Chrysler, a failing auto manufacturer, was reorganized in a controversial chapter 11 in 2009. Financial creditors were paid a quarter of the amount owed them, while other creditors were paid more. The reorganization’s defenders asserted, among other things, that the proceeding and the sale structure was typical of prior practice. To see if this view fits the evidence, we examine all prior large section 363 sales for key financial ratios that can show whether a priority distortion is very unlikely. For example, in a cash sale with the buyer not assuming any debt of the bankrupt, the sale itself cannot ordinarily disrupt standard priorities. The Wilcoxon signed-rank test for these ratios indicates that Chrysler significantly differed from prior practice. It used less cash and the buyer assumed more debt than has been typical. Examining restricted samples, such as prior section 363 sales of firms with high unfunded pension obligations, yields similar results. The evidence here thus does not support the claim that the Chrysler reorganization fit the preexisting pattern of section 363 sales.
The automotive reorganizations during the 2008–2009 financial crisis were controversial. Washington injected major resources into the failing automotive manufacturers, Chrysler and General Motors, fearing that if the two manufacturers further shuttered operations their failure would deepen the ongoing financial and economic crisis, either by a cascade of supplier failures throughout the automotive industry or by further sapping economy-wide manufacturer and consumer confidence. Questions nevertheless arose whether subsidizing a weak producer in an industry with substantial over-capacity could be justified other than as a political necessity, whether the financial concepts of too-big-to-fail were escaping from their usual financial bailiwick into new industrial terrain in the USA, and whether the automotive industry was benefiting from government largesse despite having had a long history of managerial error and poor management–labor relations.
The mechanics and distributions in the bankruptcies themselves, particularly those in the Chrysler reorganization, also proved to be controversial transactions, apart from the issue of whether government funding was sound policy. Several major financial creditors insisted that priority in bankruptcy was not respected in the Chrysler bankruptcy. Despite the fact that they had security on the bulk of Chrysler’s assets, the secured creditors received 29 cents for each dollar on their $6.9 billion claim. Other unsecured, but government-favored, claims, although not entitled to priority under the bankruptcy law, were promised to be paid in the court-sanctioned reorganization plan.
One hedge fund manager, George J. Schultze, said that creditors “will think twice about secured loans due to the risk that junior creditors might leap frog them if things don’t work out. [This Chrysler deal] puts a cloud on capital markets … .” Hals (2009). Warren Buffett said that the Chrysler plan will “disrupt lending practices in the future.” “We don’t want to say to somebody who lends and gets a secured position that that secured position doesn’t mean anything” ( Whiteman 2009). One study indicates that the cost of capital for similarly situated firms did rise, Blaylock, Edwards & Stanfield (2012, 19), although another indicates that the subsidy effect offset any other distortionary effect, Anginer & Warburton (2012, 25).
Defenders of the Chrysler reorganization stated that the process did not differ from other bankruptcy sales, that the new lender in a chapter 11 proceeding (the so-called “DIP lender,” 3 which the government became) typically is empowered to decide not just on how it will be repaid itself but also can determine the distributional results to others, such as those in the Chrysler reorganization. Defenders saw the Chrysler bankruptcy process to have been both sound in its overall structure and sound in its particulars. As one prominent bankruptcy lawyer said, reflecting the view of many of the lawyers representing players pushing the Chrysler reorganization forward: “It didn’t turn anything upside down” ( Braithwaite 2009). The bankruptcy judge approving the Chrysler transaction began his opinion by stating that: “[t]he sale transaction … is similar to that presented in other cases in which exigent circumstances warrant an expeditious sale of assets prior to confirmation of a plan” (Chrysler Bankruptcy Opinion, 2009, 87).
