Well, the initial pleadings have been filed, and Chrysler’s argument is essentially that it’s a "dead man walking." In it’s opening memorandum of law in support of its motion to approve the sale, Chrysler argues that if the "sale" doesn’t close on the accelerated timetable proposed, it will wither on the vine, resulting in "a rapid and severe loss of value." (Mem. at 10). Surprisingly, though, Chrysler’s opening memorandum doesn’t squarely address the issue laid bare in my previous post and in the preliminary objection of the dissident lenders; that is, why isn’t the proposed transaction a sub rosa plan of the kind prohibited under the law of the Second Circuit?
In dancing around this question, Chrysler’s lawyers submit a two-pronged response, arguing that the transaction should be approved because, first, Old Chrysler is receiving "fair consideration" in the transaction and, second, Chrysler’s going concern value will be preserved, jobs will be retained, and an extensive network of independent dealers and suppliers will live to see another day. Chrysler’s opening memorandum of law, however, does not address the important question of why, absent the consent of the dissident lenders, 65% of the equity in New Chrysler should go to junior creditors in satisfaction of their respective claims against Old Chrysler while the claims of senior dissenting lenders go unpaid?
One thing’s for sure, Chrysler’s (and soon GM’s) court battles will afford us a rare opportunity to witness one of bankruptcy law’s most fundamental questions being litigated in the highest stakes battles of all time, that being:
When does the "absolute priority rule" (compare FRB-Cleveland’s strict construction of the rule back in 1996 here with the Administration’s position today), which establishes a hierarchy of recovery rights among creditor classes, take a back seat to the "fresh start," rehabilitative policy of chapter 11?
Chrysler’s opening memorandum touched upon this question by focusing on the US Supreme Court’s classic pronouncement in NLRB v. Bildisco & Bildisco, 465 U.S. 513, 528 (1984), where the Court stated that the "fundamental purpose of reorganization is to prevent the debtor from going into liquidation, with an attendant loss of jobs and possible misuse of economic resources." This principle, Chrysler argues, is paramount and (quoting NY’s judicial patriarch, Bankruptcy Judge Lifland, in the old Eastern Airlines case) "all other bankruptcy policies are subordinated" to it. (Mem. at 4).
Many, however, will surely disagree with Judge Lifland’s statement from 20 years ago that all bankruptcy policies should be subordinated to the reorganization objectives of the Bankruptcy Code. Indeed, even on a very practical level, as the authors of this 1997 article entitled "Chapter 11’s Failure in the Case of Eastern Airlines" note, such a policy is a failure:
Eastern Airlines’ bankruptcy illustrates the devastating effect of court-sponsored asset stripping-using creditors’ collateral to invest in negative net present value "lottery ticket" investments-on firm value. During bankruptcy, Eastern’s value dropped over 50%. We show that a substantial portion of this value decline occurred because an over-protective court insulated Eastern from market forces and allowed value-destroying operations to continue long after it was clear Eastern should be shut down.
Relying on Bildisco to establish an unwavering rule of law is also risky because Supreme Court jurisprudence on bankruptcy matters is anything but a seamless web. Indeed, Ken Klee points out in his remarkable new book, Bankruptcy and the Supreme Court, Justice Rehnquist once wrote to Justice Stevens: "I do not feel that I am qualified to make any sort of exegesis on the meaning of the Bankruptcy Code." (Klee, p. 48).
For those looking for some alternative Supreme Court pronouncements favoring the dissenting lenders, consider Raleigh v. Ill. Dep’t of Rev., 530 U.S. 15, 24-25 (2000) (argued in victory by now Chicago Bankruptcy Judge Ben Goldgar), where the Court stated:
Bankruptcy courts are not authorized in the name of equity to make wholesale substitution of underlying law controlling the validity of creditors’ entitlements, but are limited to what the Bankruptcy Code itself provides.
