CHAPTER 3
Substantive Consolidation and Structural Subordination*
Substantive Consolidation Not of Prime Importance
The Accounting for Stock Options Controversy in Light of the Substantive Consolidation Doctrine
Structural Subordination Not a Significant Factor
Lack of Progress in Eurozone Crisis Resolution: The Failure to Use Substantive Consolidation
In fundamental finance investing; that is, value investing, control investing, distress investing, credit analysis, and venture capital promotions, securities are examined from multiple points of view, including the company itself and control shareholders. By contrast, Graham and Dodd (G&D) and modern capital theory (MCT) look at securities analysis almost solely from the point of view of outside passive minority investors (OPMIs).1 This difference in points of view leads to the asking of fundamentally different questions.
One key question in fundamental finance, including value investing in common stocks is:
The key question in G&D and MCT, however, is:
In fundamental finance, OPMIs and OPMI interests are merely the tip of a huge iceberg. To study financial phenomena by focusing on the day-to-day trading environment strictly from an OPMI point of view is akin in marine biology to studying the entire marine food chain by restricting the examination to the reactions of kelp and plankton floating on the ocean’s surface. Kelp and plankton merely react; beneath the surface, there exist myriad actors, such as shark, tuna, cod, and whales. These beneath-the-surface actors in the marine food chain are similar to the groups in the financial community that we describe in Chapter 14 when we discuss promoters’ and professionals’ compensations.
MCT appears to be useful in describing a special case with two components:
The basic problem with MCT is that it tries to make a general law out of what is really a very narrow special case. MCT teachings are not very helpful for understanding fundamental finance, where the analysis becomes relatively complicated regardless of whether the object of the analysis involves corporate control factors or buy-and-hold passive investing. Indeed, the underlying assumptions at the heart of both G&D and MCT are either downright wrong or just plain misleading for purposes of understanding fundamental finance.
In this chapter we focus on two of these implicit assumptions of G&D and MCT, which have created important obstacles to the understanding of important issues of corporate finance in general and value investing in particular:
SUBSTANTIVE CONSOLIDATION NOT OF PRIME IMPORTANCE
The ideas of substantive consolidation, in which the interests of the company and its stockholders are combined and seen as one and the same and structural subordination, in which the company’s raison d’être is to serve the best interests of its stockholders, especially its non-control OPMI stockholders, are central assumptions of both G&D and MCT. The substantive consolidation and structural subordination doctrines so important to G&D and MCT are relative rarities in the real world, though they do exist in special cases.
EXAMPLE
The 1997 annual report of Georgia-Pacific Corporation explains at length that company policy is to forgo returns on corporate investments if it is deemed that stockholders can use that cash more productively than the company itself.
In G&D and MCT, though, the underlying assumption seems to be that substantive consolidation and structural subordination are universal, not special cases. These assumptions seem based, at best, on nothing more than anecdotal evidence. In any event, these approaches to substantive consolidation and structural subordination are not helpful concepts at all in fundamental finance.
The terms substantive consolidation and structural subordination originated in reorganizations under Chapter 11 of the U.S. Bankruptcy Code.
Substantive consolidation occurs when, for purposes of a reorganization, two separate entities are combined into one; say, for example, a solvent parent company creditors are placed in the same class as the creditor of an insolvent subsidiary as part of a reorganization plan.
Substantive consolidation seems to occur only occasionally in the real world and, contrary to the teachings of G&D and MCT, financial managers working for companies rarely make decisions on how to employ and redeploy corporate assets on the basis of the risk profile of the company’s OPMI shareholders. However, this is the underlying assumption in G&D and MCT analyses.
