Goliath and the chequebook

The American economy needs private investors, perhaps now more than ever. Yet the Obama administration has been tinkering with the rules midstream. This could deter future investors.

Leapfrog
Nobody likes to end up in litigation, even in a kangaroo court. But as Chrysler struggled to reconcile creditors’ interests, negotiations to sidestep bankruptcy broke down. Some bondholders balked at proposed terms: that a union retiree healthcare trust fund would own 55% of the restructured firm, white knight Fiat get 35% and Uncle Sam the rest. The union would receive altogether 85 cents on the dollar, in a combination of equity and notes, and almost all suppliers would get 100 cents. The stunning departure is that secured creditors, who as first lien holders are entitled to 100%, were offered only 28 cents for their bonds, and no equity in a reconstituted firm.

The hold-outs, whose defiance had triggered a bankruptcy filing on April 30, caved in on May 8. It had become just too expensive to continue a legal fight. It happened that four of the 46 creditors held 70% of the debt, and were also Troubled Asset Relief Program (Tarp) fund recipients. None of those bank sources will go on record admitting to government pressure, let alone extortion. Yet it is telling how the big four fell into line with the government, cajoling their more reluctant peers to take the pre-bankruptcy deal. President Obama scolded the secured hold-outs, some of whom were allegedly receiving death threats. The self-appointed creditor-in-chief lectured them, “I don’t stand with those who held out when everybody else is making sacrifices…”

Thus the law was stood upon its head. The so-called “absolute priority” rule of bankruptcy demands that senior creditors be paid in full or consent to juniors jumping the queue. Andrea Belz, a management consultant in Pasadena, California, compares the strategy to that of private equity or venture capitalist owners, who “lend money to a company, so by calling in the note can seize control of the organisation.”

There Will Be Consequences
“If you change the rules of the game, midstream and without prior notice, you make it riskier to become a secured lender,” warns Stephen Selbst, a Manhattan attorney with Herrick Feinstein. Upsetting established legal rights sends a signal. Now, more than ever, the American economy needs private investment to help shore up failing industries. The damage incurred by monkeying with the sanctity of contract law may exceed any benefits from sustaining a zombie car company.

Lenders, both secured and unsecured, will think twice about investing in distressed bonds, and if they do so, will seek higher interest rates. “It won’t make me less interested in being a lender to strong companies that are unlikely to fall into a government situation,” notes wealth manager Mike Martin in Columbia, Maryland. “But it will raise the risk premium demanded by junk bond investors or even eliminate the category.”

Investors should beware of an unrealistically short window for alternative bids. Is Fiat the ideal partner? The bankruptcy judge is allowing only two weeks to assemble a deal – a tall order indeed. A bankruptcy court normally permits a full and fair opportunity to market a company, to seek competing bids.

Disrupting the expectations of secured lenders creates a paradigm shift, and threatens to raise the cost of capital, a lifeline on which companies often survive. Belz points out a further risk. When new creditors exercise regulatory power, new interests may not align with those of commercially motivated investors. Suppose the government pressures the auto maker to produce green cars, as part of a social agenda, even if they are not economical? Such meddling may not dovetail with internal rate of return, payback times, or other standard business drivers. A board member/creditor may not be acting with the company’s best interests at heart. Up goes the cost of capital again, indifferent as to whether President Obama “stands with” those making sacrifices.

Power of the Purse
The law could have been rewritten – in Congress. In another messy and complex bankruptcy case, the Italian government enacted changes to insolvency legislation in 2003. Selbst, who was involved in those Parmalat proceedings, maintains that the Obama administration neglected such an intermediate step. Since they might have made a legitimate public policy case, they might have succeeded. The question is, when does the ranking of recovery rights among classes take a back seat to the rehabilitative, fresh start principles of bankruptcy? Says Selbst,“at least there would have been a public debate.”

As the Chrysler bankruptcy unfolds, we will witness tension between two very equal interests, predicts Bob Dremluk, an attorney in New York with Seyfarth Shaw. There is no neat dividing line between haves and have-nots. The denigrated hold-outs are not just greedy vultures, but are pension funds, insurance companies, and others to whom people gave money to invest. “Consider a schoolteacher,” Dremluk posits, “who paid money into a pension fund that is now in Chrysler bonds. On the other side, Chrysler workers and union members will lose jobs and funding. As you peel back the onion, both sides demonstrate compelling arguments.”

The American government has picked its winners and losers. With almost unlimited ability to print money, and thereby influence the regulatory environment, the administration can direct the workings of the free market. “Obama’s spin is that he represents all our interests, and puts himself in the same position as the rest of us,” Belz comments. “Most Americans understand being a shareholder better than they understand subordinated debt.”

The next chapter will focus on General Motors (GM), which “could conceivably learn lessons from Chrysler to shape a bankruptcy case,” says Dremluk. That carmaker is much larger than Chrysler, and does not appear to be tempting buyers, the way Chrysler attracted Fiat. Right now, GM and its bondholders are jockeying to stay out of court. Unlike Chrysler’s, GM’s lenders are unsecured and have no lien, so rank lower in the pecking order. Again, however, the government is offering the union a better recovery than the bondholders, disfavouring speculators, and resorting to the power of its chequebook for pursuing industrial policy. It is fine to have a policy discussion, but the US Bankruptcy Code does not draw those distinctions.