Recently a swan of unknown color landed at the Yoda cave. Upon further examination, it turned out to be a black swan of the highest order. Unfortunately, this swan might be a scout for a whole flock of black swans heading in.The story starts in the money is flowing like water era before the credit crash. Leveraged buyouts were coming fast and furious up through 2008. To say that some of the LBO’s might have used overly optimistic projections would be an understatement. Warren Buffet bought $ 2 billion of LBO bonds for a utility company called Energy Future Holdings. He recently called that acquisition “a big mistake” as the bonds have been written down substantially from par. Energy Future Holdings was an LBO of Texas Utilities, an old, stodgy electric utility. Energy Future Holdings is still in business and has not declared bankruptcy, but the outlook is NOT good.Another LBO/merger that went bad was Lyondell Chemical. They floated $22 billion of new debt to consummate a merger with Basell in December 2007. In December 2008, Lyondell declared bankruptcy. So in a one year period of time, the financial projections that were used to justify the $22 billion in bonds were proved way off base.So you say, “too bad for the bondholders, I guess they should not have loaned the company money.” Here is where it gets interesting.In 2010, the trustee for the bondholders filed a claim in bankruptcy court in New York. The trustee is using a new “fraudulent transfer” argument in the court case. They have named every person/entity that owned over $100k in shares on the date of the buyout as defendants. The trustee claims that the $48 per share buyout price represents a fraudulent transfer. Stated differently, everyone that received the $48 was not and IS NOT entitled to it. The lawsuit seeks to “clawback” the buyout funds. The trustee wants to use the clawed back funds to help make the bond holders whole.This is without regard to how long the shares were held before the buyout was consummated. They could have been held one day or one decade, it does NOT matter. Let me emphasize the point. The trustee is not attempting to get any gains that were recognized by owning the stock. The trustee wants the bankruptcy court to order maybe 50% or $24 per share to be forfeited by the holders of the stock on the buyout date.They have served court papers on all holders of the stock above the $100k threshold. It is on the order of 2,000 funds/advisors/trusts and INDIVIDUAL INVESTORS.All ~ 2,000 MUST file a formal response with the bankruptcy court. Failure to do so will result in the trustee asking for a “default judgment” against the shareholder. I do not know if the court would approve this, nor what amount they would grant.The largest shareholder on the list “Fund 1” owned $343 million of shares on the buyout date. They have adequate vested interest and funds to fight the trustee. The folks that owned $100k of shares are lumped into the same boat legally. They have to fight the charges also. At a minimum, they have to retain their own legal counsel to file motions to the bankruptcy court seeking to join with the large holders. In the best case, these small holders will prevail in court and only be out their legal fees. Recall in America that “losers do not pay” the legal fees for the winning side. In the worst case, the holders will be out their legal fees plus a significant portion of the share buyout proceeds.You can read all 274 pages of the “Second Amended Complaint” with this link. Most of the pages are lists of all of the stock holders on the date of the buyout.http://www.kccllc.net/documents/8820800/88208001112210000000...Several legal scholars are predicting this type of litigation will expand as more of the credit crazed buyouts turn bad. Here is a legal paper that explains the new theories of “fraudulent transfer.”http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1632084BOTTOM LINE is you do not want to own any common stock that gets bought out through an LBO, then goes bankrupt. (Don’t ask me how you are supposed to always know this in advance.) If you own the shares as part of a mutual fund or ETF, they will fight the battle for you. If they lose, the losses will be amortized over the rest of the investments.Unfortunately this black swan in not mythical and landed at the Yoda cave. If is not clear how this case will be resolved, but the financial outlays will be significant, win, lose or draw.Welcome to America. . .Yodaorange
It is all a tax writeoff anyway--so they win regardless of the outcome. Why? Because losses are offset against gains BEFORE taxation.
<BOTTOM LINE is you do not want to own any common stock that gets bought out through an LBO, then goes bankrupt. (Don’t ask me how you are supposed to always know this in advance.)>I would venture that the same signals that would tell an investor not to buy the bonds would also tell the stock investor that something is rotten in the state of Denmark.During the LBO frenzy of 2005-2009, I was repelled by the "covenant lite" bonds that first became routine in LBOs at the start of the 21st century. I stopped buying corporate bonds because I couldn't get the prospectus to find out what was what. The risk to spread ratio was razor thin. It seemed to me that these deals were structured to rape the bondholders and then to fail because they had no intention of meeting loan covenants.If I wouldn't touch the bonds, I certainly wouldn't touch the stocks. These deals reminded me of the junk bond buyout frenzy of the 1980s.We have politely disagreed in the past as to which of us is more financially conservative :-). I think I was much more conservative than you were in this instance because I saw red flashing lights (bad intentions of the dealers) all over these deals and didn't touch them. They may not have wanted to go bankrupt, but they had every intention of protecting themselves and sacrificing the bondholders/ stockholders. I think this is advance warning to keep away from them.Others would say that my risk aversion costs me returns and it would be more profitable to take the losses since the average over time would be higher. I don't like doing that -- it's a personality thing.Sorry to hear of the lawsuit. Will someone organize a class action defense?Wendy
The trustee is using a new “fraudulent transfer” argument in the court case. They have named every person/entity that owned over $100k in shares on the date of the buyout as defendants.As we have seen over the past years, most recently in the case of Goldman, stockholders have no authority or control in the operation of the company. How can a stockholder be held liable for a fraud perpetrated by the officers of the company or by the LBO firm, over which he has no control? The stockholders simply accepted an offer for their shares. The same thing everyone that sells in any stockmarket does. That's the defense I would offer.Steve
<<They floated $22 billion of new debt to consummate a merger with Basell in December 2007. In December 2008, Lyondell declared bankruptcy. So in a one year period of time, the financial projections that were used to justify the $22 billion in bonds were proved way off base.So you say, “too bad for the bondholders, I guess they should not have loaned the company money.” >> Bond holders aren't suckers to be plucked??? What a novel concept. Sounds faintly anti American.Seattle Pioneer
Hysterical overreaction to a "novel" lawsuit which has almost no chance of being affirmed.
