Well before the pandemic-crisis struck, analysts were sounding warnings that corporate debt had reached such dangerously high levels that a normal downturn in the business cycle would see many corporate bankruptcies. But the analysts did not count on the rescue by the COVID-19 stimulus package. Now, just as in 2008, the wealthy are going to cream off most of the stimulus package while only a little will trickle down to the workers. The present stimulus funds will be used to pay down that massive but avoidable corporate debt.
Why avoidable? It is the result of predatory practices. I explained how corporations changed their sensible business practice from saving 50% of dividends for corporate use including economic downturns and paying out only the other half in dividends, to stripping out every cent of profit by dividends, in the first article in the series. An even more extractive, predatory practice hides under the term ‘the leveraged buyout’. Equity and hedge funds scour the country to find corporations, large or small, that have net assets and a good cash flow. Then they buy those companies primarily with their own assets. Here’s how it’s done:
The Leveraged Buyout
Here’s the pattern of how it’s done. Equity fund Pain Capital discovers Victim Co. that operates a chain of profitable supermarkets and owns the locations free and clear of mortgages. Pain needs $100 million to buy enough shares to control Victim Co. Pain is willing to put up 10 million and convinces a lender to advance 90 million by committing to have the corporation pledge its supermarket buildings as security for the debt and assume the payments. As soon Pain has control, it votes in its choices for the Board of Directors, who quickly implement the plan. If a public company, Pain may take the company private. From then on, Victim Co. is saddled with this massive debt for no proper corporate reason. Now, the stimulus money will go to pay off this type of corporate debt first; some of what’s left may go to the employees.
Eric Reed’s no bleeding-heart lefty. He writes on a very conservative, Trump friendly, Wall Street website, TheStreet. Reed worries, in enlightened capitalist self-interest, that this leveraged-buyout tactic has gone too far. He notes that many such targeted businesses, once very profitable, go bankrupt. According to him, leveraged buyouts have imposed debt payments up to seven times their gross earnings (EBITA) on the acquired companies.
How big a deal is it? As Reuters has reported, “the volume of leveraged loans reached $1.3 trillion in the U.S. and Europe in 2018, versus $734 billion in 2007”. For those of us used to thinking in hundreds, and occasionally in thousands, those numbers are so high they may be incomprehensible. But we can assume that a lot of stimulus money will be sucked up to meet those installment payments.
Profiting from an Economic Downturn: Profiting from a Bankruptcy
Why aren’t the equity and hedge funds worried about losing their investment through bankruptcy? They know how to make money on a bankruptcy too — especially by underfunding worker pensions (of course, executive pensions are always fully funded). They also know how to cherry pick, with insider information, the best assets and purchase them at fire-sale prices in the bankruptcy. For anyone who thinks it couldn’t be worse than what they have read so far, you can read here about these and other moves in the equity and hedge-fund predatory playbook using the recent Sears bankruptcy as an example.
Creeping Socialism in America
As part of the safety net to protect deposit money, which contain the savings of America, commercial banks (not investment banks) were allowed to borrow from the Federal Reserve Bank at a very low interest rate (called the discount window) on a short-term basis. During the 2008 crisis, that facility was extended to most investment banks as they became bank holding companies. Now investment banks could get relief originally intended only for commercial banks.
As part of the COVID-19 stimulus package, that safety measure has been further extended to help corporations. In recognition of the potentially disastrous effect on the economy by the towering corporate debt, a huge chunk of the stimulus will go to the Fed so it can purchase the precarious corporate bonds, including high-yield bonds (otherwise more accurately described as junk bonds — they are high yield because they are high risk) from the lenders. Does anyone see another upward transfer of wealth by socialistic measures here? Government deficit — Federal Reserve Bank — High-end lenders — Future government debt paid by taxpayers. No consideration has been given to the fact that the wealthy equity and hedge funds, who got dividends that left the companies vulnerable, should have to pay back some of what they took. The mere thought would horrify any well-conditioned mind.
This bailout is justified, as always, to save the system; but with an added justification not available in 2008: It wasn’t their fault. The large corporate entities claiming a bailout didn’t create this crisis in the first place. Nobody could have seen the pandemic coming, they plead. But it was their fault in not following the most basic risk-management precautions by keeping a reserve for any type of downturn.
When Extraction Began to Trump Reason
The Economic Policy Institute graft, below, shows how government policies reduced economic inequality after the Roaring Twenties, but how inequality increased after the 1970s.
The wealthy successfully fought back with new methods starting then. Most readers will be familiar with corporate lawyer Lewis Powell’s memo in 1971. (Nixon rewarded him a scant two months later with an appointment to the US Supreme Court for his efforts on behalf of the wealth class.) It was a manifesto to rally support against the gains made in the 1960s by consumer and environmental groups that were cutting into corporate profits. The memo ‘woke’ the corporate world to the necessity of strategies to defeat the left. The captains of industry did more than outlined in the Powell call to arms. They used invisible methods, by which I mean tactics of which the general public is unaware. There was no need for sitting around an oaken table on a secret isle to plan and plot. Different stragies were born from shared values and knowledge of parts of the system only they had. There has never been a greater example of Francis Bacon’s insight: knowledge is power. They have it; average voters don’t.
For those who doubt that this could be happening in America, I recommend reading what Gillian Tett, the US editor of the ultra conservative Financial Times, had to say on how the elite stay in power as quoted in the new documentary on Piketty’s Capitalism in the 21st Century here.
Here’s a recap of the risky extraction policies that violated any reasonable business practice for the financial health of corporations and that were abandoned for the personal benefit of the shareholders or executives. For those that have the stomach for it, I’ve explained each of these in more detail in other posts as indicated below. These are all policies that came into effect after 1970 and changed the fair distribution of the gross national product to all income groups from equally to both the income and wealth inequality that we see today.
- From 1970, the boards of directors of corporations started stripping out all profits by dividends to shareholders instead of keeping 50% for corporate needs according to the shareholder value theory discussed here. Corporations had to borrow to meet ongoing expenses.From then on Corporations had to borrow to meet normal business expenses.
- Since 1981, by SEC rule 10 b– 18, executives have been able to executive extreme insider trading by causing their corporation to buyback their shares with no oversight by the SEC. See: Cashing In on the Covid Crisis
- Since 1982, promoted by Michael Milkin, the number of leveraged buyouts exploded adding most of the cost of the takeover share purchase to the corporate debt with no benefit to the corporations.
- Beginning in 1970, executive compensation began to exceed the historic 20 to 1 median worker pay ratio. In 1990, the gap mushroomed reaching the present-day ratio of 300 to 1. Contrary to general opinion, the CEOs set their own pay. Seems impossible? I explain how here.
If economic inequality is to be stopped, those practices must be stopped.
It’s not hard to see how to do that, but the hardest part is getting voters, especially the working class, to see that these are the causes of their precarious financial situation. It’s not minority groups, and is not new immigrants. But most voters have no idea about how this part of the corporate system works. It’s a matter, first, for education.
Jan D. Weir is a lawyer who has advised international corporations, banks and accounting firms. He has taught business law at the University of Toronto, and is the co-author of The Critical Concepts of Canadian Business Law (6e) Pearson. Follow him for updates on laws that affect inequality @JanWeirLaw and at Medium.com.