EXAMPLE
The idea of net present value (NPV) revolves around discounting future cash flows estimated for a project at what Richard A. Brealey and Stewart C. Myers in Principles of Corporate Finance call “the opportunity cost of capital—that is, the expected rate of return offered by securities having the same degree of risk as the project.” To determine this expected rate of return, “you look at prices quoted in capital markets, where claims to future cash flows are traded. . . .”a According to MCT, if the internal rate of return implied in the future cash flows from a project is greater than the opportunity cost of capital for OPMIs, the project ought to go ahead; if it is not, the project ought to be scuttled.
aRichard A. Brealey and Stuart C. Myers. Principles of Corporate Finance, Fourth Edition (New York: McGraw-Hill, 1991).
To begin with, few—if any—financial managers are in a position to figure out an opportunity cost of capital for OPMIs on the basis of factors that are fundamental to the business employing the financial manager. Efficient market theorists suggest a technical chartist approach to determining an opportunity cost of capital; they do not study a business. Instead, they study the relative historical volatility of OPMI stock prices and ascertain an appropriate discount rate taking into account that volatility. This is known as the beta.
A project’s attractiveness for a company and its financial managers will be determined in almost all cases by factors particular to the company and its financial managers. Substantive consolidation based on looking at OPMI market price data is unlikely to enter into corporate decision-making. Corporate investment decision-making is instead likely to revolve around the answers to the following questions:
Net present value is a valid, extremely useful concept insofar as it compares the cost of a project with its expected returns. It seems useless, however, when cost and returns are measured in a substantive consolidation context.
EXAMPLE
Brealey and Myers explain on pages 73 and 74 of Principles of Corporate Finance that the goal of the business ought to be to make the shares “as valuable as possible” and that the company attitude ought to be that “instead of accepting a project, the firm can always give the cash to shareholders and let them invest it in financial assets.”
Almost no financial manager, however, will believe that watching stock prices, as is implicit in beta, is a way of making shares as valuable as possible for long-term OPMI shareholders and control shareholders. Financial managers, too, have agendas both for themselves and their companies that prevent them from just giving the cash to shareholders.
EXAMPLE
For most companies—even forgetting about restrictions on shareholder distributions that would be contained in loan agreements or bond indentures—to just give the cash to shareholders would have a negative effect on the company’s continuing relationships with trade creditors and bank lenders.
As an aside, modern capital theorists seem to measure attractive finance solely by interest rates, deeming, say, a 6 percent margin borrowing by an OPMI stockholder as more attractive in a substantive consolidation context than a corporate issuance of 12 percent subordinated debentures. The real world is a lot more complex. Attractive finance includes many factors other than interest rates. In fact, you cannot analyze without looking at all the terms and conditions attaching to a borrowing. A 12 percent 12-year subordinated debenture with a bullet maturity may be (and probably is) much cheaper money than a margin loan bearing a current interest cost of 6 percent. The margin loan may, in effect, be a demand loan, with the possible negative cash flow consequences being draconian, when compared with the 12-year non-amortizing bullet loan.
Under MCT, the fruits of attractive investments by a company will be reflected immediately in an increase in OPMI market prices, if it is assumed that the market is efficient and the information is announced. As stated in Corporation Finance (McGraw-Hill College, 2002), by Stephen A. Ross, Randolph W. Westerfield, and Jeffrey E. Jaffe:
Because information is reflected in prices immediately, investors should only expect to obtain a normal rate of return. Awareness of information when it is released does an investor no good. The price adjusts before the investor has time to trade on it. (p. 363)
Although their statements seem to have validity from a minute-to-minute or day-to-day trading point of view, there is no evidence whatsoever that new information immediately affects common stock valuations from the point of view of fundamental finance investing. The academic evidence is grounded in the statistical proof that no OPMI or groups of OPMIs outperform a market consistently (i.e., all the time). From a fundamental finance point of view, this observation proves nothing outside of an immediate trading environment. No long-term fundamentalist ever tries to outperform an OPMI market consistently. Consistent outperformance is strictly the domain of short-run speculators. An underlying credo of value investing is that no one not engaged full-time in high-frequency trading, option trading, or risk arbitrage can be expected to outperform a market over the short run by conscious effort. In fundamental finance, there is no focus on being the first to know. Rather the focus is not on having superior information but on using the available information in a superior manner.