Consider also these two important pronouncements in Howard Delivery Serv., Inc. v. Zurich American Ins. Co., 547 U.S. 651 (2006) (pdf) (discussed at length in this previous blog post), where Justice Ginsburg, writing for a 6-3 majority, stated:
In holding that claims for workers’ compensation insurance premiums do not qualify for § 507(a)(5) priority, we are mindful that the Bankruptcy Code aims, in the main, to secure equal distribution among creditors. We take into account, as well, the complementary principle that preferential treatment of a class of creditors is in order only when clearly authorized by Congress…. (Id. at 655-56)
[W]e are guided in reaching our decision by the equal distribution objective underlying the Bankruptcy Code, and the corollary principle that provisions allowing preferences must be tightly construed…. Any doubt concerning the appropriate characterization [of a bankruptcy statutory provision] is best resolved in accord with the Bankruptcy Code’s equal distribution aim. We therefore reject the expanded [i.e., "plain meaning"] interpretation Zurich invites. (Id. at 667) (citations omitted).
Let’s also not forget an absolute favorite of Chicago’s Chief Bankruptcy Judge Carol A. Doyle, Northern Pacific Railway Co. v. Boyd, 228 U.S. 482 (1913). There, following the Panic of 1893, shareholders and bondholders combined in a proposed reorganization plan to transfer the debtor’s assets to a new company that they would own, while freezing out the railroad’s general unsecured creditors, whose priority fell between the bondholder and shareholder classes (proving, yet again, that the more things change, the more they really just stay the same). The unsecured creditors argued (much like Chrysler’s dissident lenders today) that the foreclosure sale contemplated by the plan "was the result of a conspiracy between the bondholders and shareholders to exclude general creditors" from the new company. The trial court overruled the unsecured creditors’ objection, holding that (as argued by Chrysler and the Administration today) because the debtor was insolvent and there was no value for unsecured creditors (or in this case, the dissident lenders), the unsecured are entitled to nothing. The Supreme Court, however, reversed in a 5-4 opinion written by Justice Joseph Lamar (see 4/29/1913 NY Times article), in which he stated:
If the value of the road justified the issuance of stock in exchange for old shares, the creditors were entitled to the benefit of that value, whether it was present or prospective, for dividends or only for purposes of control. In either event it was a right of property out of which the creditors were entitled to be paid before the stockholders could retain it for any purpose whatever.
This conclusion does not, as claimed, require the impossible, and make it necessary to pay an unsecured creditor in cash as a condition of stockholders retaining an interest in the reorganized company. His interest can be preserved by the issuance, on equitable terms, of income bonds or preferred stock. If he declines a fair offer, he is left to protect himself as any other creditor of a judgment debtor; and, having refused to come into a just reorganization, could not thereafter be heard in a court of equity to attack it.
Nowadays, collusive efforts to squeeze out the dissenting middle are often called "reverse cramdowns." As noted in this previous blog post, the Third Circuit held that plans proposing such "reverse cramdowns" may violate the so-called "absolute priority rule." More significantly, however, the Second Circuit in Motorola, Inc. v. Official Comm. of Unsecured Creditors (In re Iridium Operating, LLC), 478 F.3d 452 (2007), recently addressed attempts to squeeze out the middle in the context of a settlement that the debtor sought to have approved under Bankruptcy Rule 9019. While the Court in that case approved the settlement, it provided critical guidance in gauging the authority of Judge Gonzalez to approve the proposed "sale" transaction in contravention of the requirements of the absolute priority rule. The court stated:
Motorola claims that a settlement can never be fair and equitable if junior creditors’ claims are satisfied before those of more senior creditors. The phrase "fair and equitable" derives from Section 1129(b)(2)(B)(ii) of the Bankruptcy Code, which describes the conditions under which a plan of reorganization may be approved notwithstanding the objections of an impaired class of creditors, a situation known as a "cramdown."
