Auto Bailouts and the Rule of Law

Todd Zwicki has a great article on the auto bailouts.  Here is a brief excerpt of a long and very comprehensive article.

Of the two proceedings, Chrysler's was clearly the more egregious. In the years leading up to the economic crisis, Chrysler had been unable to acquire routine financing and so had been forced to turn to so-called secured debt in order to fund its operations. Secured debt takes first priority in payment; it is also typically preserved during bankruptcy under what is referred to as the "absolute priority" rule — since the lender of secured debt offers a loan to a troubled borrower only because he is guaranteed first repayment when the loan is up. In the Chrysler case, however, creditors who held the company's secured bonds were steamrolled into accepting 29 cents on the dollar for their loans. Meanwhile, the underfunded pension plans of the United Auto Workers — unsecured creditors, but possessed of better political connections — received more than 40 cents on the dollar.

Moreover, in a typical bankruptcy case in which a secured creditor is not paid in full, he is entitled to a "deficiency claim" — the terms of which keep the bankrupt company liable for a portion of the unpaid debt. In both the Chrysler and GM bankruptcies, however, no deficiency claims were awarded to the wronged creditors. Were bankruptcy experts to comb through American history, they would be hard-pressed to identify any bankruptcy case with similar terms.

To make matters worse, both bankruptcies were orchestrated as so-called "section 363" sales. This meant that essentially all the assets of "old Chrysler" were sold to "new Chrysler" (and "old GM" to "new GM"), and were pushed through in a rush. These sales violated the longstanding bankruptcy principle that an asset sale should not be functionally equivalent to a plan of re-organization for an entire company — what bankruptcy lawyers call a "sub rosa plan." The reason is that the re-organization process offers all creditors the right to vote on the proposed plan as well as a chance to offer competing re-organization plans, while an asset sale can be carried out without such a vote.

In the cases of GM and Chrysler, however, the government essentially pushed through a re-organization disguised as a sale, and so denied the creditors their rights. As the University of Pennsylvania's David Skeel observed last year, "selling" an entire company of GM or Chrysler's size and complexity in this manner was unprecedented. Even on a smaller scale, it would have been highly irregular: While rush bankruptcy sales of much smaller companies were once common, the bankruptcy laws were overhauled in 1978 precisely to eliminate this practice.

At first, the fact that the companies' creditors (and especially Chrysler's creditors, who were so badly mistreated) put up with such terms and waived their property rights seems astonishing. But it becomes less so — and sheds more light on how this entire process imperils the rule of law — when one considers the enormous leverage the federal government had over most of these creditors. Many of Chrysler's secured-bond holders were large financial institutions — several of which had previously been saved from failure by TARP. Though there is no explicit evidence that support from TARP funds bought these bond holders' acquiescence in the Chrysler case, their silence in the face of a massive financial haircut is otherwise very difficult to explain.

Indeed, those secured-bond holders who were not supported by TARP did not go nearly as quietly.

  • caseyboy

    Union pay back, pure and simple.

  • Ignoramus

    This was a union pay-back, but the author is wrong in his premises.

    The US taxpayer is the one who got screwed. Were it not for government involvement GM's secured creditors would have gotten less. It's true that the UAW VEBA got 40% on the dollar -- when they shouldn't have gotten at all, while secured only got 29% -- but secured would have gotten far less without the government.

    It's true that we've never had a 363 so big, but it was blessed by three courts. A 363 is usually used to quickly sell a division of a company in bankruptcy -- e.g. Vlasic pickles. A lead buyer gets to sign a deal, but is subject to getting topped by any better bid within 30 days. Here the buyer was a USA-led consortium. There were no other bidders. The real problem was that this consortium far overpaid. Most of this overpayment went to the UAW VEBA, some to creditors.

    Obama & Co is very concerned with the optics of the return on taxpayer investment. So they've been cheating on this in several respects. e.g., They often leave out the $18B that Bush put in first.

    Worse still, New GM got an unprecendented IRS tax ruling so that they could get the full benefit of Old GM's tax losses. This has an NPV of about $18B, much of which in effect passed through to the UAW VEBA. It also made the IPO pricing look better, so that the tax payer's investment didn't look so bad. Normally tax losses are capped or even lost when there's an ownership change. It's unprecendented to deem a 363 asset sale to not be an ownership change. Don't try this at home.

