As readers may know, secured lenders make loans against which specific assets are pledged. For consumers, mortgages and car loans are examples. If you default, the lender can seize the asset and sell it to try to recoup.
In bankruptcy, secured lenders are normally the top of the food chain, but in the Chrysler bankruptcy, the secured lenders failed to reach a deal outside of court (most of the big lenders agreed but a dissident group held out) and the court looks likely to approve a deal that arguable favors the junior creditor over the senior. The synopsis at the Financial Times is fairly typical:
George Schultze will think twice before lending to another troubled company such as Chrysler.
Mr Schultze is one of a group of dissident Chrysler creditors….He rejected an offer aimed at slashing Chrysler’s debt in order to allow the carmaker to be sold.
Mr Schultze and other investors – some of whom claim to have received death threats – say the deal is unfair because it does not honour their rights as senior lenders to get paid before other claims, such as a union benefit plan, are met.
They also argue that the deal was orchestrated by the US government, which held sway over the majority of the other lenders, namely a group of banks, following widespread bail-outs.
The question of whether the Chrysler creditors got a raw deal will be decided in a New York bankruptcy court over the next few weeks.
Already, the verdict on Wall Street and in the conference rooms of investment firms round the country is that, at the very least, the situation raises questions about the solidity of time-honoured lending principles and parts of the bankruptcy code…
“It will increase the cost of credit in the capital markets for lots of companies by tinkering with the well- settled priority system,” Mr Schultze said. “Our firm and many other lenders will think twice about lending to companies who have junior creditors that might get an unfair sweetheart deal.”…
“Given that so much of total borrowing across all asset classes is first lien in nature, the damage that would occur to the economy as a result of higher first lien borrowing costs resulting from lenders requiring a higher return to compensate them for an unknown interpretation of claim priorities could be substantial,” says Curtis Arledge, co-head of US fixed income at BlackRock, Inc. “Many lenders make loans by being investors in US financial markets where contract law has been sacrosanct, and deviation from that could have far-reaching implications to the US economy.”….
“It is particularly important at this stage of the distressed cycle for lenders to have confidence in pre-existing contracts and rules. We are entering a period of record corporate defaults and the need for bankruptcy financing and financing for distressed companies will only continue to grow,” says Greg Peters, global head of credit research at Morgan Stanley….
Investors, including hedge funds, began purchasing loans over the past decade. Previously, this arena was dominated by banks. Either way, the buyer accepts a lower interest rate for the perceived safety of the senior claim on assets.
The fear is that investors will demand a premium for senior debt such as loans, prompting a repricing of unsecured debt and general rise in the cost of borrowing.
“The financial interests of investors may conflict with what the government is trying to do from a social perspective,” says Steve Persky, managing director of Dalton Investors, a Los Angeles-based hedge fund that specialises in distressed debt…
And, in a downturn, lenders facing losses often say they will get tough and demand higher interest payments to compensate for risk. What is unique in this cycle is the new focus on the government’s role.
“Now there is a new risk: government intervention risk,” Mr Persky says. ”And it is very hard to hedge.”
Notice that everyone who is complaining is an investor. Not a single lawyer weighed in.
Now I am most decidedly not an attorney, and would welcome input from anyone who knows the bankruptcy code. I had thought that the deal depended on the use of Section 363, which is seldom used in Chapter 11. I have seen it argued that relying on Section 363 in Chapter 11 would gut a lot of existing bankruptcy practice and a judge would be cautious about using it. The flip side is that Chrysler may have been designed in such a way that this is considered to be a narrow application and does not set a broad precedent. It was used in Lehman, but Lehman was effectively a liquidation.
The folks at Credit Slips (and these are bankruptcy experts) aren’t troubled and argue the press has it wrong, Stephen Lubben notes:
I think these commentators have misunderstood the structure of the sale, no doubt in part because the overall structure of the deal has been somewhat “over-described.” There are obvious political reasons for this – in particular, the Administration needs to present a complete story of how Chrysler’s employees will keep their jobs when the dust settles. There is also a general lack of chapter 11 understanding among both politicians and the press.
As I comprehend the sale structure, based on the pleadings filed late Sunday, the debtor will transfer key assets and contracts to a new Delaware LLC in exchange for $2 billion in cash and various cure payments. As part of the deal, the new owner (the Delaware LLC) will assume some contracts, including the labor agreements.
The last piece of this does technically violate the absolute priority rule, but in a way that is mandated by the Bankruptcy Code. Contract counterparties always get their prepetition claims paid in full when their contracts are assumed and assigned in a §363 sale. §365(b)(1).
