1 BY RALPH BRUBAKER & CHARLES J. TABB 2010 U. ILLINOIS L. REVIEW 1375 Bankruptcy Reorganizations and the Troubling Legacy of Chrysler and GM

2 Or, how scary is the § 363 revolution? § 363

3 Or, what is the essence of reorganization? Reorganization = ???

4 Sea change : Plan 363 sale Chrysler & GM cases are the poster children highlighting the sea change in recent years from the traditional Chapter 11 reorganization model of a duly confirmed plan to an all-asset sale under § 363 Plan 363 sale

5 The cases Chrysler: went through bankruptcy in 41 days $2 billion sale from Old Chrysler to New Chrysler free & clear of underwater senior secured debt GM: went through bankruptcy in 39 days Credit bid sale from Old GM to New GM, to underwater secured lenders

6 Traditional points of controversy re 363 sales 1 st : all-asset sale under 363, rather than via plan, deprives economic stakeholders of procedural & substantive protections in plan process 2 nd : not really a sale at all But a reorganization wolf masquerading in sale sheeps clothing Sub Rosa plan

7 Historic tests to ferret out the twin concerns The sales are suspect issue: good business reason (Lionel) i.e., why cant we wait for a plan? The reorganization wolf / sales sheep issue: No sub rosa plans in a sale (Braniff)

8 What is not the problem Neither the sales are suspect nor the wolf/sheep sub rosa issue is real concern raised by auto cases Although the sub rosa plan issue, properly understood, is implicated Problem: the plan / sale dichotomy is a false one almost any sale can be effectuated as a plan, and any plan can be structured as a sale So not helpful for a court to seek guidance on whether to approve a 363 sale in a model of a true sale or plan – no such thing!

9 What is the problem So what is our worry? Boyd risen from the dead Boyd * referring of course to the 1913 Supreme Court ruling in equity receivership case that any value in the debtor had to be distributed in accordance with distributional entitlements, notwithstanding a supposed sale structure And yet this is precisely what the auto cases – and especially GM – appear to allow

10 Boyd resurrected – and no one noticed It is bad enough that the reorganization fallacy that the Supreme Court laid to rest in Boyd was resurrected in the auto cases Even more disturbing is that no one seemed to notice – it happened sub silentio Which makes it even more likely that reorganization lawyers will be able to circumvent distributional entitlements via a 363 sale Without the real issue even being on the table

11 The central point Whether reorganization value is captured by sale or by plan is not the central question, as long as the means chosen preserves and upholds chapter 11s distributional norms … Thus, courts confronting these issues must keep their primary focus on the core need to protect the normative distributional entitlements of stakeholders, whether the reorganization proceeds by sale or plan (p. 1379)

12 A nod to plans? Given that central thesis, I might be willing (probably more willing than my coauthor Ralph?) to acknowledge that IF distributional issues are implicated, then a plan may be favored my basic point is that the plan process makes it easier for the court to monitor the fairness of, and for affected parties to have a meaningful say in, the question of who gets what But it COULD be done via a sale as long as court was alert to need to enforce distributional norms

13 Our Grades: Chrysler & GM on the real issue Chrysler: passed -- did not contravene stakeholders distributional entitlements GM: failed – did violate the rights of stakeholders to share in value of entity according to distributional norms Acknowledge that our view (esp. on Chrysler) is controversial (but of course correct!)

14 Chrysler sale All assets 35% Fiat [Old] 8% US $2B + debt assumption 2% Canada 55% equity + Senior Secured VEBA ($10B $4.6B) (owed $6.9B)Trade ($5.3B) Warranty, dealer ($4B) Pension ($3.5B) OUT: Jr. secured; Unassumed unsecured; Old equity New Chrsyler

15 GM sale All assets + pref + $6.7 B [Old] 60.8% US Credit bid 11.7% Canada + 10% common stock + pref + $1.3B + debt assumption [ eg, warranty, product liability, non-govt secured ] US & Canada secured (~ $50B) Unsecured ($117B)10% Old GM + warrants - Bonds ($27B) - UAW trust ($21B) 17.5% VEBA + warrants + pref + $6.5B New GM

