By on May 5, 2009

Well, the initial pleadings have been filed. Chrysler’s argument is essentially that it’s a “dead man walking.”  In its opening memorandum of law in support of its motion to approve the sale, Chrysler argues that if the “sale” doesn’t close on the accelerated timetable proposed, it will wither on the vine, resulting in “a rapid and severe loss of value.”  (Mem. at 10).  Surprisingly, though, Chrysler’s opening memorandum doesn’t squarely address the issue laid bare in my previous post and in the preliminary objection of the dissident lenders; that is, why isn’t the proposed transaction a sub rosa plan of the kind prohibited under the law of the Second Circuit?

In dancing around this question, Chrysler’s lawyers submit a two-pronged response, arguing that the transaction should be approved because, first, Old Chyrsler is receiving “fair consideration” in the transaction and, second, Chrysler’s going concern value will be preserved, jobs will be retained, and an extensive network of independent dealers and suppliers will live to see another day.

Chrysler’s opening memorandum of law, however, does not address the important question of why, absent the consent of the dissident lenders, 65% of the equity in New Chrysler should go to junior creditors in satisfaction of their respective claims against Old Chrysler while the claims of senior dissenting lenders go unpaid?

One thing’s for sure, Chrysler’s (and soon GM’s) court battles will afford us a rare opportunity to witness one of bankruptcy law’s most fundamental questions being litigated in the highest stakes battles of all time: when does the “absolute priority rule” which establishes a hierarchy of recovery rights among creditor classes, take a back seat to the “fresh start,” rehabilitative policy of chapter 11?

Chrysler’s opening memorandum touched upon this question by focusing on the US Supreme Court’s pronouncement in NLRB v. Bildisco & Bildisco465 U.S. 513, 528 (1984). The Court stated that the “fundamental purpose of reorganization is to prevent the debtor from going into liquidation, with an attendant loss of jobs and possible misuse of economic resources.” This principle, Chrysler argues, is paramount and (quoting NY’s judicial patriarch, Bankruptcy Judge Lifland, in the old Eastern Airlines case) “all other bankruptcy policies are subordinated” to it.

Many, however, will surely disagree with Judge Lifland’s statement from twenty years ago that all bankruptcy policies should be subordinated to the reorganization objectives of the Bankruptcy Code. Indeed, even on a practical level, as “Chapter 11’s Failure in the Case of Eastern Airlines” note, such a policy is a failure:

Eastern Airlines’ bankruptcy illustrates the devastating effect of court-sponsored asset stripping—using creditors’ collateral to invest in negative net present value “lottery ticket” investments—on firm value. During bankruptcy, Eastern’s value dropped over 50%. We show that a substantial portion of this value decline occurred because an over-protective court insulated Eastern from market forces and allowed value-destroying operations to continue long after it was clear Eastern should be shut down.

And what of Northern Pacific Railway Co. v. Boyd?

Following the Panic of 1893, shareholders and bondholders combined in a proposed reorganization plan to transfer the debtor’s assets to a new company that they would own, while freezing out the railroad’s general unsecured creditors, whose priority fell between the bondholder and shareholder classes (sound familiar?).

The unsecured creditors argued that the foreclosure sale contemplated by the plan “was the result of a conspiracy between the bondholders and shareholders to exclude general creditors” from the new company.

The trial court overruled the unsecured creditors’ objection. They held that as the debtor was insolvent and there was no value for unsecured creditors (or in this case, the dissident lenders). So the unsecured are entitled to nothing.

Nowadays, collusive efforts to squeeze out the dissenting middle are often called “reverse cramdowns.” As noted previously, the Third Circuit held that plans proposing “reverse cramdowns” may violate the so-called “absolute priority rule.”

More significantly, the Second Circuit in Motorola, Inc. v. Official Comm. of Unsecured Creditors, addressed attempts to squeeze out the middle in the context of a settlement that the debtor sought to have approved under Bankruptcy Rule 9019.

