The bankruptcy blogosphere is replete with commentary on Chrysler LLC’s sale, through Section 363 of the Bankruptcy Code, to a newly-formed entity. The sale, of substantially all of Chrysler’s assets for $2 billion, gave secured creditors an estimated $0.29 on the dollar. Other, unsecured creditors received more. Though challenged, the sale ultimately received the 2d Circuit’s approval in a decision issued August 5.
Was the Chrysler sale proper? Or did it constitute an inappropriate “end run” around the reorganization provisions that ordinarily apply in a confirmed Chapter 11 plan?
Harvard Law’s Mark Roe and Penn Law’s David Skeel tackle this question in a paper released earlier this month entitled “Assessing the Chrysler Bankruptcy.” Roe and Skeel argue, in essence, that there was no way to tell whether or not the sale was proper because the sale lacked valuation, an arm’s length settlement, or a genuine market test (i.e., an auction) – all traditional measures of whether or not secured creditors received appropriate value for their collateral. They then suggest that the Chrysler transaction may portend a return of sorts to the equitable receiverships used to reorganize the nation’s railroads at the end of the ninenteenth century.
Roe and Skeel follow two fundamental strands of thought.
First, they review the basic facts of the Chrysler sale against the context of other so-called “363 sales” and ask where Chrysler fits within this context.
Their answer is that it really doesn’t fit.
Most complex bankruptcy sales (i.e., sales that effectively determine priorities and terms that the Code is structured to determine under Section 1129) are insulated from running afoul of the Code’s reorganization provisions through judicial innovations such as expert valuations or priority determinations, creditor consents, or competitive auctions. According to Roe and Skeel, the Chrysler sale had none of these. Instead,
“[Chrysler's] sale determined the core of the reorganization, but without adequately valuing the firm via [Section] 1129(b), without adequately structuring a . . . bargain [with creditors or classes of creditors], and without adequately market testing the sale itself. Although the bankruptcy court emphasized an emergency quality to the need to act quickly . . . there was no immediate emergency. Chrysler’s business posture in early June did not give the court an unlimited amount of time to reorganize, but it gave the court weeks to sort out priorities, even if in a makeshift way.”
How was the Chrysler sale deficient in these respects?
Though it involved a valuation presented by Chrysler, “the court did not give the objecting creditors time to present an alternative valuation from their experts . . . . Here, the judge saw evidence from only one side’s experts.”
For those who may protest that the Chrysler sale did, indeed, enjoy the consent of Chrysler’s secured lenders, Roe and Skeel argue that the largest of these lenders were beholden to the U.S. Treasury and to the Federal Reserve – not only as regulators, but as key patrons via the federal government’s rescue program. They were, therefore, willing to “go along with the program” – and the Bankruptcy Court was inclined to use their consent to overrule other objections from lenders not so well situtated. On this basis, Roe and Skeel contend that the secured lenders’ “consent” – such as it may have been – wasn’t independent “consent” at all.
Roe and Skeel also point out that the “market test” proposed as a means of validating the sale was, in fact, not a test of Chrysler’s assets, but of the proposed sale: “There was a market test of the Chrysler [sale], but unfortunately, it was a test that no one could believe adequately revealed Chrysler’s underlying value, as what was put to market was the . . . [sale] itself.”
The authors then go on to argue that the sale was mere pretense – and that, in fact, “there was no real sale [of Chrysler], . . . at its core Chrysler was a reorganization”:
“Consider a spectrum. At one end, the old firm is sold for cash through a straight-forward, arms-length sale to an unaffiliated buyer. It’s a prime candidate to be a legitimate [Section] 363 sale. At the other end, the firm is transferred to insider creditors who obtain control; no substantial third-party comes in; and the new owners are drawn from the old creditors. That’s not a [Section] 363 sale; it’s a reorganization that needs to comply with [Section] 1129.
. . . .
[To determine where a proposed sale falls along this spectrum,] [a] rough rule of thumb for the court to start with is this stark, two-prong test: If the post-transaction capital structure contains a majority of creditors and owners who had constituted more than half of the old company’s balance sheet, while the transfer leaves significant creditor layers behind, and if a majority of the equity in the purportedly acquiring firm was in the old capital structure, then the transaction must be presumed to be a reorganization, not a bona fide sale. In Chrysler, nearly 80% of the creditors in the new capital structure were from the old one and more than half of the new equity was not held by an arms-length purchaser, but by the old creditors. Chrysler was reorganized, not sold.”
Was the Chrysler transaction – however it may be called – simply a necessary expedient, borne of the unique economic circumtsances and policy concerns confronting the federal government during the summer of 2009?
Roe and Skeel argue that, in fact, the government could have acted differently: It could have picked up some of Chrysler’s unsecured obligations (i.e., its retiree obligations) separately. It could have offered the significant subsidies contemplated by the deal to qualified bidders rather than to Chrysler. It could even have paid off all of Chrysler’s creditors in full. But it did none of this.
Second, Roe and Skeel consider that “[t]he deal structure Chrysler used does not need the government’s involvement or a national industry in economic crisis.” Indeed, it has already been offered as precedent for proposed sales in the Delphi and Phoenix Coyotes NHL team bankruptcies – and, of course, in the subsequent GM case.
One very recent case in which South Bay Law Firm represented a significant trade creditor involved a similar acquisition structure, with an insider- and management-affiliated acquirer purchasing secured debt at a significant discount, advancing modest cash through a DIP facility to a struggling retailer, and proposing to transition significant trade debt to the purchasing entity as partial consideration for the purchase.
The deal got done.
What’s to become of this new acquisition dynamic? Employing a uniquely historical perspective, Roe and Skeel travel back in time to observe:
“The Chrysler deal was structured as a pseudo sale, mostly to insiders . . . in a way eerily resembling the ugliest equity receiverships at the end of the 19th century. The 19th century receivership process was a creature of necessity, and it facilitated reorganization of the nation’s railroads and other large corporations at a time when the nation lacked a statutory framework to do so. But early equity receiverships created opportunities for abuse. In the receiverships of the late 19th and early 20th century, insiders would set up a dummy corporation to buy the failed company’s assets. Some old creditors – the insiders – would come over to the new entity. Other, outsider creditors would be left behind, to claim against something less valuable, often an empty shell. Often those frozen-out creditors were the company’s trade creditors.”
They trace the treatment of equity receiverships, noting their curtailment in the US Supreme Court’s Boyd decision, the legislative reforms embodied in the Chandler Act of 1938, and the 1939 Case v. Los Angeles Lumber Products decision which articulated the subsequently-enacted “absolute priority rule” (but preserved the “new value exception”). Against this historical background, “Chrysler, in effect, overturned Boyd.”
But with a twist.
“One feature of Chrysler that differed from Boyd may portend future problems. Major creditors in Chrysler were were not pure financiers, but were deeply involved in the automaker’s production.” In cases where the value of the assets is enhanced by the continued involvement of key non-financial creditors, “players with similar [legal] priorities will not . . . be treated similarly.”
Translation: When non-financial creditors are driving enterprise value, a Chrysler-style sale suggests that some will make out, and some creditors – even, on occasion, some secured lenders – will get the shaft.
If accurate, Roe’s and Skeel’s Chrysler analysis raises some significant considerations about access to and pricing of business credit. It raises new concerns for trade creditors. It likewise presents the possibility that the Chapter 11 process – which has, in recent years, tilted heavily in favor of secured lenders – may not be quite as predictable or uniformly favorable as in the past.
Meanwhile . . . it’s back to the future.