16 1 st principles of reorganization Two distinct issues raised in reorganizations, and implicated in the whole 363 sale debate: 1 st : how much ? 2 nd : to whom ? One of the problems muddying the whole 363 debate is that the two issues tend to get conflated the sub rosa plan issue gets confused with the preliminary question of when an all-asset 363 sale should be permitted at all

17 All cash Way to keep the two issues distinct is to posit an all cash 363 sale In effect just converting estate assets into a pot of $ Before saleafter sale

18 1 st principle: maximize value One of the core concerns in a bankruptcy reorganization is to maximize estate value This is a question simply of how BIG a pot of $ we can get It is in everyones interests to get a bigger pot of $ Which prefer?

19 Sale v. plan agnostic on pie size! This crucial threshold issue of maximizing estate value is NOT really implicated in the sale v. plan debate

20 Value max? No reason cant get just as big (or bigger!) a pie out of estate assets in a 363 sale as in a plan Sending out disclosure statements, voting, etc. does not grow the value of the estate Individual stakeholders dont enjoy unique & special value maximization insights that can only be captured via the plan direct democracy process Indeed, give much deference to firm in business decisions Only concern should be, is the pot of $ as big as it can be ?

21 Aggregate vs individual Note, though, that just because the action proposed may maximize the AGGREGATE value of the estate does not always mean that the value to each INDIVIDUAL stakeholder will be maximized So do possibly disadvantage some individual stakeholders if we partially disenfranchise them via a sale process, rather than giving them a direct vote under a plan But, is such a harm worthy of protection, if may make the entire pot smaller? Answer: no

22 Big pot who gets The question of, is this as big was we can make the pot of $ ? is totally distinct from the question ofwho gets what out of the pot We should worry more if the who gets what issue is decided via a sale OK sale not OK sale

23 Reorganization premise -> capture surplus The whole point of trying to salvage a firm via a bankruptcy reorganization – rather than just liquidating the firm (in or out of bankruptcy) -- is the belief that extra value (the going concern surplus) can be captured going concern surplus liquidatereorganize

24 363 Sale may be ok if get surplus In principle, if our 1 st driving concern is to make sure we capture the surplus for the benefit of the stakeholders of the firm (viewed in the aggregate), then we should not necessarily object if we can realize that surplus via a 363 sale 363 sale? If realize ->then

25 Judicial test In theory, then, a 363 sale should be fine if the only issue is whether that sale allows us to maximize aggregate estate value i.e., are we still capturing the surplus? OR Judicial test: good business reason for 363 sale Gets at the getting the surplus? issue, but indirectly

26 The lose-by-waiting OK for sale Could just ask directly in any 363 all-asset sale: does this maximize the estate value? Instead, the Lionel good business reason test is framed on a would we lose estate value if we waited for a plan? and then only approve if answer yes: Sale now =Wait for plan =

27 Why require lose-if-wait justification? Query why courts will only approve an immediate 363 all-asset sale if evident would lose $ by waiting? Deference to the plan process protections (e.g., disclosure, voting, etc.) As contrasted with the more limited process rights in a sale (notice, opportunity to be heard, etc.) But do these really matter on the question of how to maximize estate value? Plan dissent usually is over the who gets what issue, not over the what should we do with the assets question

28 Could change test Could change the test to ask only if the sale = max Even if would not lose anything by waiting Thus, argue no reason not to approve 363 sale if: Sale now = Wait for plan = its going to be the same size pot either way!

29 Applying the GBR test in auto cases Even with quibble about whether it really makes sense to use a good business reason test for a 363 sale, rather than a is this really the max test, was not much of a hurdle for courts to clear on the facts in either Chrysler or in GM Courts in both cases saw the estate value as amelting ice cube – i.e., waiting likely would cause enormous loss in aggregate value

30 Call the governments bluff? One of main reasons the proverbial ice cube would melt in the auto cases was the risk that the US and Canadian governments would walk away They were putting up all the $, and said sale now or forget it Some critics say should have called their bluff – but would it really have been worth it? No other deals were on the horizon

