What Is Debt Loading?
Debt loading is an unscrupulous practice sometimes employed by entrepreneurs and businesses facing bankruptcy. Debt loading works by spending all cash reserves, maxing out lines of credit and credit cards, and failing to pay bills in anticipation of filing for bankruptcy protection. Essentially, the business loads up on as much debt as possible before attempting to clear the debt by filing for bankruptcy.
Debt loading can also be used by businesses as a way to earn money from interest payments. For example, if a company takes out loans through foreign associates offshore, it could be considered a debt-loading strategy that allows them to transfer their profit offshores, where tax laws are different, by using interest payments.
- Debt loading is an unethical practice employed by entrepreneurs and businesses in which they load up their ventures with debt before filing for bankruptcy.
- Debt loading can also be used as a way for businesses to earn interest made from offshore loans.
- The bankruptcy code has many provisions to prevent debt loaders from piling on debt before bankruptcy.
Understanding Debt Loading
Many companies end up in bankruptcy because they are not able to make their debt payments. Their business is not generating enough profits to pay down their debt and so as a way out, companies file for bankruptcy. This often leads to either a reduction in debt, a restructuring of the debt and the debt payments, or other options.
When a company is about to file for bankruptcy, viewing it as a way out of their debt crisis, they may engage in debt loading, since much of the debt may be absolved to a certain degree.
Debt loading is not an ethical practice, and thus there are laws to prevent this type of behavior. For example, the bankruptcy code prohibits purchasing luxury goods or services that total more than $725 within 90 days of filing a bankruptcy case. Additionally, any credit cash advances totaling more than $1,000 cannot be discharged if made within 70 days prior to filing for bankruptcy.
As well as being unethical, debt loading may also be considered a civil fraud or even a criminal act, if a judge can determine the debt was accrued with the intent to discharge through bankruptcy.
Private Equity and Debt Loading
Private equity firms have also been accused of using debt loading to mint profits from their acquisitions. In this practice, PE firms purchase struggling firms primarily using debt. This strategy offers two advantages to PE firms. First, it multiplies gains. A company purchased using an all-cash deal is less profitable as compared to a company that is bought using debt, because the latter requires less upfront cash.
The second advantage of using debt loading is it can also result in substantial tax deductions for the purchased entity. The debt used by the PE firm is transferred to the business, which is under pressure to perform.
In some instances, PE firms load further debt onto the entity. For example, it can force the company to make an acquisition or invest in other companies owned by the same firm. During the Great Recession, many highly leveraged companies owned by PE firms defaulted on their debts.
Energy Future Holdings, a Texas utility, defaulted in 2014 with a debt of approximately $40 billion. It had been acquired by a PE consortium in 2007 and was the biggest debt defaulter after that of another PE-backed company, Chrysler Group, in 2009.
Example of Debt Loading
Mr. Smith, who owns a business on 5th Street, where he sells used books, has not been turning a profit for several months. After running the numbers, Mr. Smith realizes that he is unable to pay his bills and maintain his business or personal life. Mr. Smith performs his own research and determines that he should file for bankruptcy in order to clear his debts.
However, before filing bankruptcy, Mr. Smith takes out several lines of credit against his business and maxes them all out while also spending what little emergency cash his business had on hand. He spends all of his money on a gambling spree, inviting his friends and purchasing expensive food and drink. In order to avoid violating the terms of the bankruptcy code, Mr. Smith waits more than 90 days before officially filing for bankruptcy.