Guest Post: Rewarding Failure

Submitted by Thomas Ryan, CEO of Doddsville Investments

Every day we hear about proposed caps on CEO pay, and new regulations to make sure companies are not rewarded for failure. Nowhere is failure being more greatly rewarded than in the United States bankruptcy system. R.H. Donnelley, one of the largest yellow page companies in America, declared bankruptcy earlier this year. The Company had over $500,000,000 of cash on hand when it declared bankruptcy and has generated positive cash from operations every month since declaring bankruptcy. R.H. Donnelley had no debt coming due in 2009, and received an unqualified opinion, a clean bill of health, from KPMG during its audit. The Company is projected to make hundreds of millions of dollars in cash from operations in 2009 and will have an estimated EBITDA of $1 billion dollars.  This information is all publicly available in R.H. Donnelley’s SEC and bankruptcy filings.

Why did R.H. Donnelley fail when shareholders were against the bankruptcy? There is one simple reason: The CEO will make more money bankrupting the company than keeping it alive. It takes a year or more for shareholders to elect new board members who in turn elect the CEO. As a result, when the CEO and board of a company feel threatened they may lose their jobs; they can wipe out current equity at any time regardless of the company’s financial condition by declaring bankruptcy. David Swanson, R.H. Donnelley’s CEO, cut a deal with bondholders to keep his job and have management acquire a 10% stake of the Company when it emerges from bankruptcy. Management had approximately 1% of the shares before bankruptcy. Equity was destroyed before the shareholders could have the CEO or the board members removed. The Company has wiped out six billion dollars of debt through the bankruptcy process and significantly lowered its debt service payments. A conservative valuation puts Management’s 10% stake at a couple hundred million dollars. The stake could be worth considerably more if the economy recovers over the next few years.  I believe this is a clear breach of management’s fiduciary duty to stockholders.

This bankruptcy certainly did not need to happen. The debt markets, which were locked up for the better part of two years, have thawed in the last few months. The company generated over $100 million of cash flow in the latest quarter according to the latest 10-Q and could have used this money to pay down debt. There were dozens of other options besides bankruptcy that would have protected the interest of equity, but none of these other options would catapult David Swanson into the legions of the super rich. The worst part is that the U.S. Bankruptcy Court and the U.S. Trustee allowed this to travesty to occur. The watchdogs are allowing this to happen, and encouraging corporate behavior that is harmful to all Americans.

This is not to say the Company did not have problems. R.H. Donnelley had a lot of debt because of a slew of acquisitions it made over the last decade. David Swanson orchestrated the acquisitions and the board of directors, Barry Williams, Edwina Woodbury, Thayer Bigelow, Robert Kamerschen, Alan Schultz, Michael Connors, Ronald Rittenmeyer, David Veit, Thomas Reddin and Nancy Cooper, approved of the Company’s business strategy and acquisition binge. The problems that the Company had were the direct result of inept management. Management should be removed as a consequence of poor decision-making, not rewarded and supported by U.S. bankruptcy courts. The current corporate governance system rewards failure.  R.H. Donnelley sold a billion dollars in bonds last year and made only one interest payment before voluntarily defaulting on its debt.  One can only wonder what would happen if a homeowner walked away from their mortgage after one payment. Would the homeowner be rewarded in the same manner? The Company’s actions not only negatively impacted the equity holders and bond holders, but also Company employees who put in years of sacrifice to make the Company a success and the retirees counting on a pension. Many stockholders were also the Company’s employees and retirees. These people were doubly hurt by the bankruptcy.  The CEO and board of directors must be removed upon the failure of a company rather than be rewarded with hundreds of millions of dollars. This is what happens when banking institutions are taken over by the FDIC, and it should be what happens when any public company fails. Management must be held accountable for its actions.

There are three major problems with allowing a company that is still able to service its debt and generate positive cash flow to voluntarily enter bankruptcy. The first is the tremendous human cost to all the workers; retirees and investors who had believed their contracts would be honored. The second problem is that allowing solvent companies to declare bankruptcy raises the cost of capital for all companies. If a company that can pay its debt is allowed to enter bankruptcy, then investors will require a higher interest rate due to the increased risk of all companies defaulting. This will make it harder for companies to undertake new projects and reduce corporate profits. Fewer projects will be profitable for companies, and hiring will suffer as a result. It will mean fewer jobs in America. Finally, it will create a major incentive for other companies to follow suit. If one major company is allowed to file bankruptcy, that company has a tremendous cost advantage over its competitors. The company can under-price the competition and win new business. The companies that declared bankruptcy will be able to earn more money than competitors. Companies unencumbered by debt and legacy costs will use these earnings to expand. This will force other companies in the industry to declare bankruptcy to compete. This will harm all stakeholders and further reduce the returns for investors like pension funds, endowments, insurance companies, banks and individuals. It will again cause the cost of capital to rise further for all companies, and further reduce employment.

Congress needs to address corporate governance immediately to make sure the failures of the last few years are not repeated. Bankrupting a company should be a last resort for a company, not a winning Powerball ticket for the CEO. The current system is not only encouraging risky behavior; it is actually encouraging corporations to default on their debt. The human cost is too high to allow this to continue.  We must act now to make sure failure is no longer rewarded in bankruptcy. 


Thomas Ryan

CEO Doddsville Investments
Largest Shareholder of R. H. Donnelley