That case provided critical guidance in gauging the authority of Judge Gonzalez to approve the proposed “sale” transaction, in contravention of the requirements of the absolute priority rule. The court stated:

Motorola claims that a settlement can never be fair and equitable if junior creditors’ claims are satisfied before those of more senior creditors. The phrase “fair and equitable” derives from Section 1129(b)(2)(B)(ii) of the Bankruptcy Code, which describes the conditions under which a plan of reorganization may be approved notwithstanding the objections of an impaired class of creditors, a situation known as a “cramdown.”

Bottom line: the court must be certain that parties to a settlement have not employed a settlement as a means to avoid the priority strictures of the Bankruptcy Code.

Glaringly absent in Chrysler’s motion in support of the sale: reference to Bankruptcy Rule 9019. This could be fatal.

While Section 363(f) permits sales free and clear of liens, nothing in Section 363 contemplates the kind of restructuring of rights preposed. Given the seemingly narrow instances in which the Second Circult would authorize a compromise that violates the absolute priority rule, the omission may be intentional.

It’s surprising that the dissident lenders didn’t raise this point in their preliminary objection to the sale, but I suspect it won’t be long before they do.

[Steve Jakubowski works for the Coleman Law Firm]

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14 Comments on “Chrysler Bankruptcy Analysis III: Will The “Absolute Priority Rule” Kill The Sale?...”

  • avatar

    Yeah, What he said.

  • avatar

    Memo to Chrysler: the “rapid and severe” loss of value has already happened.

  • avatar

    I think the most relevant part of the Northern Pacific case is this:

    “7. This conclusion does not, as claimed, require the impossible, and make it necessary to pay an unsecured creditor in cash as a condition of stockholders retaining an interest in the reorganized company. His interest can be preserved by the issuance, on equitable terms, of income bonds or preferred stock. If he declines a fair offer, he is left to protect himself as any other creditor of a judgment debtor; and, having refused to come into a just reorganization, could not thereafter be heard in a court of equity to attack it. If, however, no such tender was made and kept good, he retains the right to subject the interest of the old stockholders in the property to the payment of his debt. If their interest is valueless, he gets nothing. If it be valuable, he merely subjects that which the law had originally and continuously made liable for the payment of corporate liabilities.”

    228 U.S. 482, 508

    What I take away from that passage is the notion that the dissenting Chrysler creditors can ask for all the cash they want. But they might not get it, especially if it isn’t there. They could ask for, and get, equity or other securities in NewCo, if that’s something they want to chance. They have no complaint with the current equity holders, because those holders are walking away with pretty much nothing, not even an equity stake in the NewCo. They can complain that creditors junior to them (U.S. Gov’t, UAW) are trying to queue-jump when they have no right to do so. But again, that does not automatically entitle the senior creditors to a sufficiently rich cash payout; circumstances being right, the bankruptcy judge could stick them with no cash but a mix of securities in the NewCo, and let their fortunes hinge on the success of Fiat as the new manager.

    I suppose the mix of securities would hinge on the going-concern value one attached to the enterprise: If you thing it’s worth $27bn, then a 10% stake is worth $2.7bn. If you buy out the assenting bondholders for a pennies-on-the-dollar settlement, and leave bonds with a face value of ~$2.5bn outstanding, then the Treasury and the UAW can keep most of the equity. If you argue the going-concern value is lower, you’d need to give more to the bondholders. You could probably even issue them senior notes in NewCo with a face value equal to the face value of what they currently hold, give them a small bit of equity in lieu of the next interest payment or two, and see if Chrysler can start selling cars at a profit again. As usual, this all comes down to dueling valuations.

  • avatar

    Great analysis, Mr. Jakubowski; glad to see you double-posting here from your bankruptcy blog. NBK-Boston‘s comments are excellent as well, and I’ve really enjoyed toxicroach‘s insights. Who needs to search around the web for analysis of the Chrysler bankruptcy when TTAC serves as a gathering place for so many sharp legal minds? (Speaking of which, have you ever figured out how many of your readers are lawyers, RF?)

