The speed with which Chrysler and GM entered and rapidly exited Chapter 11 protection has redefined whiplash. GM filed for and emerged from bankruptcy protection in 40 days; Chrysler in 42, and that included a pit stop at the U.S. Supreme Court. In contrast, K-Mart, a smaller company with $36.9 billion in revenues at the time, filed for Chapter 11 in January 2002 and didn’t emerge until May 2003.
More recently, Delphi, one of GM’s parts suppliers and its onetime subsidiary, has languished in Chapter 11 for four years. At press time, Delphi’s board had just approved an exit plan.
What’s clear is that both automakers’ bankruptcy proceedings traveled at an unusually fast pace thanks to a popular sales process that the Bankruptcy Code allows and that has come to redefine what a corporate bankruptcy is. Up for debate is whether certain crucial steps in the Chrysler and GM sales were sidestepped, and how that question might apply to other distressed companies.
“The predictions that the end of bankruptcy is here, in the sense that creditors drive the process–we’re there for sure, and Chrysler and GM represent the pinnacle of that process,” says Steve Jakubowski, a member of the Coleman Law Firm in Chicago and founder of the Bankruptcy Litigation Blog. “It will certainly not regress to 15 or 20 years ago when companies would file and stay in bankruptcy for years and years on end.”
Easy as 363
In 2002, Douglas Baird along with Robert Rasmussen, dean of the University of Southern California’s law school, wrote a paper called “The End of Bankruptcy.” It argued that the traditional notions of Chapter 11 were outmoded, that it no longer meant sitting down with creditors to hash out a new capital structure and trade old debt for new equity.
“That’s incredibly well illustrated by GM and Chrysler, in the sense that these are not typical reorganizations,” says Baird, a University of Chicago law professor and director of the American College of Bankruptcy. “They’re just sales, and the bankruptcy judge is just an auctioneer.”
The sales take place under Section 363 of the Bankruptcy Code, which allows bankruptcy trustees or debtors-in-possession to sell assets with fewer of the creditor protections that are part of the traditional Chapter 11 process, such as having them vote to approve the reorganization plan or otherwise participate in the process. For this reason, so-called 363 sales, which take place early in the process, allow companies to emerge from bankruptcy protection much sooner.
Chrysler sold most of its assets to Fiat in a 363 sale, which allowed it to do so absent confirmation of a reorganization plan. The sales money went to creditors. But the sale didn’t come without objections, and legal practitioners and scholars are still split on its propriety.
Many, including one of Chrysler’s secured creditors, a group of Indiana pension funds, argued in a challenge to the sale in bankruptcy court that the 363 sale was in fact a sub rosa plan, or a backdoor reorganization disguised as a 363 sale as an end run around creditor protections attached to the stringent reorganization process. If it was, Chrysler would have to submit a plan of reorganization and allow creditors to object to it.
Another objection to the Chrysler sale was that it seemed to violate traditional rules of priority among creditor classes. All the value Chrysler got through its asset sales should have gone to its senior creditors; instead most of the value went to unsecured creditors such as a health care trust for retired union auto workers.
In a decision that paved the way for GM’s similarly rushed 363 asset sales, U.S. Bankruptcy Judge Arthur Gonzalez of the Southern District of New York disagreed with the Indiana pension funds’ challenge in a June 1 order allowing the sale to proceed. He said Chrysler’s sales plan was not a sub rosa plan because it “neither impermissibly restructures the rights of [Chrysler's] creditors nor impermissibly dictates the terms of a liquidating plan of reorganization for [Chrysler].”
On the priority question, the court said the Indiana pension funds had entered an agreement under which they were considered part of a larger consortium of creditors and therefore didn’t have the individual right to object. Finally, Gonzalez noted “compelling circumstances … in that, among other things, [Chrysler's interests] will suffer immediate and irreparable harm” if he blocked the sale.
Jakubowski–who represents a class of GM creditors, tort claimants fighting for the new GM to take responsibility for their pending claims–agrees with that assessment. “If a company can’t, by its own cash flows, make it to confirmation [of a reorganization plan], then I don’t think you can say you’ve somehow violated the Bankruptcy Code’s preference toward plans over 363 sales,” he says. “That’s what happened here.”
While the urgency of the situation is clear to M. Jonathan Hayes, he is reluctant to endorse practices applied in the GM and Chrysler proceedings. “If it’s true [that they couldn't survive otherwise], then keeping them alive is probably better than killing them,” says Hayes, author of “Bankruptcy Jurisprudence from the Supreme Court” and mediator for the Bankruptcy Mediation Program for the Central District of California. “But they really jammed it down the creditors’ throats.”
GM and Chrysler were two massive companies on the verge of collapse in the worst economic crisis of our time. The government was standing by ready to write a check, and the only other option the companies had, as they asserted and as the judge in Chrysler’s bankruptcy case seconded, was liquidating–a costly, complicated process. Those extraordinary circumstances make it unclear how much the Chrysler and GM precedent will apply to other 363 sales.
Not surprisingly, commercial Chapter 11 filings are way up. In June, 1,140 Chapter 11 commercial petitions were filed, according to the Bankruptcy Data Project at Harvard. A year earlier, in June 2008, there were 645; there were 407 filings in June 2007. Matt Porzio, VP for product marketing at IntraLinks, a “virtual dataroom” provider, says the company expects bankruptcy filings to continue rising through the first half of 2010. With all the activity, some fear that the questionable aspects of the 363 sales in GM and Chrysler could be applied to other 363 sales.
“The problem is that 363 does not have an established set of rules and guidelines, and hence there is more room to cut corners,” Baird says.
Baird testified July 22 before a House Judiciary subcommittee on the ramifications of the auto industry bailouts, pointing out that a 363 sale should be open to bidders, and noting the shift in priority rules as “another danger.” Still he recognizes that this may have been the companies’ only option, and that the government played an unusually large role in both cases. “I just hope [judges approving similar sales] doesn’t become a trend for the future because to do sales in Chapter 11, you have to make sure they’re done right,” he says.
Of course, every distressed company has to have the sense that if it stops operating as a going-concern, it will be the end of the world. And Hayes anticipates that the Chrysler and GM sales–while they probably won’t shape 363 jurisprudence–will be cited in the future.
“It will arise a ton in the future, and most judges will probably say, ‘Well this isn’t Chrysler–this isn’t a $5 billion, $35 billion company,’” he says. “There aren’t many companies that large around, but it’s one more reason for lawyers to say: ‘You have to approve this right now, Judge!’”