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The Absolute Priority Rule?

posted by Stephen Lubben

Part of the debate about the GM and Chrysler cases has turned on the putative violation of the Absolute Priority Rule. I've previously argued that the actual deal structure in both cases contains no such violation, because the value going to the unions is not the debtors' and the senior lenders have no claim on it.

But there is also a good deal of unreality in the notion that the Absolute Priority Rule is a hard and fast rule, never to be violated. Professor Epstein snidely notes that President Obama is "no bankruptcy lawyer." Well neither is Professor Epstein, and one of the key problems with much of the debate about these cases is that the most vocal commentators have failed to acknowledge that the Absolute Priority Rule is routinely violated in modern chapter 11 practice.

Quite frankly, it would be impossible to keep most businesses operating in chapter 11 without some violations of absolute priority.  Virtually every first day paper filed in a large chapter 11 case asks for permission to violate absolute priority -- either by paying pre-petition claims of critical trade vendors, or paying certain claims in the "ordinary course" (i.e., as though the bankruptcy didn't happen), or by paying employees even if they don't technically fit into the requirements for priority or the debtor has so much secured debt that priority claims might not actually be "in the money."

Chrysler would seem to be an example of the latter case.  Maybe GM too.  Yet all of the ire is focused on the Unions, when it is not even clear that their stakes in the reorganized automakers is a violation of absolute priority.

Senior lenders routinely violate absolute priority when they demand a "rollover" of their prepetition debt into a post-petition DIP loan that often has even more liens and greater protection for the lenders than the pre-petition loan did. The lenders also get fees for their violation of the "rule."

And buyers of assets routinely "pick and choose" which contracts and agreements they want, and which they don't.  Those creditors lucky enough to be chosen are happy, the others not so much.  This is not new (see here too -- note the dates on both), yet commentators continue to pretend, either intentionally or because they don't know better, that until these two automotive cases it was somehow unheard of.

I get that these cases are political, yet not every political disagreement is a violation of bankruptcy law. It would be helpful if the "experts" stopped confusing their readers by confounding the two.

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Comments

Stephen:

First, I certainly agree that the end result in most bankruptcies varies from absolute priority. The scale of that variance in this case is just plain absurd. Unsecureds get $10.337 billion and secureds get $2.0 billion?

By the way, how do you reconcile Justice Ginsburg's opinion in Associates Commercial Corp. v. Rash?

In that case, the 8-1 majority ruled that the second sentence of 506(a)(1), which reads "Such value shall be determined in light of the purpose of the valuation and of the proposed disposition or use of such property, and in conjunction with any hearing on such disposition or use or on a plan affecting such creditor’s interest" means that you can't claim secured assets should be valued based on liquidation to repay the secured creditors and then use those assets as part of a going concern. If you use the assets, their secured value, under that opinion, is the going concern value.

Am I missing something?

The $2.0 billion is no longer directly associated with the liquidation value (it WAS when the value was initially broached), but it certainly does not reflect going concern value.

Capstone's projections show an estimated EBITDA of $3.7 billion for 2010. Even assuming a minimal 4x EBITDA multiple, that means the enterprise value should be the present value of $14.8 billion. Using the ubiquitous 9% rate (the rate associated with the VEBA's compensation - both debt and equity), that equates to $13.58 billion at the beginning of 2009 for the new company (without consideration of cash). Assuming Fiat's contribution is valued at $3 billion (one of the estimates that has been tossed around - and a rather high one at that), that leaves $10.58 billion. What asset doe that value reflect - other than the assets transferred from the Estate?

Its a basic question of evidence. While there may be problems with the debtor's valuation, it was not fatally flawed. And the objectors simply presented no alternative valuation. The court can't simply make up a valuation -- it has to work with what is presented.

Epstein is also appalled that "By injecting unneeded uncertainty into the picture, Obama has created the need for a secondary market in which nervous secured creditors, facing demotion, sell out to speculators who are better able to handle that newly created sovereign risk." Um, I hate to tell Epstein, but there's a long-established market in bankruptcy claims that has nothing to do with the facts of the Chrysler case, and, like all investment markets, including plain old debt finance, it is, at core, speculative.

He also misses that bankruptcy does not always solve the hold out problem. That depends on classification and the priority of the holdout's claim.

The difficulty with a valuation argument is if Chrysler really were worth $10B, why did no one else want it?

Stephen:

There are stated values to the equity granted to the VEBA, but I don't know if that was pointed out very well by the briefs (or if they were trying for an unproven, but higher value).

