Bankruptcy Myth

Myth: The company is safe because it has no long-term debt to default on.

Counter-Examples: Long-term debt isn’t all. Short-term liabilities or off-balance sheet items (e.g. pensions, potential liabilities from class action lawsuits) may be significant enough to push a company to protect itself from its creditors. For instance, PCG in 2019, when the company was blamed for some disastrous California wildfires. Or bankruptcy can often be used as a bargaining chip when negotiating with labor unions (e.g. airlines). Some insurance companies filed for bankruptcy when faced with a slew of unexpected asbestos claims. Then there's Texaco strategic bankruptcy in 1987. The company just chose to not post collateral on a legal dispute it was having with Pennzoil.

Myth: A company wouldn’t file for bankruptcy if it has enough cash on hand to pay coupon payments and other short-term liabilities (i.e. ability to meet immediate financial obligations).

Counter-Examples: ANR elected not to pay down $109 million of notes that matured on 01-Aug-15, filing instead for bankruptcy soon thereafter. WLT also chose to skip an interest payment in July of that same year (that is could easily have made).

Reality: A liquidity event or covenant breach can push a company in bankruptcy.

Myth: The company won't file because management says it isn’t planning to file for bankruptcy (or vehemently denies reports to that effect).

Counter-Examples: Some companies deny the obvious all the way to the bankruptcy court, like HMNY (better known for its MoviePass flame-out). It isn’t their fault, they have to say bankruptcy isn’t in the cards, as the company needs to reassure suppliers, customers and investors in order to stay in business. Consider for instance, Tom Guttierrez, CEO of GTAT who said this two months before filing for bankruptcy: "we don't expect need to go out into the marketplace to raise additional capital". Maybe GTAT should have raised for cash when it still had the chance!

Myth: At the current burn rate, the company says it has adequate cash reserves to last it into X quarter of next year.

Reality: Companies don’t go bankrupt only when their bank accounts reach $0 and they can’t meet payroll. Put yourself in the shoes of a vendor, would you accept to wait until the last solvent quarter for your payment?

Myth: A company wouldn’t file for bankruptcy if it has access to credit and/or other liquidity?

Counter-Example: BTU drew down the remaining $1.65B on its revolver (with another $1B used previously) shortly before filing, which it didn’t immediately need, but which effectively provided it with DIP financing for the long restructuring process.

Myth: A company wouldn’t file for bankruptcy if it announces its intention to repurchase its debt at a discount.

Counter-Examples: CZR attempted plenty of financial wizardry with its distressed bonds, but it didn’t save them from the inevitable. ACI announced an exchange offer in 2015 that ultimately failed – even though it reached agreements with a majority (i.e. 56.9%) of bondholders (in aggregate principal) – due to opposition from more senior lenders. WLT also announced a debt swap to extended maturities that never closed.

Reality: Even if the company could theoretically extinguished all the debt on their balance sheet at today’s low bond prices with the cash they have on hand, you cannot always buyback bonds on the open market in sufficient quantities before prices start creeping up.

Myth: A company wouldn’t file for bankruptcy if it had positive equity/book value (i.e. assets > debt).

Counter-Examples: An example is Allied Nevada Gold (ANV), who said in 2013 (before bankruptcy) that it had assets of $1.5B and debts of only $736M. Then in 2014 (while under creditor protection), it had to write down nearly a half a billion in assets ($388M and $42M on its two main assets). In court, gross assets were independently estimated a $176M to $225M if liquidated, $200M to $300M if reorganized, a far cry from the initial carrying value of $1.5B.

Reality: You can't always trust the balance sheet. Book value just measures what the company historically paid for its assets, not what they are worth. As Warren Buffett explained in his exit from the textile industry in 1985: “Relatively modern looms that we bought for $5,000 apiece in 1981 found no takers at $50. We finally sold them for scrap at $26 each, a sum less than removal costs”. As the Berkshire example illustrates, a lot can happen to the market value of long-term assets in as little as 4 years.

