published Sep 20, 2017, 8:17:26 AM, by Matt Levine

(Bloomberg View) —
Toys ‘R’ Us.

One thing to say about Toys “R” Us Inc.’s bankruptcy filing yesterday is that Toys “R” Us’s business is basically fine. It had $460 million of GAAP operating income last year, up from the year before; its adjusted earnings before interest, taxes, depreciation and amortization — the company’s preferred metric — was $792 million. Like all retailers, Toys “R” Us faces a tough environment and competition from Amazon and Wal-Mart, but that’s not what brought it to bankruptcy.

Instead, Toys “R” Us’s problems are “the legacy of a $7.5 billion leveraged buyout in 2005 in which Bain Capital, KKR & Co. and Vornado Realty Trust loaded the company with debt to take it private.” It currently “has more than $5 billion in debt, which it pays around $400 million a year to service.” “If they didn’t have the debt they would be making $500 to $600 million a year in profit,” said one analyst. “The problem is the debt.”

One possible conclusion here is that the retail business is fine, but the private equity business is bad. “The only good to come out of Toys ‘R’ Us troubles is that people are finally waking up to the damage done to the sector by private equity,” tweeted my Bloomberg View colleague Joe Nocera.

But another thing to consider is that the point of modern Chapter 11 bankruptcy reorganization law is to make sure that a business that can cover its operating costs is allowed to keep operating, even as it changes its capital structure. If Toys “R” Us stores are a good business they can just stay open and be good stores, while if the leveraged-buyout debt is bad it can just go away. And in fact that seems to be the plan: The company has gotten financing to “fund operations while it restructures the liabilities,” and it “doesn’t plan to close stores and says its locations across the globe will continue normal operations.” Major suppliers seem to be strong supporters of the company’s continuing operations. Toys “R” Us plans to raise store employees’ wages in bankruptcy.

Meanwhile: Bain Capital, KKR & Co. and Vornado Realty Trust stand to have their Toys “R” Us Inc. investment erased as the retailer they bought in 2005 for $7.5 billion seeks bankruptcy protection.

The three firms and their co-investors sank $1.3 billion of equity into the takeover of the Wayne, New Jersey-based toy company, financing the rest with debt, according to company filings. The debt included senior loans in which they held a stake.

The investors have marked their equity stakes down to zero. “The owners didn’t pay themselves any dividends and though they have been drawing advisory fees, the amounts represent a small fraction of their overall losses.”

Obviously things don’t work out perfectly in practice. Bankruptcy imposes real costs; a September 6 news report that Toys “R” Us was considering bankruptcy earlier this month spooked its suppliers and, according to the company’s bankruptcy declaration, “started a dangerous game of dominos: within a week of its publication, nearly 40 percent of the Company’s domestic and international product vendors refused to ship product without cash on delivery, cash in advance, or, in some cases, payment of all outstanding obligations.” And the debt itself has probably impaired Toys “R” Us’s competitive position: “Cash has run short and Toys ‘R’ Us has fallen behind competitors, without the ability to invest in its business and future, Chief Executive Officer David Brandon said in a court declaration.”

Still it is worth noting that this is what bankruptcy is for: not to destroy a good business because it took on too much debt, but precisely to save a good business even though it took on too much debt. The point is to make the debt go away and keep the business around. Maybe that won’t work — maybe the process will fail and the creditors will obstruct the turnaround, or maybe the process will work great and the turnaround will fail anyway because retail is doomed — but reading this story as “private equity destroyed an otherwise fine business by driving it into bankruptcy” is too simplistic. Private equity drove Toys “R” Us into bankruptcy, sure, but that isn’t quite the same thing as destroying it.

Insider trading.

We talked yesterday about Richard Lee,the former SAC Capi tal Advisors LP analyst who pleaded guilty to insider trading in 2013 and who asked to withdraw his guilty plea because he forgot about evidence that proves he was innocent. I made a bit of fun of this, promulgating an Eighth Law of Insider Trading — “If you did not insider trade, don’t forget!” — but he’s actually got a pretty good point. The facts of the case, as Lee’s motion describes them, are:

Sandeep Aggarwal, a sell-side research analyst at Collins Stewart, got an insider tip “that Yahoo and Microsoft were likely to enter into an internet search partnership deal within approximately two weeks.” Aggarwal told Collins Stewart salespeople about this, and Collins Stewart salespeople sent instant messages to their clients saying things like “Sandeep, my msft/yhoo analyst is making a major call that the recently cooled off MSFT/YHOO talks have heated back up in a big way.” A couple of people — including an SAC trader — forwarded those messages to Lee. Lee started buying Yahoo! Inc. stock. A few hours later, Aggarwal called Lee and gave him the tip directly.
According to Lee’s motion, he forgot about steps 2 and 3, and the government, in his plea talks a few years ago, misled him into believing that step 5 came before step 4: that is, that the sequence was that Aggarwal got inside information, he passed the information directly to Lee, and Lee started buying Yahoo stock. But in fact the sequence was that Aggarwal got inside information, he disseminated it to a bunch of hedge funds, Lee got wind of it and started buying Yahoo stock, and only later did Aggarwal tell him the information directly.

