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Toys R Us’ Bankruptcy Raiding Shows Why Congress Should Consider A Fire Sale Tax

Toys R Us shut all of its stores last week and we say goodbye to an American icon. As the company’s 182 locations shuttered, its remaining 31,000 employees found themselves without a job, or even severance pay.

This sad situation didn't necessarily have to happen – and it wasn’t because of anything its private equity owners in particular did. Bain, KKR and Vornado held on for 12 years and tried to grow, fix, and save the business. Their efforts amounted to a colossal investment failure and one that will go on their records for life, and they lost a whopping $1.3 billion dollars on their original purchase price of $7.5 billion in 2005. No love lost for them, however these private equity firms are not the true reason the stores are closing this week and suddenly we are seeing the end of a classic American company that has been with us for over half a century.

Bankruptcy is an ugly but sometimes necessary process. While it carries negative connotations, not every bankruptcy filing is a permanent end to a venture. Many bankruptcy options are available to reorganize a financially distressed organization’s current debts and assets to find a way back to sustainability, as some of the various bankruptcy “chapters” allow. For Toys R Us, at least if you read the filings, the company (and PE sponsors) saw bankruptcy as its second chance, the chance to reset the balance sheet.

A bankruptcy is supposed to offer protection which is why the bankruptcy code emphasizes the rehabilitation of the debtors (in this case, Toys R Us). In this instance – and several others – it can be red meat to circling vultures. Short-term oriented hedge funds will buy certain “controlling” pieces of debt at a discount with the sole goal of shaking it down to make as much money as possible. The asset, let alone the people and other stakeholders that are part of it, are irrelevant beyond the financial numbers on the spreadsheet. Sure they are investors; that’s their job to maximize gains.

But when it comes to the outrage you feel over not being able to take your child to America’s favorite toy store, it merits a closer look. These predatory hedge funds have no interest in running the business or in its long-term viability. Different hedge funds have different motives and game plans for their investments but they are almost all short-term, sometimes called “raiding,” and some even have special strategies focused on late stage bankruptcies of liquidations. And that is precisely what happened to Toys R Us.

Bloomberg wrote a piece in June noting that there was almost a deal to save the company through a sale to another buyer, but the creditors leaned toward liquidation. I looked into one of the funds mentioned, Solus Alternative Asset Management. The firm doesn’t say much about itself on its website but there are a few articles from which you can glean that they have built an entire business reliant on profiting from their ability to time the bankruptcy process and cause enterprises to liquidate. The firm’s name has popped up for its trading in bankruptcy claims in cases including MF Global Holdings Ltd., Bernard L. Madoff Investment Securities Inc., Hostess Interstate Bakeries, and Lehman Brothers Holdings.

And they aren’t the only one, as the raiding and bankruptcy process has become institutionalized as a $40 billion business. Other funds in the Toys R Us lender group that controlled the demise of the company are Howard Marks’ Oaktree, Angelo Gordon and mutual fund complex Franklin Mutual.

In Toys R Us, these firms had the pole position because their investment was secured by its most valuable collateral – the real estate and the inventory in the stores creditors. So, what happens when they decide they will make more money by setting a bomb off and blowing up the business? The employees lost their jobs. Vendors don't get paid for inventory they shipped but were never paid for. Baby clothing stores owned by mom and pop will go under. The intellectual property gets auctioned and other parts of the business are sold.

The proceeds on those valuable assets– for the most part – go to that same group of secured creditors because they took all the risk – enough to put them first in line to get paid. It’s incredibly smart, supervillain-esque evil and you have to wonder how it’s even legal.

These companies are abusing the bankruptcy process and in cases like with Toys R us, playing with some of our country’s most vulnerable enterprises and, in turn, thousands of lives. Toys R Us’ employees are now claiming that they lost their severance. What they don't realize is that with this group in charge, they never had a chance of getting that severance.

Congress should think about a fire sale tax that can be redistributed when a short-term oriented profiteer raids a business like these hedge funds firms did. Such a regulation could strike a worthwhile balance by reducing the most outright destructive and nefarious raiding activities while preserving positive long-term aspects of capital flows in the market.

Until then, we likely will see more unfortunate situations as what has happened with Toys R Us and many other companies over the years, where good companies find their ignoble ends in legal courtrooms fighting over the scraps.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.