And, in a post-mortem on the Chrysler bankruptcy, the congressional evaluation committee indicated that the government was acting in the role of the typical debtor-in-possession lender and that, as such, it had a wide ambit for action. The debtor-in-possession (DIP) lender’s power, said a major official congressional review of the Chrysler transaction, “is extremely high. Some refer to DIP lenders as following the Golden Rule: Those with the gold make the rules. There are no statutory limits on the conditions that DIP lenders may impose on the business” ( Congressional Oversight Panel 2009a, 44). The implication is that since the government filled the role of the DIP lender in Chrysler, it got to make the rules, distributional and otherwise. Academic testimony at Congress’s oversight panel on the auto bailouts was similar: “[D]espite … commentary to the contrary, the basic structure used to reorganize both GM and Chrysler was … entirely ordinary.” 4 “[T]he government was nothing more than a debtor-in-possession (DIP) lender in an otherwise typical bankruptcy reorganization.” 5
The Chrysler transaction of course differed from other section 363 sales: Chrysler was sold during a severe financial and economic downturn, when the entire American auto industry was in trouble with two of the big three bankrupt. The government bailed out the auto industry and bankruptcy was a central mechanism in the bailout. But a main strain of bankruptcy opinion was that Chrysler was a mainstream section 363 sale in terms of doctrinal precedent, structure characteristics, and financial basics. Mainstream analysis, including that of the deciding bankruptcy court and the Second Circuit Court of Appeals, saw the structure as well within the parameters of section 363 sales. Prior bankruptcy work has addressed the first two issues of precedent and statutory fidelity, with analysts on both sides of the issue. We here address the question of whether the financial structure of Chrysler’s section 363 sale resembled that of the bulk of prior section 363 sales. It did not. On multiple key financial characteristics, Chrysler was well outside the mainstream, in the company of only the most controversial of prior 363 sales. On several major measurements, it was unique.
Hence, we here address whether the Chrysler reorganization resembled the typical process that has developed in the past decade or so for entire-firm sales in bankruptcy. We conclude that the best evidence available indicates that it did not. We demonstrate two aspects of bankruptcy relevant to the Chrysler reorganization. First, we show how a so-called section 363 sale can lead to priority deviation and how a straight sale for cash should not. Second, we show how the Chrysler reorganization was in the range in which a priority deviation would have been easy. It was also at the far end of the range of prior practice in that few reorganizations were as deeply into the risk-of-deviation zone as was Chrysler’s.
Less new cash flowed into the reorganized Chrysler, proportionate to the liabilities assumed by the buyer, than is typical; much more old pre-bankruptcy debt was assumed by the purchaser than is typical. (The purchasing entity’s assumption of pre-bankruptcy debt was the mechanism by which priority might have been violated, as explained below in detail: some major debts were assumed by the reorganized operating entity, some were not. If the assets ended up primarily in the purchasing entity and not in the original firm, creditors of the purchasing entity would be favored over those left behind in the original firm. Those creditors that were left behind to assert their claims on the shell from which the automotive assets had been transferred did poorly relative to those who moved over to the purchasing entity.) DIP lenders have wide-reaching authority, but the evidence here indicates that courts do not regularly approve 363 sales that allow them to favor selected pre-bankruptcy creditors.
Specifically, we compute several ratios for all large firm bankruptcy sales from all available data and compare them to those of the Chrysler reorganization. The potential for priority distortion rises to the extent that the deal structure differs substantially from a pure sale of the bankrupt’s assets and operations for cash. If, instead of just cash, the deal structure has a significant amount of pre-bankruptcy debt carrying through the reorganization to the exiting entity, the opportunity for priority distortion is higher than if the sale is of all the bankrupt’s assets for cash and only cash. It’s the size of the carry-over of pre-bankruptcy debt to the buying entity that can distort priority. For the carried-over debt, the purchasing entity promises to repay the creditor from the value transferred out from the original debtor and into the purchasing entity. The debt that is not carried through can only obtain value from the assets left behind, if any assets are left behind.
The potential priority problem can be easily described: Consider a bankrupt firm with claims coming from a high-priority creditor and a junior creditor. If all of the assets are transferred to the purchasing entity, with none left behind, but the purchaser only picks up the bankrupt’s obligations to the junior creditor and picks up none of the obligations to the senior creditor, then statutory priorities would be fully reversed.