31 What DO we need a plan for? If a 363 sale (rather than a plan) may be just as – indeed if not more – effective in maximizing aggregate estate value, then one might ask – what role does a plan ever serve? The answer is: determining who gets what, i.e., making decisions on how to DISTRIBUTE estate value to the interested stakeholders

32 Negotiating over the surplus Premise of the whole plan democracy process is to ensure a fair method of allocating the supposed going concern surplus Surplus: to whom? Plan may be required Liquidation baseline ->

33 Informed suffrage on who gets what Idea is that the various stakeholders should have the right to negotiate over, be informed about, and have a formal say (via a vote) as to which of them gets what share of the reorganization surplus, all subject to baseline protective allocation rules And that is what we call a plan

34 Sale problems If try to allocate reorganization value under a 363 sale, lose both (i) process and (ii) substantive protections Process: disclosure, voting, etc Cannot really substitute fully for in sale under 363. Fatal? Substantive: best interests, absolute priority, etc. Court COULD invoke these norms in deciding whether to approve a 363 sale

35 When 363 sale is not OK? 363 sale usually should NOT be approved when that sale directs the distribution of the sale proceeds among various stakeholders Group A Group B Group C 20% 50% 30%

36 Or, at least import distributional norms As 2 nd -best option, if otherwise a quick sale does seem necessary (due to exigencies, e.g., auto cases) the court at the very least should import distributional norms from the plan confirmation rules, including: Best interests test Fair and equitable No unfair discrimination Class treatment Plan rules 363 sale import

37 Sub rosa plan issue This distribution-by-sale problem parades under the rubric of no sub rosa plans in a 363 sale We dont think the use of the sub rosa terminology moves the analytical ball forward –begs questions of what is a sub rosa plan, and why is that bad? better to focus directly on what the real concern is And that concern is allowing unchecked & unmonitored distribution to stakeholders contrary to rights

38 Chrysler distributional attacks (1) Indiana Pension Funds (a secured Cr) argued sale was an invalid sub rosa plan because it gave value to unsecured creditors (i.e., in the form of the ownership interest in New Chrysler provided to the union benefit funds) without paying off secured debt in full. (2) Unequal treatment of unsecured creditors -> through the debt assumption of some unsecured claims, but not others

39 Reprise: Chrysler sale All assets 35% Fiat [Old] 8% US $2B + debt assumption 2% Canada 55% equity Senior Secured VEBA ($10B + 4.6B) (owed $6.9B)Trade ($5.3B) Warranty, dealer ($4B) Pension ($3.5B) OUT: Jr. secured; Unassumed unsecured; Old equity New Chrsyler

40 Secured Cr objection? nay Indiana Pension Funds objection to the distribution to the VEBA was properly rejected by Judge Gonzalez – no distributional violation in the sale 1 st : IPFs class consented to the give-up 2 nd : even if class had not consented, the fair and equitable protection for a secured class is not through absolute priority rule (i.e., cut out jr classes), but through sale of collateral with credit bid right

41 The consent? One main argument that has been leveled agst the consent point is that secured CR consent was tainted by conflict of interest, b/c the US govt was dangling TARP $ out to those banks, and effectively forced them to consent to Chrysler deal as a condition of getting the TARP $: just say yes

42 Sale / plan -> no difference re consent 1 st problem with the tainted consent argument is that Judge Gonzalez found no factual evidence to support it 2 nd, and more fundamentally – no reason why judge would have made a different finding on legitimacy of consent if in a plan context Would challenge to designate in a plan But same factual decision as in sale setting Purely a judicial call – parties dont vote on consent!

43 Protect Secured via Credit Bid For class of secured claims, a primary fair and equitable distributional protection is the right of secured class to CREDIT BID their claim on a sale In Chrysler: sale price = $2 billion Secured class had claim of $6.9 billion, secured by all assets If thought $2 billion not enough, senior secured class could have credit bid up to $6.9 billion and acquired all assets of Old Chrysler Did not do so – suggests ok with $2 billion price tag

44 {bracket caveat: Philly Newspapers!} Wont dwell on it here, but of course you all know of the possible problem wherein secured creditors are denied the right to credit bid in a chapter 11 sale, see, e.g., Philly Newspapers and Pacific Lumber Of course, even there the secured Cr is protected by an indubitable equivalent standard, so could be OK if bankruptcy judge does her job right

45 Bigger problem: CR inequality in debt assumption ? Have been considering the distribution-by-sale issue on premise that have a cash-only sale And suggest there is usually little to worry about there But what if the sale instead is not all cash, but is for cash PLUS assumption of some debts?

