Big Three Bailout and Bankruptcy

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With the country in the midst of the largest economic crisis since the Great Depression, with unemployment at its highest in decades, and with job creation as the top priority of the incoming Obama administration, it is likely that the Government will act to prevent the massive unemployment and huge economic dislocation that would be occasioned by the failure of the Big Three automakers. Absent a miraculous reversal of misfortune, the Big Three cannot survive without governmental help. No private lender or consortium of lenders has the ability or the desire to finance their continuing multi-billion dollar losses pending a retooling. And, however well made and energy efficient their vehicles are or become, the Big Three cannot expect to sustain sales, when the buying public is uncertain whether they will be able to keep their long-term purchases properly maintained with warranty service and available parts.

Yet the Government will not write a blank check. Bailouts are not popular with taxpayers who must ultimately fund them. Because of the enormous amount of sacrifice to be borne by the public, it is politically unthinkable to provide governmental assistance without demanding sacrifice by the private creditors and shareholders of the Big Three. Therefore, concessions must be made by many groups, not just labor and management, who have existing legal entitlements. Lenders, trade creditors, bondholders and shareholders will all be asked to make concessions. This is where chapter 11 becomes a necessity. It is the most conducive forum to obtain and enforce concessions from large groups of entitlement holders.

To be sure, businesses may obtain concessions without filing for bankruptcy. In labor relations, collective bargaining can achieve such results. So can bond exchanges with SEC-approved prospectuses. Businesses with relatively few creditors use out-of-court restructurings or workouts to get extensions of time to pay or reductions in liability. Workouts, however, require a sort of functional unanimity in the creditor body. While complete unanimity on a concession program is desirable, the program can succeed if almost everyone agrees, and the amount of debt held by those who do not, or those who keep silent, is small enough so that the holdouts cannot use the threat of lawsuits to disrupt the program. For large and multifaceted businesses, like the Big Three, it is unrealistic to think that functional unanimity can be obtained from all constituencies from which concessions will be sought.

Chapter 11 bankruptcy is designed to permit restructurings without functional unanimity. A chapter 11 plan places groups of similarly situated creditors and shareholders in classes, and proposes for each class a treatment, such as debt reduction, extensions of time, or swapping debt for equity. Except for those classes that either get all their entitlements preserved, or, at the other end of the spectrum, get nothing, the plan is sent out to be voted on by the class members, with acceptance or rejection measured on a class-by-class basis. Significantly, chapter 11 requires much less assent than functional unanimity. For creditor classes to accept the plan, the affirmative votes must comprise two-thirds of the debt and simple majority of the number of voting creditors. Silence is unavailing, because the majorities are determined on the basis of votes that are actually cast. The court confirms the plan, making it legally binding, even on those who do not vote for it or do not vote at all, if, in addition to the satisfaction of all other statutory requirements, each class accepts the plan. Moreover, a rejection by a class is not necessarily the death knell for the plan. Chapter 11 permits the confirmation of plans rejected by one or more classes, colloquially, “crammed down” on these classes, if the court determines that the treatment provided to the dissenting classes is economically fair, equitable and nondiscriminatory. For example, a class of shareholders that gets nothing nonetheless receives a fair, equitable and nondiscriminatory treatment, if the business is insolvent, based on the fair value of its assets, and any other shareholder class of equal or lower priority also receives nothing.

Although most chapter 11 plans are negotiated and voted on after the business files for bankruptcy, that need not be the case. So-called “prepackaged bankruptcies” allow the reorganizing businesses to strike deals with various classes and put a plan to a vote prior to the formal bankruptcy filing. Classes who get all their rights preserved are presumed to accept, so they do not vote. Classes who receive nothing are presumed to reject, and they also do not vote. The prepackaged plan must satisfy the “cram down” criteria for the rejecting classes. If the prepackaged plan receives the requisite votes, the business can file chapter 11 and emerge fairly quickly, minimizing the risks, costs and delays inherent in any court process.

For these reasons, chapter 11 will likely be used in conjunction with a bailout. Of course, Congress could attempt to assist the Big Three by enacting special legislation without the stigmatizing “bankruptcy” label. This would run into constitutional problems. There are a couple of lessons that we have learned from the Supreme Court’s reaction to special legislation to assist troubled railroads in the 1970’s and 1980’s. Any legislation that deals with an adjustment of a failing debtor’s obligations is enacted under the Bankruptcy Clause of the Constitution, which, unlike the related Commerce Clause, has a uniformity requirement that cannot be circumvented. This uniformity requirement means that the law must be the same for a defined class of debtors, even though differences in types of businesses and regions of the country can be taken into account. A law that applies to only one debtor, and therefore by strong implication, only three debtors, cannot satisfy the uniformity requirement. Unless legislation applicable only to the Big Three, like the legislation nationalizing former President Nixon’s White House tapes, can be upheld as addressing a “legitimate class of one,” or in this case, three, the expected bailout will bound up in a bankruptcy. If possible, one of the prepackaged variety.




©2009 by Alec P. Ostrow. All rights reserved.



Alec P. Ostrow is a shareholder of Stevens & Lee, P.C., in its New York City office, and co-chair of its Bankruptcy & Financial Restructuring Department. He can be reached at (212) 537-0402 and apo@stevenslee.com. He is also an adjunct professor of law in the LL.M in bankruptcy program at St. John’s University School of Law, and a fellow of the American College of Bankruptcy.

Date published: Jan 21, 2009

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