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Lehman Brothers Examiner’s Report Reveals Inaccurate Disclosure

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The Lehman Brothers Bankruptcy Examiner’s report is out, and anyone interested in knowing more about the reasons behind the largest bankruptcy in U.S. history should at least take the time to read the Executive Summary.  Much of the initial press coverage has focused on Lehman’s use of “Repo 105” transactions to reduce reported net leverage,  for example, from 13.9 to 12.1 for the end of the second quarter of 2008.   An even bigger gap between reality and what was reported to the public is noted just a page or two later in the Examiner’s Report:  “By Sept 12 [2008], two days after [Lehman] publicly reported a $41 billion liquidity pool, the pool actually contained less than $2 billion of readily monetizable assets.”  By understating its leverage, and overstating its liquidity, Lehman Brothers misled the rating agencies, government officials and the investing public.  The Examiner’s report is shining a much needed spotlight on what happened, and why, and may result informer Lehman officers being held accountable for their roles.

Why Businesses Go Bankrupt: Mervyn’s

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Private Equity firms Cerberus Capital Management and Sun Capital Partners, along with real estate investors Lubert-Adler and Klaff Partners led a 2004 buyout of Mervyn’s discount retail chain for $1.26 billion in 2004.   Upon closing, the new owners split Mervyn’s into two companies, one owning the real estate, and the other operating the stores.   The real estate company borrowed $800 million to fund the LBO, and then dramatically raised store rents to the operating company.  In October 2008, Mervyn’s went into bankruptcy, with its remaining 149 stores liquidated, and more than 18,000 employees thrown out of work.

Lesson learned: Financial engineering often increases the risk of failure.  After the split of Mervyn’s into two companies, the retail stores were left with $674 million of assets and $664 million of liabilities and worse yet, negative working capital. According to a 11/26/08 “Business Week” article, the moves left Mervyn’s “so weak it couldn’t survive.”

Why Businesses Go Bankrupt: FairPoint Communications

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FairPoint Communications filed for bankruptcy under Chapter 11 on October 26, 2009, hampered by interest payments resulting from the excessive debt it took on in the $2.3 million acquisition of Verizon’s northern New England landlines and Internet network in early 2008.  Remarkably, FairPoint Communications CEO David Hauser was quoted as saying this about the bankruptcy filing, “From a consumer point of view, this is a nonevent.”FairPoint Communications has been plauged by complaints from retail, business and wholesale customers since changing over from Verizon computers to its own computer systems, the “New Hampshire Union Leader” recently reported.  Prior to that, in mid-2008, Vermont 911 calls were not being properly routed, with state officials assigning blame to FairPoint.

Lesson learned: A look at FairPoint’s 10-k report shows that its long term debt went from zero in 2007 (the year before the acquisition) to $2.1 billion at the end of 2008, while net income (profits after interest and tax) went from a profit of $32.8 million in 2007 to a loss of $68.5 million in 2008.  I completely agree with the many bloggers who have already opined that it is hard to understand what the regulators in Maine, New Hampshire and Vermont were thinking would happen when they approved FairPoint’s acquisition of the assets being spun off by Verizon.  Regulators should have considered the advice my friend Cotty, a financial adviser in Toronto gives his clients: you may be able to make the down payment on a fancy new house, just be sure you can also handle the “cost of ownership.”

Why Businesses go Bankrupt: R. H. Donnelley / Dex Media

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R. H. Donnelley filed for bankruptcy in May of 2009 after missing a $55 million interest payment to creditors, but the seeds of its bankruptcy were planted more than five years earlier when Dex Media borrowed $1.5 billion to pay a special dividend to its private equity owners, including Carlyle Group and Welsh, Carson, Anderson & Stowe.   The two Private Equity firms acquired Dex Media from Qwest Communications International in a 2003 LBO for a total purchase price of $7 billion, and were subsequently able to recoup their entire equity investments of $775 million each through a series of special dividends, as reported by the WSJ on Sept. 21, 2005. Dex Media was taken public at $19 a share in early 2005, and R.H. Donnelley acquired Dex Media  in a cash and stock deal later that year, which also involved R. H. Donnelley assuming $5.3 billion in debt, bringing Donnelley to a total of $10.7 billion in debt.

A look at the S-1 statement for Dex Media’s initial public offering shows that the lead underwriters for the January 2005 IPO were Lehman Brothers, Morgan Stanley and Merrill Lynch, and that the company had an 8-to-1 debt equity ratio on 9/30/2004.  The risks section of the S-1 stated that “our substantial indebtedness could adversely impact our financial condition, and impair our ability to operate our business” and went on to say “despite our substantial indebtedness, we may still incur significantly more debt.” 

Lesson Learned:  Dex Media’s underwriters were right on both counts.   R. H. Donnelley’s total debt load, including the debt assumed in the Dex Media acquisition, deprived it of the needed financial cushion in the face of tough competition and adverse economic conditions.

Why Businesses Go Bankrupt: Shane Company

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Shane Company, a family-owned $200 million jewelry retailer filed for Chapter 11 bankruptcy early in 2009, partly attributing “cost overruns and functionality problems on an SAP software implementation,”  “ComputerWorld” reported.  The company also acknowledged that the recession, and slow holiday sales were the biggest cause of its problems, as sales slumped from $275 million in 2007 to between $207 and $210 million in 2008.  The SAP implementation had cost Shane $36 million by the time they pulled the plug vs. an original cost bid of $8 to $10 million, and had also caused Shane to become “substantially overstocked with inventory, and with the wrong mix of inventory.”  But here’s a question for Shane management: What systems and business practices were they using to manage inventory on their way to becoming a $275 million company, and why didn’t they keep things in place as they were until thoroughly testing the new SAP system, and then cutting over, to protect against the ensuing problems.

Lesson Learned:  Company managers have to take responsibility for the business systems they recommend for purchase and their subsequent implementation.   While competitor Blue Nile was riding out the recession with less than a 6% revenue decline in 2008, Shane’s 25% revenue decline meant there was little or no leeway for a botched  SAP implementation.