Myth: A company doesn’t need to file for bankruptcy because its balance sheet is strong, especially compared to its peers.

Counter-Examples: REXX had a $900M cushion (on its tangible assets), but the company used ‘Successful Efforts Accounting’ on its properties, which overstated their value. BCEI had positive equity too (also under SE accounting). Both ended in bankruptcy court.

Myth: This company has an amazing new drug/product/technology/project about to hit the market. It will be a game-changer.

Counter-Example: Again, Allied Nevada Gold (ANV) reported proven and probable mineral reserves of $20B for a new mine it owned, which was also appraised to have a NPV of close to $2B. This potential windfall didn’t stop the company from filing for bankruptcy before the mine came online (once bankrupt, it became clear that valuation was wildly optimistic and ANV couldn’t monetize that investment as hyped). MCP fanatics were also touting the immense earnings power of rare earth minerals and how their new mine was a game changer. It now belongs to creditors.

Reality: Often, shareholders look at a potential market size and naturally assume that the company will be in a position to capture all that demand, without making allowances for execution risks and the response from competitors, who won't sit ideally by. If the pie is indeed that large, better capitalized companies will come to the table and muscle the innovative company out of existence.

Myth: The company has incredible growth prospects due to an upcoming blockbuster product about to hit the market.

Counter-Example: DNDN literally had a novel cure for cancer. The problem was demand insufficient to recoup the high R&D costs.

Reality: As soon as you hear "total addressable market", you should stop listening to whatever pitch follows!

Myth: A company wouldn’t file for bankruptcy if it has big name shareholders.

Counter-Example: XCO was backed by Prem Watsa’s Fairfax Financial, Howard Marks’ Oaktree Capital and Wilbur Ross’ WL Ross & Co. (later named Commerce Secretary).

Reality: Oftentimes, hedge funds play many layers of the capital structure at once, and holding equity might be a loss leader to maintain control over the company in a way that makes their bond returns (or preferred shares) more profitable. To think that these knowledgeable participants will have the common shareholders' best interest at heart throughout the bankruptcy process (including emergence) is incredibly naïve. Hedge funds love to monetize control rights and will run over fellow equity holders in the process.

Myth: An activist hedge fund (or investor) with a proven track record has bought a substantial stake with the goal of ‘unlocking’ shareholder value?

Counter-Example: A ECTE shareholder mounted a vigorous campaign to oust entrenched management, to no avail (though the company didn't declare bankruptcy – it instead got delisted). And the CZR bankruptcy featured a who's-who of hedge funds. Ultimately, the smaller fish got eaten.

Reality: Sometimes activists are looking at acquiring control rights to hedge their bets. Their name says it all: hedge funds. They may be playing the long game where they can use their equity stake (and possibly board position) to receive sensitive information that might help them make money off other areas of the capital structure (e.g. trading debt, arranging DIP financing, poaching assets, playing the CDS and/or options market). For instance, they may arrange that shareholders receive a debt instrument or rights offering in exchange for surrendering their shares. The only problem: due to securities legislation, only qualified institutional buyers are allowed to buy into these sweetheart deals, leaving the mom-and-pop investor in the lurch. If that doesn't seem fair, you are correct, and yet the courts have ruled that certain securities can be offered to certain shareholders and not others, based on their 144 status (if you don't know what SEC Rule 144 is, it's probably because you don't qualify to purchase unregistered securities through private placements).

Myth: Several prominent institutions are holding shares and/or institutional ownership is high.

Reality: Lots of these so-called "smart money" institutions are actually passive investment vehicles (e.g. ETFs and mutual funds). They may not have conducted any due diligence on the company.

Myth: A company wouldn’t file for bankruptcy if it has insider stock purchases.

Counter-Examples: ATPG, SD, HK had insider buying in the preceding months. Besides, lots of the stock "buying" is the exercising of options received as compensation, not open market purchases.

