With Chrysler LLC's sale to Fiat SpA past the U.S. Supreme Court, and with General Motors Corp. commencing its own "surgical" bankruptcy on the Chrysler model, it may be tempting to think that we've turned a corner: Tentative deals with most major stakeholders of the automakers assure a quick trip through the Chapter 11 emergency room. Now, we might think, it is just a matter of convalescence. This sense of relief may help to explain why the S&P 500 stock market index reached a 2009 high the same day GM declared bankruptcy.
We should not, however, pop the champagne just yet. These companies are still extremely fragile. Bankruptcy may save them — but only if the operations are performed correctly. Plenty can still go disastrously wrong.
One problem is speed. President Obama has promised that both the Chrysler and GM bankruptcies will be quick, which seems likely. Yet those who study bankruptcy know that going through it hastily may simply result in a second or, as in the case of some airlines, a third bankruptcy. Just because a reorganization is fast does not mean it is successful. Repeat trips to the operating table are rarely good.
Paradoxically, there is also risk in delay. If these cases linger, serious complications could arise. A loss of consumer confidence and reduced profitability come to mind. But a more insidious — yet under-appreciated — side effect of delay is the toxicity of "shadow bankruptcy," shorthand for the machinations of the nonbank financial actors (hedge funds, private equity funds and investment banks) that share responsibility for the financial crisis and that increasingly dominate large Chapter 11 cases.
Like the "shadow bankers" for which they are named, shadow bankruptcy players exploit regulatory gaps in the bankruptcy system. For example, like many Chrysler and GM bondholders, these investors may buy claims, before or during bankruptcy, in order to obtain control of a company. If they were buying stock of these companies with the same goal, they would probably have to disclose this under federal securities law. But because they are buying debt, they don't. Their actions remain in the shadows.
More problematic still will be the "hedging" strategies they use. Historically, creditors of companies in bankruptcy usually held one type of claim. They had simple, predictable incentives. If the company was viable, they would support reorganization. If not, they would support liquidation. Either way, Chapter 11 encouraged the parties to negotiate among themselves, to decide these sorts of issues, and thus the debtor's fate.
HIDDEN INCENTIVESThe problem today is that sophisticated investors often hold many different types of claims against a debtor. Their real incentives may be impossible to discern and may, covertly, be antithetical to the debtor's success. An investor may, for example, hold senior secured bonds and an undisclosed short position on the company's debt or equity. The secured bond will pay in full no matter what happens, if there is enough collateral. But the short may pay only if the company goes into bankruptcy, or if the stock is eliminated in a fire-sale liquidation.
In that case, what would the investor want? Probably not a successful reorganization. A successfully confirmed plan of reorganization would pay only on the bonds, not on the short. Of course, they would not come out and say this. And they don't have to, because bankruptcy doesn't require these disclosures.
This combination of complex claims and secrecy is like a multidrug-resistant infection: It is lethal because you don't know exactly what you are fighting. You can't negotiate with someone if you don't know what he or she really wants.
Shadow bankruptcy may be the real threat that concerned the president enough to become bankruptcy-lawyer-in-chief. When Chrysler went into the tank, he railed against hedge funds — "speculators," he called them — that had purchased the carmaker's bonds. "They were hoping that everybody else would make sacrifices, and they would have to make none," Obama said in The New York Times . "I don't stand with them."
Maybe not. But he faces enormous challenges in fixing the auto industry, more than simply reducing bloated work forces and building better cars that consumers actually have the money to buy. He also has to get these companies out of bankruptcy, and on a sound footing. The operating theater for these surgical bankruptcies is, however, fraught with greater dangers than many imagine.
Bankruptcy scholar Jonathan C. Lipson is a professor at Temple University Beasley School of Law in Philadelphia, where he teaches and writes on the U.S. bankruptcy system.
