Twinkies, Unions, Debt and Bankruptcy

Hostess is shuttering its bakeries and plants that produce Twinkies, Wonder Bread and other iconic snacks because of a strike, mismanagement and shifting preferences of the American consumer.  Pro-union advocates are blaming poor management and hedge funds.  Pro-management advocates are blaming unreasonable union demands.  Clearly neither side wanted the company to liquidate its assets.  Yet what happened to Hostess, and its workforce, is what we should expect from union-management battles in the U.S.  More than twenty years ago fellow Welch Consulting economist Donald Deere and I explained why management, faced with the threat of unionization and strikes, would use debt as a tool to protect its investors.

First, recognize that the valuable asset of union membership, unlike ownership of a company, is non-transferrable.  Upon retirement older union members can’t sell the property rights to their job in a unionized plant.  This means union members discount the future more than firm owners and shareholders.  The thousands of Hostess workers who retired in the past two decades were harmed less by the decline in the profitability of the company after their retirement than they would have if they could have sold their unionized jobs to the next generation of workers.  The right to work as a union member at a healthy company would sell for far more than the right to work for an unhealthy company.  (The absence of a market for the purchase and sale of union membership rights even though these rights yield a share of firm profits is an example of incomplete markets.)

Second, recognize that unions can bargain over the return on sunk investments (plant and equipment) and not just bargain over profits.  Once a billion dollar plant has been built, a union can hold-up management for the returns on that specific investment.  If the union succeeds, investors will get a lower return than they anticipated from their investment, but as long as variable costs are covered they won’t shut down the plant.  It is impossible for a union to pre-commit to only negotiating and striking for a share of the profits.  So even if a union has good intentions and promised only to negotiate for a share of profits, investors and management would be wary and assume the worst; the returns to sunk investments are assumed to be on the negotiating table.

What can firms do to protect investors from union demands?  They can use debt to make management threats more credible.  Investors and management facing the scenario described above will prefer debt finance to equity finance because debt makes the threat of bankruptcy more credible.  (Union threats are another reason why the Modigliani-Miller theorem doesn’t hold.)  The more debt-financed a company is, the more likely an adverse demand shift, bad management decisions or excessive labor costs will push the firm into bankruptcy.  Debtors must be paid whereas union demands come before dividend payments to shareholders.  So companies like Hostess use debt-finance as leverage against unions, knowing that this allows them to get more wage and benefit concessions from unions.  Unions are constrained more if a company threatens to file for bankruptcy because it can’t pay its debts than if the company threatened to suspended dividend payments to its shareholders.

The high debt to equity policy for management is similar to the sequestration policy agreed to by the President and the Congress.  At the time the sequestration deal was made, neither branch of government wanted to go over the fiscal cliff.  The deal’s purpose was to constrain the negotiations of the parties going forward.  Likewise, the owners of Hostess did not want their negotiations to end in the liquidation of the company.  They put in place a mechanism designed to limit future union wage demands even though they knew it would increase bankruptcy risk.  They likely made such a choice in order to protect their profits and the return on their sunk investments.  The lesson is that poison pills designed to constrain bargaining positions will sometimes have to be swallowed.

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