Myth: A company wouldn’t file for bankruptcy if it is able to print more shares.

Counter-Example: AREX had a distressed exchange where the shares issued created 50% dilution (note that for the purposes of shareholder dilution, the 20% rule – like NASDAQ’s – only applies when shares are offered at a discount [i.e. the legal definition of dilution differs from the commonly-used one]).

Myth: The company has years of NOL tax credits that could be valuable to another company.

Reality: Even if you found a profitable company to use those NOL (i.e. they are of no value to the current company, which can’t generate its profit to save its life – literally), tax law regarding NOLs is notoriously complicated. Any change in ownership invalidates some or all of their transferability. Furthermore, since the corporate tax rate was decreased from 35% to 21%, carryforwards have significantly less value. And finally, large profitable companies can avoid paying taxes without having to resort to buying up unused NOL (net operating losses) on other companies’ balance sheets.

Myth: After filing for bankruptcy, the stock price is still elevated. Surely, shares can't be truly worthless if the market cap is substantial?

Counter-Examples: LINEQ sported a $34M valuation the day before it exited bankruptcy (and had precisely zero value).

Myth: There was a substantial spike in the share price of a bankrupt company (i.e. 50%+) without any news, so there must be something brewing and hence someone who knows something (i.e. unexplained buying).

Counter-Example: SHLD popped several times and still ended up being worth $0. The mechanics of trading bankrupt companies involve small floats (most CEOs and insiders won't sell even if they wanted to, due to image and legal concerns), short-selling constraints (high rebate rates and random buy-in notices) and low volume (most institutions won't or can't trade these shares). Sometimes (as was the case in BTUUQ) a short squeeze is triggered a few days before the bankruptcy plan is declared effective, because traders engage in naked short selling (thinking they won’t have to deliver the shares), but a buy-in notice is unexpectedly issued beforehand (by their brokers’ compliance departments).

Myth: There is a buyout offer pending, or the company has received several expressions of interest following its search for strategic alternatives.

Counter-Examples: SFXE’s management announced several times it wanted to take the company private. As usual, it was conditional to financing being secured, and predictably nobody stepped forward to take on the risk. Lots of so-called offers are wishing thinking, with no reasonable expectation of closing (or for shareholders to receive cold hard cash for their worthless shares). "Conditional to external financing" is a phrase that kills. A lot of Chinese buyouts never happened because of this. Besides, buyout offers don’t always come in at a premium (e.g. PGH at $0.05, significantly less than the pre-announcement price). Even Citrix Systems, which wasn't depressed, got acquired for less than the share price on the announcement date.

Myth: The company is still paying a dividend, so surely they can’t be under threat of filing for bankruptcy.

Counter-Example: DEER was accused of fraud, so as a way to defy the skeptics who said its cash reserved were inflated, the company offered a token dividend. It didn’t end well for DEER shareholders.

Myth: The stock was worth 5X, 10X or even 100X what it is now. Surely it can recoup some of those losses (i.e. bargain share price)?

Counter-Example: The anchor price is meaningless. Even if the business is worth some money, the creditors are the ones who are rightfully owners of the company now. Shareholders get paid last. A company with strong assets was GM, and yet, shareholders got nothing. The company was worth something; the shares, however, weren't (don't confuse the old shares with the new shares ).

Myth: The short interest is so high (and the days to cover) compared to the float that a short squeeze is inevitable, notwithstanding any financial difficulties the company could be experiencing.

Counter-Example: RSH had huge short interests, and shareholders still lost their money despite a few random days of optimism.

Myth: Popular opinion thinks the company will succeed in its turnaround.

Counter-Example: Actual turnaround stories are extremely rare; many more than are attempted. For example, after the Superbowl, RSH’s share price in 2014 rose after it launched a new commercial (featuring Hulk Hogan and other 1980 icons), that was extremely well-received and convinced some investors that it would avoid bankruptcy through rebranding.

