Winners And Losers

Via CalcRisk, we get a pretty deep legal perspective on the Chrysler bankruptcy and how it very well may set a strong legal precedent for years to come:

One thing's for sure, Chrysler's (and soon GM's) court battles will afford us a rare opportunity to witness one of bankruptcy law's most fundamental questions being litigated in the highest stakes battles of all time, that being:

When does the "absolute priority rule" (compare FRB-Cleveland's strict construction of the rule back in 1996 here with US Government's position today), which establishes a hierarchy of recovery rights among creditor classes, take a back seat to the "fresh start," rehabilitative policy of chapter 11?

Chrysler's opening memorandum touched upon this question by focusing on the US Supreme Court's classic pronouncement in NLRB v. Bildisco & Bildisco, 465 U.S. 513, 528 (1984), where the Court stated that the "fundamental purpose of reorganization is to prevent the debtor from going into liquidation, with an attendant loss of jobs and possible misuse of economic resources." This principle, Chrysler argues, is paramount and (quoting NY's judicial patriarch, Bankruptcy Judge Lifland, in the old Eastern Airlines case) "all other bankruptcy policies are subordinated" to it. (Mem. at 4).

Many, however, will surely disagree with Judge Lifland's statement from 20 years ago that all bankruptcy policies should be subordinated to the reorganization objectives of the Bankruptcy Code. Indeed, even on a very practical level, as the authors of this 1997 article entitled "Chapter 11's Failure in the Case of Eastern Airlines" note, such a policy is a failure:

Eastern Airlines' bankruptcy illustrates the devastating effect of court-sponsored asset stripping-using creditors' collateral to invest in negative net present value "lottery ticket" investments-on firm value. During bankruptcy, Eastern's value dropped over 50%. We show that a substantial portion of this value decline occurred because an over-protective court insulated Eastern from market forces and allowed value-destroying operations to continue long after it was clear Eastern should be shut down.

Relying on Bildisco to establish an unwavering rule of law is also risky because Supreme Court jurisprudence on bankruptcy matters is anything but a seamless web. Indeed, Ken Klee points out in his remarkable new book, Bankruptcy and the Supreme Court, Justice Rehnquist once wrote to Justice Stevens: "I do not feel that I am qualified to make any sort of exegesis on the meaning of the Bankruptcy Code." (Klee, p. 48).

In other words, there's two sides in this battle. On one, is Chrysler, the UAW, Fiat, and the Obama administration. They are arguing that Chrysler's case represents a unique situation that demands that the company and its jobs be kept intact so it can be sold to Fiat and the UAW.

On the other side are Chrysler's creditors. They are arguing that if the bankruptcy courts start making exceptions for Chrysler, then any company will want to make the same argument. The specific reason that the Obama administration didn't want this to go to bankruptcy court is that a precedent would be established either way that could end up hurting the country down the road.

If the court decide to side with Chrysler, then creditors are going to want a lot more up front knowing that companies can pull the "Chrysler Rule" and get out of paying creditors should things go bad. It would be a devastating precedent on the part of corporate bondholders, and investment in corporate bonds will dry up overnight, recreating the credit crisis. Who as a creditor will want to invest in a risky company knowing you're going to lose 80 cents on the dollar if things go bad?

Likewise, should the court decide to side with the creditors, the Chrysler sale is doomed, Fiat will pull out, and the company will be liquidated, wiping out tens of thousands (if not hundreds of thousands) of jobs, again setting a brutal precedent and all but assuring that GM's creditors will demand the same liquidation. Both companies will be annihilated and perhaps a million jobs or more along with them.

Somebody has to win, and somebody has to lose here. Either way, it's going to be a major knock on the economy and could decide the fate of companies for years.