Assessing the Chrysler Bankruptcy

In a recent working paper Assessing the Chrysler Bankruptcy, which I presented at the Law and Economics seminar here at Harvard Law School, David Skeel and I evaluate the Chrysler bankruptcy. Chrysler entered bankruptcy 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 transaction that transferred its auto business and most of its preexisting creditors to a new company principally owned by some of Chrysler’s old creditors.

The transaction proved controversial in capital markets, as some lenders — those left behind with claims on the shell company that had owned the auto business — complained that their entitlement to priority wasn’t honored. Warren Buffett wondered out loud that there would be “a whole lot of consequences” if the transaction was approved, as it was, because it could “disrupt lending practices in the future.”

Our overall conclusions are not favorable to the process and results. The Chrysler bankruptcy process used undesirable mechanisms that federal courts and Congress struggled for decades to suppress at the end of the 19th and first half of the 20th centuries, ultimately successfully. If the mechanisms are not firmly rejected, either explicitly or via judicial (or legislative) distinction or via a collective forgetting of the event among bankruptcy institutions, then future reorganizations in chapter 11 will be at risk, in ways that could potentially affect capital markets.

We begin by outlining the structure of the Chrysler transaction, which moved under the Bankruptcy Code’s permission to sell all of part of a firm in bankruptcy — § 363 of the Code. We next analyze the theoretical structure and prior appellate history for how the sales provision should interact with the Code as a whole, in particular with the Code’s stiffer priority requirements. In general, sales should not proceed in ways that oust the priority provisions of the Code.  For sales to be approved by the court, they generally need to be arms-length transactions and market-validated via auctions, or they should proceed through the protective measures elsewhere in the Code. Courts need to be alert, as many courts had been previously, when the principal buyers are prior owners or creditors of the selling firm, not operating at arms-length. Such transactions are ripe for insider distortions.

While cast as a sale, the Chrysler transaction had so many pre-sale creditors reemerging on the other side of the transfer that the transaction can, and should, be re-characterized as not being a sale to a third party, but as an ordinary reorganization, but one not done in accordance with chapter 11, which gives dissenters substantial rights, including rights against conflicted creditors at the same priority level. We suggest a rough rule-of-thumb for courts to sort presumed reorganizations (which need to proceed under alternative, well-honed Code provisions) from plausible § 363 sales.

Although the government’s presence obtained judicial deference in Chrysler, the government’s presence as a noncommercial lender isn’t needed, as a matter of Code structure, for interested players to use the Chrysler pseudo-sales mechanism. Every reorganization in chapter 11 can use the same, defective process. Not only did the subsequent General Motors opinion rely heavily on Chrysler, but other courts and plan proponents are already citing the Chrysler decisions as precedent.  In fact, any coalition of creditors and managers can use the § 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 § 363 sales that did not always carefully consider § 1129 priority issues. But by blessing an artificial sale in a very large case that carried over and restructured the bulk of Chrysler’s creditors’ claims — at a level greater than the prior norm in such sales — Chrysler sharply expands this strategy’s potential scope. The sale overwhelmingly determined the distribution to pre-bankruptcy creditors. If it becomes the pattern, Chrysler could displace the traditional chapter 11 process, potentially affecting both lending markets and vulnerable nonfinancial creditors adversely.

The damage will need to be undone.  The Second Circuit magnified the harm by giving its imprimatur to the bankruptcy court’s result. The courts’ 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.  If not, Congress may need to restructure § 363, along the following lines:

The trustee, after notice and a hearing, may, and any party in interest may propose to, use, sell, or lease, other than in the ordinary course of business, property of the estate. If such use, sale or lease involves substantial operations of the debtor, it shall be approved only if validated in an open auction that does not materially determine the distribution to claims on and interests in the debtor’s property.

The full paper is available for download here. Also, an earlier post on the Chrysler bankruptcy, which also appeared as an op-ed on Forbes.com, is available here.