Myth: Analysts are bullish on the stock and have high price targets.

Counter-Examples: Some once-prominent darlings include Nortel, Enron, Lehman Brothers, Valiant.

Reality: Analysts are often clueless and have heavy conflict of interest (especially bottom-tier investment banks), especially when they might be looking to underwrite a future stock offering. Hence, analysts are notorious overly-optimistic with their forecasts (especially price targets), often looking to curry favor with management. Most ratings are ‘strong buy’ or ‘buy’, even on failing and highly speculative companies. When the company files for bankruptcy the analysts will either downgrade after-the-fact, or quickly drop coverage.

Myth: The company has more (net) cash per share on its balance sheet than the current stock price.

Reality: Assuming the cash is indeed unrestricted and unencumbered, hidden liabilities and obligations make it impossible to instantaneously walk away from a company without incurring costs (e.g. severance packages, commissions and discounts on the fire sale of assets, clean-up and demolition costs). Wind-down obligations are substantial.

Myth: Even though the company is posting losses, it is cash flow (or free cash flow) positive.

Counter-Example: Free cash flow excludes capital expenses. A company like YRCW who is running its truck fleet into the ground cannot postpone replacement costs indefinitely. It must re-invest in its business in order to remain competitive and maintain operations. Cutting CAPEX to unsustainable levels isn't a viable long-term strategy (you usually end up paying more to fix problems that haven't properly addressed in due time).

Reality: Besides, operating cash flow is not immune to accounting shenanigans (e.g. delaying AP payments and offering discounts for early AR collections). And often, companies use EBITDA as a proxy for cashflow. The fact remains that interest is a business expense and no income can accrue to shareholders before that cost is taken care of.

Myth: The company’s intellectual property is worth much more than the market capitalization because it is considered a break-through technology or because the patent portfolio has considerable value to other (profitable) companies.

Counter-Example: DNDN’s technology was supposedly worth billions of dollars. It sold for less than $1B and shareholders received nothing.

Myth: The company just had a stock split (forward).

Counter-Example: It’s still possible to fall from grace in record time. SUNE being a prime example.

Myth: The stock just got uplisted to the NMS.

Reality: It’s not unheard of for company insiders to push for an uplisting when they are trying to unload their shares. Besides, even when management doesn’t have bad intentions, some companies don’t even last a year on the national markets before being delisted.

Myth: The company just had an IPO.

Reality: Insiders were often in a rush to dump their shares and run. And guess what, they usually find plenty of suckers. The record IPO-to-bankruptcy timespan is measured in months, not years.

Myth: The company is too important for the government or a large customer/supplier to let it go under (or too big to fail).

Counter-Examples: MCP, GTAT (to Apple) were allowed to restructure their capital structures, without endangering the output produced from their operations. USEC also got restructured, even though it is a vital U.S. government contractor.

Myth: The company just bought another company in a merger/acquisition.

Counter-Example: CHK bought Wildhorse and was on an expansion trajectory before the high leverage caught up with them.

Myth: The company has a stock buyback program in place (and possibly has been buying up shares on the open market).

Reality: Announcing a stock buyback (or its approval by the Board) doesn’t guarantee it will be carried out (i.e. such agreements are not-binding, may include exit clauses like price caps, and may just be for show to juice the stock price).

Myth: The company has positive EPS, or is about to reach profitability (i.e. management guidance calls for a turnaround at any moment).

Reality: Accrual management (and pro forma accounting) can account for some of these artificial profits. In extreme cases, financials statements may have been inflated due to fraud or questionable accounting practices. In other cases, positive EPS is a relic of an old business model that has reached the end of its lifespan (or various asset sales disguised as revenues). Additionally, the company may have taken an accounting big bath (with lots of write-down), so the depreciations costs may be have been adjusted downward, to an artificially low level, hence boosting profitability (at least on paper).

Myth: The company is the dominant player in its industry, based either on market share or profitability.