THE ACCOUNTING FOR STOCK OPTIONS CONTROVERSY IN LIGHT OF THE SUBSTANTIVE CONSOLIDATION DOCTRINE
It is much more important for the U.S. economy to have its accounting systems geared toward informing creditors in a meaningful fashion than it is to have accounting systems directed toward meeting the perceived needs of outside passive minority investors (OPMIs). First, there is a lot more credit outstanding in the economy than there is net worth. Second, creditors use accounting to help determine the creditworthiness of a company by estimating whether that company will be able to generate cash internally, both long and short term, to pay its bills, and by estimating whether that company is likely to have relatively continual access to capital markets, especially credit markets. In contrast, OPMIs tend to place overemphasis on two accounting numbers—reported earnings or cash flows from operations—in order to predict what stock market prices in the immediate future might be. Bluntly, accounting systems do not seem as if they can really be very helpful as a tool for predicting near-term equity prices in OPMI markets. As far as we can tell, near-term market prices for common stocks (where there are no near-term terminal events such as maturing options, tender offers, mergers) continue to be a random walk.
From a creditor’s point of view, cash payments by a company are very different from the issuance of stock options. Cash payments can affect the creditworthiness of a business. Cash payments, therefore, are a company and creditor problem. With minor exceptions, the issuance of stock options has no effect whatsoever on the creditworthiness of a company. Instead, stock options result presently, or prospectively, in the dilution of existing stockholders’ ownership interests. Stock options are not a company and creditor problem. They are a stockholder problem. This simple fact is what people subscribing to the substantive consolidation doctrine miss.
Those who think of options as an expense have it wrong, at least from the company and creditor points of view.
EXAMPLE
Warren Buffett is quoted as saying, “If options are not a form of compensation, what are they? If compensation isn’t an expense, what is it? And if expenses shouldn’t go into the calculation of earnings, where in the world should they go?”
Frankly, the Buffett statement is an overgeneralization, even though most finance academics, and among others, Alan Greenspan, seem to be wholly in concurrence. Stock options are not compensation from the points of view of the company itself, or its creditors. Stock options certainly are “compensation” when looked at strictly from the point of view of stockholders. The issuance of options results in present, or potential, dilution of common stockholders’ interests. Given that options result in dilution, they are best accounted for by reporting their dilutive effect in calculations of earnings per share (EPS) available for common stockholders, rather than as a theoretical expense of the company.
Stock options might well be accounted for using the treasury stock method, where it is assumed that the proceeds from an exercise of options would have been used to purchase the company’s common stock at the average market price, and the incremental shares would have been added to the common stock outstanding.
Assume Company XYZ has 1,000,000 common shares outstanding and has net income of $1,000,000, or EPS of $1. Assume further that Company XYZ has 100,000 executive stock options outstanding with a $5 per share strike price and that the average market price for the common stock is $20 per share. Therefore, EPS would be reduced from $1 per share to $0.93 per share because of the existence of in-the-money options calculated as follows:
| Event | Calculation | Shares |
| Shares assumed issued by company upon exercise of options | $500,000 divided by $5/share strike price |
100,000 |
| Shares assumed purchased by company at market price using proceeds from exercise | $500,000 divided by $20/share market price |
25,000 |
| Assumed increase in common stock outstanding | 100,000 – 25,000 | 75,000 |
| New common stock outstanding | 1,000,000 + 75,000 | 1,075,000 |
| EPS calculation | $1,000,000 net income / 1,075,000 shares | $0.93/share |
Assuming stock options are to be treated as a company expense, which is now required under GAAP, what should that expense be? Under current accounting rules, the cost of options to the company equals the theoretical value of the options to the recipients. However, it is utterly ludicrous to suppose that the value of a benefit to a recipient has any necessary relationship to the cost to a company to bestow that benefit. It is as if a sales clerk who has a 40 percent off employee discount buys a $100 sweater from her department store for $60 and the store then states that it incurred a cost of $100 because that is what the sweater is worth to the clerk, even though the company’s actual cost for the sweater might be, say, $35. The real cost of an executive option to the company (rather than to its stockholders) equals the expected present value that the option program will reduce the company’s future access to capital markets, especially equity markets. We would not know how to measure such a cost. In fact, there should be an offset to this cost, namely the expected present value that the option program increases the retention of talent and/or motivates that talent productively. Quantifying this benefit is also difficult.