Recall in America that “losers do not pay” the legal fees for the winning side.<SNIP>Several legal scholars are predicting this type of litigation will expand as more of the credit crazed buyouts turn bad. Here is a legal paper that explains the new theories of “fraudulent transfer.”EXCELLENT, AND OUTSTANDING!!!!This is *EXACTLY* the kind of beyond-sanity outrageousness we *MUST* incur in order to overcome the litigation racket with serious tort reform.BRING THE PAIN!(PS. very sorry, Yoda, that you're one of our martyrs... ;~(
It would be interesting to know if the the people filing the lawsuit bought the bonds for pennies (or small fractions of a penny) on the dollar with the intent of filing this lawsuit. It could be that the people being sued may also get a letter saying that they can settle out of court for a modest amount or pay a lawyer a lot more to defend the lawsuit and risk losing a large amount. It would not surprise me at all.Greg
Thanks to all for your comments. Here a few replies:Wendy wrote: “I think I was much more conservative than you were in this instance because I saw red flashing lights.”Wendy, you have been proven correct! In 2007, this was part of strategy I thought was reasonably conservative. I was aware that LBO’s were in a bubble. I was widely on record as saying that many of them would fail and not be able to service their debt. My mistake was thinking that once the stock transaction closed and you received the proceeds, you would be OK. I 100% missed the fact that you would be named in a clawback lawsuit, 5 years after the deal closed.Wendy wrote: “Will someone organize a class action defense?”I have not received any notification of a class action defense. Some very large firms like Morgan Stanley, Merrill, Fidelity etc appear to have joined together to mount a defense, but they did not offer to include the other folks named in the suit.Steve203 wrote: “The stockholders simply accepted an offer for their shares. The same thing everyone that sells in any stock market does. That's the defense I would offer.”Steve, I agree that is a reasonable defense. The challenge is that you cannot just send the court a letter to that effect. To file any kind of response to the court, you have to retain a lawyer that is licensed to practice in the “Southern District of New York” aka New York City. Say an investor is in Smalltown, Kansas he still has to retain a law firm to represent him. The retainer fee will be in the range of $10,000 to $25,000. Depending on what the lawyers have to do, the cost’s can go up from there.Goofy said: “Hysterical overreaction to a "novel" lawsuit which has almost no chance of being affirmed.”Goofy, I sure hope you are right. So far the judge in the case has not agreed with you. The large investors have requested a summary judgment to dismiss the case. They requested it on January 29, 2011. Here is the link to their 79 request for dismissal:http://www.kccllc.net/documents/8820800/88208001112050000000...For whatever reason, the judge has not seen fit to grant their motion in the last 13 months. I have no idea when and if the motion will be granted. In the meantime, small investors get to write the $10k to $25k check to retain counsel with the understanding there is NO recourse to recover legal fees. I do not have a feel for how much additional legal fees will be incurred, even if the motion to dismiss is granted.Dwdonhoff wrote: “Yoda, that you're one of our martyrs . . .”Dave, I didn’t exactly plan it this way, but at this point, I will be happy to take one for the team! This is the most novel way to turn a profitable investment in an unprofitable one that I have personally experienced. If it turns badly, I might end up sending them a check for 100% of the proceeds, NOT profits, but the amount I received when the buyout was consummated. In that case, I will be in the unique position of losing more than 100% of the initial investment, because of the added legal fees.Watty56 said: “It would be interesting to know if the people filing the lawsuit bought the bonds for pennies (or small fractions of a penny) on the dollar with the intent of filing this lawsuit. It could be that the people being sued may also get a letter saying that they can settle out of court for a modest amount or pay a lawyer a lot more to defend the lawsuit and risk losing a large amount.”Watty, I have no idea if those behind the suit bought the debt at distressed prices. I do know there are many specialized investors that buy bonds like these. However, this is the first time I have ever heard of them trying to recover via a clawback like this.So far, I have not received any settlement offers from the suit. If they were to ask for a number before the judge rules, my 100% guess is that it would be 50% of the buyout price, regardless of what you paid for the stock or when you bought it. As I mentioned above, it is certainly possible that the court will award something on that order . . . Still searching for the investment lessons to learn from this . . . . Yoda
Then again, you could buy options on the bonds, and if you lose you could send the money to yourself.CheersQazulight
looks like a straight-up fraud case against the insider shareholders--particularly Smith who made out with $300mm.As for all the other shareholders, I see unjust enrichment in your future.
Watty56 said: “It would be interesting to know if the people filing the lawsuit bought the bonds for pennies (or small fractions of a penny) on the dollar with the intent of filing this lawsuit.My hunch is that anyone who bought the bonds after they had been severly downgraded, or in default, would not "have standing" to recover, because they did not personally suffer the loss.My takeaway from this would be "don't hold a stock through the buyout date". Eons ago, I had shares in Comair. Delta bought out Comair, actually twisted the Mueller's arms to the breaking point to get them to sell. I sold my shares well before the closing date of the aqusition and got nearly the full buyout price.Steve
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