Chrysler and Bankruptcy Law in Gory Detail

I was talking to an old friend last night about the Chrysler bankruptcy and, in particular, whether Chrysler (and Treasury, and the UAW) will be able to get around the order of priority of creditors in bankruptcy – which ordinarily would favor the senior secured lenders who are trying to block the proposed plan. I thought I would do a little research, but then (again via Calculated Risk) I found Steve Jakubowski’s analysis of precisely this issue, which apparently everyone on the Internet has already been linking to. It’s actually Part 3 of a series; you may want to start with Part 1.

My summary, for those who don’t like reading citations from court opinions: The issue with the “restructuring initiative” agreed-upon by Chrysler, the government, Fiat, and the UAW,  is that it only pays the senior secured creditors $2 billion in cash for $6.9 billion in secured debt; since secured creditors’ claims should come first, they argue they would get more from a liquidation. In particular, the VEBA created to fund retiree benefits is owed $8.5 billion; it is getting $4.6 billion debt and 55% of the equity in New Chrysler.

The government’s plan is to get around this by creating a new entity, New Chrysler, and having the existing entity, Old Chrysler, sell its assets to New Chrysler. Technically speaking, Old Chrysler is not being reorganized; it is just selling assets. However, as Jankubowski explains, a bankruptcy court can block such an asset sale if it is effectively a reorganization by another name. The Second Circuit (the appeals court that would hear the appeal of the bankruptcy proceeding) has said that such an asset sale may go ahead if there is a “good business reason” for it – a test that is spelled out, not entirely clearly, in other court opinions.

Behind the legal test, the underlying legal principle at issue, discussed in Part 3, is whether the “absolute priority” rule, which determines the order of claims by creditors in bankruptcy, prevails over the general policy consideration that bankruptcy is intended to enable companies to return to healthy operations. To simplify greatly, Chrysler and the government”s argument is that without the “asset sale,” the company will simply disintegrate; the creditors’ argument is, or could be, that that doesn’t matter.

If you want to know what corporate law is like, I recommend reading the posts in full.

Update: It looks like the creditors’ opposition may fall apart, although we can’t be certain. well, at least you learned something about bankruptcy law.

By James Kwak

19 responses to “Chrysler and Bankruptcy Law in Gory Detail

  1. Questions:
    If senior secured creditors are not treated as such in this bankruptcy, what happens to the perception of risk for all (system wide ALL, as in “each and every”) of the other senior secured creditors? What happens to interest rates? And what does that say about the legal system?
    I really think that this is a benchmark that will tell something about whether or not the oligarchy has bought the judiciary…

  2. Well put.

  3. You ask good questions, but you lost me in the last sentence. Could you be more clear about who the “oligarchy” might be and in what sense is the judiciary “bought”? In particular, what decision by the court would you tag as being bought?

    [I'm not trying to be provocative, I just don't see the big picture yet, and so these hints fly over my head...]

  4. Even if we grant the premise that these obstructionists are legally in the right, it still contradicts the broader premise that growth capitalism can and should be “recovered”, since if this were true, it seems clear that heroic measures should be taken to try to recover something like Chrysler.

    How is this overarching goal, which presumably these obstructors agree with in theory, served by their still insisting on sociopathy in detail?

    This is of course not an isolated corporate bankruptcy, but rather part of a systematic economic failure (the possibility of which is something their quant models denied as a matter of religious dogma).

    No one has the luxury or the right to say in principle, “we must act together to save the system”, yet where it comes to a modest sacrifice of his own personal profit opportunities throw up barricades and say, “this is a discrete legal case which has nothing to do with the general effort; this case must stand alone and apart from everything else”.

    To simplify greatly, Chrysler and the government’’s argument is that without the “asset sale,” the company will simply disintegrate; the creditors’ argument is, or could be, that that doesn’t matter.

    To sum up, each of them wants as a general principle corporatism and government-driven redistribution of wealth upward through the bailouts and the general capture of government by the FIRE sector (heads I win); but each also wants to reserve the right to demand that “capitalism” and “law” still function ad hoc, in individual cases, where it’s to his particular benefit (tails you lose), even if this obstructs to general feudal premise.

    So it’s the sort of internecine squabble you’d expect among thieves who have ostensibly come together for a common purpose. (Needless to say, the public interst plays no role whatsoever in anyone’s calculations.)

