Lehman, Chrysler, GM: The fallout

Sitting on the bench in his Manhattan courtroom before more than 100 attorneys and advisers at half past midnight on a muggy Friday last September, Judge James M. Peck of the U.S. Bankruptcy Court for the Southern District of New York could hear a pin drop. He had just heard closing arguments to approve Barclays Capital Inc.'s hastily put together acquisition of Lehman Brothers Inc., and he was prepared to rule.

Everything had been done at breakneck speed since Lehman Brothers Holdings Inc. had filed Chapter 11 four days earlier. Regulators had already signed off on the so-called Section 363 sale of Lehman's investment bank -- at one time the fourth-largest in the U.S -- and now all that was needed for the deal to close was the bankruptcy court's blessing. Events had occurred so swiftly that it was creditors, who usually call for fast, efficient proceedings, who pleaded with Peck to slow it down until they could examine the deal more thoroughly. But Peck didn't relent.

"I know that I need to approve this transaction, and I am absolutely confident in my judgment," the judge said while signing off on the deal. "But I also know that this is so exceptional relative to the experience that I have had both as a bankruptcy lawyer and judge to know that it could never be deemed as precedent for future cases unless someone could argue that there is a similar emergency. It's hard for me to imagine a similar emergency."

But that's exactly what came next -- twice. Along came the Chrysler LLC and General Motors Corp. Chapter 11 cases in the same bankruptcy court as Lehman, as well as similarly wing-footed Section 363 sales. And that has bankruptcy lawyers worried about the long-term effects of the three cases when it comes to creditors' rights in future cases.

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"You can't have effective rights, justice and due process when your rights are severely constrained by the process," says Michael Richman of Patton Boggs LLP, who was counsel to a group of GM bondholders that objected to the automaker's sale to a U.S. Department of Treasury-backed entity. "In GM, the need for speed was contrived in order to oppress creditor rights. And absent some clarification of [Section] 363, this could always be the case."

In other words, the changes in latitude when it comes to Section 363-related decisions could result in serious changes in judicial attitude, to borrow Jimmy Buffett's phrase. After all, Judge Arthur Gonzalez cited the decision of his colleague on the Manhattan bench in the Lehman case as grounding for his own decision to approve Chrysler's expedited sale to Italian automaker Fiat SpA in May.

Some lawyers already think the genie is out of the bottle. "As creditors, we are all becoming desensitized," says Jean Robertson of Calfee, Halter & Griswold LLP, who often represents creditors. "Our definition of due process is changing. When you've had a year or two of lightning-fast sales, how are you going to go back to 60 days?"

No longer are Section 363 sales a secret to only savvy buyers, either. Section 363 of the U.S. Bankruptcy Code affords debtors the opportunity to sell assets free and clear of liens, essentially allowing a buyer to cherry-pick which liabilities to assume and which to leave behind. So buyers haven't just discovered Section 363; they're making it a requirement of sale.

Consider Chardon, Ohio-based rubber and plastic components manufacturer, Chardon Rubber Co., which filed Chapter 11 on May 15 with an asset purchase agreement in place with Westinghouse Air Brake Technologies Corp. for $3.9 million. "Chardon filed [bankruptcy] because the purchaser of the assets required the sale be done in 363. It was a condition of the APA," says Robertson, Chardon's debtor counsel. Westinghouse "wanted the benefits of a court order that provides for the sale free and clear of liens."

Section 363 sales have become so popular that, "in just about every [M&A] transaction that's distressed, there's a cost-benefit analysis" that compares a 363 sale to an out-of-court restructuring, says Rick Chance of KPMG Corporate Finance LLC. And the analysis is favoring the sale more often.

Indeed, according to pipeline.thedeal.com, there have been 200 Section 363 sales announced, completed or withdrawn this year through July 31, worth $84.5 billion. The Chrysler ($2 billion) and GM ($48.7 billion) sales strongly influence those numbers, of course. But for the same time frame in 2008, there were 164 deals for just $5.3 billion, and in 2007, only 87 deals for $12 billion.

Another key factor in 363 sales is the ability of debtors to sell assets expeditiously outside the confines of a traditional Chapter 11 plan, which needs creditor support. Alas, while the law has evolved over the past 20 or so years as a way for debtors to sell a wasting asset in time to save value, using this strategy leaves creditors with little to no voice in the process. For example, the U.S. Bankruptcy Code requires that a debtor provide its creditors with a 20-day notice period before seeking court approval of a 363 sale. Lehman's creditors, however, had only two days to examine the deal and file objections.

