Toys “R” Us
(September 2017 — $6.6 billion in assets)
Scapegoat cause: Market shift to online retail
Real causes: Competition from low-cost brick-and-mortar, problematic partnership with Amazon, internal inertia, precarious debt positioning, investor and executive strip-mining, skin-in-the-game issues
The decade was unsurprisingly brutal to retailers. In September of 2017, several generations’ source of childhood dreams was forced to liquidate everything down to its name, its website, and even Geoffrey the Giraffe.
However, to blame the downfall of Toys “R” Us solely on the industry shift to online retail is to miss the crucial lessons.
First, the central competitive forces that lured customers away from Toys “R” Us did not initially come from direct online sales but from other brick-and-mortar competitors like Target and Walmart. The toy company thought it had staved off online competition by entering into an (ill-fated) referral agreement with Amazon, and so deliberately neglected its online presence until as late as May 2017 (four months before their bankruptcy).
At the time, Toys “R” Us’s (first) global chief technology officer noted, “In a year to two years, we have to catch up on 10 years of innovation and that’s no small feat.’’
Simultaneously, the ownership and executive bonus structure of the company exemplifies what is now commonly criticized as the excesses of the private equity leveraged buyout structure. Toys “R” Us’s private equity ownership deliberately engineered its smothering $7.9 billion debt position, extracting handsome management fees while forcing the retailer to shoulder the debt from its own acquisition. Ownership, which could blithely liquidate in the event of a bankruptcy, had no skin in the game vis-à-vis the 33,000 retail workers who would lose their jobs without severance. They did, however, pay out pre-bankruptcy bonuses to executives, including a $2.8 million bonus to the visibly opulent CEO just five days before the bankruptcy filing. These oppressive debt conditions robbed the company of the operating cash necessary for any kind of turnaround.
When ownership and management are assured of payouts no matter the outcome of the company, it transfers away risk downside in a way that causes unhealthy incentives. Nassim Taleb covers this concept in his book, Skin in the Game. This will not be the last skin-in-the-game issue appearing within this list.
(October 2018 — $6.9 billion in assets)
Scapegoat cause: Market shift to online retail
Real causes: Over-diversification, inexperienced leadership, self-destructive management practices
It started by selling a single product category. But when it became clear that a sleepy, overpriced retail sector would crumble before it, there was nothing to stop the company from selling anything and everything. You could order from the comfort of your own home. You could pay a fair price. It would ship the goods right to you. Sales exploded, and if you’d picked up a big enough chunk of stock when the company went public, you’d never have to work again.
The Investopedia article from which this quote is taken points out that while the description could apply to the original Sears Roebuck mail–order company, it could just as easily apply to the retail industry’s future disruptor, Amazon.
Contrary to ownership’s claims of the acute competitive pressures as the cause of its collapse, Sears’s market share has been flagging over the last 50 years. When Sears’s retail dominance started eroding in the early ‘70s, their first solution was to diversify out of trouble. While a diversification strategy can have merit, you take on asymmetrically higher risk as you move further away from your core competency. Sears pushed heavily into financial services, insurance, real estate, and the early online venture Prodigy.
Unable to shake the tough big-box competition, Sears merged with Kmart in 2004. This merger is now seen as the beginning of the end for Sears. First, because it handcuffed them to a retailer struggling even more than they were (“Can you think of an example of a retailer that was successfully turned around?” asked Warren Buffet in 2005).
Second, because the new majority owner and CEO, Eddie Lampert, was a hedge fund speculator and notorious Ayn Rand devotee who thought that the best way to manage the organization was to split all the divisions into separate quasi-companies and let them compete for his affection and funding.
Ironically, the company that showed it could anticipate the marketplace with ventures like early online retail adoption, ultimately fell to a risk that it inflicted upon itself: dysfunctional management.
The company ultimately fell to a risk that it inflicted upon itself: dysfunctional management.
