Inside today’s Daily Journal…

Editor’s note: Porter is traveling today and has turned the Journal over to Marty Fridson, lead analyst for Porter & Co.’s Distressed Investing. For nine consecutive years, Marty was ranked No. 1 in high yield strategy. He has written seven books, the most recent of which is The Little Book Of Picking Top Stocks… and Marty is such a legend that there is a recently published book about corporate finance that devotes an entire chapter to him. We excerpted last year in the Daily Journal.

Marty takes over from here…

You can run, but you can’t hide when filing for bankruptcy…

FAT Brands filed for bankruptcy on January 26. The company, which operates the Fatburger and Johnny Rockets restaurant chains, is based in Beverly Hills, California, yet it filed more than 1,500 miles away, in Houston, Texas.

And that’s OK…

According to federal law, a bankrupt company can choose to file in a number of locations: the district of its domicile, its residence, its principal place of business, or where its principal assets have been located during the 180 days immediately prior to the filing. While it primarily operates in California, FAT Brands had good reason to prefer the Texas Southern District – a court with a reputation as one of the most friendly to debtors and less friendly to their creditors, including bondholders.

Like many companies before it, FAT Brands took advantage of a looseness in the rules that allows a company to file where an affiliate files. The restaurant operator’s 95%-owned Twin Hospitality Holding Group, based in Dallas, also entered bankruptcy on January 26.

FAT Brands’s gambit wasn’t by any means the most aggressive exploitation of the maneuvering room offered by the U.S. Bankruptcy Code. In March 2024, BowFlex (BFXXQ) filed for bankruptcy in New Jersey, 3,000 miles away from its corporate headquarters in Washington State. The health-and-fitness products manufacturer’s basis for filing in that debtor-friendly jurisdiction was a prior filing by a subsidiary, BowFlex New Jersey LLC, which was formed just one month earlier.

Bankruptcy expert Stephen J. Lubben of the Seton Hall University School of Law commented,

Forum shopping is only one manifestation of the fundamental problem that Lubben sees in the present U.S. Bankruptcy Code. Ever since several big 19th-century railroad bankruptcies were controlled by robber barons such as Jay Gould and banking titans such as J. Pierpont Morgan, power has too often trumped fairness in how the company’s assets were distributed to the various claimants, for example, bank lenders, bondholders, and stockholders.

Congress revamped federal bankruptcy laws in 1898, in 1938, and again in 1978. Intended fixes in these various iterations included a filing category specifically designed for large corporations, a procedure involving appointment of an independent trustee, and injecting the U.S. Securities and Exchange Commission into the process. But each time, players with lots of financial clout figured out how to circumvent Congress’s attempts to level the playing field on behalf of less well-heeled participants.

Lubben advocates a new overhaul of U.S. bankruptcy law. It hasn’t been done in almost 50 years, so judging by history, it’s about time. Unfortunately, today’s dysfunctional Congress probably isn’t up to the task.

That leaves it to bankruptcy judges to ensure that all creditors get a fair shake. Relying on their good judgment and integrity should work, theoretically, because the law prescribes a simple formula that the judges must follow when a company reorganizes in bankruptcy.

It’s called Absolute Priority. The court determines the total value of the company’s remaining assets. Secured debtholders stand at the top of the food chain. Only if their claims can be paid in full with some combination of cash, newly issued debt, and equity in the reorganized company can unsecured debtholders’ claims be paid in part or in full. This process continues through the claims of subordinated debtholders, preferred stockholders, and common stockholders.

The catch is that the total value of the bankrupt company’s remaining assets isn’t an objective quantity equivalent to the accounting numbers reflected in the balance sheet. Experts hired by the secured debtholders will testify to a low total valuation, so that most of the assets will be assigned to their class of claimants. The equity holders’ experts, on the other hand, will testify to a valuation large enough to justify some assets going to claimants at the very bottom of the food chain.

Judges can influence the outcome because the reorganization plan requires a judge’s approval. And just as U.S. Supreme Court judges lean in particular political directions when making judicial decisions, many bankruptcy judges are regarded as pro-debtor or pro-creditor.

One tool with which they can affect the outcome is the cramdown provision. It enables a judge to say, “I believe the proposed plan provides every class of claimants as much as they’d receive if we simply liquidated the company and distributed the proceeds. Therefore, I approve the reorganization plan, even though one class of claimants opposes it.”

In summary, the U.S. Bankruptcy Code isn’t perfect and it isn’t possible to predict precisely how much each class of creditors will recover when the reorganization plan ultimately gets approved.