Although the statute by its terms applies only to plans of reorganization, the Supreme Court has held that a settlement presented for approval as part of a plan of reorganization, because it constitutes part of the plan, may only be approved if it, too, is "fair and equitable" in the sense of conforming to the absolute priority rule. See TMT Trailer Ferry, 390 U.S. at 424 ("The requirements . . . that plans of reorganization be both ‘fair and equitable,’ apply to compromises just as to other aspects of reorganizations."). When a settlement is presented for court approval apart from a reorganization plan, however, the priority rule of 11 U.S.C. § 1129 is not necessarily implicated. Without the requirement that pre-plan settlements conform to the absolute priority rule, only the bankruptcy court’s invocation of Rule 9019 factors would protect the interests of any nonsignatory intermediate or impaired creditors.
In response to this concern, the Fifth Circuit held that the absolute priority rule should also apply to pre-plan settlements, concluding that "a bankruptcy court abuses its discretion in approving a [pre-plan] settlement with a junior creditor unless the court concludes that priority of payment will be respected as to objecting senior creditors." United States v. AWECO, Inc. (In re AWECO, Inc.), 725 F.2d 293, 298 (5th Cir.1984).
The Fifth Circuit accurately captures the potential problem a pre-plan settlement can present for the rule of priority, but, in our view, employs too rigid a test…. Rejection of a per se rule has an unfortunate side effect, however: a heightened risk that the parties to a settlement may engage in improper collusion. Thus, whether a particular settlement’s distribution scheme complies with the Code’s priority scheme must be the most important factor for the bankruptcy court to consider when determining whether a settlement is "fair and equitable" under Rule 9019. The court must be certain that parties to a settlement have not employed a settlement as a means to avoid the priority strictures of the Bankruptcy Code.
In the Chapter 11 context, whether a settlement’s distribution plan complies with the Bankruptcy Code’s priority scheme will often be the dispositive factor. However, where the remaining factors weigh heavily in favor of approving a settlement, the bankruptcy court, in its discretion, could endorse a settlement that does not comply in some minor respects with the priority rule if the parties to the settlement justify, and the reviewing court clearly articulates the reasons for approving, a settlement that deviates from the priority rule. (Emphasis added).
Glaringly absent in Chrysler’s motion in support of the sale is reference to Bankruptcy Rule 9019 as a basis for the relief requested. This could be fatal, since while Section 363(f) permits sales free and clear of liens (but see Judge Markell’s bombshell ruling in PW, LLC), nothing in Section 363 contemplates the kind of restructuring of rights called for by the proposed transaction. Rather, such relief seems better framed as a request for approval of a compromise and settlement under Rule 9019. But, given the seemingly narrow instances in which the Second Circult would authorize a compromise that violates the absolute priority rule, perhaps the omission is intentional. It’s surprising that the dissident lenders didn’t raise this point in their preliminary objection to the sale, but I suspect it won’t be long before they do.
Special thanks to the following sites, some new, some favorites, who linked to previous posts. Thanks for your kind words and links, I already have more page views in the first four days of May than I did in all of April:
Calculated Risk, Volokh Conspiracy, The Wall Street Journal, The WSJ Deal Journal, Truth About Cars, Baseline Scenario, Daily Bankruptcy News (the best daily collection of links to bankruptcy-related stories around), ABI Blog Exchange, Keith Hennessey.com, Credit Slips, Bankruptcy Prof Blog, Infectious Greed, Robert Salomon’s Blog, Seeking Alpha, The Epicurean Dealmaker, Houston’s Clear Thinker, Simoleon Sense, i-Stock Analyst, Fear and Greed, A Clean Slate, Ohio Practical Business Law, Red Lion Reports, Underbelly, Capital Gains and Games, Futronomics, Decline and Fall of Western Civilization, Business Week Business Exchange, But Then What, Reddit Economics, Three Legged Stool, The Smart Globalist, and Red State.
Note: The inset graphic is a marketing poster used to promote "War of Wealth," a play by Charles Turner Dazey that opened on Broadway February 10, 1895 and is favorably reviewed in this February 25, 1895 New York Times artiicle.
© Steve Jakubowski 2009