Todd Zywicki criticizes the Obama Administration in the Wall Street Journal:
Fleecing lenders to pay off politically powerful interests, or governmental threats to reputation and business from a failure to toe a political line? We might expect this behavior from a Hugo Chávez. But it would never happen here, right?
Until Chrysler.
The close relationship between the rule of law and the enforceability of contracts, especially credit contracts, was well understood by the Framers of the U.S. Constitution. A primary reason they wanted it was the desire to escape the economic chaos spawned by debtor-friendly state laws during the period of the Articles of Confederation. Hence the Contracts Clause of Article V of the Constitution, which prohibited states from interfering with the obligation to pay debts. Hence also the Bankruptcy Clause of Article I, Section 8, which delegated to the federal government the sole authority to enact “uniform laws on the subject of bankruptcies.”
The Obama administration’s behavior in the Chrysler bankruptcy is a profound challenge to the rule of law. Secured creditors — entitled to first priority payment under the “absolute priority rule” — have been browbeaten by an American president into accepting only 30 cents on the dollar of their claims. Meanwhile, the United Auto Workers union, holding junior creditor claims, will get about 50 cents on the dollar.
The absolute priority rule is a linchpin of bankruptcy law. By preserving the substantive property and contract rights of creditors, it ensures that bankruptcy is used primarily as a procedural mechanism for the efficient resolution of financial distress. Chapter 11 promotes economic efficiency by reorganizing viable but financially distressed firms, i.e., firms that are worth more alive than dead.
Violating absolute priority undermines this commitment by introducing questions of redistribution into the process. It enables the rights of senior creditors to be plundered in order to benefit the rights of junior creditors.
Well, you can’t make an omelet without breaking a few eggs, can you? If you break a few laws in ensuring the financial security of UAW members, what’s the harm? After all, neither the press nor the members of your own party, dominant in both houses of Congress, are likely to call you on it. And if re-writing bankruptcy law via regulation to suit the problems of today reduces the willingness of future lenders to lend money so that companies can dig their way out of their problems, they’re just being short-sighted, not looking at the bigger picture. The financial sector commissars can always tighten the screws on them a bit.
What’s doubly frustrating is that by avoiding reorganization by selling the company to the Italians, Chrysler failed to take advantage of the opportunities available in bankruptcy. Trimming some creditors might be all that some companies need to return to solvency. I don’t think anybody thinks that is the case here.
TWA was an example of the shortcomings of a pre-negotiated bankruptcy; all the players compromise just enough to keep the business going until the next bankruptcy a few years down the line. How many years until people Chrysler goes the way of TWA?
I’m not privy (or haven’t done the research) to understand the cash flow projections that resulted in the filing. However, it is obvious that the debt service requirements of the $5B the taxpayers put in and the $5B the lenders had in were sufficient to submerge the company.
Now, the taxpayers are putting in an additional $6B and the old obligations are wiped out. The new debt service requirements damn well better be a lot less than when $10B was on the BSheet. Otherwise………ugh, BK2
Of course, the fresh taxpayer money may have very light repayment requirements……….which of course makes it semi-“permanent” capital……which of course basically makes it equity. But they got just 10%. And the UAW 55%. Nice.
Not to make this personal, but I’ve been banging this drum for awhile. This is a travesty. Over at OTB, during the election cycle and subsequently, I have repeatedly seen AK and BF sarcastically denounce Obama critics as wild eyed zealots for bemoaning Obama’s “marginal,” “incremental” increases in taxes or changes in policy or whatever. “Relatively mainstream” policy I read. Well I have to call BS. Anyone who actually listened to Obama, and knew his IL politics pedigree, could have predicted what would happen if elected. I did, and here we are.
AK may be an IT wizard, or whatever he does, and BF a defense policy guru, that’s fine; but they have NFClue when it comes to business/finance and what this Administration is doing right now. NFC.
Anyone who reads this blog. Here’s a straighforward question. Given the abrogation of contract at Chryler, and the gift to the UAW, if you got a knock on your door by a capital raiser and were asked to loan YOUR money, say $250K, into some unionized company – of course with assurances that in the event of trouble you’d be first in line to get paid out – would you? Would you? With what you now know?
I wouldn’t. And no lender with an ounce of fiduciary sense now will.
This is serious. And this is how these policy malformations strangle economies.
As odo observes, spleen venting over………
Sam –
I found that essay shockingly intellectually light. I’ve been through my share of workouts / lender negotiations. The writer’s observation that purity gives way to practicality in these matters is what every 25 yr old associate learns when they go through their first one.
But the writer also sarcastically and conveniently glossed over several crucial points. First, the 800 lb gorilla was the government. It wasn’t a secured lender (the usual gorilla in these things) hoping to rely on historical commercial practices in these matters, and knowing full well a concession to “absolute priority” might be required to get the deal done. (eg sometimes old equity, not owed a damned penny, gets a stub equity piece just to grease the wheels). The government is not historically the gorilla. More on that in a minute.
Second, by focusing only on the secureds the writer conveniently glossed over the biggest moral tragedy in this case (because a theoretical case can be made that liquidation would have resulted in the secureds getting less than they did) which is this: the taxpayers will have $11B in the game, and only 10% of the ups. Estimates are now varying about the size of the UAW claim, from $4B to $6B. But even at $6B they get 55% ??!!
Not right. Inexcusable. Which brings me back to…..
