Corporate Crossfire: the Insecurity Of Creditors when Companies Collapse

Listener 3 November, 2001.

Keywords Business Economics & Finance

Every business has a legal and a physical side: a legal entity with financial assets and liabilities (including bonds – fixed interest loans) and a production activity with physical assets and employees. Usually they work in harmony. …

… Sometimes they become disjointed. There was nothing wrong with Air New Zealand’s production activities (other than the possibility of a world tourism recession), but its financial side was in trouble – too much debt relative to the owner’s equity – so the New Zealand taxpayer will inject $885m of capital which will be used to pay off debt.

Sometimes the two sides get in conflict. Catherine Handley’s Receiving Orders: Caught in the Corporate Crossfire provides an insightful account of what can then happen. (Everyone I know says to skip the first twenty pages and the last forty. The book’s philosophizing is not as rivetting as its narrative.) By way of background (my source is Bruce Jesson’s Only Their Purpose is Mad – he would have loved Catherine’s book), as a result of various financial manouevrings, Brierley’s Skellerup Group of companies was sold to Maine Investments in 1996. The deal involved a leveraged buyout, where most of the sale price was financed by ‘junk bonds’, which give high yield returns, but offer no security other than the future trading income. (Why would any sensible investor buy junk bonds?) The price paid was too high. When interest rates rose and the cash flow slowed, the bond holders got agitated. Eventually they put some of the companies that Maine owned into receivership. The best known were Levenes and Palmers Gardenworld.

Handley was the chief executive of Palmers, and had been horrified by the treatment of Levenes. The chain of home tradesmen’s (and women’s) suppliers was making a financial loss. It was closed down with the valuable bits sold off, without concern for its staff, suppliers or customers. She had recently turned Palmers around, and thought its cash flow made it safe from a similar treatment. However the bond holders were so nervous they dumped on Palmers too, although this time they wanted to sell it as a going concern. Handley describes the open warfare between the company’s staff and the receivers from Melbourne. It is a great read, displaying the determination and humour of the resistance from the production side, against often thoughtless and arrogant behaviour on the financial side.

As there will be more New Zealand firms going into receivership or liquidation, it is worth going through some of the financial issues. The liabilities of a business are ranked from the most secure to the least secure, which is the equity owed to its shareholders. Under a leveraged buyout, there is little equity, so that if anything goes wrong – say a business downturn with a reduction of cash flow – the bond holders are more exposed to losing their investments than if there had been a lower debt to equity ratio. If the bond holders get too agitated, they can put the company into receivership as means of recovering all or part of their investment. In the case of Palmers a consequences was unsecured creditors made losses too.

Unsecured creditor only get (whole or part) of their money back after the secured bond holders are paid off. Among the unsecured creditors are ordinary New Zealanders just like you, dear reader. They might be workers owed holiday leave in excess of two weeks, or redundancy payments. (Remember Qantas New Zealand?) They might be suppliers yet to be paid. (Like the nurseries which supplied Palmers, or subcontractors when a big construction company goes bust.) They might be purchasers who have paid but not yet received all their goods and services. (All the pre-purchased tickets and airpoints could have become valueless had Air New Zealand had gone into liquidation. The consumer guarantees on what you have bought may become worthless.) You can see this in the Palmers story. Protecting the investments of the secured creditors, meant that the unsecured creditors suffered.

You may think this is unjust, or just the inevitable consequence of the market economy. It is certainly dependent upon the provisions in the law. For instance, the law gives greater protection to the first two weeks of holidays owed to workers, to money used for goods on layby, for livestock at freezing works (following the Fortex fiasco) and of course the taxman ranks at the top.

There has to be some ranking of creditor security. Whether we have the right order I do not know. Is it time to have a review? And while everyone wants to have their investments ranked above the bondholders’, exposing bonds to greater risk may mean that there will be a shortage of quality finance to good businesses, or their debt servicing will become more onerous. Dont forget that any money you may have in a bank, even in your cheque account, may be indirectly invested in the bonds by your bank. If your bank loses too much money, you may lose your investment (as happened in the case of the DFC). Perhaps consumer, union, and trade magazines should explain unsecured creditorship to their readers. In the interim read “Receiving Orders”.