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Wednesday, September 12, 2012

Mitt Romney, Leveraged Buyouts, and Morality

 
This past summer I taught a course in Debtor-Creditor Law at The Ohio State University using the textbook I wrote on this topic with Professor Jeffrey Morris of the University of Dayton Law School.  The first chapter the book covers “fraudulent transfers,” which means various devices used by debtors or creditors to work fraud on others (such as competing creditors).  The chapter ends with a discussion of leveraged buyouts as fraudulent transfers.

A leveraged buyout (LBO) is a controversial method of acquiring a corporation. Suppose you are a savvy investor who comes across an ailing corporation. You believe that if you could take over the corporation you could provide sufficient clever leadership so as to restructure it and make it profitable. You decide to purchase controlling stock in the corporation, but there’s one difficulty: you’re unwilling to risk much money. Undaunted, you persuade the current owners of the stock and a local bank to cooperate in the following suspicious scheme: the bank will loan the corporation the money to buy the stock from its current owners (but the amount of this loan will be given to you so you can buy the stock), with the bank taking as collateral an interest in the assets of the corporation, which the current owners of the stock will vote to grant to the bank.  [The corporation, as the borrower, itself will have to pay off this debt to the bank.] Why would the current owners go along with this outrageous plan which loots their own company?  Because that way they can sell their stock before the company goes under, but if they wait they will get nothing in the bankruptcy that’s likely to follow.  You sweeten your offer by putting up a small amount of the purchase price yourself.

Thus is the property of the corporation “leveraged” (read “misappropriated”) to allow the buyout to occur. Such is a classic LBO.  The existing creditors of the corporation (and its employees too) will usually object vehemently to this new encumbrance on the corporate assets, and if the corporation itself had a voice other than the selling stockholders it would surely complain that it received no value in return for the transfer of an interest in its property to the bank.  When the smoke has cleared you, the savvy investor, have bought a majority interest in a corporation, but paid little money for your new asset.  It’s a strange “purchase” that costs the buyer almost nothing to buy something.  If your prediction proves right and you fire employees, cut costs, trim fat, and make the corporation profitable again, then you gain hugely—you’ll own the controlling stock in a profitable business.  If not, and the looted corporation fails, you walk away whistling, having lost nothing, and in fact gained whatever you paid yourself for running the company before it crashed.

When LBOs fail, and the corporation collapses because after leveraging it had insufficient assets to keep going, the courts have often found that the selling stockholders, the buying new stockholders, and the bank that took a loan using the assets of the corporation but then paid the loan amount to the new stock purchasers are all guilty parties to a fraudulent transfer of the corporate assets, and thus required them to cough up their ill-gotten gains (the remedy is civil, not criminal).  For a thorough analysis of all this see the splendid opinion of Bankruptcy Judge Samuel L. Bufford in Bay Plastics, Inc. v. BT Commercial Corp., 187 B.R. 315 (Bankr. C.D.Cal. 1995), which I use as a central case explaining leveraged buyout fraud in my textbook.  Judge Bufford explains that a LBO that is
leveraged beyond the net worth of the business is a gamble. A highly leveraged business is much less able to weather temporary financial storms, because debt demands are less flexible than equity interest. The risks of this gamble should rest on the shoulders of the shareholders (old and new), not those of the creditors: the shareholders enjoy the benefits if the gamble is successful, and they should bear the burdens if it is not. This, after all, is the role of equity owners of a corporation. The application of fraudulent transfer law to LBOs shifts the risks of an LBO transaction from the creditors, who are not parties to the transaction, back to the old and new shareholders who bring about such transactions.
 
Mitt Romney took over Bain Capital when he was in his 30s and in the beginning the firm concentrated on venture capitalism, meaning that it invested in companies and helped them grow.  Staples is one of its major success stories.  But Romney then decided that there were much greater profits and less risk involved in leveraged buyouts, and in his fifteen years of running the company he made Bain the king of LBOs.  In a Time Magazine cover story on this called “The Mind of Mitt” (September 9, 2012), the writer Barton Gellman first compares an LBO to buying a farm by making the farmer take out a mortgage to finance your purchase, and then describes in detail how Bain operated:

As the new owner, Bain Capital will demand that the company squeeze costs, close money-losing divisions and shift resources to more profitable lines of business. Sometimes—more often than its peers—Bain Capital will buy a company and stay with it for years, improving management and restoring it to health. Other times it will shutter factories, lay off workers and leave a company loaded with debts it cannot pay. In either case, Romney's firm will boost its own profit or cushion its risk by charging the company special dividends for its services and by structuring the deal to take advantage of tax and regulatory rules. These transaction features, known as tax arbitrage, can easily reap enough profit to let Romney come out ahead even if a company fails. . . .

In his management-consulting years, Romney and his team used the starkest of images to persuade corporate executives to cut loose unproductive assets. They compared the benefits to "a forest fire—it clears out the detritus even if you lose some animals in the short run," one colleague explained. "We would say to CEOs that all of their different divisions and businesses are like the little hatchlings in a nest," says McCurry, another Bain & Co. colleague. "When the momma bird shows up with a worm, all those little open beaks are down there sending the signal 'Give the worm to me!'" He added, "Where the CEO needs help is to know you can't give everybody what they want." . . . 