    Here we see the very visible hand, not of private interest leading to the general good, but of vandalism and sabotage.

  5. To rephrase the last sentence as two questions:

    1. Has too-big-to-fail finance, which (as argued by the author of the article above) has apparently corrupted the executive and legislative branches of the Federal Government, corrupted the Judiciary?
    2. Given the threats coming out of both Congress and the White House regarding the dissenters, is the Judiciary independent enough to judge fairly?

    As I see it (i’m an engineer not a lawyer), awarding subordinate creditors more than the senior secured ones sets a really bad precedent that could have horrible repercussions to the overall credit market. I’m hoping that someone will have some idea as to what the repercussions might be.

  6. Agreed, but the executives do have the fiduciary responsibility to their shareholders. One way to look at it, they can capitulate and cite the systemic consequences of their dispute, but they have the responsibility to at least perform due diligence on behalf of the shareholders and try and get more before giving in.

    This is why I see this as the watershed: the judge can show that the Constitution applies to everyone, or the case can be another version of the “stress test”. The disputers could lose the case but the judge can show that he is independent and impartial based on his written decision…

  7. This has very little to do with the law and very much to do with why you don’t fight City Hall.

    The Administration wants to scare the GM claimants, so it decided to make an example of Chrysler: either the senior secured would capitulate (thus showing the GM bondholders, who don’t have structural priority, that theirs is a lost cause) or the senior secured would fight, in which case the Administration would find a dirty judge and roll them.

    There is absolutely no legal justification for tolerating the complete stripping of all security from the senior secured lenders. In fact, this is exactly the circumstance the priority rules envision – the senior-most creditor (the UST as DIP) and the junior-most creditor (the UAW VEBA) team up to screw the middle creditor (the senior secured).

    The VEBA is a retiree healthcare trust. No one has asserted a reason for it to have a claim to New Chrysler except as compensation for its claim to Old Chrysler (by contrast, if the interest were given to the current UAW workforce, you MIGHT be able to argue that it is as compensation for work to be done in the future for the benefit of New Chrysler).

    If there is compensation for the holders of Old Chrysler, it should go in order of priority. But the Administration wants to transfer value to the UAW without publicly disclosing it as such (the alternative would be to liquidate Chrysler, have the government buy it for $2bn, and simply cut the UAW a check from government funds, which would be transparent, honest, and potentially unpopular).

    The government likely believes it is ignoring the law in the interest of a better cause. Maybe it is. But this habit is going to bite us.

    http://tauntermedia.com/2009/05/04/chrysler/

  8. i think every stakeholders should compromise and find a win win solution for them. Always think what is the best for long term, not only short term.

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  10. Please consider that you are discussing Ch 11 bankruptcy … Corporate reorg. and not discharge.

    Discharge maintains the priority rules for payment of secured creditors.

    Reorg. is to reorganized the company so that it can come out of bankruptcy and continue to do business.

    Think airlines.

  11. Will the Second Circuit hear any potential GM cases as well? Put another way, how much will any decisions made in this case affect any GM case?

  12. For a different take on this you might want to take a look at David Skeel’s article. He looks at it from an historical perspective. It notes that the Obama administration is apparently doing an end run around New Deal reforms to the Code. Here is the link. http://www.american.com/archive/2009/may-2009/why-the-chrysler-deal-would-horrify-a-new-dealer/article_print

  13. Prof. Kwak —

    the general policy consideration that bankruptcy is intended to enable companies to return to healthy operations

    With sufficient government largesse, any company can “return to healthy operations”. I thought the primary purpose of bankruptcy law was to protect the interests of creditors, especially secured creditors, since a viable company is worth more than a corpse.

    But aside from that, why are the courts concerning themselves with “general policy considerations”? They are supposed to be concerned with interpreting the law. Both the letter and the spirit of BK law clearly include the absolute priority rule for secured creditors.

    This is a clear abuse of the law by the executive branch in order to achieve the outcome they desire. I opposed such blatant abuses when it was the Bush administration, and I oppose them equally now. We are on a very dangerous course, IMO.

  14. S. R. Barbour

    “if senior secured creditors are not treated as such in this bankruptcy, what happens to the perception of risk for all (system wide ALL, as in “each and every”) of the other senior secured creditors? What happens to interest rates? And what does that say about the legal system?”

