Bankruptcy revisited

In the past month we have perhaps seen the most dramatic evidence of the fall of U.S. dominance of the global manufacturing sector -- a collapse that has been taking place for decades, ultimately culminating in the bankruptcies of two of America's most dominant automobile manufacturers.

The Chrysler LLC and General Motors Corp. bankruptcies present enormous economic risks to the U.S. economy. The direct losses associated with the liquidation of these companies -- to their employees, creditors, dealers and suppliers -- would have staggered any hope of recovery from our economic malaise. But the secondary losses -- to communities and the hundreds of thousands of employees of companies that dealt with GM -- would have been much worse. And the magnitude of the psychological impact of the failures of these two companies would have been immeasurable. Liquidation was not an option.

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The solution, perhaps the only solution, was to put these companies into bankruptcy, and to use the protection afforded by the bankruptcy system to permit the companies to restructure themselves: to rid themselves of crippling debt, onerous labor agreements and unprofitable franchisees, and to downsize to more economically viable enterprises. But a typical bankruptcy reorganization in the case of enterprises as complex as Chrysler and GM normally take months if not years, and the uncertainty during the normal bankruptcy process could have put the viability of both companies at risk.

So the government and the management of the two companies came up with a plan. While one might laud the creativity behind the plan, there are serious questions as to its legality.

The Bankruptcy Code contemplates two bankruptcy options available to companies in financial distress.

Chapter 7 is quick but very dirty; it would have involved the liquidation of Chrysler and GM. Conversely, Chapter 11 takes time. It requires the bankrupt company to develop a reorganization plan, to provide creditors with adequate information about the plan, to permit those creditors to vote on the plan and ultimately to obtain court approval of the plan. The code does not require that all classes vote in favor of the plan, but if the company cannot obtain unanimous creditor consent by class, then a judge must approve the plan in accordance again, with a priority scheme set out in the code. Chapter 11 also contemplates that where unanimous creditor consent is not forthcoming, the bankruptcy judge will review the plan to ensure it does not "unfairly discriminate" among or between classes of creditors.

The government and Chrysler in its bankruptcy, and the government and GM in its bankruptcy apparently decided that neither of these two options was desirable. A Chapter 7 liquidation would have thrown the U.S. economy into turmoil, and a Chapter 11 reorganization would have taken too long. So the government and the companies decided to use a third option to pursue their bankruptcy objectives -- but one that is not reflected in any comprehensive Bankruptcy Code chapter. The government and the automakers are, instead, using a specific power granted to bankruptcy trustees and debtors-in-possession under s. 363(b) of the Bankruptcy Code. Section 363 authorizes a trustee or debtor-in-possession to sell assets of the bankrupt firm, either before liquidation or ahead of the development of a reorganization plan. In most cases, this power is used by a bankrupt firm that is developing a reorganization plan to sell assets quickly if it can obtain a good deal for them -- a deal that might not be around months in the future.

But in these two bankruptcies, GM and Chrysler are not selling an asset or two. The automakers are selling all of the valuable assets of the companies, and they are selling them to a group of former creditors. Indeed, the strategy appears to be a "short form" bankruptcy: sell valuable assets to a third party, and then liquidate the remaining assets of the firm; file a "Chapter 11 liquidation plan" and distribute the proceeds in accordance with the Bankruptcy Code's rules. There is no "reorganization plan" being developed for the old GM and the old Chrysler. The reorganization is taking place through the asset sales.

While this approach might be desirable as a pragmatic technique to run these two companies through the bankruptcy process quickly, the strategy confronts at least two major legal challenges.

First, the strategy disenfranchises GM and Chrysler creditors, both secured and unsecured. The creditors' voting rights, which Chapter 11 substitutes for their contractual or economic rights, are rendered superfluous when the bankrupt uses the s. 363(b) sale process. If this were a true liquidation bankruptcy, there would not be a problem. But here, GM and Chrysler are selling their assets to a company owned by groups of their former creditors, including the U.S. and Canadian governments, the United Auto Workers and secured bondholders. It is what the courts call a sub-rosa plan, a reorganization in the guise of a s. 363(b) sale. There is no "plan" that the creditors -- some of whom may not be pleased with the distribution of benefits implicit in the s. 363(b) sale -- can vote on.

Second, the approach the companies and the U.S. government are taking radically changes the role of the bankruptcy judge. When an s. 363(b) asset sale is proposed, the court simply asks whether the sale is in the best interests of the bankrupt firm. If the senior management and major creditors say yes, the court is likely to listen seriously to those claims. The use of s. 363(b) does not permit a judge to assess the legality of the reorganization plan, as there is no plan. Thus, there is no consideration whether the proposal accords with the Bankruptcy Code's priority scheme applicable to reorganization plans. There is no plan that a bankruptcy judge could evaluate to ensure that there is no "unfair discrimination" among classes of creditors. Again, there is no plan.

The approach advocated by the U.S. government and the automakers' senior management allows for a subset of major creditors -- including the U.S. government -- and the senior management of the bankrupt companies to ignore the priority rules that provide a framework for the distribution of benefits under a plan of reorganization. The approach denies all creditors -- including secured bondholders and unsecured lenders, dealers, suppliers, employees and others -- their right to vote on a reorganization plan after having received adequate disclosure of material information. Further, it denies the court the ability to perform its duty to review the plan ensuring that it does not unfairly discriminate among the companies' creditors and that it distributes the reorganization's benefits in accordance with the law.

We know that the Supreme Court decided against reviewing the decision of the 2nd Circuit in the Chrysler case. But one should not think that the same would happen if the GM sale were challenged. In the Chrysler bankruptcy, the court was made aware that any delay could very well result in Fiat SpA pulling out of the deal. The Supreme Court decision to not review the Chrysler sale, should not be interpreted as approval of the lower court decision -- but rather as a necessity given the consequences of delay. The GM bankruptcy does not involve a third party "white knight." While a delay in the GM bankruptcy sale would be expensive, it would not result in the collapse of the GM bankruptcy process. 

David Cohen served as the dean of Pace Law School from 1999-2004. Cohen came to Pace after having served for five years as dean of the University of Victoria (Canada) Faculty of Law. He teaches in the areas of law and regulatory policy, commercial law and planning, contract law, and law and economics.

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