    I agree that the apparent “misses” in the recent filings are puzzling, though perhaps intentional. Personally, if I were paying $900/hr for the work of senior partners on my bankruptcy case, mistakes of that sort would not be even remotely acceptable (even if, given the pace of these proceedings, they are perhaps somewhat understandable). Then again, in law you don’t always get what you pay for.

  • avatar

    Great analysis, Mr. Jakubowski; glad to see you double-posting here from your bankruptcy blog. NBK-Boston’s comments are excellent as well, and I’ve really enjoyed toxicroach’s insights.

    It would be nice if TTAC could get Robert Tilton’s comments on the Chrysler filings.

    As a non-attorney it seems like a lot of attorneys familiar with bankruptcy are saying “not so fast” when it comes to the PTFOA’s plan for Chrysler’s quick restructuring.

  • avatar
    Robert Schwartz

    Steve Jakubowski: Thank you for an excellent article. You might wish to add to the the list of readings SCOTUS’s most recent exploration of the absolute priority rule, Bank of America v 203 N. LaSalle St. 526 U.S. 434 (1999). One of its teachings is that the rule is now codified at 11 USC 1129. Parsing the Boyd case is of historical interest, but can not be dispositive of this case.

    Personally, I would think the better arguments might be more procedural. First, I think that there is a good argument that a 363 sale should not be used to take the place of a plan of reorganization which may only be approved after disclosure and voting. In this case the 363 would seem to condemn the rest of the proceeding to being a low asset Chapter 7.

    Furthermore, the dealers could argue that the 363 sale acts to reject their dealership agreements without compliance with 365.

    I said last night, and I still believe that this deal shines and stinks. I hope that Judge Gonzales will not be bowled over by the full weight of the Federal Government, and will take control of this process before it is further corrupted.

  • avatar

    They can complain that creditors junior to them (U.S. Gov’t, UAW) are trying to queue-jump when they have no right to do so.

    Adding to that complaint the creditors have claimed that because it is the gov’t that is queue jumping (both on its own behalf and on behalf of the UAW) the deal constitutes an illegal “taking” by the gov’t and violates the Fifth Amendment.

  • avatar

    I distinguish a fifth-amendment taking from a more mundane queue jumping attempt by asking the following question: Is this something that a private party could do / attempt to do?

    Proposing a reverse-cramdown, an accelerated transaction schedule, and all the other hardball moves we’ve seen so far are not beyond what private parties can do (and sometimes actually try to do) in court. If a bank can do it, on its own, it’s not a taking.

    Going out and seizing property by eminent domain, or, more subtly, arguing for different treatment in bankruptcy court because of a government interest, is more in the realm of “taking.”

  • avatar

    This to me sums up the entire situation with both the GM and Chrysler Bail Outs:

    Eastern Airlines’ bankruptcy illustrates the devastating effect of court-sponsored asset stripping—using creditors’ collateral to invest in negative net present value “lottery ticket” investments—on firm value. During bankruptcy, Eastern’s value dropped over 50%. We show that a substantial portion of this value decline occurred because an over-protective court insulated Eastern from market forces and allowed value-destroying operations to continue long after it was clear Eastern should be shut down.

    The only chance either of these companies have is to shed ‘value destroying operations’ and get down to a sustainable size right now.

    Of course, that goes against the goal of saving every single UAW job.