The cases where stock options become a company problem as well as a stockholder problem seem few and far between. Options are a company problem long term insofar as they either cause the company to pay out cash (or property); or if their issuance reduces access to capital markets. In general, those cases where stock options become a company problem seem to encompass the following:
On this last point, Fitch Ratings published an interesting article on April 20, 2004, in which it recognized that stock options were basically a stockholder problem, not a creditor problem; but then went on to state, “Because of their dilutive effect, many companies have a high propensity to repurchase shares issued upon exercise of employee stock options. In this context, from a bondholder perspective, employee options have a true cash cost and can be thought of as a form of deferred compensation, which has the effect of reducing available cash to service debt and increasing leverage.”2
Fitch Ratings seems to be involved in overkill. First, most companies issuing stock options probably don’t have stock repurchase programs. Second, any company making cash distributions to shareholders for any reason—whether such cash distributions are in the form of dividends or share repurchases—“has the effect of reducing available cash to service debt and increasing leverage.” Indeed, from a creditor point of view, cash distributions to shareholders are helpful only insofar as they enhance the debtor’s access to capital markets. Third, share repurchases are strictly voluntary and thus do not have as adverse a credit impact as do required cash payments to creditors for interest, principal, or premium. Finally, some share repurchases can be beneficial to creditors and companies if the common stock being repurchased pays an ultrahigh cash dividend.
The controversy over stock options, that is, whether options ought to be expensed using the fair value method—FASB 123; or whether options ought to be expensed using the intrinsic value method—APB 25, sheds much light on the reach of the substantive consolidation doctrine and the resulting bad direction for GAAP, which decided that FASB 123, in effect, reflected economic reality.
The FASB 123 versus APB 25 dispute was strictly about form over substance. Companies that used APB 25, the intrinsic value method, were required under GAAP in financial statement footnotes to disclose the far greater expense of the fair value method as contained in FASB 123. The whole dispute revolved around whether disclosure of an ephemeral “expense” ought to be made in the income account or in the footnotes to the financial statements. The question for the serious investor who is not a short-run stock market speculator is “Who cares?” except that in an overall appraisal of management by a trained analyst, information about management attitudes can be gleaned from looking at management opting either for FASB 123 or APB 25.
Aside from accounting issues, stock options, like virtually every other financial practice, are subject to abuse. And abuses will be common. Management ownership of stock options does not really align management interests with those of OPMIs. Rather, options give management a sharing of the upside while avoiding the risks of the downside. Certain option practices—for instance, repricing when the OPMI stock price falls—seem notorious. Further, the tax treatment of options for Internal Revenue Service purposes seems unfair from the taxpayers’ point of view. Ostensibly, to avoid double taxation, when a management member becomes subject to ordinary income tax because of the exercise of an option, the company issuing the option receives a full tax deduction from its ordinary income equal generally to the difference between the market value of the exercised option and the executive’s cost basis for the option shares. Other parts of the Internal Revenue Code sometimes recognize a need for relief from double (or triple) taxation, but frequently that relief is not 100 percent relief.
EXAMPLE
When a domestic corporation less than 80 percent owned by another corporation receives dividends from the other corporation, only 70 percent, not 100 percent, of the dividend income received is excluded from taxable income.