If the assets remaining behind are insufficient to pay off the remaining senior debt, as they were in Chrysler, that left-behind debt is paid less than in full. This ratio of assumed debt to the liabilities existing at the time of the bankruptcy filing (or, expressed differently, the ratio of debt left behind to total original liabilities) is thus a critical number for understanding the potential for priority distortion. We compare this ratio for the Chrysler reorganization to that of typical section 363 sales. In the Chrysler reorganization, nearly half of the preexisting balance sheet liabilities (mostly of pension and health trust claims) were assumed by the exiting entity. For the 63 large firm bankruptcy sales prior to Chrysler’s with data available, the mode of the debt assumed as a proportion of the total liabilities of the bankrupt is zero. The median is also zero. This result is summarized in column (3) of Table 2. Although the Chrysler result—with half of the pre-bankruptcy debt assumed by the purchasing entity—was not unprecedented, it was only matched in a handful of prior reorganizations, such as Trans World Airlines (TWA), itself a controversial reorganization. In the other instances where the Chrysler ratios are matched, the assumed debt was secured by assets integral to the firm’s operations (while in Chrysler it was the secured debt that was left behind and unsecured debt that the buying entity assumed) or the court oversaw a strong auction process, or both.
We also calculate the portion of debt assumed to the total purchase price, as this similarly indicates the potential for priority distortion. Before Chrysler, the mode for debt assumed as a proportion of the purchase price was zero, the median only 2 percent, and the mean 21 percent, as column (2) of Table 2 indicates. Yet, in Chrysler, the debt assumed amounted to more than 90 percent of the purchase price, a result that is more than two standard deviations from the pre-Chrysler mean. The Wilcoxon signed-rank test indicates that the Chrysler result significantly differs from pre-Chrysler section 363 sales, with a p-value of less than 0.01.
These results strongly suggest that in section 363 sales prior to the Chrysler reorganization major debts were not moving from the pre-bankrupt entity to the post-bankrupt entity to the extent that they did in Chrysler. Prior reorganizations accordingly were typically not accomplished in ways that risked significant priority violation.
Chrysler had major obligations to its employees and retirees. Although these obligations do not have a generalized priority over financial creditors, perhaps courts have been constructing a de facto priority for them. There are bankruptcy doctrines, such as critical vendor doctrine, that could justify such results. To examine whether the Chrysler section 363 sale was one more of a line of pension-based section 363 sales, we also examined a restricted sample of prior large section 363 sales of firms with a high level of pension liabilities, similar to that of Chrysler’s. We did so to see if courts have been fashioning a de facto priority for pension liabilities. But the data shows that these prior section 363 sales of firms with pension liabilities as high as Chrysler’s had relevant ratios that did not significantly differ from the low-pension section 363 sales. Pension obligations did not seem to be gaining a de facto priority. Only Chrysler among the high-pension firms differed significantly from prior practice.
Other ratios also evidence that Chrysler was different. Cash was an overwhelmingly large portion of the purchase price in most pre-Chrysler section 363 sales. A third-party pays cash for the bankrupt’s assets; those assets exit the core bankruptcy proceeding and the cash that the bankrupt entity obtains for those assets is then used to pay the bankrupt’s creditors. Cash is hard to misvalue or misdistribute, while deciding which liabilities stay behind and which move to the new entity can distort priority in ways that are hard to detect. But for the 63 post-2000 sales on which full data is available, the mode for cash consideration for an asset purchase was 100 percent, the median 94 percent, and the mean 75 percent. In Chrysler, most of the purchase was not paid for by cash, but paid for via gifts to some creditors and via exchange of some but not all of the preexisting debt. With only 10 percent paid in cash, the Chrysler reorganization again differed significantly from prior section 363 sales on this metric, with the Wilcoxon signed-rank test yielding a p-value of less than 0.01. Finally, we aggregated the ratios via factor analysis and re-ran the test, which yielded similar results, again with a p-value
As far as this evidence indicates, Chrysler, indeed, was different.
