Chrysler and Section 363: Myth and Reality

August 20, 2009

There has been a lot of conversation about the Chrysler bankruptcy in US business and legal circles and in particular how it seemed to run counter to the basic principles of priority embedded in the US Bankruptcy Code.  It seemed on its face that creditors with unsecured claims or claims otherwise further down in the priority ladder of the Bankruptcy Code were getting “paid” ahead of those that were supposed to be on the top of that ladder:  the secured creditors. 

We need to separate myth from reality.  It is certainly “reality” that lenders providing financing during a Chapter 11 are at the top of the priority structure.  It is also certainly “reality” that the secured lenders to a pre-petition company (that is the company before it filed its petition to commence a Chapter 11 case) are to be paid before the unsecured creditors of such company under the US Bankruptcy Code.  Were these principles violated in the Chrysler bankruptcy?

The answer is clearly not, but nonetheless there is a cautionary tale for secured lenders to be found in the Chrysler story.

What gave rise to the myth? On April 30, 2009, Chrysler LLC and 24 of its domestic direct and indirect subsidiaries filed for protection under Chapter 11 of the US Bankruptcy Code.  On May 1, the newly minted Chapter 11 Debtors received approval to engage financial consulting and advisory firms and investment bankers. That same day, the second day of the case, the Debtors sought approval for an expedited hearing on a motion to approve bidding procedures and to schedule the hearing to consider the sale of the Debtors’ assets.  On May 5, the bidding procedures were approved and an order approving them entered on May 7, 2009.  Matters slipped a little bit from the originally scheduled date, but the hearing to approve the sale was scheduled for May 27, 2009.  On May 31, 2009, Judge Arthur Gonzalez of the Bankruptcy Court for the Southern District of New York rendered his opinion approving the Debtors’ motion seeking authority to sell substantially of its assets.

The pre-petition capital structure of Chrysler was not that unusual, except perhaps for one aspect. Chrysler had received a $10 billion first lien term loan secured by substantially all of Chrysler’s assets from a syndicate of lenders for whom JPMorgan Chase was the administrative agent.  There was a $2 billion term loan secured by second liens on the same assets as those securing the first lien facility, of which $1.5 billion came from Daimler Financial and $500 million came from Madeleine LLC, an affiliate of Cerberus.  The somewhat unusual element was that the US Treasury came along to provide a $4 billion credit facility secured by a first priority lien on all otherwise unencumbered assets and certain parts inventory and a third-priority lien on all other assets behind the first and second lien pre-petition lenders.

On top of all of the above, the US Treasury and Export Development Canada (the “EDC”) provided the debtor-in-possession financing for 60 days in the amount of $4.96 billion.  

Based on this capital structure, when the Chrysler assets were sold, the proceeds of the sale should have been applied to the debtor-in-possession financing and then the first lien debt, second lien debt and third lien debt. And so they were. As the Bankruptcy Court made clear in its decision, In re Chrysler LLC, decided on May 31, 2009 by Judge Arthur Gonzalez, the proceeds from the sale of the collateral were to be applied in the traditional order of priority with first lien, second lien, third lien, and unsecured creditors each getting their share in the appropriate order.  How the sale proceeds were applied was ultimately no different than most 363 sales of ongoing businesses.  And, notwithstanding certain dissident lenders in the first lien credit facility, given that the “Required Lenders” under Chrysler’s first lien credit facility did not object to the sale, it is hard to say that the rights of secured lenders were violated.

So what gave rise to this notion that the secured lenders were treated unfairly?  Here is where the role of the Government was critical.  Not only did the US Treasury and EDC provide the Chapter 11 financing, which gave them a significant role in the case (as any DIP lender would have--even putting aside the minor detail of being the Government), the US Treasury and the EDC agreed to provide a $6 billion senior secured financing facility to support the acquisition of the Chrysler assets by New CarCo Acquisition LLC, the “New Chrysler”, the purchaser of the collateral for the first, second and third lien pre-petition debt.

The Chrysler bankruptcy was a classic use of Section 363 for the benefit of certain creditors--it was just that with the Government involvement, those creditors were not the senior secured creditors, as is more customarily the case.  The traditional lenders were simply no match for the Government, not to mention the overt pressures of the highly politicized agenda arising from the banks’ receipt of TARP funds, the UAW and the Obama administration.  In a very dramatic fashion, this bankruptcy proves the rule that unless the lender is willing to commit the dollars in the Chapter 11 financing, it will “lose control of the case”.  Yet no private lender is going to be a match for the Government as lender, particularly one with a specific agenda.  This case would have gone any number of different directions if the Government had not been in the mix.

The part that perhaps rankles the secured creditor is in looking at the end result. It just so happens that, instead of the pre-petition secured lenders owning the equity of a “new” or reorganized Chrysler as might have been the case in a more traditional Chapter 11, pursuant to a swap of the pre-petition debt for equity, the equity owners of the New Chrysler are the “VEBA” (voluntary employees beneficiary association designed to fund legacy retiree health care obligations) with 55% of the company, the US Treasury with 8%, the EDC with 2% and Fiat with 20% (and having contributed “zero” cash that could be used to repay the pre-petition secured lenders). 

As Judge Gonzalez notes in his decision, the capital structure and equity ownership of a “non-debtor” (that is a company not subject to a bankruptcy case), like New Chrysler, even as the purchaser of the assets out of a bankruptcy case, is beyond the purview of the Bankruptcy Court.  This is no different than any other bankruptcy.  The fact that the Government in effect chose to “gift” the ownership of New Chrysler to these constituencies is ultimately a political decision, based on some very practical considerations, but not a distortion of the principles of the Bankruptcy Code.

The first problem for the secured lenders in the Chrysler bankruptcy was that the value of the assets subject to their liens did not cover their debt.  If it had, the secured creditors could have come into court and objected to the sale and demanded a better price or offered an alternative.  Second, the secured lenders lost control of the case by not being in a position to provide the Chapter 11 financing. But, the third problem, was that the Government was prepared to step in and provide financing that would not have been available in a purely commercial context.  Still,  one wonders how it might have turned out if the secured lenders had actually used all or some portion of their debt to make a credit bid for the “good” Chrysler assets?