46 risk inequality The sale purchasers assumption of some unsecured debts, and not others, raises serious risk of improper distribution-by-sale Some unsecured creditors (those whose debts are assumed) do better than others (those whose arent) And occurs as a consequence of the sale itself

47 The distributional norm implicated Unsecured creditor equality Implement in plan context through rules governing: Classification (substantially similar only) Same treatment in class Class voting No unfair discrimination if in cramdown

48 Unequal distribution? What about this all-cash sale? NOT approve Obviously group B gets more than C, which gets more than A 100 proceeds sale Unsecured class A Unsecured class B Unsecured class C 20 50 30

49 Can reach same result via debt assumption Could restructure sale to reach the same result, with equal distribution of sale proceeds to the unsecured classes, but with a differential debt assumption by the purchaser of the to-be-preferred classes 60 + Assume zero + Assume 30 + Assume 10 proceeds sale Unsecured class A Unsecured class B Unsecured class C 20

50 Economically equivalent The two structures just described are economically identical in substance: Purchaser commits to pay 100 1. All-cash: pay 100 2. Cash + assumption: pay 60, assume 40 = 100 Creditor benefits total 100, differentially; same totals 1. All-cash: pay A 20, B 50, C 30 2. Cash + assumption: pay A 20; pay B 20+ assume 30 = 50; pay C 20 + assume 10 = 30

51 Is differential debt assumption in sale ok or not? At first blush, one is tempted to (and indeed probably should) say of course it is not okay As a form / substance matter, should treat as same case (viz., unfair discrimination as between same status unsecured creditors) whether done by all-cash sale or by cash-plus-assumption structure In a plan, the classes discriminated against could vote for plan (assume meet best interests test), but cant vote on sale so cant consent to discrimination

52 When might be ok … However, in one factual situation, the (i) all-cash and the (ii) cash-plus-assumption scenarios are NOT identical That is when the Purchaser would not pay more -- even if debt assumption were not allowed E.g., in the Hypo -> Purchaser still will only pay $60 for the estate assets, NO MATTER WHAT – whether or not allowed to assume debts In article, this is what we call Scenario One (p. 1396)

53 debt assumption $ not available to all creditors? Necessary factual premise, then, is that the $ represented by the debt assumption (in hypo the extra $40) is NOT $ that the Purchaser ever would pay as part of the sale price in an all-cash sale Stated otherwise – if Purchaser WOULD pay the extra $ as part of cash sale price (in hypo, pay $100, not $60) if debt assumption not allowed, then court should NOT allow the debt assumption We call this a Scenario Two (p. 1396 & ff.)

54 Evidentiary problem The theory is easy enough to grasp The problem for bankruptcy judges is the factual one of deciding whether a case is a permissible Scenario One (where Purchaser really, truly, wont pay more) or a verböten Scenario Two (where Purchaser would in fact pay the debt assumption $ as part of the cash purchase price)

55 Impenetrable inquiry into WWPD A major proof difficulty is the impenetrability of the factual inquiry into the question of What Would Purchaser Do if debt assumption were not allowed Self-serving testimony by Purchaser High risk of collusion And Purchaser may be completely indifferent to form

56 Analogous to other preferential give-ups The sort of problem encountered here is very similar conceptually to other preferential treatment situations, such as critical vendor payments or preferential lending terms (such as cross- collateralization) There I have suggested that only way to be sure is a OK Scenario One is to never approve a possible Scenario Two! i.e., have a flat prohibitory rule

57 Purchaser could still pay later If have a flat prohibitory rule against a debt assumption as part of a 363 sale, does not preclude the Purchaser from paying off the critical parties AFTER the sale occurs In Hypo – Purchaser pay $60 in sale, distribute $20 each to classes A, B, and C; then, after sale, Purchaser can assume $30 of Bs debt and $10 of Cs debt, if so wishes

