Reorganizing does not always mean the end

By DAVID MOON, Moon Capital Management, LLC
December 2, 2012

What do Henry Ford, Reader’s Digest, Thomas Jefferson, Delta Airlines, Milton Hershey, Edison Records, Walt Disney, and Abraham Lincoln have in common?

They all filed for bankruptcy.

In the ancient world, the Torah describes methods by which debtors could periodically discharge their financial obligations without legal recourse. Repercussions for one’s inability to pay a debt weren’t always so humane. If someone defaulted on debts three times in the Mongolian Empire, Ghenkis Kahn had them put to death.

Until the mid 1800s, England allowed corporate creditors to recover debts from the shareholders of a corporation. A similar law today might inspire a bit more responsible analysis prior to investing in a stock.

Today there are various ways for both individuals and corporations to either discharge or reorganize financial obligations they would otherwise not be able to repay.

Individuals filing for bankruptcy aren’t required to surrender their passport or their personage. Some go on to start massively successful businesses or become US President. Four presidents filed for bankruptcy. Corporations can similarly emerge. Bankruptcy doesn’t necessarily require the liquidation or closing of the reorganizing business.

That’s why this Hostess Twinkie thing doesn’t bother me.

I’ve never eaten a Twinkie, but I have enjoyed a Ding Dong and Ho-Ho on occasion.

Like airlines that repeatedly file for bankruptcies, Hostess filed for a second time earlier this year. Unlike previous Sbarro and US Air bankruptcies, however, the company’s and unions’ inability to reorganize Hostess’s legacy costs apparently pushed the company into liquidation.

Even less severe reorganization bankruptcies are not all created equal.

When a company is discharging or reorganizing its debts, the bondholders and other company lenders have a senior claim on the assets of the struggling company. Shareholders generally get whatever is left over – if anything – after the lenders receive full payment. That’s a terrible oversimplification, but a usable description of liquidation preference.

This process sometimes results in a much healthier and successful company – and it doesn’t necessarily spell doom for all lenders. When General Growth Properties and its subsidiaries filed for bankruptcy in April 2009, both secured and unsecured creditors were paid in full, including accrued interest. Equity shareholders received a small residual interest – but they did receive something. Today the company is the second largest retail property REIT in the US.

When Kmart went through bankruptcy in 2002, the existing shareholders didn’t fare so well. There weren’t enough liquid assets to fully repay the creditors in cash so the shareholders lost their entire investment. Depending on the class of creditor, they received some combination of cash and newly issued shares in the reorganized company. Since 2002 those shares have traded between $13 and $190 per share, so the bondholders’ ultimate payout depended on if/when they sold their shares.

Bankruptcy is not a business panacea. A poorly run company will always struggle, no matter how many times it stiffs its creditors. But it is a legitimate tool in a system where people should know the risks of accepting IOUs.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

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