There have been times when Romney acknowledged the ruthlessness of the marketplace. Twelve times in [Romney’s book] No Apology, he embraces "creative destruction." 

 
The Bain Boys Celebrate (click to enlarge)
There’s nothing wrong with taking over an ailing company and ruthlessly taking steps to restore it to financial health.  That’s good business and laudable.  But what is wrong is to do so by gutting the company of its unencumbered assets—assets that the other creditors were counting on to pay debts owed to them, as were the employees for the stability of their paychecks—setting things up so that by gambling with the company’s assets and not your own money you are in a win-win situation even where everyone else suffers (except the selling stockholders, who also escaped unharmed).  Where the buyer of stock risks little because the sale is financed by looting the company to pay for the purchase (a practice hurting innocent parties right and left), that’s despicable.   

In a recent article Rolling Stone article called “Greed and Debt: The True Story of Mitt Romney and Bain Capital,” August 29, 2012, which calls an LBO “financial piracy” and explains all of this in much more detail [see http://www.rollingstone.com/politics/news/greed-and-debt-the-true-story-of-mitt-romney-and-bain-capital-20120829#ixzz26HFx2iWn], we are given many examples like this one:

Take a typical Bain transaction involving an Indiana-based company called American Pad and Paper. Bain bought Ampad in 1992 for just $5 million, financing the rest of the deal with borrowed cash [$35 million]. Within three years, Ampad was paying $60 million in annual debt payments, plus an additional $7 million in management fees. A year later, Bain led Ampad to go public, cashed out about $50 million in stock for itself and its investors, charged the firm $2 million for arranging the IPO and pocketed another $5 million in "management" fees. Ampad wound up going bankrupt, and hundreds of workers lost their jobs, but Bain and Romney weren't crying: They'd made more than $100 million on a $5 million investment. . . .

Romney has always kept his distance from the real-life consequences of his profiteering. At one point during Bain's looting of Ampad, a worker named Randy Johnson sent a handwritten letter to Romney, asking him to intervene to save an Ampad factory in Marion, Indiana. In a sterling demonstration of manliness and willingness to face a difficult conversation, Romney, who had just lost his race for the Senate in Massachusetts, wrote Johnson that he was "sorry," but his lawyers had advised him not to get involved. (So much for the candidate who insists that his way is always to "fight to save every job.")  
 


 
In his private life Mitt Romney is a kind, compassionate, and deeply religious man, and all the available evidence shows this to be true.  As a Mormon he’s devoted much of his time selflessly to the care and comfort of other Mormons in distress, a fact he has not publicized and for which he deserves much credit and approbation.  I applaud him for it. 

But in business he’s made a fortune out of a slimy practice that, while not criminal, is a moral sewer.
 
 
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Related Posts:
“President Mitt Romney?” April 21, 2012
“Ohio To Put Guns in Baby Strollers,” June 17, 2012
“Obamacare, John Roberts, and the Supreme Court,” July 3, 2012
“Supreme Court Overturns Roe v. Wade!” August 27, 2012
“Mitt Romney: A Mormon President?” October 17, 2012
“A Guide to the Best of My Blog,” April 29, 2013
 

3 comments:

  1. I found your post while searching for "what is a leveraged buyout?" I must admit you do a great job of painting a bleak picture. Perhaps it's even acurate. With all sincerity I have to ask, if these businesses are "ailing", as you say, what other course of action is available to them? Bain was able to save some businesses and get them back in the black, while other companies, despite Bain's best efforts, still failed. If my business is failing, what alternatives do I have? On the other hand, if I'm a corporation who specializes in providing countless hours of management, advice, counseling (and whatever else is involved) to get a business back on track, what incentive can a failing business provide me for my expertise? The business is ailing! They cannot afford to hire a management firm, let alone a lawyer. The risk is great that despite my best efforts the business will fail and, just like all of those other creditors, I will never see a dime for my work. I'm not for or against LBOs. I'm trying to understand what options might be available to a company. Bankruptcy? Bailout? Aren't those dishonest to creditors?

    On the other hand, in an LBO, if the company makes money, does it pay off it's creditors? So everyone wins?

    Leveraged Buyout firms like Bain seem no more dishonest than law firms. But despite the awful reputation lawyers get, I see the value a good lawyer can provide if he aims to be honest and provide valuable service to his clients. Sometimes it works out. Sometimes the client still loses lawsuits — either way, the lawyer needs to be paid for his service.

    Please engage me in an intelligent discussion. I'm eager to learn and make the right decision in 2012. Right now, I believe Romney is our best choice. He knows how to cut spending (even if I lose my job) and foster growth in new areas (a new job for me, perhaps in a new field).

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    2. Your argument is exactly what Bain would say to justify what it does, but here is what’s wrong with that, and with the analogy to hiring a lawyer. If a company is ailing and needs help or legal assistance, it can go out into the marketplace and hire such aid. Whoever it hires will be paid a just salary for its assistance or legal advice, and will have to satisfy the client or be fired. With an LBO the “client” has no choice. Its stockholders sell the stock to an entity whose goal is not primarily to help the target company, but to loot it of its remaining available assets, saving the company only if enough is left over to do so. The other creditors and the employees have no voice in the matter. This is ugly stuff, and if you read the cited Rolling Stones article it will show you that Bain did this over and over again.

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