The writer got one observation correct: its POLITICS. Indeed. And that of course is the problem. Politics trumped both the rule of law, but also well worn commercial practices. And that will have consequences in the form of a higher cost of capital.
I’ve been lending and then PE investing for 19 years now. One of the areas we never, ever touch is health care companies. We don’t want to wake up one morning and read in the paper that Teddy Kennedy or Nancy Pelosi has thrown a hissy fit and our company’s business model is irrelevant. In the trade its called “regulatory risk.”
Well, now every unionized company, and every secured lending situation has increased “regulatory risk.” And that will be a retardant on economic activity. The reason I get so exorcized about a matter like this is that very few people understand what the implications are. Its just not their field of expertise; so they shrug their shoulders at the propagandistic arguments made.
If you are interested in appealing to authority rather than the actual argument, you don’t have to believe me. Warren Buffet sees it the same. And I think he understands a thing or two about investment.
As for the guy who wrote that article that reads like Bozo wrote it, I’d be wary of quoting it at dinner parties. It could be embarrassing.
The government had (indirectly) spent $18.9 million dollars in legal fees towards the bankruptcy by the time of the filing and had even filed a motion to make sure that money would keep flowing through any challenge. The non-Tarp lenders originally had $1 to $2 billion in debt. When the judge denied the motion to keep their identities secret, most of the objectors dropped out, leaving $300 million in debt. That wasn’t enough to fund to make the challenge worthwhile, so they dropped out.
sam, your linked article seems to believe that the objectors arguments were all addressed and denied in court. I don’t believe they had, the objectors had until May 19th to file their objections and alternatives to the sale. Their lawyer indicated he was going to file objections on several other issues as well. In any event, I would expect most of these issues to be resolved on immediate appeal (one way or another).
It may not be unusual that a party has to bow out because it doesn’t have the resources or the stake to fight for the correct outcome. It doesn’t make the result just.
BTW/ the best defense of the Chrysler bankruptcy that I’ve read is from law Professor Lubben, which is partly in response to the Zywicki article quoted by Dave. He is not untroubled by the government’s role, but his primary defense lies on the assumption that Chrysler may not be worth more than the $2 billion the secured creditors obtained.
Frankly, I don’t know what’s more disturbing, that the government was so reckless in abrogating security interests to save a few hundred million dollars, or that we are going to be spending billions and billions of dollars to save a company that ain’t worth it.
http://www.creditslips.org/creditslips/2009/05/chrysler-363-sales-again.html
Sam, please, I “get it” and the article, in spades.
In every one of these things there is a titanic negotiation before its turned over to the bankruptcy authorities. Its the specter of the courts that forces people off their initial negotiating stances to “cut a deal.” (Hence my statement that the author of that piece just stated the obvious, which you reproduced. But where he went off the rails is to explicitly condone a government cramdown during the negotiation phase, as if the observation that “its just politics” makes it OK. Its not. If Obama feels its politically advantageous tomorrow to dictate the reduction of auto worker wages to minimum wage, is it OK?)
And further, we have to specify just exactly who lost.
WRT the secureds, the majority caved because they were TARP’d, and beholden to the government. That doesn’t mean what happened to the non-TARP’s secureds was right, or that their negotiating stance was wrong. They made the assumption that 100 years of commercial practice would stand. They guessed wrong, because in today’s world, politics trumped commercial standards. And as I have said, this will have greater negative repercussions than the Average Joe understands. And by the way, the real loser will be the Average Joe. That’s why I’m upset.
WRT the taxpayers and the UAW, the notion that the taxpayers “lost” in the negotiation phase is absurd on its face. They were represented by an entity, the Obama Administration, that did not in any way shape or form fulfill any fiduciary responsibility to represent their interests. They were sold down the river for political favor with the UAW. For votes. (You’ve seen the math, Sam. Care to make the argument that the UAW and taxpayers got equitable shakes???)
As for your last paragraph, I think you are just saying if you are a big business, the government may come in and Bofo you, regardless of economics, morality or law. I can’t believe you are saying this. Is it President Obama, or President Chavez?
PD –
I think you’ve got that right (and Lubben). We can speculate that the secureds may have given up because liquidation would have resulted in an inferior result to what they took. My horse sense is that its not correct, but at least its a plausible reason for what transpired.
I think the govt actions vis a vis the secureds stinks, but the reason I save my investive mostly for taxpayer vs UAW is because its just plainly not equitable at all. In fact, in 19 years I can’t recall a more absurd outcome for players in a cap structure.
invective
Well, now every unionized company, and every secured lending situation has increased “regulatory risk.â€
Don’t forget that Obama wants more companies to be uniuonized, by whatever methods necessary.
And who is this “Sam” everyone is speaking to? Are you all hearing the exact same voice in your head?
sam I am, and for some reason, all my comments have been dropped…including my response to Drew’s response to my first posting (sorry bro, you deserved an answer).
Well, let’s try this again:
@Drew
What I’m asserting is that if you’re big enough so that the government believes that your demise will adversely affect the economy as a whole, the government will act. This is not partisan: this tendency of government is not party dependent. I see that Hindraker over at Powerline has some memos that show that Paulson muscled some banks, which didn’t need them, to accept TARP funds. (Was that President Bush or President Chavez?) I am amazed that folks find this controversial. What is controversial, of course, is the nature of the actions taken. That government will act is as certain as death and taxes.