Chrysler, at one-time the tenth largest industrial company in the USA, suffered a multi-decade decline whose nadir came with its chapter 11 filing on April 30, 2009. Its cars were poorly received by consumers. Consumer Reports (2009, 15; 2010, 15) rated Chrysler’s cars as the least reliable of the 15 automotive companies with a substantial U.S. presence. Its market share had deteriorated, and it suffered losses of $2.9 billion in 2007 and $9.1 billion in 2008 (Daimler Benz 2008; Annual Report 2009). It had gone through one government-sponsored billion-dollar bailout in 1979–1980, was sold to Daimler-Benz in the 1998, and then re-sold and taken private in 2007 by the private equity firm Cerberus, which was unable to turn around Chrysler’s operations. Initial reports of the government’s thinking during the financial and economic crisis of 2008–2009 were that Chrysler could not be saved at any reasonable cost and that it would be allowed to close ( Lizza 2009).
The government changed its view, however, and injected significant resources into both Chrysler and General Motors. The decision to save Chrysler was hotly debated in the White House and the executive branch ( Lizza 2009). One view was that Chrysler’s failure would boost GM, which would pick up much of Chrysler’s market share. But the sense that the economy would be damaged by a Chrysler failure reportedly dominated in policy circles. Major costs from Chrysler’s failure, including those from unemployment benefits and government guarantees of pension payments, were thought to offset much of the losses or distortions that a bailout might cause ( Rattner 2009). 6
The initial pre-bankruptcy cash infusions were accomplished as ordinary loans from the government to the car companies. Thereafter Chrysler filed for reorganization under chapter 11 of the U.S. Bankruptcy Code. It quickly proposed that its principal automotive assets be sold for $2 billion in cash. But the sale would not be an arms-length sale to a fully separate third-party. The car company’s assets were sold within a month and a half to the government-sponsored and government-financed entity. The government loaned cash to the new Chrysler entity, which purchased the automotive assets from old Chrysler. The cash that went to the old Chrysler entity (which no longer owned the main automotive assets) was used to settle out the $6.9 billion in pre-bankruptcy debt at 29 cents on the dollar.
The sale was not to an arms-length, true third-party buyer, but to an entity that would be owned by the government, preexisting creditors, and FIAT. The latter paid no cash as consideration for the purchase, but agreed to manage the new entity. There was little opportunity for a true arm’s-length auction in which third-parties would bid for the assets to be sold, as the transaction moved rapidly. The bidding period was short and the formal terms required that any qualified bid conformed to the priority structure of the government-sponsored deal—bids would only be qualified if the purchase structure would have the favored creditors move with the assets and would leave the disfavored creditors behind to be paid out of any available residual assets. Such conditions would be likely to deter new bidders, if there were any interested in buying Chrysler or its assets. 7 Regardless, no alternative bids came in. Chrysler was, in effect, sold to itself, or rather to a subset of its prior owners.
Chapter 11 of the U.S. Bankruptcy Code provides a framework for reorganization that roughly corresponds to the conceptualization of strict priority in the finance literature (with some deviations, to be discussed below). Secured creditors are entitled to the value of their security, with any insufficiency in collateral typically entitled to claim as an ordinary unsecured creditor on the bankrupt’s unsecured assets. Ordinary unsecured creditors must be paid ratably, unless they voluntarily accept a deviation from proportionate treatment. Priorities among creditors, via contractual seniority and subordination agreements, are respected as written. (Consent to deviation from the statutory priority is done by a vote among the creditors, with a minimal value that any creditor can insist upon, even if the class consents to a deviation. Oftentimes what seems to be consent to a deviation is really a settlement, as asset values and future cash flows are uncertain and often there are intercreditor claims for wrong-doing.) Equity holders are not entitled to receive anything in the reorganization until creditors are paid in full (or unless creditors consent to the payment, to settle a claim or to just speed up the proceeding).
