Assessing the Chrysler bankruptcy.

• Author: Roe, Mark J.

Chrysler entered and exited bankruptcy in forty-two days, making it one of the fastest major industrial bankruptcies in memory. It entered as a company widely thought to be ripe for liquidation if left on its own, obtained massive funding from the United States Treasury, and exited via a pseudo-sale of its main assets to a new government-funded entity. The unevenness of the compensation to prior creditors raised concerns in capital markets, which we evaluate here. We conclude that the Chrysler bankruptcy cannot be understood as complying with good bankruptcy practice, that it resurrected discredited practices long thought interred in the nineteenth- and early twentieth-century equity receiverships, and that its potential for disrupting financial markets surrounding troubled companies in difficult economic times, if the decision is followed, is more than small.

TABLE OF CONTENTS INTRODUCTION I. CHRYSLER'S [section] 363 PROBLEM A. The Deal Structure B. The [section] 363 vs. [section] 1129 Problem: Concept II. THE PRE-CHRYSLER APPELLATE CASES A. Reconciling [section] 363 Sales with [section] 1129 Protections B. Makeshift Remedies that Validate Priority 1. Judicial Valuation and Priority Determination 2. Class Consent 3. A Market Test III. THE CHRYSLER SALE A. Valuation B. Consent C. The Market Test D. The Emergency--How Immediate? IV. WAS CHRYSLER REORGANIZED OR SOLD? A. The Case That Chrysler Was Reorganized, Not Sold 1. Old Chrysler's Mandates to New Chrysler 2. The Before-and-After Resemblance 3. A Rule of Thumb to Sort Legitimate [section] 363 Sales from [section] 1129 Reorganizations B. Consequences of a Nonsale: Valuation Inconsistencies C. Could the Treasury Have Acted Any Differently? V. Chrysler AS CHAPTER 11 TEMPLATE? A. Replication Without Government Funding B. Recommendations VI. THE BIG PICTURE CONCLUSION INTRODUCTION

The Chrysler Chapter 11 proceeding went blindingly fast. One of the larger American industrial operations entered Chapter 11 and exited forty-two days later. Clearly this speed was propelled by the government's cash infusion of $15 billion on noncommercial terms into a company whose assets were valued at only $2 billion. (1) The influx came at a time when the American economy was sinking, financial institutions were failing, and the government feared that a collapse of the auto industry would have grave consequences for the rest of the economy. Never before had the government used bankruptcy to bail out a major industrial corporation. As a matter of bankruptcy technique, the rapidity of the Chrysler Chapter 11 was a tour de force.

The economic policy and political background is worthy of its own analysis, but we note that level of policy and politics only in passing, when they interact with the Bankruptcy Code. Briefly, Chrysler was a weak producer, making cars that had limited consumer acceptance, in an industry suffering from substantial domestic and worldwide overcapacity. Industries facing such pressure normally need to shrink, and their weakest producers, like Chrysler, are the first candidates for shrinkage.

We focus primarily on the technical structure of the Chrysler bankruptcy under the Code. Did the bankruptcy introduce, or did it magnify, tactics, procedures, and doctrines that would facilitate sound, fast bankruptcies in the future? Or did the Chrysler reorganization reveal defects latent in the Chapter 11 mechanisms? Could the rapid results be obtained in the future only if the government is willing to flood the bankrupt firm with cash on subsidy-type terms? Was the process sufficiently innovative as to be new? And, if new, is it desirable?

Our overall conclusions are not favorable to the process, results, and portents for the future. The Chrysler bankruptcy process used undesirable mechanisms that federal courts and Congress struggled for decades to suppress at the end of the nineteenth and first half of the twentieth centuries, ultimately successfully. If the mechanisms are not firmly rejected (or forgotten), then future reorganizations in Chapter 11 will be at risk, in ways that could affect capital markets. Although the government's presence commanded judicial deference, its presence is not needed for the defective procedures to be part of future reorganizations. Every reorganization in Chapter 11 can use the same, defective process.

