Bankruptcy in the News

[Part I: Assessing the Financial Carnage; Part II – Testing the Limits of Section 363 Sales]

[6/09/09 UpdateSee also my analysis of the Chrysler Sale Opinion (Part I) and (Part II).]

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:

Continue Reading Chrysler Bankruptcy Analysis – Part III: Will The “Absolute Priority Rule” Kill The Sale?

[Part I: Assessing the Financial Carnage; Part III: Will the Absolute Priority Rule Kill the Sale?]

[6/09/09 UpdateSee also my analysis of the Chrysler Sale Opinion (Part I) and (Part II).]

"Be careful what you wish for," the old saying goes, and so too for those who wished for Chrysler to file for bankruptcy in order to achieve their objectives.  Chrysler and all its major constituents will argue that the house is on fire and absent a quick sale on the agreed-upon terms (well summarized in this Treasury release), asset values (whatever’s left of them) will be irrevocably destroyed.  The dissident lenders will argue that the fire is an ingenious illusion meant to force them to accept a deal that denies them their first priority rights to Chrysler’s assets and is merely a disguised plan of reorganization that a Court has no authority to approve in the 363 sale context.

So what’s the risk for the proponents of the sale?  As Chrysler’s own counsel at Jones Day wrote in this 2002 publication:

[U]nder certain circumstances a debtor may sell all or substantially all of its assets without making the sale part of a plan of reorganization. Where a chapter 11 debtor proposes to sell its assets or business "outside of a plan of reorganization," creditors are entitled to notice of the sale and an opportunity to voice any objections they may have with the court. However, the sale will not be subject to the same creditor disclosure and voting rights attendant to a sale as part of a plan of reorganization. Moreover, the proposed sale will be subject to the less exacting "business judgment" standard of review. For this reason, some courts refuse to approve a proposed sale outside of a plan of reorganization if it appears that the transaction is really a "sub rosa" or "de facto" plan because the terms of the sale will necessarily dictate the provisions of any future plan.

You don’t have to be a bankruptcy maven to see from the face of the term sheet that the proposed sale dictates the provisions of a future plan of reorganization and sure has the feel of a "sub rosa" or "de facto" plan under which:

  • Lenders with a first priority interest in Chrysler’s assets will receive $2 billion, nothing more.
  • The junior VEBA claimants will receive a $4.6 billion note payable over 13 years at a 9% rate of interest and additionally will receive 55% of the equity of New Chrysler.
  • Unsecured trade payables of about $1.5 billion get paid in full.
  • The US Treasury will receive 8% of the equity of New Chrysler as repayment of its $4 billion junior TARP loan while the Canadian government gets a 2% stake for its junior loans.

What’s the governing law?  Well, since the case was filed in New York, the law of the Second Circuit Court of Appeals applies.  The latest pronouncement from the Second Circuit on whether 363 sales are disguised "sub rosa" plans came in Motorola, Inc. v. Official Comm. of Unsecured Creditors, 478 F.3d 452 (2007), where the Court wrote:

The trustee is prohibited from such use, sale or lease if it would amount to a "sub rosa" plan of reorganization.  The reason "sub rosa" plans are prohibited is based on a fear that a debtor-in-possession will enter into transactions that will, in effect, “short circuit the requirements of [C]hapter 11 for confirmation of a reorganization plan.”  Pension Benefit Guar. Corp. v. Braniff Airways, Inc. (In re Braniff Airways, Inc.), 700 F.2d 935, 940 (5th Cir. 1983).  In this Circuit, the sale of an asset of the estate under § 363(b) is permissible if the “judge determining [the] § 363(b) application expressly find[s] from the evidence presented before [him or her] at the hearing [that there is] a good business reason to grant such an application.”  Comm. of Equity Sec. Holders v. Lionel Corp. (In re Lionel Corp.), 722 F.2d 1063, 1071 (2d Cir. 1983).

The Court noted in a footnote a "number of factors that a judge might consider when determining whether there is a ‘business justification’ for the asset’s sale."  These factors include, but are not limited to, the following:

Continue Reading Chrysler Files Bankruptcy – Part II: Testing The Limits Of Section 363 Sales

[Part II – Testing the Limits of Section 363 Sales; Part III: Will the Absolute Priority Rule Kill the Sale?]

[6/09/09 UpdateSee also my analysis of the Chrysler Sale Opinion (Part I) and (Part II).]

And so, with these fighting words by President Obama, Chrysler files for bankruptcy in the Bankruptcy Court for the Southern District of New York.  Clearly, we’re in uncharted waters as never has the Office of the President become so engaged in the restructuring of America’s largest businesses.  In supporting Chrysler’s filing, a visibly angry President Obama came out swinging, stating:

A group of investment firms and hedge funds decided to hold out for the prospect of an unjustified taxpayer-funded bailout. I don’t stand with those who held out when everyone else is making sacrifices. They were hoping that everybody else would make sacrifices and they would have to make none. We will use the bankruptcy laws to clear away remaining obligations. It will be designed to deal with the last remaining holdouts. It was unacceptable to let a small group of speculators endanger Chrysler’s future by refusing to sacrifice like everyone else.

For his part, Congressman John Dingell, the longest serving member of the House, promised that “[t]he rogue hedge funds that refused to agree to a fair offer to exchange debt for cash from the U.S. Treasury – firms I label as the ‘vultures’ – will now be dealt with accordingly in court."

The secured debt holdouts didn’t see things quite the same, obviously, and issued this statement justifying their holdout, saying:

[W]e offered to take a 40 percent haircut even though some groups lower down in the legal priority chain in Chrysler debt were being given recoveries of up to 50 percent or more and being allowed to take out billions of dollars. In contrast, over at General Motors, senior secured lenders are being left unimpaired with 100 percent recoveries, while even G.M.’s unsecured bondholders are receiving a far better recovery than we are as Chrysler’s first lien secured lenders. We have a fiduciary responsibility to all those teachers, pensioners, retirees and others who have entrusted their money to us. We are legally bound to protect their interests. Much as we empathize with Chrysler’s other stakeholders, the capital is just not ours to contribute to their cause by accepting a deal that is outside the well-established legal framework and cannot be rationalized as being commercially reasonable.

So the petition is now filed.  Let’s examine the carnage:

Continue Reading Chrysler Files Bankruptcy – Part I: Assessing The Financial Carnage

9/22/08 UpdateHere’s the final complete Asset Purchase Agreement (including First Amendment and Clarification Letter).  Also, this notice of appeal was filed by Bay Harbour Management and others.  Here and here are the best news reports I’ve seen describing the surreal hearing.

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Just after midnight early today, Judge Peck entered