You may not have heard of First Brands Group, but if you own any car other than one you’ve just driven off a new car lot, you’ve probably been its customer.
That’s because Cleveland-based First Brands is the maker of a raft of aftermarket auto parts — Trico windshield wipers, Fram air filters, AutoLite sparkplugs and Raybestos brake linings are among its 24 subsidiaries. Its products fill the shelves of parts retailers including AutoZone, NAPA, O’Reilly, Walmart and Amazon.
But financial firms in the U.S. and abroad have become familiar with First Brands to their profound disenchantment. That’s because the company abruptly filed for bankruptcy protection, along with dozens of special-purpose vehicles it used to borrow billions of dollars, at the end of September.
The bankruptcy filing discloses that First Brands carried some $6.1 billion of debt on its balance sheet, against annual operating earnings of only about $1.13 billion. That’s not counting another $2.3 billion in off-balance-sheet financings and $600 million of unsecured other debt. Because First Brands is privately owned, its financial disclosures were scanty, leaving its lenders largely in the dark.
How complicated is this case going to be? Consider this: When bankruptcy Judge Christopher Lopez of Houston convened an initial hearing on Oct. 1, there were 750 lawyers in attendance — 500 by telephone and 250 by video call.
“It’s not a routine Chapter 11 case,” a lawyer for lenders that have agreed to provide First Brands with more than $1 billion in emergency debtor financing told the judge.
No one seems to know what has become of that $2.3 billion, money that was supposed to be paid to First Brand by financing companies in return for First Brand turning over its receivables to financiers in a process known as “factoring.”
It’s certain, however, that tracing the missing money is going to be a focus for the creditors. On Oct. 2, a lawyer for one of the bigger creditors put two questions to the lawyers for the bankruptcy estate by email, inquiring about $1.9 billion in missing funds: “First, do we know whether FBG [First Brands Group] actually received $1.9 billion (no matter what happened to it)? Second, would you tell us how much is in the segregated accounts in respect of the factored receivables as of today?”
The answers were: “#1—We don’t know,” and #2—$0.”
Yet, the First Brands breakdown may have ramifications extending beyond its effect on lenders. It points to the laziness and complacency that emerges in the late stages of a bull market, when investors start casting caution to the wind.
“At the end of cycles everybody’s guard is let down, right?” the veteran short investor Jim Chanos told the Financial Times after the First Brands implosion. “The sense of healthy disbelief erodes, due to fear of missing out.”
Chanos’ words should be heeded. The investor who foresaw the collapse of Enron, he has one of the most sensitive noses for financial chicanery — and the ebbs and flows of investor credulence — in the business.
“The longer the cycle goes on, the more investors’ sense of healthy skepticism erodes and they begin to believe things that are too good to be true and/or they don’t do the work,” Chanos told the FT. “That’s the ultimate fertile field for financial fraud. …As long as everything works nobody asks questions. It isn’t until something stumbles, or the markets stumble, that people say ‘wait a minute what are we doing here, this doesn’t make any sense.’ ”
No one connected to First Brands has been accused of criminal wrongdoing. But federal prosecutors are reportedly looking into its collapse, and an independent investigation is being sought by creditors. A hearing on their motion is scheduled Nov. 17.
Most market meltdowns have been triggered by some unique new financial contrivance. That appears to be the pattern here. The Great Recession was triggered by the rise of subprime lending in the home mortgage market. In the case of First Brands, the new wrinkle was the rise of private credit — lending by lightly-regulated creditors on opaque terms that bankruptcy lawyers are just now beginning to unravel.
First Brands’ capital structure might have held up indefinitely, if not for some unexpected developments in the financial markets. Chief among them was Donald Trump’s incoherent tariff policies.
“Headwinds from newly imposed tariffs have pressurized global supply chains and layered additional complications” on First Brands’ operations, its bankruptcy filing states. The tariffs not only increased the cost of its imported goods, but forced it to make new investments “to minimize tariff exposure in the future.” These and other factors “snowballed into a liquidity crisis” — that is, the company needed a hasty infusion of cash.
Let’s take a closer look at how the crisis developed.
It started with its founder and owner, Patrick James, a Malaysian-born and Ohio-educated businessman. James resigned as CEO earlier this month; the business is now being run by restructuring specialist Charles M. Moore, overseen by the bankruptcy court, who are trying to sell off the First Brands portfolio. A spokesman for James told Bloomberg that he is “deeply committed to the success of the business and the maximization of value of its customers, suppliers, employees and lenders.”