  • avatar


    Here’s the bondholders’ pleading in regard to the Fifth Amendment issue. IANAL (though I did successfully file for a patent) but it seems to me what what they are saying is that the Radford case establishes that property rights are protected in bankruptcies under the takings clause and that according to Radford even subsequent legislation, in this case the TARP, doesn’t give the government the power to take away those property rights without just compensation:

    III. The Taking of Collateral through a Direct or Indirect Use of TARP Authority is Unconstitutional.

    13. The Treasury Department relies on TARP as the purported authority to justify the disparate treatment under the 363 Sale, even though TARP was enacted after the Senior Lenders’ liens on the Debtors’ property were already in place. The Supreme Court long ago recognized, however, that a secured creditor’s interest in specific property is protected in bankruptcy under the Fifth Amendment. Louisville Joint Stock Land Bank v. Radford, 295 U.S. 555, 594 (1935). That case involved a Depression-era statute that was intended to help bankrupt farmers avoid losing their land in mortgage foreclosure. The statute in Radford provided that the bankrupt debtor could achieve a release of the security interests either (i) with the lender’s consent, purchasing the property at its then appraised value by making deferred payments for two to six years at statutorily-set interest rates; or (ii) by seeking from the bankruptcy court a stay of the proceedings for up to five years during which time the debtor could use the property by paying a rent set by the court, which payments would be for the benefit of all creditors, with a purchase option at the end of that period. Id. at 856-57.

    14. Justice Brandeis noted that the “essence of a mortgage” is the right of the secured party “to insist upon full payment before giving up his security [i.e., the property pledged].” Radford, 295 U.S. at 580. In invalidating the statute, the Court stated that “[t]he bankruptcy power . . . is subject to the Fifth Amendment,” and that the pernicious aspect of this law was its “taking of substantive rights in specific property acquired by the bank prior to the act.” Id. at 589-90 (emphasis added). Thus, Congress could not pass a law that could be used to deny to secured creditors their rights to realize upon the specific property pledged to them or “the right to control meanwhile the property during the period of default.” Id. at 594. That is precisely what the Treasury Department would have Chrysler do here, with respect to the Chrysler Non-TARP Lenders’ property rights that were acquired prior to the enactment of TARP.

    15. Relying on purported authority provided by TARP, the Treasury Department is demanding that Chrysler’s assets be stripped away from the coverage of the Senior Lenders’ liens – thereby impairing the rights of the Senior Lenders to realize upon those assets – so that those assets may be put in New Chrysler and used to the benefit of unsecured creditors in this proceeding, who will then be paid much more than the Senior Lenders. But, even assuming that TARP provides the Treasury Department with authority to provide funding to the Debtors and impose the transfer of collateral away from the Senior Lenders, TARP was enacted long after the Senior Lenders contracted with the Debtors and received senior liens on the Debtors’ property. Radford specifically disallowed the use of a law to retroactively alter existing liens on property.

    16. Here, the proposed sale of the Debtors’ assets will leave the Senior Lenders with a diluted pool of assets and no further interests in the operating assets covered by their specific liens. The Constitution forbids this application of a law retroactively to undercut the Senior Lenders’ pre-existing property rights in favor or inferior creditors.

    17. Finally, that the Treasury Department would take these unconstitutional actions to help the United States address difficult economic times is not an answer. Indeed, the same justification was expressly rejected in Radford, where Justice Brandeis noted that a statute which violated secured creditors’ rights, but which was passed for sound public purposes relating to the Great Depression, could not be saved because “the Fifth Amendment commands that, however great the nation’s need, private property shall not be thus taken even for a wholly public use without just compensation.” Id. at 602.

    18. What is really striking here is that what is being proposed by the Sale Motion would strip the Collateral away and allow it to be put to use as new capital in New Chrysler for the benefit of existing and other creditors – even though the Chrysler Non-TARP Lenders have been given no opportunity to realize upon that Collateral to the point of full repayment ahead of at least $14 billion of selectively identified unsecured creditors.

  • avatar


    That statement of the law is based on some sound footings, but it is being spun a notch too far. If you take their argument at face value, every 363 sale would be unconstitutional — a result that does not seem reasonable.