Section 363 "has become a strategic device that purchasers are able to utilize much more freely than before," says Richman. The dominance of senior secured creditors in the current cycle, many of them hedge funds and other distressed investors adept in the "loan to own" strategy, have essentially turned 363 "into a straightforward foreclosure practice," he says.

Almost always, the only financing a bankrupt company can raise nowadays comes with covenants that demand a fast-paced sale process. And lenders usually credit-bid their debt at a 363 auction, loans that were often extended only weeks before a bankruptcy filing. "The increasing speed of 363 sales necessarily impinges due process rights," Richman argues. "Creditors often have no realistic opportunity to organize and mount a real opposition."

In the Lehman case, the big fear was that the firm's value was declining precipitously during its first week in bankruptcy as large hedge funds and money managers were shifting their accounts to other brokers. Indeed, the book of securities going to Barclays had declined in value from about $70 billion to $47.4 billion in the three days before the deal was closed. That provided the rationale for rushing things along.

For Chrysler and GM, bankruptcy was the last option but ultimately the best. Both companies had gained material concessions from key creditors -- including the United Auto Workers -- as part of their initial attempts to restructure out of court, but in each case key roadblocks remained. Chrysler, which would file first, on April 30, could not get unanimous consent among its secured lenders on a proposal to swap $6.9 billion in debt for $2 billion cash, a key component to its deal with Fiat.

The secured lenders, however, were no longer senior on Chrysler's capital structure as a result of being primed by some $9 billion in financing extended by the Treasury before the filing. As such, they would have less control in the bankruptcy. Also, by selling its assets to Fiat via 363, and outside a plan of reorganization, Chrysler did not need unanimous support from now-junior debtholders. Most importantly, the 363 sale allowed Fiat to acquire Chrysler's assets free and clear of liens and let the Italian automaker leave behind pieces of Chrysler it didn't want, such as environmental and asbestos-related liabilities. Chrysler also easily rejected 789 of its dealership contracts, despite objections.

"I don't think [terms of the deal] would have been as favorable to Fiat outside of 363," says Tim Cullen, a partner at Jones Day who was part of the firm's team counseling Chrysler. "In terms of strategy, all we needed was a viable enterprise on the back end. We were all working very hard at the necessary concessions, but 363 made it so that all of those concessions wouldn't be needed."

About one week into the case, and after being branded as "speculators" by President Obama, a group of 20 or so holdouts, calling themselves a committee of non-TARP lenders (a not-so-veiled reference to the fact that much of Chrysler's senior debtholders on board with the Obama administration's restructuring plan had borrowed funds under the Troubled Asset Relief Program), disbanded. The group, including OppenheimerFunds Inc. and Stairway Capital Management II LP, held about $1 billion in secured debt. The latter, seeing the writing on the wall, said in a statement that the opposition was "too small to have a voice within the bankruptcy" but said it believed it should receive "significantly more value ... given a normal course bankruptcy negotiation."

But Chrysler and GM, which filed for Chapter 11 one month later on June 1, were not the products of "normal" bankruptcy negotiations. Common to both proceedings was the dominating presence of the Treasury, which ultimately committed an astounding $64.7 billion in financing to the two automakers. The total figure consists of loans given to the companies before their bankruptcies ($9 billion for Chrysler, $19.4 billion for GM), DIP financing during the cases ($4.96 billion for Chrysler, $24.2 billion for GM), a $6 billion exit financing facility for Chrysler and up to $1.175 billion in wind-down funds for GM's bankrupt estate. (For exit financing of its own, GM will carve out $7.7 billion from its total $33.3 billion DIP. Export Development Canada, a financing arm of the Canadian and Ontario governments, is providing the supplemental $9.1 billion.)

As by far the largest debtholder of each automaker and the only entity willing and able to finance the cases, Treasury was in the driver's seat in both bankruptcy negotiations. This was particularly the case in GM, where Treasury was not only GM's financier, but its buyer. "In GM, unlike all other 363 sales, you had the government on all sides of the table," Patton Boggs' Richman says. "This was not Fiat [as a commercial buyer] using 363. Instead of going to Congress to get authorized legislation to nationalize the company, [Treasury] used 363."

He goes on to note that because Treasury was not a commercial purchaser such as Fiat, it should not have been allowed to set similar deadlines to complete the sale, leaving opposing creditors in a race against the clock to examine the deal or propose better alternatives.