James’ vision was to consolidate the aftermarket auto parts business into First Brands, starting in 2013 and 2014, when he acquired Carter Fuel Pumps and Trico. Subsequently he acquired Fram, Autolite and other manufacturers. These acquisitions were typically funded through borrowing, according to the bankruptcy filing. In July, James tried to refinance First Brands’ debt by raising $6.2 billion with the help of the investment bank Jefferies Financial Group, which has had a long-term relationship with First Brands.
But prospective lenders began to look askance at First Brands’ earnings. They demanded a Quality of Earnings report, a document often sought by lenders as a step in their due diligence examination of prospective borrowers. That forced a halt to the refinancing, the bankruptcy filing says.
Other pressures kept rising. Some lenders alleged that the company was in default on some loans and “threatened to exercise remedies, and/or demanded unconscionable late fees.” Reorganization under the protection of Chapter 11 of the bankruptcy code eventually emerged as the best option.
In the lead-up to the bankruptcy filing, a special committee of board members raised questions about the company’s factoring deals. Typically, factoring allows a company to receive near-term payments of money it’s owed — in this case, by retailers and others — by pledging the ultimate receivable payments to the factoring firms, for a fee or by paying interest.
In some deals, according to the bankruptcy filing, First Brands received payments from factors within 30 days by pledging payments from retailers that might not be due for a year. Some deals required the receivables to be paid directly to the lenders; others allowed the receivables to be paid initially to First Brands, which was then supposed to forward the payments to its lenders.
First Brands owes some $2.3 billion to third-party factors. The special committee is trying to determine whether the third-party factors have received what they’re owed.
Of greater concern, the company says, is the question of whether some receivables have been factored more than once — in other words, whether the same collateral has been pledged to more than one lender. The company calls these “third-party factoring irregularities” in its bankruptcy documents, which lawyers for a lender criticized as unduly “euphemistic,” given “the enormity of this potential defalcation.”
What has Wall Street vibrating about the First Brands bankruptcy is the possibility of widespread losses by creditors. Jefferies disclosed on Oct. 8 that a factoring firm owned by its Leucadia Asset Management arm had invested $715 million in First Brands receivables due from retailers including Walmart, AutoZone and NAPA, and that payments on the factoring deals had stopped on Sept. 15. Jefferies stock fell by about 30%, from $70.36 on Sept. 18 to as low as $48.80 on Oct. 16, as questions about First Brands proliferated.
That prompted Jefferies to respond to “articles and snippets that mention Jefferies” in connection with First Brands by assuring its own investors that its exposure to First Brands isn’t more than $45 million. The bank’s top executives stated in a letter to clients that it can weather the damage, insofar as it has $10.5 billion in equity and $11.5 billion in cash on hand. They blamed the collapse entirely on First Brands, namely “possible fraudulent or otherwise improper activity” at the company
“Relative to the scale of Jefferies, we are confident that any losses or expenses from these investments or otherwise in respect of First Brands can readily be absorbed and do not threaten our financial condition or business momentum,” they said. They added that “nobody at Jefferies was aware of fraudulent activity at First Brands,” and that they learned of the fraud allegations “when the rest of the public learned,” and only when First Brands stopped making payments on the factoring deals.
They also noted that they aren’t alone in their First Brands-related misery: “We are aware of nine other banks being involved in acquisitions or loan arrangements for First Brands.”
It’s certain that there will be more to learn about First Brands. At the Oct. 1 hearing, an attorney for the emergency bankruptcy lender called the company “effectively a black box.” Raistone Capital, a factoring firm owed $670 million, alleged in its motion for an independent investigation that the $2.3 billion owed to his firm and others “has simply vanished.”
What may be more important is what the First Brands debacle tells us about the condition of the financial markets these days. It’s not good. When a small maker and distributor of auto parts can turn itself into a financial firm with some $10 billion of debt without its lenders paying much attention, something smells.
A common adage about the breadth of economic gains during a bull market is that “a rising tide lifts all boats.” But there’s a corollary, often attributed to Warren Buffett, that’s heard less often: “Only when the tide goes out do you discover who’s been swimming naked.” At this moment, the tide appears to be rising inexorably, despite tariff headwinds and other obstacles. But nothing lasts forever. First Brands may only be the first naked swimmer exposed by an ebbing tide.
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