News reports, as well as spoken remarks by the President yesterday, indicate that the White House has warmed to the idea of an "orderly" reorganization in bankruptcy of General Motors and Chrysler, backed by government loan guarantees. Though the best approach would be to let the bankruptcy process run its course without any interference, and without putting taxpayer dollars at risk, a managed bankruptcy is far more likely to succeed than a bailout.
Only bankruptcy provides the necessary legal authorities, as well as the appropriate incentives and accountability, for the troubled automakers to make the changes necessary to survive in the global marketplace. If some degree of government oversight, as well as taxpayer funding, is to be a part of this process, the government must take care to avoid putting politics above economic realities by subsidizing business plans that fail the market test. Doing so would undermine the benefits of bankruptcy and increase the likelihood that the Detroit automakers' decline will continue unabated.
The Benefits of Bankruptcy
Chapter 11 reorganization allows businesses that have run up against adverse economic realities to change course quickly, avoiding the legal shoals that so often prevent radical changes outside of bankruptcy. For the automakers, the benefits of this process would be enormous. Specifically, they would gain the power to restructure their bloated dealership networks, trim unnecessary and duplicative brands, and reform their labor agreements and obligations to retirees to accord with what the market can bear. Outside of bankruptcy, the automakers simply lack the legal authority to achieve these concessions.[1]
Further, Chapter 11 requires that these changes are implemented in a way that is likely to succeed and that creates the right process and incentives to start even the largest corporate reorganizations on their way. Unlike a bailout, bankruptcy pulls politics out of the equation and focuses on simple economic viability without putting any taxpayer dollars at risk. Reorganization in bankruptcy is designed to transform firms that are economically viable but have failed financially and can no longer meet their obligations.[2] Any deviation from this neutral standard reduces the chance that a business will successfully reorganize and remain viable over the long term.
Thus, the White House's new focus on using the bankruptcy process to rescue the automakers is promising, so long as it is done in a way that maintains the essential aspects of the system. According to reports, the White House plan aims to achieve an "orderly" bankruptcy by providing bridge financing for several months, appointing an overseer to help negotiate a "prepackaged" bankruptcy, and then guaranteeing financing during bankruptcy reorganization, which is discussed below.[3] The goal, according to a White House spokesperson, is to provide "an orderly way to do bankruptcies that provides for more of a soft landing."[4] The plan is intended, then, to prevent both catastrophic liquidation of the companies, as well as protracted and contentious bankruptcies that last years and fail to conclude successfully.
Those worst-case scenarios, however, are extremely unlikely, making the proposed protections unnecessary. First, if the automakers are economically viable, as they seem to be, a damaging liquidation is unlikely because reorganization financing will be available, as discussed further below. Second, complexity and contention are hallmarks of organizations that file for bankruptcy, which is why its procedures are designed to overcome such challenges that would otherwise overwhelm the orderly dissolution or reorganization of an insolvent firm. Corporations such as energy and finance giant Conseco, Delta Airlines, and WorldCom entered bankruptcy with billions in debt owed to tens of thousands or more creditors, business models that had come up short, and major internal strife, such as untenable labor agreements. Despite this enormous complexity, all of these businesses were able to reorganize successfully, and expeditiously, under the protection of the bankruptcy process and emerge as viable, competitive businesses.
Nonetheless, the additional features of the White House plan, if implemented carefully so as to not undermine the market-based discipline of a Chapter 11 reorganization, remain superior to a straightforward bailout. Specifically, the plan should give the overseer no authority to dispense additional funds beyond the initial bridge financing, thereby focusing the automakers and their constituent parties, like the United Auto Workers union, on the need to reach agreements before the financing runs out. The overseer's only roles should be to act as an honest broker between parties, to report to Congress and the public about any failures to reach agreement prior to bankruptcy, and to structure the guarantees for financing during bankruptcy. Finally, the overseer's role should cease at the time of filing, when the bankruptcy court takes over responsibility for oversight of restructuring. These safeguards are essential to retain the fundamental features of the bankruptcy process, put an end-date on the government's entanglement with the automakers, and ultimately, ensure a successful result.