58 But Chrysler still OK Having said that a flat prohibitory rule has much to recommend it, we still conclude that the Chrysler debt assumption = legal Scenario One As Judge Gonzalez said: not one penny of value of the Debtors assets is going to anyone other than the First-Lien Lenders any of the obligations … do not constitute a distribution of proceeds from the Debtors estates

59 Why Chrysler OK? Chrysler is perhaps the one factual situation where we CAN verify the factual claim that the Purchaser would not pay more. Why? Because the First-Lien Lenders had every incentive to get every additional dime from Purchaser that Purchaser would pay, b/c it all was going to them Paid $2 billion, owed $6.9 billion And could credit bid up to $6.9 if did not like the $2 billion price tag

60 Evidence that purchaser really means it Thus, in Chrysler, the fact the senior lenders went along with sale structured as $2 billion + debt assumption is strong evidence that the entirety of the debt assumption … was incremental value that the government was willing to pay only in the form of debt assumption. (p. 1399) * of course, one could resurrect the coercion claim re TARP funds, but that is a distinct factual question

61 Bottom line Chrysler Not a prohibited sub rosa plan The sale itself does not dictate distribution of sale proceeds in a manner that set aside the Codes rules about priority and distribution Furthermore, the dynamics of the Chrysler sale were such as to give considerable comfort as to the verifiability of that central fact, which is almost equally as important

62 GM: ritualistic self-sale = reorganization On the crucial sale-approval issue of whether the sale dictates distribution in a manner that sets aside the Codes rules about priority and distribution (and on whether that fact is verifiable), we gave Chrysler a (somewhat surprising) thumbs-up But GM is, as we say, a horse of a different color, on both counts

63 the GM sale = reorganization horse GM not a cash sale Through a credit bid of secured debt, substantially all of GMs assets were transferred to a newly formed acquisition entity whose new capital structure had already been divvied up amongst GMs creditors with a much larger allocation … to UAW retirees than to GMs other unsecured creditors

64 Reprise, GM sale All assets + pref + $6.7 B [Old] 60.8% US Credit bid 11.7% Canada + 10% common stock + pref + $1.3B + debt assumption [ eg, warranty, product liability, non-govt secured ] US & Canada secured (~ $50B) Unsecured ($117B)10% Old GM + warrants - Bonds ($27B) - UAW trust ($21B) 17.5% VEBA + warrants + pref + $6.5B New GM

65 Time machine: back to equity receiverships equity receiverships developed in 19 th century to save insolvent railroads Keep the road running Readjust the debt structure GM is a back to the future resurrection of the form of equity receiverships – but without the protective rules designed to safeguard normative entitlements!

66 A real sale Hypo: Borrow from Boyd Assets {free & clear} $61M cash Debtor PurchaserActual sale 1.Mortgagees $157M 2.Unsecured Creditors (Boyd) 3.Stockholders

67 The equity receivership structure: self-sale Northern Pac. Ry. Co. v. Boyd, 228U.S. 482 (1913) Assets {free & clear} $61M bid DR: N. Pac. Railroad Purchaser: N. Pac. Railway Judicial sale 1.Mortgagees $157M 2.Unsecured Creditors (Boyd) 3.Stockholders 1.Old Mortgagees 2.Unsecured Creditors (Boyd) 3.Old Stockholders

68 Boyds beef Argued that his claim, ranking with the unsecured creditor class, had to be paid before the stockholders could retain an interest in the new company Standard fare that debts have to be repaid before equity The supposed sale was just a sham (and thus void) as to him – old stakeholders transmuted themselves into the new stakeholders, while squeezing him out, and leaving intact those classes senior AND junior to him Thus he should be able to enforce his unsecured claim against the purchaser (Railroad)

69 The no value argument Justification proffered was that Boyd was out of the money anyway, since the 1 st -lien mortgages were for $157M and the sale bid price was only $61M: It is insisted, however, that … the specific finding in the Paton Case, established that the property was worth less than the encumbrances of $157,000,000, and hence that Boyd is no worse off than if the sale had been made without the reorganization agreement. In the last analysis, this means that he cannot complain if worthless stock in the new company was given for worthless stock in the old. 228 U.S. at 507.

