less, and don't rely on a defined-benefits pension as your sole source of income.