Recently, I came across a defense of the auto bailouts that rests on the premise that the key difference between the Obama administration and its critics was over debtor-in-possession (DIP) financing. That is, because Mitt Romney suggesting that a public injection of DIP financing was not necessary in November of 2008, there is no question that he would have opposed using TARP funds for this purpose had private DIP financing not materialized.
My understanding, however, is that the public provision of DIP financing has not been the central criticism of the president’s approach to the auto bailouts. For example, Todd Zywicki of GMU Law School included the following passage in his National Affairs article on ”The Auto Bailouts and the Rule of Law“:
In late 2008, General Motors was a classic case of a financially distressed rather than an economically failed enterprise. It had a skilled and experienced work force, a stable of longstanding and well-respected brands, and an extended system of relationships with suppliers and customers — all of which illustrated both its underlying value and potential. But the company also had several major financial liabilities: expensive labor contracts, massive legacy costs for pensions and health care, and an outdated and overgrown distribution system of dealerships that needed to be streamlined. A Chapter 11 re-organization would have given GM an opportunity — perhaps its only opportunity — to cut loose this dead weight.
The only obstacle to such a restructuring might have been the requirement that a re-organizing company obtain so-called “debtor in possession” financing — loans of funds it can use in the actual process of re-organization, and which receive first priority in repayment. Some have argued that, in light of GM’s size and the instability in the credit markets at the time, the automaker might not have been able to secure such loans.
While this may be true, a reasonable argument could be made that, under those circumstances, it would have been appropriate to use funds from the Troubled Asset Relief Program to lend or guarantee debtor-in-possession financing to GM. After all, the purpose of TARP was to address liquidity problems in lending markets and to stave off bank runs that might have threatened the stability of solvent institutions. And any failure by GM to obtain debtor-in-possession financing would have been attributable to such liquidity problems in the lending markets. Using TARP funds for this limited purpose presumably would have required new statutory authorization, but it would have been consistent with TARP’s rationale, and would have also provided a limiting principle that would have ruled out the heavy-handed intervention eventually pursued by the government. Plus, congressional approval of such a measure probably would have been more forthcoming than approval of a straightforward bailout. Instead, the Bush administration — evidently in a state of panic as the economic crisis continued to mount — pursued a far more open-ended use of TARP funds, injecting billions directly into Chrysler and GM. [Emphasis added]
In a related vein, David Skeel wrote the following in his Wall Street Journal op-ed titled “The Real Cost of the Auto Bailouts”:
General Motors was a perfectly viable company that could have been restructured under the ordinary reorganization process. The only serious question was GM’s ability to obtain financing for its bankruptcy, given the credit market conditions in 2008. But even if financing were not available—and there’s a very good chance it would have been—the government could have provided funds without also usurping the bankruptcy process. [Emphasis added]
So what is the central criticism of the auto bailouts? Zywicki and Skeel were both primarily concerned about what they saw as an inappropriate commandeering of the bankruptcy process:
In the years leading up to the economic crisis, Chrysler had been unable to acquire routine financing and so had been forced to turn to so-called secured debt in order to fund its operations. Secured debt takes first priority in payment; it is also typically preserved during bankruptcy under what is referred to as the “absolute priority” rule — since the lender of secured debt offers a loan to a troubled borrower only because he is guaranteed first repayment when the loan is up. In the Chrysler case, however, creditors who held the company’s secured bonds were steamrolled into accepting 29 cents on the dollar for their loans. Meanwhile, the underfunded pension plans of the United Auto Workers — unsecured creditors, but possessed of better political connections — received more than 40 cents on the dollar.
So: the UAW was treated far more favorably than secured creditors.
Moreover, in a typical bankruptcy case in which a secured creditor is not paid in full, he is entitled to a “deficiency claim” — the terms of which keep the bankrupt company liable for a portion of the unpaid debt. In both the Chrysler and GM bankruptcies, however, no deficiency claims were awarded to the wronged creditors. Were bankruptcy experts to comb through American history, they would be hard-pressed to identify any bankruptcy case with similar terms.