The sale will be free and clear under §363(f)(3), using the argument that “value” in that provision means economic value. Reasonable parties can disagree on that point. But notice that if the dissenting lenders win on the (f)(3) argument it does not necessarily stop the sale, rather it probably just means that the sale price gets lowered (because of the increased risk for the buyer). Also keep in mind that the objecting creditors would seem to have the burden of proof here. §363(p)(2).
I don’t see how (a) the new owner’s renegotiation of the labor agreement or (b) the distribution of ownership interests in the new owner are issues for the bankruptcy court to approve.
He does raise an issue in a later post:
I think that many of the arguments advanced against the Chrysler sale motion are largely noise, generated by confusion over the structure of the deal. But I also mentioned that one real problem I see here turns on the dissenting lenders’ apparent inability to credit bid.
The Bankruptcy Code expressly recognizes the right of a secured creditor to “credit bid” its claim in a §363 sale, just as a home lender can bid the value of its mortgage in a state foreclosure sale. § 363(k).
Thus, if the debtor moves to sell its assets worth $100 in a 363 sale, the bank with a $40 lien on the assets can bid “$40” and offset its secured claim against the bid, meaning that the bank only has to pay cash for the debtor’s assets if the auction price goes above $40.
Thus, if Chrysler were a typical chapter 11 case, the senior lending group would be able to credit bid up to $6.9 billion for the debtor’s assets. If the lenders won the auction, they could then sell the assets to Fiat or anyone else.
Here the lenders (as a group) decided to forgo their right to credit bid and instead accept $2 billion in cash. The offer was at one point raised to $2.2 billion, but that has apparently been taken off the table since Chrysler entered chapter 11.
Normally I’d say that the lenders’ decision to take the $2 billion was a strong indication that they expected Chrysler’s assets to sell for a price less than or equal to that amount, mooting their need to credit bid. But in this case the decision to take the $2 billion offer is being driven by the largest lenders, all of whom are to some degree under the control of the Treasury Department…..
I think we have to concede that this control, and the conflict it creates, and the President’s decision to publicly scold the dissenting senior lenders has tainted this process, making it unlike a normal chapter 11 case. The decision to scold the dissenting lenders – perhaps driven by the lenders somewhat juvenile press release – is perplexing, since it seems to blame them for a chapter 11 case that I believe would have happened anyway. Moreover, holdouts are a fact of life in workouts and chapter 11 cases – the trick is to figure out how to deal with them…..
The real issue is how much do we believe all this has tainted the process. In this case, you could argue that the Fiat price would be so low without the union agreement that the secureds are getting the same or even a higher recovery on an absolute basis. But we’ll never know for sure and in that sense the process is tainted, and I think this is not harmless. Future hedge funds may pay lower prices to buy distressed debt in large companies like Chrysler and future secured lenders may therefore require higher interest rates from borrowers. Moreover, the global story that we tell about the benefits of having a system like chapter 11 is diminished by this case.
If Chrysler were a one-off, this would not matter much, but the fact that GM now looks almost certain to file for bankruptcy and Section 363 is expected to be used again makes this much more nervous-making for lenders and investors. Indeed, Lubben suggests that the reason the deal was done this way was that Chrysler entered bankruptcy late in the process. That also will prove true for many cov-lite deals, since the absence of many normal covenants means lenders cannot force a restructuring or BK filing while the company is only in moderately bad shape (or is a decent company simply suffering from too much debt). We’ll see in due course how big an issue this becomes.
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So I think the argument that the lawyer is making is that the labor unions are not junior creditors, but rather key vendors in the surviving entity, which must have priority over senior creditors. That makes sense to me legally and logically.
Also, the government is a party in this, and government action risk is real during crisis. That may seem like a precedent, but I doubt it is. I don’t see judges citing japanese internment to justify guantanamo, and I see politicians leaving the stage as quickly as they can after the embers cool.
The labor argument doesn’t make sense. As Ron Gettlefinger himself has made clear, the UAW as representative of the labor force and the UAW VEBA are different things.
The VEBA is a trust whose mandate is paying for retiree health care. It does not provide an ongoing service to Chrysler. Its obligations could be discharged with a cash payment from Chrysler. It is no different from any other unsecured lender; if it makes you imagine it better, think of CalPERS holding that security.
The terms of the deal involve the VEBA exchanging its interest in Old Chrysler for an interest in New Chrysler. It’s a pretty clear case of the most senior lender (UST as DIP provider) teaming up with the most junior remaining claimant (VEBA) to screw the middle guy by asset stripping the very security that supports the middle guy’s claims.
