Robinhood Retail Traders Are Getting Shafted by Bankrupt Corporations - The Irony Hertz

On May 22, Hertz, one of the oldest auto rental companies in the United States, filed for bankruptcy. The company let sixteen thousand employees go, while the CEO made over $9 million using his golden parachute.

Founded over 100 years ago in 1918, Hertz was a staple of the car rentals industry, enjoying a market share at par with companies such as Enterprise. However, the now-defunct car rental company has carried out a bizarre series of events following its bankruptcy, and the story is unrivaled.

Following the bankruptcy declaration, Hertz's stock price leaped over 1400%, a fluctuation that is the complete opposite of what you would expect in a healthy market. Companies in bankruptcy generally go through what's known as a "chapter 11" or "chapter 7" process by which they issue a debtor-in-possession loan, which is considered senior debt. After the company in question uses their remaining capital and assets to satisfy senior debt obligations, the company must then address junior debt. Finally, the company pays any equity (stock) shareholders what is leftover following the satisfaction of the senior and junior debt.

At this point, Hertz's stock is virtually worthless. This reality is crucial for understanding the absurdity of the company's equity value trading 1,400% higher after declaring bankruptcy.

The CEO's golden parachute

Hertz fired 16,000 employees amid a global pandemic, which should be a burning red flag to the almost 160,000 proud Hertz stock owners on the Robinhood platform. That number is an increase from 40,000 just over a month ago. This disconnect between retail traders and seasoned institutional professionals (accustomed to the cycles of bankruptcies) has never been more acute.

Hertz is seeking to not only profit from not only their meteoric stock price rise but is also hoping to continue to milk the calamity as long as the company possibly can. Hertz seeks to raise over a billion dollars in this now useless equity by essentially fleecing retail traders. The company's actions should, at least in theory, be in flagrant violation of ethics. The courts and government regulatory bodies, such as the SEC, should intervene in full force. However, this Initial Bankruptcy Offering (IBO), as it's come to be known, has been given the official seal of approval by a Delaware judge.

Judge Mary Walrath ruled that Hertz can go ahead with this equity offering. The company is set to receive 3% on the deal if the bank can find enough individuals to fill the buy orders. A company selling fundamentally useless equity to individuals who are, for all intents and purposes, not qualified to purchase it, in a period of nosebleed levels of irrational exuberance from retail traders, is unprecedented.

Hertz stock soaring with influx of volume from retail traders; Source: Yahoo! Finance

On the other side of the coin are seasoned institutional investors who are familiar with complicated instruments such as credit default swaps. A credit default swap is an instrument for hedging against the potential of a bond issuer defaulting. For example, if an individual purchased a five-year bond for Hertz, the purchaser would receive periodic interest payments. At the end of the five-year term, the purchaser would receive their principal back. Hertz would have issued this bond under the assumption that at the maturity date, the company would have enough capital to pay the principal back, plus the periodic interest payments along the way.

A credit default swap is a type of insurance on a bond. In the event of Hertz defaulting on its obligations (as it did), the credit default swap issuer would pay the principal to the bondholder in place of Hertz. In the chart below, you can see that in February, credit default swaps for Hertz remained relatively flat. Then beginning around February 26 and into March, credit default swaps skyrocketed up until the company's inevitable default. The data demonstrates how individuals who held more senior debt were sensible enough to hedge against a potential default.

In contrast, retail traders waited until after the bankruptcy announcement to pile into the most junior level of debt possible -- equity. Apollo Global Management, a company that manages funds for investors, had picked up a surplus of credit default swaps right before Hertz went bankrupt, assumingly hedging their bets and perhaps even profiting massively from the situation.

The Hertz Corporation 5Y Credit Default Swaps Price; Source:

As said, this demonstrates the stark contrast between institutional investor mentality and their ability to understand these often complicated instruments in finance and the retail investors. The latter rushed en masse to bid the stock up, despite the news of default and the subsequent crash in stock price. Far from being a "buy the dip" bargain, this collapse occurred on the back of decidedly negative fundamental news for Hertz. This disconnect is not a sign of a healthy market, and it demonstrates the Pavlovian effect of central bank intervention into stock markets around the world. Time will tell the outcome of this bizarre scenario, but one thing's for sure -- This has opened Pandora's box for defaulting companies in the future.

For now.

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