Chrysler and the Absolute Priority Rule

The bankruptcy process is, from a procedural standpoint, solely a function of federal law. One aspect of the the federal bankruptcy law applicable to chapter 11 bankruptcies is the absolute priority rule, codified at 11 USC 1129(b)(2). Essentially, the absolute priority rule requires that secured creditors (loans made to company secured by assets of company) and senior unsecured creditors (unsecured lines of credit, trade claims, etc.) will be paid 100% of their claims before equity (company investors and management) receive anything. The article below questions whether the absolute priority rule should be applicable to the chapter 11 reorganization of Chrysler. tom Lauria, lawyer for secured and senior creditors of Chrysler is asserting that his clients must be paid in full before equity can receive anything, fully in accordance with the absolute priority rule. Judge Gonzalez, who oversaw the Enron and WorldCom bankruptcies, has developed a reputation as a debtor-friendly judge, meaning that in some cases, the rules (and creditors) be damned. While it perhaps morally pleasant that a judge would invoke equitable concerns (people will lose their jobs and retirements) over of the commandments of the law, such a tack provides no assurance that creditors who extend funds to a debtor under the premise that the creditors' rights will be protected by law. Moreover, one can easily presume the retirees of WorldCom and Enron would have liked a piece of their reorganized companies, instead of getting the jack squat they received. Where were you then, Judge Gonzalez?

"What's Good for Chrysler..."

By Harold Meyerson
www.washingtonpost.com
Wednesday, May 6, 2009


There's creative destruction -- economist Joseph Schumpeter's term for the normal churnings of capitalism -- and then there's destructive destruction. Anyone interested in the latter should pay close attention to the arguments being made in federal bankruptcy court by attorneys for the hedge funds that held out for more in the Chrysler bankruptcy deal.

Thomas Lauria, who represents those funds, argued Monday that the court should block the federal bridge loan that will keep Chrysler afloat during the bankruptcy proceedings. As Judge Arthur Gonzalez noted in denying Lauria's request, blocking the loan would force Chrysler (and, he could have added, many of its suppliers and dealers) to liquidate -- throwing tens (perhaps hundreds) of thousands of Americans out of work during the most serious recession since the 1930s and terminating medical benefits to tens of thousands of Chrysler retirees. Liquidation would also compel the American public to write off the loans the government has made to the company, rather than become shareholders in the slimmed-down Chrysler, as the Treasury's plan suggests.

But the public, the retirees, the dealers, the suppliers and the workers be damned. Liquidation is what the hedge funds want, on the theory that they could realize more than what the Treasury's plan offered them, from the sale of -- well, it's not clear what they think Chrysler can sell off at a decent price. Old auto factories in Michigan and Indiana? Who would buy them? To what end?

If the hedge funds are standing on principle, it's the principle that holders of secured debt should always have first claim to a bankrupt company's assets. But if they thought the administration would honor their claims above those of the public and other Chrysler stakeholders, they didn't do their due diligence about the Treasury officials who are in charge of restructuring the auto industry. In particular, they missed a 2006 speech delivered to a group of investors by Ron Bloom, the onetime investment banker who left Wall Street for the Steelworkers union, which he represented in scores of steel company restructurings, and whom President Obama tapped, along with Steve Rattner, to head up the administration's auto task force.

The banks and bondholders that lend companies money, Bloom said, constantly track the value of the bonds they hold, which enables "those who like the risk-reward ratio to take it and those who don't to liquidate their position and move on." Compare that, Bloom went on, to the position of retirees who deferred wage claims so that they could have a pension and medical benefits in retirement. If the company can't honor those claims, the retiree, unlike the bondholder, can't "take the company's promise, convert it to its present value and sell it to someone who would like to own it."

The Treasury's plan for Chrysler, and its proposed plan for General Motors, gives those retirees stock in the company -- the only way to keep afloat their otherwise unredeemable investment in Chrysler (that is, their medical benefits). It gives the public a stake in the company in return for its loans. It scraps the old management and board of directors, and downsizes the company to a point where the government believes it can become profitable again. It requires that 40 percent of Chrysler's production be performed in the United States -- a perfectly sensible, if groundbreaking, condition from a government that is committed to preserving and boosting domestic manufacturing.

In other words, the Treasury's approach to the auto industry is equitable, responsible to taxpayers and economically sensible. It is also, in almost every particular, the diametric opposite of its approach to the banks. In return for its major loans to floundering auto companies too big and strategic to be allowed to go under, the Treasury opted for a structured bankruptcy, converting its loans to shares, ousting top executives, shrinking the companies. In return for its mega-loans to floundering banks that were also too big and strategic to fail, the Treasury has not opted for structured bankruptcy, has not converted its loans into shares, has not forced out top executives, has not moved to make banks smaller (save in its proposal to limit leverage). Indeed, its bailout of AIG rewarded bondholders such as Goldman Sachs to the detriment of everyone else.

Why the difference? Why compel the restructuring of one crucial industry and leave another, whose mismanagement all but brought down the world economy, basically untouched? Could it be that the leaders and folkways of American banking are familiar to the men who run the Treasury, while the leaders and folkways of the American auto industry are not -- meaning that they can assess Detroit more dispassionately than they can Wall Street? In short, where is the Treasury's Ron Bloom for banking?