STRUCTURAL SUBORDINATION NOT A SIGNIFICANT FACTOR
Structural subordination occurs when a senior class of claimants or interests are made junior to a lower class of claimants or interests even though, on the strict basis of stated claims or interests’ rights, the senior class would normally enjoy priority over other junior classes; say, for example, that because of findings of previous domination and control, secured bank debt is made the lowest class of claimant in a Chapter 11 reorganization plan.
Investors interested in fundamental finance reject the doctrine of structural subordination as it is used by G&D and MCT as utterly unrealistic. Each constituency—short-term stockholders, long-term stockholders, control stockholders, the company itself, management, creditors, vendors, employees, customers, financial professionals, governments, communities, and so on—has both communities of interest and conflicts of interest both within itself and in conjunction with other constituencies. Unlike MCT, which views things as if all constituents are structurally subordinated to the needs and desires of the OPMI, in fundamental finance it is recognized that no one constituency is necessarily senior to others in all contexts, and no one constituency is necessarily junior to all others. Myriad groups have relationships combining communities and conflicts; for example:
Tom Copeland, Tim Koller, and Jack Murrin, in their 1996 text, Valuation: Measuring and Managing the Value of Companies (John Wiley & Sons, reprinted in 2010), incorrectly observe that “. . . shareholders are the only stakeholders of a corporation who simultaneously maximize everyone’s claim in seeking to maximize their own” (p. 22). Creditors of companies where there is pressure to increase common stock dividends payable in cash would undoubtedly be very surprised to hear that their claims against the corporation are being maximized by paying out corporate cash to equity owners. Equally surprised would be managements and long-term buy-and-hold shareholders who are pressured by OPMI shareholders who want the company to maximize short-run reported earnings per share, even when this entails forgoing attractive investments in projects with a long-term payoff or results in income tax bills that are larger than would otherwise be the case. The Copeland, Koller, and Murrin view, though, is commonly held in academic circles justifying belief in the benefits of structural subordination. Suppositions that such benefits exist to any material extent where OPMIs are the stockholders in question are based strictly on anecdotal evidence.
The MCT idea of agency costs also is not helpful in fundamental finance. The concept of agency costs arose as a modification of structural subordination, giving grudging recognition to the observation that a corporation bears costs of management at the expense of shareholders and that as a consequence, management interests may not be aligned completely with those of shareholders. The concept of agency costs is too deficient in scope to describe adequately the real-world norm of pervasive communities of interest combined with conflicts of interest.
Structural subordination, in and of itself, is a nonstarter in fundamental finance. Ross, Westerfield, and Jaffe incorrectly observed, in arguing that management influence may be limited vis-à-vis stockholders, that “shareholders determine the membership of the board of directors by voting. Thus, shareholders control the directors, who in turn select the management team” (Corporation Finance, p. 22). In the real world, perhaps 99 percent of the time, membership of the board of directors is actually determined by those who control the nominating process, not by stockholders voting proxies. To suppose otherwise is to elevate form completely over substance. The director-nominating process also is controlled by management in the vast majority of cases even given new rules that give stockholders owning 3 percent or more of the common stock for over three years, the right to have their director nominees listed in the company’s proxy statement.3
Insofar as markets are efficient, with efficiency defined as each market participant trying to do as well as reasonably possible, structural subordination would exist only in that special case in which the management was a sole practitioner who owned all the outstanding equity of the business. When separate managements and separate shareholder constituencies are introduced, especially control shareholders and non-control shareholders, structural subordination becomes impractical for fundamental finance purposes.
Fundamental finance operates within the context of trying to understand the diverse agendas of the important constituencies—those constituencies with clout. Entrenchment is normally very important for managements. Managements have succeeded generally in achieving a favorable environment for management entrenchment: State antitakeover laws that insulate managements in office have become virtually universal since the 1970s.