We'll see if the case ends up being heard.

I agree with the Court that there is no irreparable harm here. The damages can be made up in cash or securities at some later date.

If the case IS heard, and IF it IS decided for the plaintiffs, is NewChrysler a potential source of the settlement, or would it be the parties to the sale themselves (the VEBA, the US and Canadian Governments, and Fiat)?

I am curious as to the impact of the stay 363(f) in relation to any future settlement.

I've blogged on the balance sheet analysis
at http://rasmusen1.blogspot.com/2009/06/chrysler-balance-sheet-estimate.html
and
http://rasmusen1.blogspot.com/2009/06/chrysler-bankruptcy.html

I don't know much bankruptcy law. There seems to be an important point of law at issue here though: When assets are sold, is the price fair if it exceeds liquidation value, or is it only fair if it is the amount that a good-faith seller could get by reasonable effort at bargaining with the buyer?

The issue comes up when, as here, there is only one potential buyer. Suppose the assets can be liquidated for $1 billion or sold to a single potential buyer who would pay up to $25 billion. Is a price of $2 billion fair according to the law? Does it matter if the majority of creditors who approve the low price are also the buyers in the deal?

The answer seems obvious to me-- no, the price is too low in that case-- but it seems Judge Gonzalez would allow it. His argument would be that if the creditor would get just $1 billion from liquidation, then a price of $2 billion is an improvement, so they cannot object to it by saying that better bargaining could have gotten a higher price.

Note that this is a point of law-- of how a fair price should be calculated-- rather than the question of what the price should be, exactly. Thus, the Indiana Pensioners didn't have to come up with an alternative price immediately-- the judge would say that whether the buyer value was $2 billion or $25 billion or $200 billion was irrelevant--- tho they would on remand if the judge's legal theory was overruled.

And, of course, I don't know whether the $25 billion is the right figure. That's what an earlier comment in this thread was estimating with going-concern value.

Hmmm... I see your point on the Absolute Priority rule.

That said, I find Epstein's argument still very compelling... particularly to the extent that the govt. used its TARP influence to suppress the opposition to the 363 plan.

Problem is, there actually isn't any proof the government did that. It's all speculation. Makes for a good story, but so did that JFK movie.

They certainly strong armed Chrysler's management, but at the sale hearing the government asserted that it told Chase and the other TARP lenders to credit bid their claim if they didn't like the deal. And nobody disputed that was true.

Eric -- on the valuation point, the only valuation evidence was that at liquidation Chrysler would bring about $800 or $900 million. Since nobody else bid on the assets, or even tried to bid on the assets, the court seemed to take that as market evidence that $2 billion was not an unreasonable going concern value for the assets.

The appellants introduced a draft valuation report with a higher value, but that was based on an alternative transaction that Chrysler never got funding for (even from the government).

I think a lot of people are getting distracted by the notion that Chryslers assets have some intrinsic value. Chrysler has no ability to wait to realize that value (even the government has rejected unlimited funding), so I think it was absolutely correct for the court to value the assets at the "today" value, which reflects current market conditions.

Moreover, whatever you think about intrinsic value, the court can only work with what is presented to it. Its basic Anglo/American law that the court can't do its own investigation of the case.

One of the great mysteries of this case is why the objecting lenders did not present a contrary valuation. Certainly judge Gonzales is well-experienced and competant to analyze the opinions of competing valuation professionals. I read some time ago that the senior secureds had retained Houllihan to counter Capstone prepeptition, but that valuation report never emerged (perhaps when the senior lender group disbanded and the majority of the group switched to support the sale, the group's valuation expert was thereafer conflicted - I have no idea). I can understand the Indiana pensioners being reluctant to pay a large fee to ramp up a new expert, adding the potential of throwing good money after bad in pursuit of their claim although they did pay White Case to pursue this through two appeals). I think the Manzo analysis was particularly vulnerable due to his contingent fee, which is in my opinion a huge issue. I understand financial advisers rendering fairness opinions often have large fees that are contingent on the deal closing (although that practice is often criticized), but it is another matter to have a massive fee for an expert witness in litigation that is effectively contingent on winning the case. I understand Manzo stands to personally receive $10 mil. fee for his services if the deal closes. In this case, there is no separating a contingency that the deal close as compared to the litigation outcome - they are directly dependant on each other.

That said, I generally agree with Mr. Lubben on the absolute priority issue. Given no contrary evidence, a bankruptcy judge would be very hard pressed to simply invent his own value.