(May 2016 — $8.28 billion in asset)
Sector: Energy (oil and gas production)
Scapegoat cause: Weak oil prices
Real causes: Overaggressive expansion, precarious debt positioning, structuring company as investment vehicle, undermining value of core asset, unrealistic dependence on continual growth and high prices
Sometimes even business reporters do not roll back the rock and find the true cause of a bankruptcy, even an $8 billion bankruptcy.
When LINN Energy filed for Chapter 11 in 2016, the mainstream business press (exemplified by this Reuters article) framed the story as just another unfortunate casualty of low oil prices. One must keep digging to find the Houston Chronicle’s Chris Tomlinson and his far more accurate take.
LINN Energy was never structured with sustainable oil production in mind, only storytelling. It was created to satisfy investor demand for a non-fracking hydrocarbon company that delivered a high yield to investors. In a fit of financial engineering that always seems to accompany deregulation, it structured itself not as a corporation but as a partnership. This gave the company favorable tax status if most of its profits were distributed to partners (called “unitholders”) rather than being retained for operations.
“LINN hoped to attract income investors by offering a unicorn company, a reliable oil exploration and production company with long-term income potential and little risk,” says Tomlinson in his article, “And it worked, sending the unit price upward.”
Engineering organizations that serve primarily as investment vehicles can lead to destructive incentives. LINN’s business plan was to grow aggressively through exorbitant debt, and then service that debt with revenues generated by high oil prices.
There are a few obvious problems with this model that founder Michael Linn failed to calculate. First, when your operation depends on perpetual growth to service its financial obligations, you start resembling a Ponzi Scheme. Second, when you grow so fast that you saturate the market with your own product, what will likely happen to the price of that product?
Tomlinson concludes his analysis in a way that underlines the theme of this article: “While I respect the creativity that goes into business, innovations in company structures and financing are easy during the good times when everyone is making money. The real test comes when an industry hits the skids. Can these newfangled ideas survive a downturn as well as the tried-and-true?”
(February 2019 — $12.3 billion in assets)
Scapegoat cause: Market dynamics (housing crisis)
Real causes: Precarious debt positioning, legal challenges, loan compliance violations, inconsistent executive team
If you were around in the ‘90s for the “Lost another loan to Ditech” ad campaign, you might wonder where that company ever went. This is where.
Ditech has a special distinction on this list: the same company filling two of the biggest bankruptcies of the decade! Ditech’s holding company, Walter Investment Management, originally filed for bankruptcy in 2017. That $15.2B bankruptcy is profiled two entries down from this one.
After shedding $800 million in corporate debt, they changed their name officially to Ditech holdings. Fourteen months after that original filing, Ditech Holdings filed again.
In addition to the legacy debt that Ditech (Walter Investments) could not eliminate during the original filing, the company had other operational troubles. It could not seem to keep a steady executive team, for one.
For another, the company had amassed over 4,000 complaints within the preceding year about wrongful or overeager foreclosures on loans it originated. Its reverse mortgage subsidiary was also accused of originating reverse mortgages to people who had not asked for one or to whom the terms had been misrepresented. Borrowers felt the need to petition the Department of Justice for a special committee to ensure that Ditech couldn’t sell its business free-and-clear of their loan mishandling claims.
(November 2011 — $13.8 billion in assets)
Sector: Energy (coal and gas plants)
Scapegoat cause: Falling energy prices, environmental regulation
Real causes: Overaggressive expansion, precarious debt positioning, financial engineering
In the early aughts the energy market deregulated and gave rise to non-utility electricity producers called Independent Power Producers (IPPs). Enron started as an IPP, and at one point, Dynegy considered rescuing Enron in a buyout.
Early in the century, IPPs scooped up powerplants like they were Monopoly properties. Trying to out-grow each other for market dominance, they expanded aggressively both domestically and overseas. Such aggressive expansion came with incredible debt, but as with LINN Energy’s investors, they never imagined prices would go anywhere but up.