One obvious point here is: That’s not really that much better! Assuming that Aggarwal did get an illegal insider tip — and he has also pleaded guilty, so let’s assume he did — then, even on Lee’s newly discovered facts, Aggarwal passed that inside tip on to hedge funds, including Lee, who traded on it. Sure, he passed the tip on to lots of hedge funds before it found its way to Lee, but if your concern in insider-trading enforcement is to create a level playing field for all investors, that probably isn’t much comfort.

But of course the point of insider-trading law isn’t to create a level playing field, and legally the sequence above is better for Lee. For one thing, he has an argument that he didn’t trade on material nonpublic information, because it was public. Public-ish, anyway. It wasn’t on the front page of the newspaper, but it was bouncing around a lot of trader IMs. “Other people were unabashedly discussing—electronically and otherwise—this supposed material nonpublic information,” argues his motion, and “there is at least a serious question—if it is not dispositive—as to whether this Yahoo information was already public by the time of the Aggarwal Call.” You can tell from the price: “Because Yahoo stock opened higher and rose during the day, Mr. Lee believes that many investors knew the same information that he did, particularly relevant institutional investors that determine the price of a stock through large volume trading.” It’s not insider trading if everyone else was doing it!

Lee’s other defense is that he didn’t know that the information was illegally obtained. In the four years since Lee pleaded guilty, insider trading law has evolved. Back in 2013, prosecutors in the Southern District of New York really believed that you could be guilty of insider trading even if you didn’t know you were getting inside information: If someone passed really juicy information along to you, and you traded on it, you could be found guilty just because you should have known that the information was so good that it had to have been obtained illegally from an insider. Prosecutors convinced juries of that theory, and got convictions at trials, and so they had a lot of leverage to convince people like Lee to plead guilty even if they didn’t really know that the information they got was illegal.

But in late 2014, the Second Circuit Court of Appeals pretty strongly rejected that theory, and two jury convictions obtained under it, in the U.S. v. Newman case. In Newman, the court ruled that a downstream tippee like Lee can’t be guilty unless (1) he knew that the information came from an insider and (2) he knew that the insider received some “personal benefit” from giving the tip. (The court has since weakened the “personal benefit” requirement, but not the requirement that a downstream tippee needs to know about it.) Here that is plainly not true: Even when Aggarwal called Lee, it seems unlikely that they discussed any personal benefit that Aggarwal’s source received, and in any case there was certainly no mention of a personal benefit (or even of an insider source) in the trader IMs earlier in the day.

For all the oddity of Lee’s sudden recovery of memory, it does seem likely that he was actually not guilty of insider trading, and that he was pushed to plead guilty in an environment where pretty much any hedge-fund guy arrested for insider trading was going to be found guilty. Since then the law, and the environment, have changed, and he’s got a reasonable argument that he should get to take his plea back.

Bridgewater.

I guess this shouldn’t be a surprise, but here is a striking sentence from Ray Dalio’s book “Principles: Life and Work,” describing the operations of his hedge fund, Bridgewater Associates:

I required that virtually all our meetings be recorded and made available to everyone, with extremely rare exceptions such as when we were discussing very private matters like personal health or proprietary information about a trade or decision rule.

We have talked before about the recorded meetings, but here I want to focus on the exceptions. There’s a library where Bridgewater employees can review its past decisions and learn more about how it makes them, except the investing decisions. They debate and analyze and learn from their past decisions, except the investing decisions. The firm spares no expense in training and acculturating its employees in how it makes decisions, except the investing decisions.

Bridgewater is a hedge fund; its business is making investment decisions with its clients’ money. But I guess this is fine: Bridgewater has a computer to make the investing decisions, and it has a small “circle of trust” of senior human employees who understand and control the algorithms that the computer uses to make the investing decisions. Everyone else just … concentrates real hard on making good decisions about how to make decisions? But not the investing ones?

Venezuela.

One advantage that Venezuela gets by avoiding default on its external debt even as it slides deeper into economic catastrophe is that it gets a lot of free legal advice about how it should eventually restructure that debt. We talked a couple of months ago about a paper by Lee Buchheit of Cleary Gottlieb Steen & Hamilton and Mitu Gulati of Duke Law School on “How to Restructure Venezuelan Debt,” and now here is “Venezuela’s Restructuring: A Realistic Framework,” from Mark Walker of Millstein & Co. and Richard Cooper, also of Cleary Gottlieb. Perhaps eventually someone will come up with a proposal that Venezuela finds congenial, and Venezuela will just do it. Though that is complicated by the fact that Walker and Cooper — and pretty much everyone else — assume that the first step in any plausible restructuring would involve replacing Venezuela’s current lawless government with one “that demonstrates a credible commitment to the necessary reforms and can undertake binding obligations in a restructuring whose validity under applicable laws is not subject to challenge.”

