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Why the Chrysler Deal Would Horrify a New Dealer

Friday, May 8, 2009

The use of a sham sale of the sort the New Dealers thought they had forever eliminated will cause mischief in future bankruptcy cases.

The Obama administration has closely patterned itself on the famous opening year of President Franklin D. Roosevelt’s New Deal. But the plans the administration has rolled out for Chrysler and is now cheering on in the bankruptcy court would make a true New Dealer turn over in his grave.

In the early 20th century, large troubled corporations did not file for Chapter 11 like they do today. They used a process known as “equity receivership,” which involved an artificial “sale” of the company to a new entity set up by the debtor and the investment banks who represented its bondholders and stockholders. The new entity was the only bidder at the sale, and creditors who were unhappy with the terms of the reorganization had very little opportunity to interfere.

New Dealers hated the process, which they saw as opaque and designed to foist a deal crafted by the insiders on everyone else. Jerome Frank, a lawyer who later headed an important New Deal agency and became a federal judge, complained in 1933 that the judicial sale in these cases “was a mockery and a sham.” He said, “A sale at which there can be only one bidder, is a sale in name only.” In 1938, thanks to the handiwork of another prominent New Dealer, future Supreme Court Justice and then-SEC Chairman William Douglas, Congress dramatically altered the bankruptcy laws, eliminating the former practice.

‘A sale at which there can be only one bidder, is a sale in name only.’

The Obama administration blueprint for Chrysler’s bankruptcy looks startlingly like the artificial sales that the New Dealers so abhorred. Unlike a traditional reorganization, in which the parties negotiate the terms of a restructuring that is then voted on by each class of creditors and shareholders, the administration plans to quickly sell Chrysler’s most important assets to a new entity—“New Chrysler”—whose stock will be owned by Chrysler’s employees and Fiat. The senior lenders who objected to the government’s offer (which amounted to little more than 30 percent of their claims) will not have any vote on the sale. Their only option is the one they have pursued: objecting to the sale, and praying that bankruptcy judge Arthur Gonzalez takes a hard look at its terms even while the government is breathing down his neck and saying in a sense, he better approve or else.

What makes the Chrysler plan unique is that it is a pretend sale and its main purpose is to eliminate the pesky creditors who might otherwise interfere with the government’s plans.

As the administration has pointed out in defense of its plan to commandeer the bankruptcy process, asset sales (known as 363 sales, based on the relevant provision) have become a common feature of Chapter 11 cases in the last 20 years. What makes the Chrysler plan unique, and makes it similar to the receiverships of the New Dealers’ era, is that it is not really a sale at all. It is a pretend sale and its main purpose is to eliminate the pesky creditors who might otherwise interfere with the government’s plans. It also seems to flout bankruptcy’s priority rules by giving Chrysler’s employees (who are general creditors) a big stake in New Chrysler while forcing senior lenders to take a major haircut. The usual rule is that senior creditors must be paid in full before lower priority creditors are entitled to anything.

Although the bankruptcy process will likely drag on for months, as Old Chrysler determines what to do with the dregs of the company that remain after the sale, the sale itself is the real ballgame. The only thing that could interfere with the administration’s plan to hijack the bankruptcy process is Judge Gonzalez, who must approve the “sale” before New Chrysler can go on its merry way. 

It is hard to imagine any judge facing down the U.S. government under these circumstances, but there are a few small tools he might use.

It is hard to imagine any judge (even Judge Gonzalez, a veteran of Enron, WorldCom, and other huge cases) facing down the U.S. government under these circumstances, but there are a few small tools he might use when he rules on the sale.

First, he could insist on an independent valuation of the sale, rather than just taking the administration’s numbers for granted. Inviting competing bids, which Judge Gonzalez did this week, might serve as an adequate test of the government’s price in an ordinary case. But bidders who are willing to go head to head with the U.S. government are not likely to be thick on the ground, which makes an independent evaluation essential. Judge Gonzalez could invite the creditors committee to hire experts, as has been done in the Lehman bankruptcy, or he could appoint an examiner for the case.

Second, he can require a complete accounting of how the sale will be structured and who will participate in New Chrysler. If the plans for New Chrysler subvert the bankruptcy rules, he can insist that the transaction be restructured. There’s no requirement that the judge accept or reject the sale as is. 

The Chrysler sale looks like the latest of a series of government interventions that have run roughshod over ordinary legal rules.

The Chrysler sale looks like the latest of a series of government interventions that have run roughshod over ordinary legal rules, and it appears to be paving the way for a similar strategy in a General Motors bankruptcy. Much of what the government is doing—allowing Chrysler to file for bankruptcy, promising to guarantee its warranty obligations—is admirable. But the use of a sham sale of the sort the New Dealers thought they had forever eliminated will cause mischief in future bankruptcy cases. Not only may the government go back to this well, but in the future private parties will conclude that sham sales are a legitimate tool in their own cases.

The government seems to have concluded—as with the bailouts of Bear Stearns and the American International Group, both of which included legally dubious provisions—that the end justifies the means in the current crisis. It will be up to Judge Gonzalez to stand up for the means. 

David A. Skeel Jr. is the David Skeel is the author of Icarus in the Boardroom (Oxford University Press, 2005) and Debt’s Dominion: A History of Bankruptcy Law in America (Princeton University Press, 2001), as well as numerous articles and other publications.S. Samuel Arsht Professor of Corporate Law at the University of Pennsylvania Law Schoolthe author of Icarus in the Boardroom (Oxford University Press, 2005) and Debt’s Dominion: A History of Bankruptcy Law in America (Princeton University Press, 2001),. He is author of Debt’s Dominion: A History of Bankruptcy Law in America.

FURTHER READING: American Enterprise Institute scholar Philip I. Levy wrote “Public Outrage as Systemic Risk,” on the problems of not allowing major companies to fail.

Image by Dianna Ingram/The Bergman Group.

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