What is Cherry Picking?
Cherry picking has two main meanings:
- In bankruptcy cases, cherry picking is when a receiver or administrator tries to get the court to accept the derivative contracts and repurchase agreements that help the counterparty that has defaulted. At the same time, they try to get the court to reject the contracts and agreements that would hurt that counterparty. This is called “cherry picking” because the receiver or administrator is trying to pick and choose which parts of the agreement to follow.
- In corporate takeovers, cherry picking is when a raider takes control of a company and sells off only its best assets. They leave behind the less valuable or profitable parts of the company. This is called “asset stripping”.
Cherry Picking in Bankruptcy Cases
Master Agreements and Netting
Usually, when two companies do business together using derivative contracts or repurchase agreements, they sign a master agreement. The master agreement covers all the different contracts and agreements between the two companies.
Some places have laws that recognize “netting”. Netting means treating all the contracts and agreements in the master agreement as one big agreement. With netting, if one company defaults, the other company adds up the total value of all the contracts. They only get the “net” amount they are owed (the amount left over).
If netting is allowed where the companies are located, then cherry picking can’t happen in a bankruptcy. The whole master agreement has to be honored or rejected together. The receiver or administrator can’t pick and choose.
What Happens Without Netting
But if netting isn’t recognized where the bankrupt company is located, the receiver or administrator might try to cherry pick. They will ask the court to accept only the contracts that help the bankrupt company (the counterparty that defaulted). And they will ask the court to reject the contracts that would make the bankrupt company owe money.
This is a big problem for the other company in the agreement. Without netting, they might have to pay the bankrupt company for some contracts. But they might not get paid what they are owed under other contracts.
Unfairness of Cherry Picking
Many people think cherry picking in bankruptcy is unfair. The two companies made a deal to work together. The bankrupt company can’t just follow the parts of the deal that help them and ignore the rest.
Some say cherry picking goes against the whole idea of an agreement. The two companies agreed to all the contracts together as a package deal. Letting one side change the deal afterward is not right.
Others argue that since the company is bankrupt, it needs special treatment. Bankruptcy law is supposed to help the bankrupt company pay off as much of its debts as possible. Sometimes that means the other company in the deal won’t get everything they expected.
Cherry Picking in Corporate Takeovers
Asset Stripping
In a corporate takeover, a “raider” buys enough shares in a company to get control of it. Once they’re in control, the raider might engage in “asset stripping”. This means they sell off the company’s most valuable property and assets.
The raider is “stripping” the company of its best “assets”. They are taking the good parts for themselves while leaving the company with only the less desirable parts.
Picking the Best Assets
The key to asset stripping is cherry picking. The raider looks carefully at all the different assets the company owns. They “pick” only the “cherries” – the best and most profitable ones.
The raider might sell off a successful part of the business, valuable real estate the company owns, or important equipment and inventory. They are looking for anything that will get a good price and make them an easy profit.
Hurting the Company
Asset stripping cherry picking often hurts the company. It loses some of its most important resources. The parts of its business that made the most money are gone. It becomes harder for the company to succeed and grow.
The company might have to cut back, since it no longer has the assets it needs. It might have to lay off workers. In some cases, the company might not be able to recover from the loss of its core assets. It could be at risk of failing completely.
Profiting at Others’ Expense
Many see this kind of cherry picking as the raider profiting unfairly at others’ expense. The raider gets a big payout by selling off the best assets. But they don’t care that it harms the company’s future.
The effects are even worse because the money from selling the assets doesn’t go to help the company. It goes into the raider’s own pockets. So the company doesn’t get any benefit from losing its cherries.
Some argue this is just part of business. Companies get bought and sold all the time. The new owners can do what they want with the assets. It’s not the raider’s job to worry about the company’s future.
Others say asset stripping abuses the idea of a “takeover”. Takeovers are supposed to help make a company better and more successful. But cherry picking the best assets for a quick profit does the opposite in the long run.
The Problem With Cherry Picking
Undermining Agreements and Ownership
Whether it’s in bankruptcy or a corporate raid, cherry picking has the same basic problem. It lets one side undermine an agreement or ownership arrangement to benefit themselves at the other side’s expense.
In bankruptcy, the two companies made a deal. But cherry picking lets the bankrupt company break its side of the bargain. It gets out of commitments it owes while still collecting on the ones in its favor.