IPPs subscribe to a riskier business model than do the public utilities with which they compete. Utilities negotiate with regulators for a specified rate of return, thereby insulating themselves from the market risks that IPPs welcome. As such, financial distress in not only common for IPPs like Dynegy, Calpine Corp, and NRG, it’s been something of a cost of doing business.
Dynegy Holdings went bankrupt partially because it was engineered to go bankrupt. The holdings company was a subsidiary of Dynegy Inc, and the official legal owner of Dynegy’s core assets. In a move that was criticized as shareholder insulation, Dynegy transferred the profitable coal and gas plants out of Dynegy Holdings prior to filing, but kept there the $2.5 billion in bond claims it hoped to discharge. Dynegy planned to let its holdings subsidiary dissolve in bankruptcy, having preserved its core assets elsewhere. An examiner later ruled that this transfer was improper.
Walter Investment Management
(November 2017 — $15.22 billion in assets)
Scapegoat cause: Market dynamics (housing crisis)
Real causes: Overaggressive expansion, precarious debt positioning, inconsistent executive team, skin-in-the-game issues
Upon emerging from this bankruptcy, Walter Investment Management would become Ditech Holdings, and file for bankruptcy yet again. Part 2 of the Ditech Saga was discussed above. This is part one.
Walter Investment Management / Ditech is a mortgage originator and servicer (i.e., payment receiver and administrator), specializing in subprime loans. In 2013 they bought the servicing rights to a portfolio of 650,000 loans owned by Bank of America and further expanded through acquisition into the reverse mortgage business.
The company struggled in the ensuing years to operate profitably under the strain of the debt from its acquisitions. Net losses piled up: -$263 million in 2015, –$529 million in 2016, and -$214 million through the first three quarters of 2017. In that same period, the company churned through four CEOs in rapid succession.
Finally, the company suffered from an industry-wide, skin-in-the-game problem that underlies the entire subprime mortgage fiasco. Subprime mortgages became the popular answer the new demand for mortgage-backed securities. The very essence of these securities is based on the mortgage originator selling off the payment streams to investors. Thus, the originator (often the de facto advisor to the customer) has no investment in the future repayment of the loan and can originate ever more dubious mortgages.
Any form of risk transference, be it through insurance, asset sale, financial hedge, or other vehicle, has the potential to undermine management incentives by removing skin from the game.
Walter Investment Management collapsed in 2017, emerged, and then collapsed again in 2019.
(May 2012 — $15.7 billion in assets)
Scapegoat cause: Market dynamics (housing crisis)
Real causes: Overdependence on continuing subprime business, loan compliance violations, fraudulent practice litigation, skin-in-the-game issues
Ally Financial (formerly GMAC), the same financial holding company that once owned the previously discussed Ditech, had another sick child that made our top-10 bankruptcies list: ResCap.
Residential Capital is a mortgage originator and servicer similar to Ditech, and like Ditech, the residential housing crisis dogged it for years. ResCap not only took direct hits to its origination business during and after the crisis, but faced subsequent litigation alleging misleading origination practices.
Many originators of subprime mortgages fielded claims of dubious practices during this period. As with Walter/Ditech, transferring loan repayment risk to third parties removed the only accountability mechanism for ensuring new mortgages would likely be repaid. Thus, risk transfer can actually increase risk to the extent that it causes managers to make decisions more parochially than they otherwise would.
(April 2016 — $20.7 billion in assets)
Sector: Energy (renewable)
Scapegoat cause: Unpredictability of solar industry
Real causes: Problematic business model, financial engineering, declining energy costs, precarious debt positioning, financial compliance issues, skin-in-the-game issues
SunEdison positioned itself as a builder of renewable energy projects for large corporations. But unlike a standard solar construction company, they went to market with an innovative business model: They would charge nothing up front for the construction and would instead receive the energy revenues on the back end. They would then commoditize and sell these revenue streams to investors in much the same way the mortgage companies sold their loan repayment streams.