In fact, terms of Treasury's DIP loans to the two automakers required Chrysler to win court approval of its sale within 45 days, GM in 40. Certainly creditors can digest the material terms of a deal in that amount of time, but the expedited process offered them little time to organize, hire advisers and put on a case of their own. At its three-day sale hearing, GM called witness after witness to offer expert testimony as to why the sale had to close expeditiously. Creditors, however, argued that they did not have a similar opportunity to mount a serious opposition. "We didn't have the funding to battle these institutions," says Richman. "The government was effectively funding Weil Gotshal, Cadwalader. But nobody was paying us. We didn't have the means to go out and hire expert witnesses. The debtors had Evercore and AlixPartners and were able to proceed in a blue-chip, spare-no-expenses way. We had a weekend to do depositions."

In a Chapter 11 proceeding, the debtor's estate pays its attorneys and advisers fees. Because Treasury funded GM's bankruptcy, it is on the hook for the expenses of GM's bankruptcy counsel, Weil, Gotshal & Manges LLP, as well as its financial advisers, Evercore Partners Inc. and AlixPartners LLP. Treasury is also paying the costs of Cadwalader, Wickersham & Taft LLP, counsel to the administration's auto task force, as well as the fees of the official committee of unsecured creditors.

But for informal creditor groups such as Richman's ad hoc committee of family and dissident GM bondholders, the creditors themselves pay the fees. And engaging Treasury in a funding battle is like walking into a gun fight with a butter knife.

With depositions of GM's key witnesses taken the weekend before the sale hearings, several creditors, including bondholders and tort claimants, had to ask Judge Robert E. Gerber for an extra day to prepare once closing arguments began. The judge, cognizant of the due process concerns throughout the case, obliged.

But Weil Gotshal's Harvey Miller, the debtor counsel for both Lehman and GM, isn't as sympathetic to the creditors' plight. He argues that Section 363 is a fundamental tool of the Bankruptcy Code that allows a bankruptcy court to save businesses and jobs and to even preserve value for creditors. "It's an emergency escape valve, when things are going bad. It's a means to salvage value," Miller says. "Here you have a provision [in the Bankruptcy Code] that preserves the value of assets when you can't do a plan process because it would last too long."

Miller says Lehman's use of 363 saved 90,000 jobs, prevented a catastrophe in the financial markets and even made Barclays a better business. "I believe creditors are entitled to a reasonable period of time in the contexts of circumstances," he says. "In Lehman, there simply was no time."

As for Richman's claim that Treasury contrived the need for speed in GM to quickly sell the assets with minimal opposition, Miller laughs. "GM is a consumer-intensive business, and its prospects in [a prolonged] bankruptcy were nil. Their sales were never going to get better [while in bankruptcy], and they were burning cash every day."

Miller, who perhaps more than any active bankruptcy attorney has had a hand in reforming the Bankruptcy Code to what it is today, says that 363 traces its roots to the mid-'60s, when debtors used the provision to dispose of assets that were burdensome to the estate and subject to erosion.

As 363 sales became more popular, a debate grew in bankruptcy circles about a debtor's power to sell off material assets outside a plan of reorganization using the section of the code. The Bankruptcy Reform Act of 1979, Miller says, left the use of 363 to the business judgment of a debtor. "It was a less harsh burden" back then on debtors to justify a 363 sale, he says.

Today the standards to sell assets via 363 outside a plan of reorganization are more rigid. The universally accepted case law, cited in virtually every 363 sale order, including GM and Chrysler, is the U.S. Court of Appeals for the 2nd Circuit's ruling in a case involving Lionel Corp. and a group of its equity securities holders.

In the 1983 bankruptcy case, Lionel used Section 363 to sell its most valuable asset, an 82% interest in the common stock of nonbankrupt affiliate Dale Electronics Inc. to Peabody International Corp. for $50 million. Though the asset was not declining in value, Lionel moved to sell it quickly at the insistence of its creditors' committee, which wanted to turn the stock into a "pot of cash" to provide the bulk of the $70 million required to repay creditors under a subsequent plan of reorganization, court filings show.

A bankruptcy judge approved the sale, though there was no imminent emergency. A group of Lionel equity holders appealed, arguing the sale deprived them of their right to participate in a Chapter 11 plan.

The 2nd Circuit overturned the sale, ruling a debtor has to have a sufficient business reason to sell assets expeditiously outside a plan and that the demand of creditors to do so is insufficient. In its ruling, the 2nd Circuit established seven standards a bankruptcy court must consider when approving a 363 sale, a precedent that remains today: the bankruptcy court must consider the proportionate value of the asset to the estate as a whole, the time elapsed since the bankruptcy filing, the likelihood that a plan can be confirmed "in the near future," the effect of the sale on a future plan, the value of the sale proceeds compared with appraisals of the asset and alternatives to the sale, and, most importantly, according to the 2nd Circuit, a court must decide whether the asset is increasing or decreasing in value.