Secured creditors were not granted “deficiency claims.”
To make matters worse, both bankruptcies were orchestrated as so-called “section 363″ sales. This meant that essentially all the assets of “old Chrysler” were sold to “new Chrysler” (and “old GM” to “new GM”), and were pushed through in a rush. These sales violated the longstanding bankruptcy principle that an asset sale should not be functionally equivalent to a plan of re-organization for an entire company — what bankruptcy lawyers call a “sub rosa plan.” The reason is that the re-organization process offers all creditors the right to vote on the proposed plan as well as a chance to offer competing re-organization plans, while an asset sale can be carried out without such a vote.
In the cases of GM and Chrysler, however, the government essentially pushed through a re-organization disguised as a sale, and so denied the creditors their rights. As the University of Pennsylvania’s David Skeel observed last year, “selling” an entire company of GM or Chrysler’s size and complexity in this manner was unprecedented. Even on a smaller scale, it would have been highly irregular: While rush bankruptcy sales of much smaller companies were once common, the bankruptcy laws were overhauled in 1978 precisely to eliminate this practice.
Creditors were not given the right to offer competing reorganization plans, despite the fact the fact that GM and Chrysler went through a process that was properly understood as a reorganization.
At first, the fact that the companies’ creditors (and especially Chrysler’s creditors, who were so badly mistreated) put up with such terms and waived their property rights seems astonishing. But it becomes less so — and sheds more light on how this entire process imperils the rule of law — when one considers the enormous leverage the federal government had over most of these creditors. Many of Chrysler’s secured-bond holders were large financial institutions — several of which had previously been saved from failure by TARP. Though there is no explicit evidence that support from TARP funds bought these bond holders’ acquiescence in the Chrysler case, their silence in the face of a massive financial haircut is otherwise very difficult to explain.
Though it is true that many of GM and Chrysler’s largest creditors accepted these terms, they were in no position to resist.
Indeed, those secured-bond holders who were not supported by TARP did not go nearly as quietly. A group of hedge funds that were among Chrysler’s creditors initially objected to the bailout plan that preferred the UAW at their expense. In a now-infamous speech in April 2009, President Obama publicly attacked these investors — who were merely standing up for their contract and property rights — as profiteers, criticizing them for their unwillingness to make the same sacrifices as other investors (but not, of course, UAW members, who received a windfall). In response to this public browbeating from the president of the United States, the hedge funds caved and agreed to the terms. In the end, only one group of Chrysler bond holders — the Indiana state teacher and police pension funds — continued to object. Indeed, they objected at every stage of the process, but the Supreme Court declined to hear their case.
Creditors who did resist become the object of sharp political attacks from the president.
General Motors, too, had issued secured debt during its years of financial turmoil, but these bonds made up a far smaller fraction of the company’s total outstanding debt. And in striking contrast with the Chrysler case, General Motors’s bankruptcy plan left the secured creditors intact, paying them the full value of their claims. From the perspective of bankruptcy law and contract rights, this development was encouraging: The Obama administration did not seek to plunder GM’s secured creditors as it had Chrysler’s. From the perspective of the rule of law, however, this differential treatment might have been even more troubling.
Chrysler creditors and GM creditors were treated very differently, but there was no principled basis for this differential treatment.
While I’m sure there is much to criticize in Zywicki and Skeel’s analysis, it does seem as though the focus on DIP financing is misleading: the critique of the auto bailouts goes much deeper than that. Moreover, the chief concern about the auto bailouts is how they might impact investment decisions going forward. That is, private investors might be reluctant to purchase the secured debt of distressed business enterprises in politically sensitive industries. As private investors turn away from these sectors, these sectors will grow more dependent on public financing. Profits in these sectors will be increasingly devoted to fostering a more favorable political environment, and so forth.