    While they point to the recently-enacted TARP legislation as the johnny-come-lately law which is supposedly stripping them of their earlier-acquired security interests, what they are really objecting to is the 363 sale: “What is really striking here is that what is being proposed by the Sale Motion would strip the Collateral away and allow it to be put to use as new capital in New Chrysler.”

    The whole point of a 363 auction is to package up the useful assets, sell them at auction with no strings attached, and so maximize the cash recovery which is then deposited into the bankrupt’s estate for the benefit of the creditors. It is in principle very similar to a foreclosure auction, which is exactly why it doesn’t violate the fifth amendment; the depression-era law did not provide for a quick auction and recovery of cash proceeds, and could force the mortgagee to lease out land that he forceclosed upon and would rather sell quickly. Lack of a quick, fair cash sale, if the lender wanted one, was why it was a violation. But that’s not lacking here.

    The critical thing then becomes how the cash in the bankrupt’s estate is then distributed; in principle, it should be first applied to fully satisfying the secured lenders, and the scraps divided among the unsecured creditors.

    One thing which the non-TARP creditors and other administration critics bring up is the fact that the government and the UAW will be getting equity in the new company after bankruptcy, which is getting the assets free and clear of any liens. The critics suggest that this shows that junior creditors are coming out ahead of senior creditors, and at their expense. But that is a red herring. Assuming that the cash deposited in the old corporate shell is the best and fairest price for the sold-off assets, that’s all the secured creditors are entitled to. Where the purchase money comes from, and how the purchasers dispose of the assets they just bought, is immaterial. (One fine point to put on that: Any DIP financing that the government provides during the bankruptcy has its own priority, distinct from the secured but junior pre-bankruptcy loans.)

    Imagine Santa Claus comes along and outbids Fiat for the Chrysler assets. He then decides to give the entire company to the UAW — neither the government nor the Fiat get a share. While the UAW was a junior creditor to the bondholders and should not get a better deal on its obligations, its receipt of equity in the new company has nothing to do with the junior debt illegally trumping the senior debt. It has everything to do with the generosity of Santa Claus.

    Only there is no Santa Claus, and the thing which entitles Fiat, the Government and the UAW to the equity in the new company is not the strength of their claims based on junior pre-bankruptcy obligations, but the fact that the U.S. Government is going to step in with yet another couple of billions of dollars to legitimately pay for the assets — and then give those assets away to its favored constituencies (itself, the unions, and the Italians, apparently). The story here is not one of the trumping of the rule of law, but of another run-of-the-mill government handout.

    Why pay off the UAW? 1. They make campaign contributions and vote. 2. If their VEBA doesn’t get something, they might be crazy enough to go on strike against the new owners. 3. If that fails, they may just start setting fire to random parts of Michigan, for all I know. Like it or lump it, but those are reasons.

  • avatar

    Why pay off the UAW?

    Some pay off — it’s worthless stock. If Fiat isn’t successful, the VEBA asset’s will consist largely of a note that they can’t collect.

    The reason to keep the UAW on board is because the buyer (Fiat, etc.) needs to have access to a workforce as soon as possible if it wants to produce cars, which it will want to do if it makes money. Fiat needs workers; it does not need bondholders.

  • avatar

    3. If that fails, they may just start setting fire to random parts of Michigan, for all I know.

    This reminds me, one hilariously ignorant aspect of folks who believe in private ownership/property religiously is they forget that early “governments” were created to protect the wealthy from mobs with torches and pitchforks, and which continue to do so to this day.

    So I guess one day those wealthy decided that instead of paying for this disproportionate protection of the law, and figured it’s cheaper to make the dumb plebs think that it’s more fair for everyone to pay for this “equal” protection. I mean, how hard could it be to manipulate poor/dumb people, right? And right they were.

  • avatar

    This is why I sold my Ford bonds. I was afraid I would get crammed down to nothing in a government bailout. I and walked away with my principal and even a substantial profit with self respect intact, which is more than i can say for the Chrysler bondholder

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