Their basic framework involves restructuring Venezuela’s debt up front, rather than trying to extend it and hoping that the economy improves; securing Venezuela’s external assets by transfering Petróleos de Venezuela S.A.’s oil receivables to a more legally protected party and by negotiating a standstill with creditors who have claims to PDVSA’s Citgo assets; implementing a new local insolvency law to restructure PDVSA or, failing that, changing the governing law of PDVSA’s bonds to English law and doing a scheme of arrangement in England; and building something like Buchheit and Gulati’s “cryonic solution” to do an exchange offer and exit consent for the bonds of Venezuela itself:

To do this, we propose that participating holders of the Republic’s bonds exchange their bonds for new credit-linked notes to be issued by a newly created creditor trust, perhaps with the guarantee of Republic itself, and that the bonds tendered to the creditor trust remain outstanding.The payment terms of the credit-linked notes would then, of course, embody the agreed restructuring terms.

The Creditor Trust’s ownership of, and voting rights in, the exchanged Republic bonds would make it more difficult for holdout creditors to marshal requisite voting majorities under these bonds. Additionally, the inclusion of a sharing clause in the old bonds as part of the exit consents, as suggested, would require any holdout creditor that managed to recover more on its bonds than the Creditor Trust, through legal process or otherwise, to share such excess payment ratably with all other holders of outstanding Republic bonds, including the Creditor Trust itself, as well as other holdouts.

Blockchain blockchain blockchain.

Sure why not:

E-Coin was not like “real cryptocurrencies”, FINMA said, because it was not stored on distributed networks using blockchain technology but was instead kept locally on QUID PRO QUO’s servers.

So the Swiss Financial Market Supervisory Authority shut it down. This strikes me as a reasonable distinction: “real cryptocurrencies” are, you know, distributed blockchainy things, while just keeping a list of people who gave you money “is similar to the deposit-taking business of a bank and is illegal unless the company in question holds the relevant financial market license.” But it is an interesting precedent; I’m not aware of any other regulator that has concluded that blockchain-based cryptocurrencies are “real” while list-based ones are “fake.” Five years ago I suspect most regulators would have concluded that they were all fake.

Elsewhere: “Bitcoin Is Likely to Split Again in November, Say Major Players.”

People are worried about unicorns.

Here’s a story about Wall Street and Silicon Valley signifiers:

One evening in May, a team of Goldman Sachs bankers helped a founder-CEO raise some secondary money for investors in BlackLine, a fast-growing software company now worth more than $1.5 billion. After the deal priced, as they ushered the hoodie-clad founder and the besuited CFO into an elevator, the bankers ran into a senior Goldman guy: “Hey, you should meet the CEO of BlackLine. They’re raising $115 million.”

The executive looked right past Therese Tucker, in her black hoodie and flower-printed blue jeans and pastel-pink hair, and directed his praise to her male finance chief: “Great job.”

The thing is of course that “hoodie and jeans” now reads “startup founder on a roadshow,” on Wall Street and everywhere else, while “besuited” reads, you know, “guy brought in to be the CFO in preparation for an initial public offering.” But I guess gender expectations still trump clothing signifiers.

Elsewhere, Social Capital Hedosophia Holdings’s unicorn-SPAC IPO drove Kadhim Shubber to comment: “The public markets aren’t nearly broken enough.”

Things happen.

Fed Poised to Set Portfolio Reduction Plan in Motion. Markets Braced for Fed’s Unwinding of Easy Money. Uber Faces Widespread Asia Bribery Allegations Amid U.S. Criminal Probe. CEO Catches Stranger After Hours, Prompting Espionage Charges. Massachusetts Attorney General Hits Equifax With Suit Over Hack. Acting Manhattan U.S. Attorney Announces Award Of $296 Million Judgment Against Allied Home Mortgage Entities For Civil Mortgage Fraud. Judge all but tosses case against ‘rogue’ trader Guy Gentile. (Earlier.) “Simply put, earnings no longer reliably reflect changes in corporate value and are thus an inadequate driver of investment analysis.” At Jefferies, Like Wall Street, Trading Cedes to Banking. “The characterization that our business is in turmoil is just plain wrong,” says Guggenheim Partners LLC. Lone Pine’s Mandel to Step Back From Fund Management in 2019. Hedge-Fund Manager David Stemerman to Close Firm to Run for Connecticut Governor. Brevan Howard to Inject up to $400 Million Into New Fund. Harvard Endowment Chief: 8% Return Is ‘Disappointing.’ Lending exposure of Europe’s biggest carmakers hits €400bn. Masayoshi Son Warns of the Singularity. “Each sturgeon has an identification number, and each tin has a code, which customers can use to trace the fish’s color as well as the results of its regular physicals.” “Britain’s sweariest man.”

If you’d like to get Money Stuff in handy email form, right in your inbox, please subscribe at this link. Thanks!

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
To contact the author of this story: Matt Levine at mlevine51@bloomberg.net To contact the editor responsible for this story: James Greiff at jgreiff@bloomberg.net

For more columns from Bloomberg View, visit Bloomberg view
COPYRIGHT © 2017 Bloomberg L.P