    Lastly, the effect of the bankruptcy was to give New GM the best of Old GM's plant without any debt to service. Ford still has to pay interest on the debt it used to build its plants. So when you compare performance, on similar bottom line net income it's Ford that's actually a far better performer because it has to pay interest and taxes.

    By the time of the GM bankruptcy, its secured debt was mostly held by distressed investors who were Monte-Carlo-ing the chances of a USA-led bailout. They did well.

    I hate the canard that debtholders got screwed because it takes attention away from how taxpayers bailed out the UAW VEBA. If you had the bad luck to be GM white collar, or be blue collar at a GM supplier, you got doubly fucked.

  • Daublin

    The especially sad part is to imagine what kind of car companies the U.S. might have if the government stopped bailing out the crummy ones.

  • Dr. T

    "Indeed, those secured-bond holders who were not supported by TARP did not go nearly as quietly."

    But, they still got screwed by the federal government. Their lawsuits have gone nowhere. Welcome to the Banana Republic of North America. (Now featuring gratuitous bombing of Libya!)

  • joshv

    @Ignoramus - if the company had been liquidated the secured creditors would have received 100%. Also, as the article notes, it's common in the case where secured creditors are not made whole, to attach a debt of repayment to whatever new entity arises from bankruptcy.

  • Ignoramus

    "if the company had been liquidated the secured creditors would have received 100%."

    True, 100% of plant, etc. that no one else wanted.

    If you didn't have a stupid bidder (the USA), the secured creditors could have outbid anyone using the face value of their debt. But the last thing the distressed debt guys wanted was to own GM. The were pleased to take 29% in cash and run, while whining about it.

    "But, they still got screwed by the federal government."

    No they didn't. Where was I not clear.

    If you think this violates the "rule of law" and the "sanctity of contract" your beef is with the big changes made to the federal bankruptcy law back in 1978, not their appplication today. These changes were made so that you didn't have things like secured creditors ripping up railroad track to sell it for scrap.

  • caseyboy

    Ignoramus, I must agree with joshv, you cannot assume that the assets do not have value to anyone. At some price someone would buy the assets, because there is 12 million unit market in the US. Chrysler and GM accounted for nearly 3.5 million units. They go out of business, that is quite a hole in the market. Those assets would not sit idle for long. Think of the efficiency a new, unencumbered owner would bring to the market. New clean capital instead of the legacy capital sunk in GM and Chrysler. Ugh, what a mess.

  • Max

    @Coyote:

    What will this do to investment and credit lines in general? Do you think this will have a lasting influence on how those big car companies can raise money?
    If this were a logical world, I would imagine that the handling of this bankruptcy might have lasting influence on lending behaviour. I would certainly be less-willing to insert any money and last of all as a secured debtor. I would probably extend this limit to all kind of politically connected behemoths.
    Do you, as a small company man, have an oppinion on this or even see some consequences to credit acquisition for you?

  • Mark

    What this proves is that property rights are much more important than any other rights. If you lose your property rights, as the secured credit holders did because of TARP and their reliance on government, you lose all of your other rights to. The right to free speech is meaningless if you are a slave. You will always do your master's bidding.

  • carnahan

    The moral hazard component of this was less egregious than AIG and Goldman for instance.

  • Dan

    @Caseyboy - The problem is that to other auto makers, the shuttered GM and Chrysler planats have literally negative value. This is why the German and Japanese auto companies built their own US factories rather than purchasing US auto companies or co-producing their models via a joint venture. It simply cost more to retrofit a US plant to manufacture higher quality and usually smaller cars than to build from scratch on a greenfield. Add to that the lower legacy and operating costs from a non-UAW workforce and the decision became a no-brainer.

    To anyone but an auto manufacturer, the real estate value of the existing plants is also next to nil, since there are legitimate fears of toxic soil contamination and legacy buildings that aren't condicive to being converted into anything else. Once the auto plants closed, there is really no residential demand for conversion to loft-style residences, for instance.

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