As for the fairness of the purchase price, an objecting party could argue all day that it is unfairly low, but in the absence of a competing bid that argument will fail every time. The only real argument to be made is to attack the sale process as unfair, an argument they lost at the outset of the case. In the cold hard world of quicky 363 sales, if you don't bring a competing buyer with cash to court, you generally lose.

I'm amused by these ruminations about intrinsic value. In my experience with 363(f) sales in the past (usually driven by the secured creditor -- how's that for irony?), the court and creditors are given no more options than were given in Chrysler. This is what the court and creditors are told: (1) if you think it's worth more than what's being offered, then bring a competing buyer to the table; (2) if another secured creditor thinks the price is inadequate, it should credit bid; (3) the buyer has no obligation to buy anything more than what it chooses to buy, and no obligation to pay any claims other than those it deems to be important to it as a buyer; (4) the secured lender driving the sale has no obligation to continue to fund operations of the debtor in order to reorganize by way of a plan, and (5) the lender chooses not to extend financing for operations for any purpose other than to achieve this sale.

Every bankruptcy lawyer and judge knows this. This is not news. Unsecured creditors who complain that a secured creditor-driven sale is a sub rosa plan typically lose. Unsecured creditors who claim that some creditors are being preferred while others are being left behind, typically lose. They lose as a matter of law, and they lose as a matter of economic reality.

All that is changed here is that the party complaining is a secured creditor, rather than a group of unsecured creditors. And their status as "secured creditors" is actually misleading because they are actually participants in a loan in which the majority of the participants (a super majority as a matter of fact) consented to the sale! If you read section 363(f), consent is enough to authorize such a sale. These objecting secured creditors' claims are derivative, not direct. They would not have the right to directly enforce their security interests against Chrysler. They would not have the right to insist on a payment that was higher than the payment made to the other participants in the loan. So most of the arguments advanced by these objecting secured creditors about how "their rights" were being trammeled either by the government or by the court were bogus from the beginning.

Seems to me that their remedies were (1) bring a better buyer to the table, (2) credit bid (assuming they had that right under the loan participation -- and I'll bet they didn't), (3) sue the indenture trustee and/or the collateral agent or the other members of the loan participation for breaching their duty to them.

But the remedy is NOT to insist that the buyer pay more money, or that the buyer pay specific creditors, or that the buyer not pay specific creditors. For all those who scream that this 363(f) sale process subverts important rights of creditors, I remind them that this device is one that secured creditors themselves have pushed on the system. Sauce for the goose, as the saying goes, is also sauce for the gander.

I couldn't have said it better myself.

I work for a competitor of Capstone as a financial advisor to troubled companies. I completely agree with lmclark and Cletis above. Of course the secureds had no stomach to credit bid and then fund a liquidation, which would require them to front tens if not hundreds of millions of dollars as de facto DIP funding. The government knew this and acted upon it.

I haven't seen their 13 week cash flow, but it wouldn't surprise me if they'd miss payroll in the next month if not sooner absent the financing incumbent with this sale. Good luck liquidating the collateral with no employees.

lmclark:

The loan agreements prevented any credit bidding by individual holders. Any credit bid would have to have been done, apparently, by the whole syndicate.

I don't know why anyone would look at this based on any prior experience. The purchaser here is the US government - using a shell company and an agreement with Fiat as a matter of convenience.

There would be no need to change the amount paid by the "purchaser," only the distribution of the payment is problematic. A portion of the payment of $10.337 billion to the VEBA (structurally by NewChrysler, but the benefit actually accrues to the Estate where the VEBA is an unsecured creditor) could be instead given to the first-lien lenders who, under the Code, are the appropriate recipients.

Structuring this deal in a 363(b) sale has enabled the Government to allocate value in a manner that would not have withstood a full Chapter 11 process.

One can only hope that the Government won't use this as a template for future restructurings. GM, at least, will not impact the secured lenders - only the unsecureds.

The consideration going to the unions "could have" gone to the secured creditors. True. But the secured creditors had no entitlement to that money. And the government had no obligation to overpay for Chrysler's assets at the 363 sale, which is essentially what your argument suggest they must do.

So long as they paid more than liquidation value, and I think we can all concede that under current market conditions (both the larger economy and the depressed state of the auto industry) the liquidation value of Chrysler's assets would be quite low, especially net liquidation costs.

The government decided to bail out the unions. They had no interest in bailing out the secured creditors. It's as simple as that.

Actually, Epstein IS a bankruptcy lawyer. He's of counsel in the bankruptcy section at Haynes and Boone in Dallas.

David Epstein is not Richard Epstein.

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