You could make the separate argument that the senior secured voted to accept the agreement. Curiously, that’s not what the actual filings argue, however, and I wonder if a reasonable position might not be that all of the TARP entities are under the common control of UST. Certainly if Hank Paulson was able to allege in the run-up to BAC/MER that he could fire the board and management of BAC, it must be the case that Geithner has effective control over the banks and the non-TARP lenders should constitute a separate class.
We abandon the rule of law at our peril:
http://tauntermedia.com/2009/05/04/chrysler/
As noted this is posturing by the investment class, who have to bring in the $750-$1000 / hr BK lawyers when their loan bets go bad. 363 sales are not uncommon, and in fact is preferable in many circumstances.
While this is no place to undertake all the permutations of the choices one makes in navigating through an 11 proceeding, because each one is case specific, a 363 sale is more likely if one has insufficient cash flow to handle regular operations (as measured by EBITDA), but which could be corrected by contract restructuring and forced shedding of unprofitable lines, as opposed to a company that is simply overleveraged and can’t cover debt service. The nice thing about 363 is the “free and clear” of liens and encumbrances and the assume and assign on contracts. To the latter point, you take the contracts you want (without any changes and they have to be made current) and everything else you reject, and that rejected goes into the unsecured bucket – not a good pace to be – which of course give the 363 buyer tremendous power to renegotiate rejected contracts.
The big problem with credit bids, is Senior Lenders, as a triuism, don’t have a clue as to how to run the business, and even more typically have vastly unreasonable expectations as to the value of the collateral – at that moment in time. Once in the process, they are forced to realize, that their credit bidding in a 363 will likely result in a Chap 7 filing say a year down the road, because they’ll screw it up.
One other quick point, since the USG is effectively providing the DIP financing, and since there is no other DIP funding source available, and even if there were a new DIP facility would need to take the USG out, if the Govt refuses to fund, the 11 will get converted to 7.
Then the Seniors will be looking at 5-10 cents on the dollar, not 30.
In most BKs that get to this point, it takes the Seniors 9-12 months to realize that (after many many fees). The USG is just making them realize it a little faster.
I wonder why we never had a law prohibiting companies from subordinating their employee benefits to other creditors. The time to go into bankruptcy would be when you can no longer affordably finance operations without putting creditors in line in front of employees. It’s a dead issue now, I suppose, since pensions and employee benefits are rapidly becoming extinct. But who knows what could have been? Maybe the under-40 set would still have pensions, etc?
In all of this discussion of the Chrysler deal, I am uncertain about some fairly basic things. Could someone fill me in?
1. Now that Chrysler is in bankrupcy, do those bondholders who “accepted” the offered deal still get that deal? Or, does everyone just start over in bankrupcy court? Or, something else?
2. What is the role of bond insurance (CDSs) in motivating the bond holders? If the bond holders are insured (or over-insured) will that affect their decision to accept or reject the offer? Was payment on CDSs predicated on bankrupcy? Or, do they pay out when creditors accept less than
full value? Suppose all had creditors voluntarily accepted the deal?
The following conversation claims to be from a lawyer:
http://www.economicpolicyjournal.com/2009/05/it-seems-like-chrysler-is-just-vehicle.htmlThe money the administration is throwing at labor unions’ unsecured debt via the Chrysler bankruptcy seems very odd to me.
I find it astonishing that one can, with a straight face, complain about a tiny bailout for labor in the face of this elephantine bailout for bankers. Seriously, I know the issues are the same, but should even a few seconds be devoted to this bailout rather than the one that is really impoverishing us?
And I think it’s really cute to distinguish the UAW VEBA from UAW. I doubt the people who actually get up every day and work for Chrysler and expect their benefits to actually be paid someday see the issue as clearly as others do. There’s a lot of complexity in the rule of law, not just the fair treatment of past actions but also creating the proper incentives for future action. Have you even taken a course in Torts? Do you understand the genesis of the rules about negligence?
If anyone thinks having the employees feel that their benefits are not secure going forward is not a “vendor” issue, then I don’t even know what to tell you.
My reaction to all the bondholder whining is who elected them pope? They made stupid bets but they seem to think that, being bondholders, this fact should exempt them from the stupidity of their decisions.
This whole lending at lower costs because of the “perceived” safety of the lendee is really a lot of hooey. They lent on the upside of a very large and very visible investment bubble. The downside correction (across markets) should have been part of their calculus.
I simply do not understand why bondholders are sacred in all of this, except as a political ploy. Homeowners have been creamed, banks have been turned into zombies, investors have been hit hard or wiped out, workers have lost jobs or forced into givebacks, the government has laid out incomprehensible amounts of money, but only two groups pretend they are above it all: CEOs and bondholders. I think they should be getting their hair cut along with everyone else.