While the overall chapter 11 structure conforms to the conceptual sense of strict priority, substantial variations are embedded in the Code and in bankruptcy practice. Creditors, for example, are not generally entitled to the time value of money for a delay in the proceedings. Exceptions to the no-interest rule are available, but they are incomplete ( Roe 2011, 395–428). The firm’s value may change substantially during the course of a bankruptcy reorganization, injecting a market-based element of uncertainty and some optionality for the out-of-the-money claimants, which they might use strategically. And values of assets and of the enterprise overall are ultimately determined by judges, not markets. If the creditors cannot settle differences, and if judges are not expert in valuation, distortions are likely to occur ( Gilson 2010; Roe 1983, 570).
Secured creditors cannot generally seize their assets without judicial permission in a bankruptcy, which often is not given if the asset is useful to the bankrupt’s operations. The creditor is promised that it will ultimately obtain the value of the security (without interest, usually), but it’s the judicial process that determines the value of that asset, not the market, and, if there’s a payment failure at the end of the reorganization (because the business completely fails), the court does not make up any shortfall.
In addition, there are priority jumps that are hard to evaluate, one of which is relevant in the Chrysler reorganization. Debts due for unpaid bills from the bankrupt’s pre-bankruptcy suppliers can, if the suppliers are judicially determined to be critical for the bankrupt—presumably because they are supplying crucial parts that debtor cannot obtain otherwise — be jumped ahead of other creditors and paid immediately in the bankruptcy proceeding. Conceptually, if such payments enable the bankrupt’s operations to be more valuable than if the extra payments were not made (Easterbrook opinion, In re Kmart (2004, 868)), then all creditors should benefit from the priority jump. But judges may not be adept at making such judgments of net value to the bankrupt and many do not even bother to estimate the costs and benefits of such priority jumps to the non-favored creditors.
The Bankruptcy Code, passed in its original form in 1978, did not contemplate that a business’s bankruptcy would lead to the business’s operations being sold, with the cash distributed to the pre-bankruptcy creditors. Rather, it contemplated that the bankrupt’s creditors, management, and, if the firm was marginally solvent, equity holders would negotiate a plan of reorganization. If the negotiation failed, parties—initially the bankrupt’s management—would propose a reorganization plan to the judge, who would determine the value of the bankrupt firm and whether the plan met the priority and other requirements of the Code. Creditors could be excluded from receiving any payment in the reorganization, if their level in the business’s priority structure had no value (ignoring any option value). If the plan conformed to the Code’s priority structure, the judge would confirm the reorganization plan. A confirmed plan binds all creditors and stockholders to the plan’s terms.
Critics saw the Code’s failure to contemplate sales of firms in their entirety, or even sales of new securities, to be a major failure of the Code. Well-developed financial markets, including well-developed merger markets in the 1980s, made market-based reorganizations plausible and superior to the structure enacted in 1978 ( Roe 1983, 571–575; Baird 1986, 141).
Although the Code did not contemplate whole-firm sales, it did contemplate sales of wasting assets. The archetypal case was that of fruit crates sitting in a bankrupt, closed fruit store. The managers of the bankrupt needed authority to sell the crates of fruit before the fruit rotted and lost value. Section 363 of the Code was the relevant section. While the phrase “363 sale” eventually became prominent in business and financial circles and came to be understood as an operational sale of a bankrupt firm, the phrase was not well-known or even used in this way in the early years of the Code, because such full-firm operational sales did not occur.
Section 363 allowed the bankrupt to sell its assets out of the ordinary course of business, but only with prior judicial approval. It would be under that authority that the managers of the bankrupt fruit seller would ask the court to approve a quick sale of the crates of fruit in inventory, to avoid further losses. The Code, however, provided no standard for that judicial approval and courts initially saw whole-firm sales to be a stretch, or even a mis-use, of that section, in part because the section had no mechanism for determining whether priorities were respected. The early judicial decisions dealing with such whole-firm sales were hostile to their occurrence. In In re Lionel (1983), a decision of the New York based federal circuit court of appeals, a court that is prominent in financial law, sought to impede section 363 sales of whole firms, by requiring that there be an articulated business justification and requiring bankruptcy courts to weigh a number of offsetting factors before approving a whole firm sale under section 363.
