As readers may know, secured lenders make loans against which specific assets are pledged. For consumers, mortgages and car loans are examples. If you default, the lender can seize the asset and sell it to try to recoup.
In bankruptcy, secured lenders are normally the top of the food chain, but in the Chrysler bankruptcy, the secured lenders failed to reach a deal outside of court (most of the big lenders agreed but a dissident group held out) and the court looks likely to approve a deal that arguable favors the junior creditor over the senior. The synopsis at the Financial Times is fairly typical:
George Schultze will think twice before lending to another troubled company such as Chrysler.
Mr Schultze is one of a group of dissident Chrysler creditors….He rejected an offer aimed at slashing Chrysler’s debt in order to allow the carmaker to be sold.
Mr Schultze and other investors – some of whom claim to have received death threats – say the deal is unfair because it does not honour their rights as senior lenders to get paid before other claims, such as a union benefit plan, are met.
They also argue that the deal was orchestrated by the US government, which held sway over the majority of the other lenders, namely a group of banks, following widespread bail-outs.
The question of whether the Chrysler creditors got a raw deal will be decided in a New York bankruptcy court over the next few weeks.
Already, the verdict on Wall Street and in the conference rooms of investment firms round the country is that, at the very least, the situation raises questions about the solidity of time-honoured lending principles and parts of the bankruptcy code…
“It will increase the cost of credit in the capital markets for lots of companies by tinkering with the well- settled priority system,” Mr Schultze said. “Our firm and many other lenders will think twice about lending to companies who have junior creditors that might get an unfair sweetheart deal.”…
“Given that so much of total borrowing across all asset classes is first lien in nature, the damage that would occur to the economy as a result of higher first lien borrowing costs resulting from lenders requiring a higher return to compensate them for an unknown interpretation of claim priorities could be substantial,” says Curtis Arledge, co-head of US fixed income at BlackRock, Inc. “Many lenders make loans by being investors in US financial markets where contract law has been sacrosanct, and deviation from that could have far-reaching implications to the US economy.”….
“It is particularly important at this stage of the distressed cycle for lenders to have confidence in pre-existing contracts and rules. We are entering a period of record corporate defaults and the need for bankruptcy financing and financing for distressed companies will only continue to grow,” says Greg Peters, global head of credit research at Morgan Stanley….
Investors, including hedge funds, began purchasing loans over the past decade. Previously, this arena was dominated by banks. Either way, the buyer accepts a lower interest rate for the perceived safety of the senior claim on assets.
The fear is that investors will demand a premium for senior debt such as loans, prompting a repricing of unsecured debt and general rise in the cost of borrowing.
“The financial interests of investors may conflict with what the government is trying to do from a social perspective,” says Steve Persky, managing director of Dalton Investors, a Los Angeles-based hedge fund that specialises in distressed debt…
And, in a downturn, lenders facing losses often say they will get tough and demand higher interest payments to compensate for risk. What is unique in this cycle is the new focus on the government’s role.
“Now there is a new risk: government intervention risk,” Mr Persky says. ”And it is very hard to hedge.”
Notice that everyone who is complaining is an investor. Not a single lawyer weighed in.
Now I am most decidedly not an attorney, and would welcome input from anyone who knows the bankruptcy code. I had thought technically was that the deal depended on Section 363, which is seldom used in Chapter 11. I have seen it argued that relying on Section 363 in Chapter 11 would gut a lot of existing bankruptcy practice and a judge woudl be cautous about using it. The flip side is that Chrysler may have been designed in such a way that this is considered to be a narrow application and does not set a broad precedent. It was used in Lehman, but Lehman was effectively a liquidation.
The folks at Credit Slips (and these are bankruptcy experts) aren’t troubled and argue the press has it wrong, Stephen Lubben notes:
I think these commentators have misunderstood the structure of the sale, no doubt in part because the overall structure of the deal has been somewhat “over-described.” There are obvious political reasons for this – in particular, the Administration needs to present a complete story of how Chrysler’s employees will keep their jobs when the dust settles. There is also a general lack of chapter 11 understanding among both politicians and the press.