In a takeover, the company’s assets belong to the company as a whole. All the shareholders have a stake. But cherry picking lets the raider take the best parts of what the company owns without paying the shareholders for their value.
The Appeal for the Picker
It’s obvious why cherry picking is appealing for the side doing the picking. In bankruptcy, the bankrupt company gets to collect money while avoiding paying. The better a deal the original agreement was for the bankrupt company, the more tempting it is to cherry pick.
In a raid, the raider can made a big profit fast by picking off the best assets. The more valuable the company’s holdings, the more the raider stands to gain just by grabbing the choicest parts.
The cherry picker gets a sweet deal either way. They get the benefits of the arrangement or ownership without the costs and obligations.
The Harm to the Picked
But for the other side, cherry picking turns a good arrangement into a deeply unfair one. In bankruptcy, the solvent company suddenly can’t count on the deal they made. The agreement they entered in good faith is no longer being honored.
In a takeover, the company’s shareholders see the value of what they own get stripped away. Their stake in the company’s assets vanishes as the raider picks it apart. The company is often left in much worse shape.
Ultimately, cherry picking undermines basic principles of deals and ownership. Contracts and agreements are meant to be followed by both sides. Owning a stake in something means your property rights should be respected.
Cherry picking allows these principles to be bypassed when it suits one side’s interests. It makes the concepts of mutual obligation and property rights insecure. The picked side has little recourse.
Protecting Against Cherry Picking
Netting Agreements
In the bankruptcy scenario, the best protection against cherry picking is netting. When netting is recognized, the whole master agreement is treated as one deal. Cherry picking becomes impossible since the agreement stands or falls together.
For any company concerned about a counterparty defaulting, getting a clear master agreement with netting is critical. It ensures that even if the worst happens, the original deal will be honored. Neither side will be able to pick and choose.
Companies should be cautious about entering derivative contracts or repurchase agreements without netting. If the other party goes bankrupt in a jurisdiction that allows cherry picking, the solvent company’s interests are at risk.
Takeover Defenses
For companies worried about raids and asset stripping, there are various defenses against hostile takeovers. Many are designed to make it harder for a raider to quickly get control and start cherry picking.
For example, a company might use a “staggered board”. This means not all of the company’s directors are elected at once. Instead, only a few directors are up for election each year.
This makes a takeover take much longer. The raider has to win seats on the board over several years to get control. That gives the company time to respond to the threat.
“Poison pill” defenses also aim to stop cherry picking. A poison pill lets current shareholders buy more stock at a discount if a raider buys a controlling stake. The flood of new shares dilutes the raider’s ownership and makes the takeover more expensive.
By putting barriers in the raider’s path, these defenses aim to prevent asset stripping. They give the company and its shareholders a chance to fight back and keep the company’s cherries intact.
The Future of Cherry Picking
Bankruptcy Laws
How cherry picking develops in bankruptcy cases will depend a lot on how laws and courts treat netting. In places where netting is not clearly recognized, there will always be a temptation for bankrupt companies to try cherry picking.
However, the unfairness of cherry picking is clear. There could be a trend toward more explicit recognition of netting in more jurisdictions. Courts could become more skeptical of attempts to get out of obligations through cherry picking.
Legislators might decide to limit cherry picking directly. Laws could specify that derivatives contracts must be treated as a whole in bankruptcies. Lawmakers may see this as important for preserving faith in financial agreements.
Corporate Governance
In corporate takeovers, the rules around how raiders can behave once they get control will influence cherry picking. If it remains easy to sell off assets quickly, cherry picking may stay attractive for some raiders.
There could be calls for more restrictions on asset sales after a takeover. Governments might argue that raiders should have to keep a company intact for some minimum period before breaking it up. This would reduce the appeal of quick cherry picking.
Changes in what defenses against takeovers are allowed could also have an impact. If it becomes easier for companies to put strong defenses in place, fewer takeovers may happen overall. Raiders may not want to spend time and resources fighting through poison pills and other obstacles.
However, some would argue that making takeovers too difficult is also a problem. It can let bad management entrench itself without fear of being replaced. There’s a balance to be struck between discouraging cherry picking and still allowing the market for corporate control to function.