70 Whats it to him? Its irrelevant, right? In effect, the argument was that since his unsecured claim against the debtor was worthless anyway, it was irrelevant as to him what the Purchaser chose to do in allocating interests in the new enterprise

71 WRONG! said Supreme Court in Boyd In one of the most important decisions, and passages, in the history of bankruptcy reorganization law, the Supreme Court in Boyd flatly rejected that argument at 228 U.S. at 508 : If the value of the road justified the issuance of stock in exchange for old shares, the creditors were entitled to the benefit of that value, whether it was present or prospective, for dividends or only for purposes of control. In either event it was a right of property out of which the creditors were entitled to be paid before the stockholders could retain it for any purpose whatever.

72 Value Debtors Estate = New Entity S. Courts determination in Boyd turns on what should have been an obvious truism: the value of the pre-sale Debtors estate is exactly equal to the value of the post-sale Purchaser = DR: N. Pac. Railroad Purchaser: N. Pac. Railway

73 No divvying up in self-sale! The result of Boyd (and similar cases, see p. 1403) is: the purchaser, acting under the guise of a sale of the debtors property to it, was not free to dole out interests in the new purchasing entity to the debtors creditors and shareholders in whatever manner the purchaser wanted

74 Vertical equity required Boyd involved a problem of vertical equity Unsecured creditor (Boyd) has HIGHER priority entitlement against DRs estate – and thus against a self-sale purchaser -- than do shareholders Cant give anything in purchaser to the junior class (shareholders) unless pay higher-ranking class (unsecured creditors) in full must respect that order 1.Mortgagees $157M 2.Unsecured Creditors (Boyd) 3.Stockholders

75 and Horizontal equity required as well Courts reorganization protections applied equally to horizontal equity Unsecured creditor has SAME priority entitlement against Debtors estate as do other unsecured creditors Cant give MORE to one unsecured CR than another, without a darned good reason – i.e., no UNFAIR DISCRIMINATION Debtor Reorganized Purchaser secured Unsecured AUnsecured BUnsecured C equity secured Unsecured B

76 Unfair discrimination protection In diagram on preceding slide, Unsecured A and Unsecured C could rightly complain about fact that Unsecured B got a stake in the reorganized purchaser, and they did not Yet that is precisely what happened in GM: the UAW retirees – who just had an unsecured claim like many others -- got a much larger share of New GM than did the other unsecured creditors {in diagram, then, UAW retirees are Unsecured B}

77 Not an absolute bar, but … Note that the no unfair discrimination does not mean that there can never be any discrimination between unsecureds – just that it cant be unfair So can be justified if PROVE the added value to the reorganization effort provided by the favored class And indeed the need to procure the good will of a key union could be just such a justification But the plan proponent has to prove it

78 GM/Chrysler sub silentio repeal of Boyd Now (in the 78 th slide), we come – at long, long last – to the troubling legacy of GM & Chrysler, which stems from those courts statement that: The allocation of ownership interests in the new enterprise is irrelevant to the estates economic interests And other similar statements, including: the purchaser was free to provide ownership interests in the new entity as it saw fit

79 Contradicts Boyd As showed earlier, in a self-sale setting, that exact argument was directly rejected by the Supreme Court in Boyd

80 Immunizes sale allocation of value from scrutiny If followed, the disturbing consequence of the GM/Chrysler theory is that ANYTHING GOES in terms of allocating value in the new entity The allocation of value in the new entity will be totally immunized from any judicial scrutiny whatsoever And the excluded parties dont even get a vote!

81 Our take (p. 1404): There are no limits; the § 363 sale assumes irrefutable and uncontestable omnipotence.

82 And can do it for a good business reason! 2 nd Circuit in Chrysler misguidedly collapsed and conflated sub rosa plan distributional concerns into the more general preliminary inquiry as to whether can do a 363 sale at all, viz., All proponent need show is a good business reason

83 So if debtor has a melting ice cube – apparently cannot only do an all-asset sale now to maximize value – but can distribute that value among creditors and stakeholders without any restriction! Goodbye Boyd!