It is the last two standards -- alternatives to the sale, and the direction the value of the asset is taking -- that Lehman, GM and Chrysler went to great lengths to prove. And, ultimately, creditors could not slow down the sales because they could not legitimately argue that there were better alternatives, such as a higher offer, or that the assets were not losing value every day. "In terms of due process concerns, the main thing we wanted to do was make a full record at how hard we tried other alternatives," says Jones Day's Cullen of Chrysler's strategy. "We're talking about the basic issue of enduring value. Are we saving the franchise by approving an expedited sale? We thought we had a relatively perfect case for 363, but you can't be dead sure."

In justifying a 363 sale for GM, Miller says, "it was easy because of the huge amount of debt GM had." Treasury credit-bid roughly $48.7 billion in debt for New GM, not counting equity to be issued by the new entity, General Motors Co., which Miller estimates brings the total deal value to almost $90 billion. Moreover, an analysis from AlixPartners concluded that GM could raise $6 billion to $10 million in a liquidation, which would not be sufficient to pay down even a portion of Treasury's debt, let alone offer anything to unsecured creditors.

Obviously, there was not a financial institution with the financial wherewithal or inclination to mount a rival bid for GM. The same can be said of Chrysler and Lehman, both of which entered bankruptcy with only one possible suitor. Experts say that the Bankruptcy Code empowers judges with broad discretion to address these extraordinary circumstances, more so than any other federal court.

"The bankruptcy court is famously flexible in process," says Jack Williams, a managing director at BDO Consulting, a division of BDO Seidman LLP. "Bankruptcy courts are courts of equity, and a judge has considerable discretion in managing the docket and even more discretion of how to fashion procedures within the code."

Williams, who has written extensively about how bankruptcy judges manage cases and write orders, says fast-paced proceedings naturally come at the expense of due process rights, but "the facts and circumstances of a case can support the rocket-docket Chapter 11 sale."

For example, Lehman is the only debtor in history to sell billions of dollars in assets through a bankruptcy court less than one week after filing Chapter 11. Miller likened the business, which was losing value every day in court protection, to a "melting ice cube," and the deal's constantly changing values are a testament to that. Lehman began a Sept. 19 hearing to approve the sale to Barclays -- just four days after its Sept. 15, 2008, Chapter 11 filing -- by handing out dozens of just-photocopied revised asset purchase agreements to attorneys in the courtroom. Not only did the book of securities going to Barclays decline by $22.6 billion in four days, but Lehman also scrapped a $700 million cash payment to the British bank because it no longer had the cash. In addition, the $1.75 billion cash component of the deal for Lehman's real estate dropped to roughly $1.29 billion.

Lehman's own attorneys didn't even know the final terms of the deal as they were pushing it through the court, so to say creditors were in the dark would be an understatement. The lawyer for Lehman's bondholders, Dan Golden from Akin Gump Strauss Hauer & Feld LLP, who didn't return calls for this story, quipped that he felt like "Daniel walking into the lion's den" as he asked the court to at least delay approving the sale for a few weeks so Lehman could shop its assets and creditors could examine the deal.

Attorneys for hedge fund Bay Harbour Management LC, which maintained prime brokerage accounts at Lehman, also asked the court to delay the sale so creditors could find out more about $8 billion that was allegedly transferred from a London Lehman affiliate before the bankruptcy and dispersed to third parties.

But Peck said it would be "reckless" to postpone the sale. "I have to approve this transaction because it's the only available transaction," he said.

The bankruptcy judge noted that only Barclays could deliver some 639,000 Lehman brokerage accounts totaling about $138 billion "to safe harbors." Said Peck: "This is really not a question of due process being denied. This is a question of due process being pursued in good faith by all parties to the transaction, even the objectors. I believe that one of the remarkable aspects of our Bankruptcy Code, as it has evolved, is its remarkable flexibility to different circumstances. ... [T]his is not bad precedent. To the contrary, it's an extraordinary example of the flexibility that bankruptcy affords under circumstances such as this."

Ultimately, the U.S. District Court for the Southern District of New York upheld Peck's ruling on appeal, finding that Bay Harbour and other creditors were afforded appropriate due process based on the need for an expeditious sale process, which the record during the sale hearing reflected. Similarly, higher courts turned down appeals by creditors of GM and Chrysler.

"A company's business judgment is not subject to distinctive black-and-white lines. You have to rely on the rationality of judges to assess the situation," says Miller, who in recent years has argued that the federal Bankruptcy Code has progressively had its rehabilitative powers diluted. "I do believe [bankruptcy] judges are very sensitive to due process. You can't come in the dark of the night and ask for a sale order and get it."

Not yet, at least.

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