But, beginning in the 1990s, bankrupts increasingly asked courts to approve a sale, under section 363, of firms’ operations in their entirety. The usual method has been for the sale proponent to come to court with a potential buyer (called the “stalking horse”) and a proposed bidding procedure (when, how long, what general terms). After the court accepts the final bidding procedure, the assets are put up for sale and, if no new bidder tops the old bidder’s price, the sale is made. The money paid for the assets flows into the bankrupt and that money is subjected to all of the priority protections and rules embedded in the Code. This sales method became favored in chapter 11 practice during the latter part of the 1990s and the subsequent decade ( Baird & Rasmussen 2003, 675; Eckbo & Thorburn 2008, 404–405).
Courts regularly stated that the sale itself could not have terms that determined the distributional structure of the proceeds among creditors, because that would risk deviation from the priority mechanisms supported by the Bankruptcy Code. A sale for cash was justified, if the cash was then used to satisfy the creditors according to the Code’s priority mandates. If there were deviations from the pure sale for cash, particularly if the terms of the sale determined important distributional results, then some judicial or other check was needed. Roe & Skeel ( 2010, 736–741) examine in detail the pre-Chrysler appellate judicial decisions’ standards for a section 363 sale.
Courts were uncertain of their own expertise in verifying the appropriateness of the price paid in a sale. To check the sale proponents’ terms, a market test became a core check on the bona fides of the section 363 sale. The statute contemplated a reorganization plan that the creditors consented to, via a vote of each creditor group. (Or, if the creditors did not approve, the court would value the firm and then verify that the plan’s terms respected priority.) Because neither creditor approval nor judicial testing of the overall plan would typically occur, the market test was important to validate section 363 sales.
It must be emphasized that courts regularly held that the sale could not be a reorganization plan in disguise. In re Braniff (1983). The sales terms could not determine how the sales proceeds would be distributed. Distributions of the proceeds needed to be done in accordance with the Code’s priorities. If the proposed sale had strings attached so that the proceeds would be distributed in ways that clashed with the Code’s priority structure, courts said they would not approve the proposed section 363 sale.
The Chrysler sale was not a clean sale of automotive assets for cash. Alternative bidders were not offered a clean opportunity to outbid the government-sponsored buyer. In these two dimensions, the Chrysler section 363 sale was atypical. That is, the sale did not solely transfer Chrysler’s assets for cash, nor was it even a transfer of Chrysler’s assets with some minimal liabilities attached. It was instead a sale of Chrysler’s assets for $2 billion in cash, but the assets transferred were coupled, as a package deal, with the purchasing entity assuming and agreeing to pay more than $17 billion of Chrysler’s pre-bankruptcy $36 billion of liabilities. 8 Additionally, the amounts that new Chrysler, the purchasing entity, promised to repay in full greatly exceeded the cash paid for the assets. The purchasing entity’s owners included one major preexisting Chrysler creditor and the government, along with FIAT, which provided no new cash but was tasked with running the company.
Much of Chrysler’s preexisting liabilities moved over from the pre-bankruptcy Chrysler to the purchasing entity, while much of Chrysler’s pre-bankruptcy liabilities stayed behind. It’s there that the potential disparity in priority could have arisen: if the amounts available to the stay-behind creditors were less than (or more than) their normal bankruptcy entitlement, they could have been short-changed (or over-compensated) as compared with what the carry-through creditors received.
Because the purchase price for the assets was $2 billion in cash, but $17 billion of Chrysler’s ongoing liability moved to the purchasing entity, the sale was far from a pure sale of operations for cash. Much of the transaction, in percentage terms, involved squeezing out the $6.9 billion in old secured creditors for $2 billion and moving $17 billion in claims over to the new entity. 9 It was not a simple sale for cash.
Figure 1 shows what such a straight cash sale might look like. Figure 2 shows the Chrysler transaction.
A clean section 363 sale.