As for incrreased costs of lending, dah. Even with a return to normal, pre-bubble lending borrowing costs should rise from their Greenspanian easy money lows.
Anonymous Jones,
We are in total agreement that the elaphantine banker bailouts are an atrocity.
I am not a lawyer. Nor am I a tort expert. What do you want me to know?
Why use junior debt to fund benefits? It seems like the labor unions and Chrysler would have avoided these problems by using secured debt.
I do sympathize with the workers and their pensions, but since they did not use secured debt, screwing the secured creditors does not seem like an immediately obvious choice to me.
Why should employees consider their benefits secure? The company is the one providing those benefits, and paying this — along with a cacophony of other mistakes — pushed the company into bankruptcy.
This crisis wrecked the retirement planning for millions of families in the United States. Why single out people associated with labor unions for special treatment with dubious legality?
I have serious concerns about the viability of the employer-funded pension model. I assume the goal for more people is to protect the people reliant on those pensions, rather than the pensions themselves. Is there another way to accomplish the former goal without peverting the meaning of senior debt?
Hugh,
The question I would ask: why are junior bondholders more sacred than senior bondholders?
Erick,
My response would be, why do any of these guys think they or their interests are sacred?
There has been a system wide meltdown. Why do only certain very specific niches maintain the fiction that for them it should be business as usual?
Normally I would agree with Mr. Schultze in this matter, however, I happen to know that Mr. Schultze is personally full of crap. This is the same bozo who purchased Tweeter Electronics out of a chapter 11 bankruptcy, and then single handedly screwed over Tweeter customers and employees by mangling bankruptcy law to his favor. He scammed unwitting customers out of 3 million dollars in cash deposits that were held, then sold their merchandise out from under them to double his money. Then before the bk hit, he paid his largest creditors with this money. Then conveniently, he filed the bk, and WHOOPS, so sorry Mr customer, you are out of luck getting your money back..go stand in line for the courts to pay you NOTHING!! BOO FREAKING HOO Mr. Schultze….life isnt fair, and you have no business preaching about fairness. Someone should do a simple google search on this fools past before quoting him as an expert.
Hugh,
What are the the characteristics of “these guys”?
I understand Yves’ complaint: that many of the creditors are big banks and other financial institutions. They receive grotesquely subsidized credit lines from the government. These players can only afford to own the debt because that subsidy. Therefore it is unethical for these government-subsidized players to dictate bankruptcy terms to the government.
I fully agree that this is a problem. I applaud Yves’ commitment to exposing it for her readers like myself. My worry is that we will consider only the subsidized players. Are all of Chrysler’s creditors a homogeneous entity with these characteristics?
My vague understanding is that those complaining the loudest received the smallest, if any, government assistance. Do you know whether this true?
My concern is that the administration is adding ever greater subsidies as time passes. I also think rewarding failure is a bad idea. The current plan rewards the union leadership who negotiated their members’ employers into bankruptcy. Why hand these people the keys to those very institutions? We all recognize that this is a bad idea for bank executives. How is this suddenly a good idea for union leadership?
typo in an great article
“woudl be cautous”
@ Erick – “I also think rewarding failure is a bad idea. The current plan rewards the union leadership who negotiated their members’ employers into bankruptcy. Why hand these people the keys to those very institutions? We all recognize that this is a bad idea for bank executives. How is this suddenly a good idea for union leadership?”
You are forgetting that management is also to blame for shoddy design and failing to adapt to the times. The union is partly to blame, but the blame is not solely theirs. The management could have gone to the mat over union benefits many times, and in the last 30 years would have won. Their failure to attempt to modify the terms earlier, or to modify their designs in the face of early pressure from the “New Domestics” was a large part of their downfall.
I am curious as to why this LLC was formed in Delaware? Isn’t Chrysler incorporated in Michigan? Is this just more tax-dodging?
@William,
Management failed royally at these companies. You are 100% right. Their shareholders are paying the price. So are thousands of laid off union members.
The interests suffering least? Large, subsidized banks and leadership at Chrysler and unions like UAW.
Why am I supposed to cheer the plan’s impact on the normal people? People who do not have intimate connections with DC and/or Wall St: the common shareholder, small investor, factory worker or federal taxpayer…
Erick,
the idea that unions did in the automakers is a very old canard. The $75 an hour malarkey is precisely that. There isn’t much difference, and hasn’t been for a few years, between what union and non-union autoworkers make. The principal difference occurs around the legacy costs of pensions which the transplants coming much later never incurred.
American automakers dillydallied, played games, and were effectively done in first by Wall Street’s manipulation of oil prices last year and then their financial meltdown this year. Face even a well run company like Toyota is hurting in this environment.