    Virtually nothing. That’s what happens.

    This isn’t new, all secured creditors accept the risk that their priority will not be observed in bankruptcy. There are any number of reasons for this.

    Just like all unsecured creditors accept the risk that the company will, after taking their loan, immediately take a second loan putting up all their assets as collateral. Which also goes by the layman name of ‘stealing’.

    In any case, this entire issue is silly. The risk of ‘non-observance’ is dwarfed by the REAL credit risks:

    1) The actual market value of the company
    2) The actual likeliness of default.
    3) The actual profit potential of the company
    etc…

    Not to mention the fact we have yet to hear the important questions of:

    What exactly were these secured loans secured by? What is THAT actually worth? When were they secured? And should the secured creditors ever have been allowed to take secured loans in the first place, or was their action of doing so merely a sophisticated and legal form of thievery.

    etc…

    Finally, this also says nothing about the legal system that pretty much everyone hasn’t figured out long long ago. Most specifically that it is absurdly complex, often unfair, full of loopholes, and favors the rich and the powerful.

    As a final point, I can’t imagine that any company would attempt to solve a bankruptcy issue with a PR campaign if they had a legal leg to stand on. This smacks of a cheap tactic for the creditors to secure themselves extra cash by ‘coercing’ their opponent to cave to political pressure.

  15. Actually, I believe capitulation by the non-TARP lenders means the ballgame is over.

    The UAW deal was, I think, more of a red herring than a real argument. It’s something they threw in to add to their argument. Technically, this is a violation of absolute priority, but that whole issue could have been avoided as I pointed out on my blog. The UAW deal makes sure that NewChrysler will have a work force, but they could have done that deal from the new entity and skipped the priority issues.

    The main argument is that the 363(b) sale being used to separate “good Chrysler” from “bad Chrysler” is being rushed; and is, in fact, a way to dodge the Chapter 11 process. Some courts have referred to this maneuver as a “sub rosa” plan and, Steve Jakubowski does a good job explaining the case law behind this, which requires a “good business reason” to justify bypassing the process.

    Furthermore, Section 363(f)(2) states that, in the case of a sale under Section 363, the liened property cannot be sold for less than the aggregate value of the liens. Courts have taken that to mean that the sale price must exceed the value of the liened property, not the value of the loan. Therefore, the effective argument is that the assets being sold are worth no more than $2 billion.

    The principal question then is, what are the Chrysler assets worth. Since the first lien creditors (both TARP and non-TARP) have the right to the first $6.9 billion in value. The non-TARP lenders believed that the total assets of Chrysler (which had a book value of $39.3 billion at the filing date – per the Affidavit of Chrysler’s CFO) were worth more than $2.0 billion (and, in prepetition negotiations, $2.25 billion).

    The court is unlikely to review the valuation given that there will be no opposition and Greenhill has provided a fairness opinion.

    Once the transaction goes through, it can only be undone if it is challenged under 363(m) by claiming that the parties did not act in “good faith.”

    It’s unlikely that, now that the opposition has folded, that any such arguments will be made.

    I don’t see any serious impediments to the accelerated sale given that the terms of the DIP (which has been accepted by an interim order of the Court) require the sale take place on a timetable, and the sales process has been accepted by order of the Bankruptcy Court.

    It seems like a done deal to me.

  16. I don’t have a valid opinion on the legality of all this, but I do think that the damage to the bond markets with this kind of behavior could very well fall under the heading of unforeseen consequences.

    What really scares me is what I’ve learned about fascism, and from there totalitarianism. We’ve been reading an awful lot about strong-arm techniques coming out of the Executive branch, a continuation of the strong-arm techniques of Paulson et al.

    I don’t want to come off as a paranoid, but in reading “The Casey Report” one particular section struck me, when he talked about when government changes from protecting citizens from force to initiating force, sociopaths become attracted to finding roles in government.

    My impression of the Chrysler situation, and GM, and BAC, is that there are a lot of strong-arm tactics being used by the government, and I don’t like it, not at all.

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  19. “Obstructionists,” “thieves”?

    Why don’t you just donate to the Chrysler VEBA since it’s such a wonderful goal, instead of selling crazy here.