Dividend policy for many corporations will be driven, in great part, by the tax positions and liquidity needs of control shareholders. The price of the company’s common stock may be a matter of indifference to a corporate management from time to time and from situation to situation. At other times, the OPMI stock price may be crucially important insofar as the company itself or key stockholders want to access the capital market by selling common stock, either newly issued or held by existing shareholders, or by using common stock owned by a key stockholder as collateral for borrowing.
None of this is to deny that many—if not most—managements feel strong communities of interest with OPMIs focused on the immediate market price of the common stock. Many managements want buoyant OPMI prices simply because they would rather have their stockholder constituencies happy, even though shareholder unhappiness would carry no downside risks for management. In virtually every case, however, these communities of interest are modified by the universal existence of conflicts of interest.
LACK OF PROGRESS IN EUROZONE CRISIS RESOLUTION: THE FAILURE TO USE SUBSTANTIVE CONSOLIDATION
We think that euro bonds issued and guaranteed by 5 of the 17 countries in the Eurozone, Greece, Italy, Ireland, Spain, and Portugal (PIIGS) are destined to become nonperforming loans sooner or later. The economists and politicians in charge seem to have no knowledge of what needs to be done to restructure debt. Put simply, if an economic entity cannot be made creditworthy, sooner or later that entity has to reorganize or liquidate. It seems as if none of the rescue actions being undertaken has any chance of making any of the PIIGs creditworthy.
Creditworthiness probably could be achieved if the Eurozone had the equivalent of Chapter 11, which then could result in restructuring euro debt under a Plan of Reorganization (POR). The POR would have two basic elements:
| Country | Treatment in the POR | Present Value |
| Germany, Netherlands, Finland | Reinstated | 100% |
| France | Impaired | 90% |
| Ireland | Impaired | 25% |
| Italy | Impaired | 25% |
| Spain | Impaired | 10% |
| Portugal | Impaired | 10% |
| Greece | Impaired | 5% |
There are four approaches to reducing the present values of an impaired credit. They can be used separately or in concert:
Liberalizing loan covenants probably would not work in a Eurozone POR. The first three might, provided that creditors were coerced into accepting a POR. In a Chapter 11 proceeding what usually happens is that all creditors are coerced into accepting a POR if each creditor class participating in a POR votes affirmatively for the plan. The required vote for each class is acceptance by those voting of two-thirds of the amount outstanding and one-half in number.
SUMMARY
The terms substantive consolidation and structural subordination originated in reorganizations under Chapter 11 of the U.S. Bankruptcy Code. Substantive consolidation occurs when, for purposes of a reorganization, two separate entities are combined into one; say, for example, solvent parent company creditors are placed in the same class as the creditor of an insolvent subsidiary as part of a reorganization plan. Structural subordination occurs when a senior class of claimants or interests are made junior to a lower class of claimants or interests even though, on the strict basis of stated claims or interests’ rights, the senior class would normally enjoy priority over other junior classes; say, for example, that because of findings of previous domination and control, secured bank debt is made the lowest class of claimant in a Chapter 11 reorganization plan.
Conventional approaches to both business and security analysis systematically substantively consolidate the interests of OPMIs with those of the company and structurally subordinate the interests of almost all other corporate constituents to the interests of the OPMI. These views are utterly unrealistic. We show examples where these views play a central role in obscuring the understanding of important issues including the accounting for stock options and the lack of progress in the Eurozone crisis resolution.
* This chapter contains original material and parts of the chapter are based on material contained in a section of Chapter 2 of Value Investing by Martin J. Whitman (© 1999 by Martin J. Whitman), and ideas contained in the 2002 2Q letter to shareholders. This material is reproduced with permission of John Wiley & Sons, Inc.
1 The concept of the OPMI and its relevance was explained at length in Chapter 1.
2 Accounting for Stock Options: Should Bondholders Care?, Fitch Ratings, www.fitchratings.com, New York, April 20, 2004.
3 Rule 14a-11.