Two creditor groups were sharply cut off in the Chrysler reorganization. Products-liability claimants with claims for damage caused by Chrysler's cars on the road were barred in the reorganization from suing the reorganized Chrysler. (2) And credit markets reacted negatively to the Chrysler reorganization process and results. George J. Schultze, a manager of a hedge fund holding Chrysler debt, said "one reason we went into it was because we expected normal laws to be upheld, normal bankruptcy laws that were developed and refined over decades, and we didn't expect a change in the priority scheme to be thrust upon us." (3) He warned:

People who make loans to companies in corporate America will think twice about secured loans due to the risk that junior creditors might leap frog them if things don't work out. It puts a cloud on capital markets and the riskiest companies that need capital will no longer be able to get capital. (4) Warren Buffett worried in the midst of the reorganization that there would be "a whole lot of consequences" if the government's Chrysler plan emerged as planned, which it did. (5) If priorities are tossed aside, as he implied they were, "that's going to disrupt lending practices in the future." (6) "If we want to encourage lending in this country," Buffett added, "we don't want to say to somebody who lends and gets a secured position that that secured position doesn't mean anything." (7)

Were they right'? Were priorities violated?

Perhaps priorities were breached, perhaps not. The most troubling Code-based aspect of the Chrysler bankruptcy is that this is difficult, perhaps impossible, to know from the structure of the reorganization. Yet obtaining that knowledge is one of the core goals of Chapter 11 in practice. Chrysler breached appropriate bankruptcy practice in ways that made opaque both Chrysler's value in bankruptcy and the plan's allocation to the company's prebankruptcy creditors. The requirement in [section] 1129(a)(8) that each class of creditors consent or receive full payment wasn't used. A market test wasn't used. There was no judicial valuation of the firm. Chrysler went through the motions of selling its principal assets to a newly formed entity controlled by its preexisting principal creditors, a process that has been historically suspect in bankruptcy.

Stunningly, the bankruptcy court did not analyze the [section] 1129 issues. Indeed, that section--the core of the modern Bankruptcy Code, outlining the conditions the judge must find prior to confirming a plan of reorganization-is not mentioned once in the bankruptcy court's opinion. If the pseudo-sale was a de facto plan of reorganization because it did so much more than simply sell assets for cash, then it was incumbent on the bankruptcy process to assess the deal's terms for consistency with [section] 1129. If a capable bankruptcy judge does not see fit to mention [section] 1129 in a sale that determines many reorganization outcomes normally made in Chapter 11 under [section] 1129, something peculiar is happening. The most obvious hypothesis is that one could not mention it, if one feared that one were witnessing a reorganization that could not comply with [section] 1129. On appeal, the Second Circuit, rather than signaling concern, affirmed the bankruptcy court decision and adopted its analysis. (8)

Worse, the Chrysler bankruptcy in core respects does not look like a simple sale, but a reorganization. The new Chrysler balance sheet remarkably resembles the old one, with only a couple of priorities, involving large dollar amounts, sharply adjusted. Courts will need to develop rules of thumb to distinguish true [section] 363 sales from bogus ones that are really reorganizations. We take a step toward doing so.

We can hope that the breach of proper practice will be confined to Chrysler. But the structure of the deal is not Chrysler-specific. Not only did the subsequent General Motors opinion rely heavily on Chrysler, (9) but other courts and plan proponents will inevitably cite Chrysler as precedent. (10) Some already have.

The Chrysler process may have revealed conceptual fault lines in the deeper structure of Chapter 11: the government's presence as a noncommercial lender isn't needed, as a matter of Code structure, for interested players to use the Chrysler mechanism. Any coalition of creditors and managers can use the [section] 363 sale in the same way, if they can persuade a judge to approve their proposed fictional sale.

Hence, Chrysler could become the template for the next generation of large scale corporate reorganizations. Even before the Chrysler bankruptcy, Chapter 11 cases were increasingly resolved through [section] 363 sales that did not always carefully consider [section] 1129 priority issues. But by blessing an artificial sale that carried over and restructured the bulk of Chrysler's creditors' claims, the Second Circuit's Chrysler opinion radically expands this strategy's potential scope. If it becomes the pattern, Chrysler could displace the traditional Chapter 11 process, potentially affecting both lending markets and vulnerable nonfinancial creditors adversely.

Its impact will need to be confined. We can hope that the bankruptcy bench and bar come to a consensus view of Chrysler as a one-off, sui generis bankruptcy, and we seek here to start us toward that consensus. But because the Chrysler techniques resonate enough with prior practice, and can be seen as extreme extensions of that prior practice, effort will be required to reach that consensus.

A roadmap for the Article: in Part I, we outline the structure of...