As I comprehend the sale structure, based on the pleadings filed late Sunday, the debtor will transfer key assets and contracts to a new Delaware LLC in exchange for $2 billion in cash and various cure payments. As part of the deal, the new owner (the Delaware LLC) will assume some contracts, including the labor agreements.
The last piece of this does technically violate the absolute priority rule, but in a way that is mandated by the Bankruptcy Code. Contract counterparties always get their prepetition claims paid in full when their contracts are assumed and assigned in a §363 sale. §365(b)(1).
The sale will be free and clear under §363(f)(3), using the argument that “value” in that provision means economic value. Reasonable parties can disagree on that point. But notice that if the dissenting lenders win on the (f)(3) argument it does not necessarily stop the sale, rather it probably just means that the sale price gets lowered (because of the increased risk for the buyer). Also keep in mind that the objecting creditors would seem to have the burden of proof here. §363(p)(2).
I don’t see how (a) the new owner’s renegotiation of the labor agreement or (b) the distribution of ownership interests in the new owner are issues for the bankruptcy court to approve.
He does raise an issue in a later post:
I think that many of the arguments advanced against the Chrysler sale motion are largely noise, generated by confusion over the structure of the deal. But I also mentioned that one real problem I see here turns on the dissenting lenders’ apparent inability to credit bid.
The Bankruptcy Code expressly recognizes the right of a secured creditor to “credit bid” its claim in a §363 sale, just as a home lender can bid the value of its mortgage in a state foreclosure sale. § 363(k).
Thus, if the debtor moves to sell its assets worth $100 in a 363 sale, the bank with a $40 lien on the assets can bid “$40” and offset its secured claim against the bid, meaning that the bank only has to pay cash for the debtor’s assets if the auction price goes above $40.
Thus, if Chrysler were a typical chapter 11 case, the senior lending group would be able to credit bid up to $6.9 billion for the debtor’s assets. If the lenders won the auction, they could then sell the assets to Fiat or anyone else.
Here the lenders (as a group) decided to forgo their right to credit bid and instead accept $2 billion in cash. The offer was at one point raised to $2.2 billion, but that has apparently been taken off the table since Chrysler entered chapter 11.
Normally I’d say that the lenders’ decision to take the $2 billion was a strong indication that they expected Chrysler’s assets to sell for a price less than or equal to that amount, mooting their need to credit bid. But in this case the decision to take the $2 billion offer is being driven by the largest lenders, all of whom are to some degree under the control of the Treasury Department…..
I think we have to concede that this control, and the conflict it creates, and the President’s decision to publicly scold the dissenting senior lenders has tainted this process, making it unlike a normal chapter 11 case. The decision to scold the dissenting lenders – perhaps driven by the lenders somewhat juvenile press release – is perplexing, since it seems to blame them for a chapter 11 case that I believe would have happened anyway. Moreover, holdouts are a fact of life in workouts and chapter 11 cases – the trick is to figure out how to deal with them…..
The real issue is how much do we believe all this has tainted the process. In this case, you could argue that the Fiat price would be so low without the union agreement that the secureds are getting the same or even a higher recovery on an absolute basis. But we’ll never know for sure and in that sense the process is tainted, and I think this is not harmless. Future hedge funds may pay lower prices to buy distressed debt in large companies like Chrysler and future secured lenders may therefore require higher interest rates from borrowers. Moreover, the global story that we tell about the benefits of having a system like chapter 11 is diminished by this case.
If Chrysler were a one-off, this would not matter much, but the fact that GM now looks almost certain to file for bankruptcy and Section 363 is expected to be used again makes this much more nervous-making for lenders and investors. Indeed, Lubben suggests that the reason the deal was done this way was that Chrysler entered bankruptcy late in the process. That also will prove true for many cov-lite deals, since the absence of many normal covenants means lenders cannot force a restructuring or BK filing while the company is only in moderately bad shape (or is a decent company simply suffering from too much debt). We’ll see in due course how big an issue this becomes.
Originally published at Naked Capitalism and reproduced here with the author’s permission.