Counter-Example: Especially if many of its peers have restructured their liabilities, the company may be at a cost disadvantage (e.g. higher interest payments, pension liabilities, debt overhang). Nonetheless, market leaders go bankrupt all the time. GM was once the biggest carmaker in the world.

Myth: The credit rating isn’t at junk status and/or its bonds are not trading at distressed levels (i.e. bond markets aren’t bearish).

Counter-Examples: Enron & Lehman Brothers weren’t downgraded before they defaulted. Besides, the outlook for creditors may be completely different than shareholders, who are further down the capital structure. Bondholders claims might be secured with collateral and/or they expect to be paid from the estate, while shareholders are last in line and likely to be wiped out. In fact, senior noteholders frequently recover 100% on their investments, even in bankruptcy.

Myth: The company has an experienced management team that is well-respected.

Counter-Examples: Plenty of big names, once heralded as business leaders have had a sudden fall from grace, including Ken Lay, who was on the cover of several magazines prior to Enron imploding. Nortel and Worldcom were also admired companies, before their difficulties were laid bare.

Myth: The company was given an unqualified audit opinion (i.e. no a going-concern warning was issued by its auditors on its last financial statements).

Reality: 50% of defaults don’t get a GCO [2166].

Myth: Bankruptcy is said to be "priced in" to the stock price.

Reality: That statement doesn't make much sense. The value of a bankrupt share is zero (except in exceptional circumstances). Any price above zero is merely an option value on the company pulling out a miracle. Likewise, the expected value of a lottery ticket is zero, but it usually sells for a few bucks before the draw on irrational optimism. If your investment strategy is dependent on an unexpected windfall, you are gambling, not investing!

Myth: A prepackaged bankruptcy is planned and equity holders are said to be receiving equity in the new company.

Counter-Example: PGN filed paperwork indicating current shareholders would receive new equity. The bankruptcy judge ruled that that wasn't feasible. Current management resigned and a new plan was put forward with a 0% recovery. Shareholders got nothing for their old shares. The shares were cancelled and when the post-bankruptcy company got acquired by Borr Drilling in 2018, the poor Paragon Offshore stockholders couldn't share in the windfall ($42.28 in cash per share). [Instead, they are still waiting on the outcome of the Paragon’s Litigation Trust Agreement].

Myth: A company has a crown jewel in its portfolio of assets. It can monetize that division/mine/product line by selling it to a deep-pocketed competitor.

Reality: The sale price is likely not be enough to cover the debt incurred to build up the asset (or acquire it in the first place). Plus, usually financial difficulties don't happen during a seller's market. There are possibly many companies with assets to shed and a race to the bottom will develop amongst desperate companies. A choice asset at fire sale prices, isn't much to look forward to. Besides, selling the company's best shot at achieving profitability is a stupid business strategy. It's like burning the furniture to stay warm (or in this case: to allow current management to continue to pillage the company for a little while longer - if you doubt it, check the management's total compensation in the last year, in certain situations it exceeds the market capitalization of the company).

Additionally, a potential buyer might be better off letting the company go bankrupt and purchase the best assets in liquidation. That way, they get to purchase the good stuff, while leaving the bad alone. In other words, even better than a choice asset, is one that's been "wiped" of most of its debt. Think about it. if you got to buy a mattress and you know that the retailer is going bankrupt tomorrow, you would likely wait to get the same mattress once the liquidation sale starts.

Also, company insiders are privy to confidential estimates that will allow them to price most of the company's assets of uncanny accuracy. That's why you often see a management group pick the carcass clean in bankruptcy court, because they know exactly what the true value of the company outside of bankruptcy protection is likely to be. Other potential buyers won't have the time and expertise to complete proper diligence before deciding to place a bid. This knowledge gap depresses the price of competing bids and hinders the auction process. It also gives incumbents a huge advantage. Unfortunately, shareholders will be the last to know any of this. They can't self-deal on asset deals or debt restructuring.