Here we see a repetition of downfall factors from earlier in the list. Like LINN Energy, SunEdison was engineered not as an operation but as an investment vehicle with an attractive story (and just as reliant on energy prices remaining high). Like Ditech and ResCap, their business model involved transferring downside risk (the customers’ inability to continue paying) to third-parties. Predictably, debt piled on quickly, and projects became increasingly financially fraught due to management’s confidence in being able to sell-off the risk.
Like Dynegy, questions arose as to the balance–sheet relationship between SunEdison and the subsidiaries to which it “sold” many of its projects. Commoditizers like energy companies, mortgage companies, and “financial innovators” like Enron commonly use the technique of selling an asset to an internal company (sometimes called a Special Purpose Vehicle) to facilitate further splitting and selling to investors. Note how many such companies appear on this list.
(October 2011 — $40.54 billion in assets)
Sector: Financial services (commodity futures broker)
Scapegoat cause: Market devaluation
Real causes: Hyper-aggressive risk positioning, executive conflict of interest, financial engineering, financial compliance issues (violation of account separation), skin-in-the-game issues (synthetic derivatives)
MF Global, spun off from Man Group in 2007, had the ambition to join the Goldmans, Merrills, and Morgan Stanleys of the world as the next global investment powerhouse. And they planned to do so by taking on more risk than the other guys were willing to absorb. This corrosive culture gave rise to incidents of improper trading (e.g., the wheat futures trade in Feb ’08), and constant liquidity fears (e.g., the Mar ’08 stock drop).
This culture suited John Corzine, New Jersey’s former governor and senator and the former CEO of Goldman Sachs. As analyst Marc L. Ross notes, “A fatal flaw in the management design, and an apparent violation of the canons of enterprise risk management, was his assumption of the role of both CEO and head trader – two functions that should remain separate. The role and responsibilities of the chief risk officer (CRO) were insufficient.”
Many will remember Corzine’s 2011 congressional testimony on the financial crisis, where he repeatedly insisted that he “did not know” about the operational procedures of the firm where he was both CEO and head trader.
MF Global had created a massive liquidity crisis for itself with an “innovative” style of off-balance sheet trading in the Repo Market, a short-term secondary market accessible only to brokers. The bottom fell out of this style of financing once the underlying assets looked problematic to the market. Unable to meet trading obligations with its own cash, MF Global violated an inviolable rule by raiding unrelated client funds to cover costs (Futures accounts are not insured by the FDIC, so this unrelated client money would not be federally insulated from a default.)
In the end, MF Global’s fragility came from the exact source as the other banks that contributed to the financial crisis: a culture which insisted that it could always unload its position (e.g., transfer its risk) in time to avoid disaster, because the traders assumed themselves smarter than everyone else.
Energy Future Holdings
(April 2014 — $41 billion in assets)
Sector: Energy (coal plants)
Scapegoat cause: Natural gas competition
Real causes: Precarious debt positioning, skin-in-the-game issues (private equity model), unmitigated exposure to energy price markets, environmental compliance issues, reputational issues
Energy Future Holdings edges out MF Global for the number one spot in our list and is the fourth energy provider to appear. Sudden energy deregulation, particularly in Texas, attracted developers and financiers who saw the new playing field as low risk. Indeed it was — the risk had been transferred to customers, for whom no regulation existed to protect their energy continuity once these organizations went belly-up.
Dallas-based EFH owned at the time the largest power network in Texas. It was the (still) largest leveraged buyout in the history of the country, created when four private equity firms purchased TXU Corp.
We’ve seen already from the Toys “R” Us story what can happen when the private equity model is given to excess. Similarly, in this case, the debt servicing from the $45 billion buyout was only sustainable if natural gas prices remained high. They did not.
Additionally, EFH owned four of the nation’s highest polluting power plants, subjecting it to increasing environmental scrutiny and boycott campaigns. Interestingly, this is one of the few instances on this list when bad publicity and social media played a prominent part in a bankruptcy.
Conclusion: Which Risks will Bankrupt You?
