Be Fair But Beware: The Spectre of Self-Dealing & In/Solvency

In some cases that I’ve worked, the officers or owners are working against me – and their creditors – by self-dealing.

What is Self-Dealing?

For the record, self-dealing is not necessarily stealing but it is fraudulent. For example, self-dealing can be when an officer of a company tries to gain an unfair tactical advantage on the creditors or bank, so that he can do something like buy the assets at a reduced cost or own the company some other way.

When trying to understand self-dealing, it is important to know that when a company is in “the zone” of insolvency the fiduciary responsibilities of the officers and directors of that company shift from a duty to the shareholders to a duty to the creditors. Though “the zone” of insolvency can be  difficult to prove, presumably when I’m brought in to a company, insolvency is already roosting or on the horizon. Thus, if any officer is creating value for himself or the shareholders instead of the creditors, he is automatically self-dealing even though it might not have been considered thus had the company been solvent at the time of his actions.

I could devise a strategy for a client because I believe he is in the “zone of” insolvency, but he could say that his definition of insolvency is different and that he is going to continue acting in the interest of himself and his shareholders. Obviously, there are a lot of interpretations of insolvency which makes this legal concept very difficult to understand or litigate.

Self-Dealing or Not

In one huge turnaround case, I was blind-sided by an officer of the company who was trying to buy the assets of the business through a shell company. He obviously wasn’t acting in the best interests of the creditors because he was trying to drive down the price of assets to purchase them himself.

With proper disclosure to the creditors and without other credible purchasers in the game, self-dealing could possibly be approved by the creditors, but it’s a very fine line that requires a lot of honesty. By creating a process that inserts a turnaround person in the company, self-dealing will not occur.

Though I’d had an early gut-feeling that someone was self-dealing, I wasn’t able to uncover what was happening before I had to speak with the creditors. Therefore, despite my promising the creditors that there was no self-dealing, as I’ve already said, this officer was doing exactly that.

This undermined my credibility with the creditors and created a conflict between me and the officer, which delayed the resolution of the case. Though I regained my credibility, these actions behind my back created unnecessary hurdles for the company and case.

Trust Your Gut

When I have to give expert testimony, like in this case, I have to know the truth, and I pride myself on my ability to find the truth when I’m working a case.

I had a valuable lesson emphasized for me during this case: trust my gut.

If you don’t trust someone, keep an eye on him. Ask lots of questions. Don’t feel bad about mistrust; if that person does nothing wrong then you will find nothing wrong and be pleasantly surprised.

Have you ever seen a case of self-dealing? Tell us about it.

Liquidity versus Solvency: A Lesson in Lacking Money, a guest post by Vic Taglia

As managing partner of GGG and the Turnaround Authority, I get the pleasure of providing guest posts by our other partners. The following post is by our newest Partner, Vic Taglia.

Lehman: From Illiquidity to Insolvency to Bankruptcy to Liquidation

You’re likely familiar with the Lehman failure of 2008. The business model of Lehman and other investment banks relied on leverage of up to 50 to 1 (a 2% capital ratio) and its creditors’ belief that the collateral pledged for these borrowings would maintain its value.

The investment bank business model relies on the market to provide liquidity to allow the investment bank to carry billions of dollars of securities. When Lehman’s creditors began to doubt the value of the securities already pledged, they demanded more collateral.

This led to a liquidity problem; Lehman couldn’t get the cash it needed to operate. When Lehman ran out of collateral to pledge, it had a solvency problem. Bankruptcy and liquidation followed.

Game over.

Understanding the Path to Illiquidity or Insolvency

An industrial business frequently relies on its bankers and other creditors to provide liquidity to operate through open accounts payable and lines of credit. That’s normal.

So long as the business cycle from purchases of raw material through production, distribution and collection remains on schedule, a business can continue to operate. If the schedule is disrupted however, a liquidity problem emerges. Now the business needs to find cash.

Working capital fixes include lengthening payment terms to vendors, offering prompt payment discounts to customers and finding external financing from a friend, a bank or a partner.

This will work until someone loses faith in the business and decides to stop participating in the extended payment terms, the prompt payment discount or the rolling over of bank debt. At this juncture, a new plan becomes critical.

What asset can the business convert to cash? What can it sell for cash now? Equipment, vehicles and real estate are all illiquid assets, but they all have value today—probably much less today than if you had six months to sell, but if you need cash now, you become a very motivated seller.

The end game starts when you discover that these illiquid assets are really illiquid.

Surviving Illiquidity or Insolvency

You can’t sell them fast enough or for enough money to save your business, for instance. If you collect all your receivables, sell all your equipment, all your real estate, all your inventory and still can’t cover your debts, you are now insolvent.

A liquidity problem can lead you to a reorganization filing in the bankruptcy court. Your business can survive a reorganization, perhaps with different owners, employees, and strategies, but insolvency will lead to liquidation.

Illiquidity can be temporary and fixed with relatively simple steps – but you must act quickly. First, identify what can be sold now, for cash.

Insolvency is more difficult; you need more capital, debt relief (forgiveness, payment holiday, etc.) or other more drastic help, and you don’t have a compelling story to attract this help.

Obviously you want to avoid both of these situations. Remember, though, you can survive illiquidity, but rarely insolvency.

What are your experiences with illiquidity and insolvency? Please ask any questions about these differences or what to do if they arise in the comments section below.