But in Porter & Co’s Distressed Investing – where we regularly find obscure distressed bonds and stocks that eventually provide investors double-digit returns – we make sure to take these factors into account whenever (and wherever!) we analyze a distressed security. Even if we believe the issuer will almost certainly steer clear of bankruptcy, we want to be confident that investors’ asset value is well protected if unforeseen circumstances cause it to go belly-up.

Accordingly, we always make sure there’s a sizable cushion in our calculation of the company’s total asset value. Among other potential hazards, the company’s management may succeed in getting its case heard in a faraway court where creditors don’t tend to make out as well Bankruptcy Code says they ought to.

But even there, we’ll be watching to find a gem that others will no doubt miss.

Tell us what you think: [email protected]

Good investing,

Martin Fridson

New York, New York

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1. With supplies of oil and natural gas threatened, the world looks for options. When gas gets expensive enough – oil is above $100 per barrel and spot and futures natural-gas prices have skyrocketed – utilities and industrial users globally switch to the cheapest available thermal fuel – and right now, that’s coal. We saw exactly this dynamic in 2022 when the Russia supply shock sent European and Asian coal demand surging – and it’s benefitting Complete Investor holding Core Natural Resources (CNR) with shares up 22% in the last month.

2. The wealth gap in stocks has never been wider. Federal Reserve data show the top 20% of U.S. earners hold a record 87% of the total market in equities and mutual funds – meanwhile, the bottom 80% own just 12%. Since the COVID crash, that top quintile has added $29.8 trillion in equity wealth, a 154% increase, while everyone else captured just $4.2 trillion. As the U.S. government debases the dollar, Americans who don’t own assets are being left behind.

3. The SEC makes the most consequential U.S. crypto regulatory action in history. This week, the U.S. Securities and Exchange Commission (“SEC”) and the Commodity Futures Trading Commission (“CFTC”) jointly declared that most crypto assets are not securities, naming 16 tokens – including Bitcoin, Ethereum, Solana, and XRP – as digital commodities under CFTC jurisdiction. Mining, staking, and airdrops are now all cleared of securities law obligations. This marked a significant departure from the stance of previous administrations – but a future SEC chair could reverse it. Only passage of the CLARITY Act – currently stalled in the Senate over a stablecoin-yield dispute – would make this permanent.

While the war in Iran has been terrible news for the global economy, it’s provided a boost for our Complete Investor energy stocks, including royalty company Viper Energy (VNOM), a recent Best Buys selection hitting its own 52-week high.

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Rolf J. writes:

Porter Comment: Rolf —

You must have missed my detailed comments a few days ago.

I’ve explained that in a credit default cycle (as I think it’s clear we’re entering) credit defaults can actually reduce the total amount of credit outstanding. Credit creation is what drives gold prices higher. Credit destruction typically leads gold lower.

I’m fairly certain that we’ll see Bitcoin (which is linked to liquidity) serve as a better hedge against this recession. Gold will, of course, rebound when credit growth resumes.

Regards,

Porter

Gregory T. writes:

Porter Comment: If you’ll notice, the entire property and casualty (P&C) insurance sector has been in a downtrend for about the last year – it’s not company specific.

#1. When interest rates decline, P&C companies will see a decrease in their earnings, as their investment income is tied to benchmark interest rates.

#2. There haven’t been any significant “cat” (catastrophic loss) events – huge hurricanes or other big disasters – in a while. As a result, the underwriting profits of the industry have been unusually strong, for an unusually long time. That sounds good… but it also measures the pool of risk capital in P&C has grown very large. Lots of capital chasing the same amount of risk = lower premiums. This cycle is common and it will likely continue until there’s a notable “cat.”

#3. In raging bull markets, where people can make 50% a year in the right tech stock or the Magnificent 7, steady conservative businesses like P&C often are overlooked as capital is chasing growth.

None of these trends are unusual. And none of them impact our intrinsic value estimate on Kinsale Capital (KNSL).

Regards,

Porter

Kendrick M. writes:

Porter Comment: Kendrick –

There’s no such thing as monopoly power in a free market. That’s the definition of a free market. Governments grant monopolies, not businesses.

Some employees have to take risks – it’s in the businesses’ self interest to limit these risks. If not, they’re exposed to liability.

Killing customers is bad for business.

Murdering competitors is obviously against the law.

Maybe you’re unaware, but the Code of Federal Regulations (“CFR”) are the permanent rules published in the Federal Register by federal agencies – the regulators. These codes are divided into 50 titles and organized into approximately 200+ bound volumes. The most recent detailed count shows the CFR contains roughly 190,000 pages of regulations.

You think that’s a good thing, I suppose? To stop all of those evil business owners?

We’re from the government – we’re here to help!

Porter

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