Overcoming the Credit Crisis
The automakers contend that restructuring in bankruptcy, though perhaps an option in ordinary times, would be impossible because sufficient debtor-in-possession (DIP) financing is not available in the current economic climate. Without such financing, an automaker would be unable to reorganize and so would be forced into a Chapter 7 liquidation. This, they argue, would risk the collapse of the entire U.S. auto sector and perhaps millions of jobs. The White House seems to share this view.
It is not apparent, however, that credit would be unavailable to an automaker filing for bankruptcy. While credit markets remain tight, a number of businesses that have recently entered bankruptcy have managed to obtain DIP financing to continue their operations. This makes sense: DIP financing is given priority over other debts and so generally presents a low risk of default. Thus, Circuit City, Pilgrim's Pride, and Tribune, Inc.-all businesses facing major challenges to their business models-have managed to secure significant DIP financing over the past month. There is good reason to believe that the automakers, bearing serious reorganization plans that chart a realistic course toward profitability, could do the same.
But there remains the risk that credit would not materialize, and this is the possibility that the White House plan would address. According to reports, the government would offer guarantees on DIP loans to the automakers, thereby overcoming reluctance among lenders to make available the necessary sums.
To enforce the accountability of the bankruptcy process, it is essential that such guarantees are structured solely to address the current lending environment and not because of the structure of the loans or the underlying business case for them. To that end, two elements are necessary. First, the government should not offer such guarantees preemptively but adopt a wait-and-see attitude and then consider whether to intervene in DIP financing in the new year. Such intervention should occur only if, after an automaker has arranged other major details of its bankruptcy filing, it proves unable to secure financing due to market conditions. Second, any guarantees must be structured carefully so that lending decisions are driven primarily by market forces rather than political considerations. This means that the guarantees must not cover all the financing and that the lenders must have as much "skin in the game" (i.e., downside risk) as possible to encourage them to make sensible lending decisions and to conduct proper oversight of the borrowers. These precautions will both increase the likelihood that the automakers are able to reorganize successfully and protect taxpayers against a default.[5]
A Careful Plan
An "orderly" bankruptcy process, such as the White House is now contemplating, holds the promise to avoid the inevitable fate of a bailout: staying the course and guaranteed failure, if not now, then in a few short years. Relying on bankruptcy is the right approach. But the details matter. A "bankruptcy lite" that alters the essential features of the Chapter 11 process will only prolong the automakers' decline. If the Big Three are to survive and prosper, the White House must require them to undergo real reorganization in bankruptcy, not anything less.
Andrew M. Grossman is Senior Legal Policy Analyst in the Center for Legal and Judicial Studies at The Heritage Foundation.
[1] See Andrew M. Grossman, "Automakers Need Bankruptcy, Not Bailout," Heritage Foundation Legal Memorandum No. 33, November 15, 2008, at http://www.heritage.org/Research/Economy/lm33.cfm
[2] See Todd Zywicki, "Bankruptcy and the Detroit Three,' The Volokh Conspiracy, November 20, 2008, at http://volokh.com/posts/1227191956.shtml (December 9, 2008).
[3] David Stout and Micheline Maynard, "Bush Weighs 'Orderly' Bankruptcy for Automakers," The New York Times, December 18, 2008, at http://www.nytimes.com/2008/12/19/business/19auto.html(December 18, 2008).
[4] Ibid.
[5] For further details, see Edward Altman, testimony Before the House Committee on Financial Services, December 5, 2008, at http://www.house.gov/apps/list/hearing/fin
ancialsvcs_dem/altman120508.pdf (December 18, 2008); Joshua Rauh and Luigi Zingales, "Bankruptcy to Save GM,' The Chicago Tribune, November 23, 2008, at http://faculty.chicagogsb.edu/luigi.zingales/resea
rch/PSpapers/bankruptcy_to_save_gm_ctribune_11-23-08.pdf (December 18, 2008).