I think too you have to look at the economics of all this. Autoworker jobs are really a Keynesian imperative. Keep them employed. If anyone wants to and can find the financing, let them buy their products. So much the better although it isn’t particularly important if this happens at the moment.
There is no similar Keynesian argument that I know of that can be made for bondholders. They belong to a paper economy that has created great destruction of wealth and just is not productive in any real world sense. Money that goes to them is not stimulative. It’s wasted.
I would agree with you that there is unfairness in the government’s approach. But this is not because bondholders are taking a hit but because the government is not responding to a systemic crisis in a systemic way. If it were, lots of people would still be getting burned but at least something would be accomplished.
@Hugh,
Both you and Yves have been very critical of the administration’s apparent fear of bondholders. I am in full agreement: creditors who financed the boom in inservicable debt deserve to find large losses on their principal.
Debt prevents prices from falling to what the (increasingly small) fraction of people and businesses not on government live support can afford to pay. There is too much debt to repay; the most ethical way to resolve this is to assist the process through which people default on that debt.
If we are in agreement here, what is the rationale for using taxpayer dollars/credit to bail out the UAW’s unsecured bonds?
How is bailing out the unsecured bondholders and UAW leadership more effective or ethical than simply wiping them out and assisting the pensioners directly?
Autoworker jobs are really a Keynesian imperative. Keep them employedI agree that employment is very important. I want to see more doctors, electric car manufacturers and teachers. I also want to keep my sources of income.
I do not love my job so much that I will do it for free. How about you? People rarely do because that employment is merely a means to accomplish other ends: retiring, sending the kids to college, buying that shiny new computer…
If this were not the case and employment was an ends by itself then the solution is easy: dig holes and fill them up.
Unfortunately this cannot work: no one would be making food. Everyone will starve.
So how does society choose the right things to do?
Robert Barro provides evidence suggests that the multipler effect of stimulus spending is always less than one. This means there is always a finite amount of available capital at any given time. That makes logical sense to me.
Unless someone wants to argue that is an infinite amount of capital, we are constrained in our production. We must choose what to produce and this amount of production is forever finite.
Therefore, directing capital at failed automobile organizations in Detroit is capital unavailable to the electric-car startup or health care provider.
Some argue that we still have a functioning automobile industry: in the southeastern United States.
I am no expert on this last claim, but it does not seem immediately obvious to me how taking away capital from universities, hospitals, an electric car companies helps create more of their products.
“Robert Barro provides evidence suggests that the multipler effect of stimulus spending is always less than one.”
That’s an oxymoron. If stimulus spending’s multiplier effect were less than one it wouldn’t be stimulative. This flies in the face of our experience with Keynesian economics and common sense.
Barro’s argument sounds like that of a typical contrarian. The problem is that his argument is too powerful for his point. If spending really wasn’t stimulative, then how could an economy ever grow? Spending is demand. If you contract demand, you contract your economy. Barro sounds like one of the economists whose stupid ideas got us into this mess. I must admit I am tired of economists who gave intellectual cover for this disaster and who continue to tell me not to believe my lying eyes.
You also use strawmen. I am certainly not saying that no one should grow food. My point is that we have to look at the macro-economics and if that means keeping some people less than fully productively employed (so as to improve the demand side) that’s preferable to seeing the whole economy go splat.
Similarly, with the auto industry, cars that are more fuel efficient with a smaller carbon footprint are great but it is going to take a while to get there from here. And if we let the auto industry fail, then that will never happen at all. Not to mention, sinking the economy further into depression in the process.
Parenthetically, if want smaller greener more fuel efficient cars, we have to set up the conditions that would favor them. This means increasing CAFE standards, tailoring them more specifically to models, maybe giving some tax breaks to small car buyers, and taxing the hell out of large gas guzzlers. Although I do not like its regressivity, a gas tax might be needed as well but I would try these other things first.
In addition to Hugh’s last comment, the market currently does not account for externalities such as carbon dioxide production from processes, the social costs from poor health care and inadequate education (In SC it is “Minimally Adequate” in the state constitution) These skew the market and fear of actually having to account for them are the reason you see the arguments about capital usage.
The economy has shrunk, and the equipment and people are still there, just under utilized without the capital because of the distrust. During WWII, the market expanded back to existing production and then some on the back of the government. (Contrary to Amity Shales) If growth is the driver of the economy, when businesses and those who hold the capital won’t spend (ie – scared consumers, myself included) the whole point of stimulus is to prime the pump again. What is happening now is a mix of supply side and Keynesian economics. It is neither black nor white which must be scary to some, but economics, like life is also a gray area.