So, what can be learned from this (admittedly highly unscientific) survey? Consider the following:
- Convergence on certain industries: A few industries are over-represented, such as energy and mortgage services. This could be because such industries were more likely to have high asset values concentrated in few companies, making the bankruptcies bigger. Or it could be that specific industries underwent high growth leading into this period, and fast growth is correlated with failure through debt encumbrance. Note that most of the companies on this list took advantage of industry bubbles (mortgage), rapid deregulation (energy), and other outsized growth circumstances. These types of rapid growth situations should be regarded with caution.
- Organizational strip-mining: The quarter-by-quarter glare of the stock market often tempts executives to trade the future viability of the company for increased profits, growth, or optimization in the present. High-growth debt encumbrance, mentioned above, is an example of that, as is neglecting to invest in online retail infrastructure for cost management reasons (Toys “R” Us).
- Precarious debt: In almost all cases, debt played a significant role in the company’s demise. Companies tended to underestimate the amount of cash they’d need on-hand to operate, compete, and absorb shocks (Toys “R” Us). Or they wrongly supposed that their assets were more liquid than they really were (MF Global).
- Limited reputational involvement: Apart from Energy Future Holdings (the subject of anti-pollution campaigns) the reputational risk that influenced these stories mostly involved the company’s reputation among investors. In the cases of LINN Energy and SunEdison, investors withdrew at the first indications of cracks in the storytelling, forcing both into a death spiral. The special case of EFH demonstrates that public reputational damage that puts pressure on revenues can also contribute to bankruptcy by depriving you of cash with which to maneuver.
- Transference of risk: Narrowly speaking, risk transference is what happens when a risk manager buys insurance to mitigate against a certain event. But more broadly, risk transference is any process that moves a risk impact away from the party taking the risk. The 2007-8 TARP bailout is an example of the impacts of mortgage-back security speculation being transferred from investment banks to taxpayers.Any time you transfer risk to another party, you put yourself in danger not being able to see the lurking consequences. You may imagine that you have traded away the downside of a risk when in fact you’ve simply converted it into opaquer, more systemically damaging risk (Ditech, SunEdison). Risk transference can also serve to divorce decisions from their consequences, as when management earns fees and bonuses irrespective of company performance. Wise risk management requires that decision–makers retain skin in the game.
- Financial engineering: Several of the companies discussed in this roundup managed their investor relations using complex financial techniques popularized during this period. Many used the Special Purpose Vehicle (SPV), a special sub-company that’s not quite a subsidiary and not quite an independent partner. This is the preferred vehicle for commoditizing revenue streams to sell to investors (SunEdison, Ditech, Walter) and can also be used for Enron-style balance sheet manipulation (MF Global, Dynegy using a plain subsidiary). Financial “innovation” should be regarded with much more skepticism and regard for long-tail risk than it has been to date.
- Risk correlation: This is probably the most important takeaway. In every case, the executive leadership (and sometimes the press) tended to blame a certain single dynamic, like the retail industry’s online shift. But every case featured contributing exposures that combined to make the company fragile to the final shock. Risk is better analyzed in the context of an entire ecosystem rather than in isolation.
This last point is particularly crucial. This glance at a few of the biggest bankruptcies of the last decade strongly suggests that a single, unpredictable Black Swan event is not as likely to bring down an enterprise as is a combination of exposures that deprive the company of crucial flexibility when harder times come.
Risk management and compliance professionals often have separate conversation about different kinds of exposure: operational, legal, reputational, vendor, etc. This kind of siloed thinking can drastically underemphasize the cumulative exposure and subsequent outcome. Human resource compliance, risk management, and market dynamics are rarely talked about in the same conversation until a sudden downturn necessitates layoffs, and a disgruntled employee brings a $100 million discrimination suit.
Risk is risk, regardless of which business silo deals with it. Risk management systems and analytics are most powerful when they tell the story of how risks correlate. The information and insights that will allow our companies to survive only come to us if we take a 360-degree view of risk.