Last week, the chiefs of the Big Three automakers returned to
Washington bearing "turnaround plans' that they say will, with the
addition of $34 billion in government loan guarantees, return their
firms to profitability. But in revealing the dire straights faced
by General Motors and Chrysler (Ford, despite its request, says it
really does not need taxpayer dollars), the plans provide further
evidence that a taxpayer bailout will be insufficient to save the
industry. Future bailouts, or eventual bankruptcy, would be sure to
follow, say industry analysts and economists.
Nonetheless, the automakers continue to maintain that allowing
them to restructure under the protection of a bankruptcy court
would not work, devoting pages of their plans to this point. The
automakers' criticisms contain, at most, grains of truth, but they
fail to demonstrate that bankruptcy would not work for their firms,
as it has worked for so many others. Though a bailout may be better
for the automakers' current executives and shareholders,
restructuring in bankruptcy remains the best choice for the
automakers' continued viability and future success. This paper
considers, in turn, each of the automakers' arguments against
allowing the normal operation of law--that is, bankruptcy--when a
firm becomes insolvent.
Argument: Bankruptcy would lead to
"failure' and millions of jobs lost.
Fact: Bankruptcy actually prevents
failure, and liquidation makes sense only when a firm's business
model is obsolete and its resources could be put to better use
elsewhere in the economy--a circumstance that a bailout could not
Officials of the Detroit automakers claim that allowing any of
the Big Three to "fail' would have a devastating effect on jobs and
the economy. In particular, they frequently cite a report by their
trade association that finds that a "major contraction' of the Big
Three would cause 3 million job losses and billions in economic
That doomsday scenario, however, is impossible, for two reasons:
First, bankruptcy and "failure' are not synonymous; indeed,
bankruptcy protection actually prevents failure. Though a
bankruptcy filing may imply that a business has "failed' at
maintaining solvency as it is currently organized, it does not mean
that the business and its assets will "fail'--that is, cease
operations. Many companies, including the bulk of the airline
industry following 9/11, have entered bankruptcy, reorganized under
its protection, and then emerged as stronger, sustainable
Second, the auto industry's job-loss projections are premised on
assumptions that actually ignore bankruptcy protection. Their chief
assumption is that, without government aid, the industry would
suffer a 100 percent contraction--that is, it would just stop.
Under bankruptcy, however, that would not be possible. Once a
company has filed for bankruptcy, it receives an automatic stay and
may suspend payment of all debts, giving it breathing room to take
stock of its assets and situation. Most likely, the automakers
would file under Chapter 11 of the Bankruptcy Code (a
reorganization). But even if they file under Chapter 7 (for
liquidation), there is no reason to believe that the entire auto
industry--all the factories, all the assembly lines, etc.--would
simply shut down. More likely, entire plants and brands would be
sold to other companies. In neither case, however, would the
industry experience anything like the 100 percent shutdown assumed
in the auto industry's projections.
Argument: The automakers are too
complex for bankruptcy.
Fact: The bankruptcy process is
designed to confront and resolve complex problems and has
successfully done so many times in the past.
The usual situation leading to bankruptcy is known as the
"common pool' problem. This occurs when a business's assets and
income are insufficient to meet its obligations--in other words,
its creditors' claims exceed the common pool of assets available to
pay them, meaning that some will not be paid in full or possibly at
all. When a business's looming insolvency becomes apparent, then
creditors rush to collect their debts, which may hobble an
economically viable business and actually shrink the common pool
available to all creditors. The immediate solution to this
contentious situation is the protection of bankruptcy's automatic
stay, which gives a business breathing room from its debtors'
claims from the moment of filing.
The long-term solution is either reorganization or liquidation.
Either would be impossible, of course, if any creditor or
stakeholder could block the actions of the bankrupt firm, "holding
out' for full payment or more favorable terms. This is why it is a
universal feature of bankruptcy law that creditors and other
stakeholders can be forced to accept concessions that are necessary
to maximize the common pool. Thus some debtors may see their claims
transformed into equity stakes so that a business, free of debt,
can operate profitably and sustainably. Others may receive pennies
on the dollar. Collective bargaining agreements may, as described
further below, be modified to put costs in line with industry
norms, and other contracts may be rejected.
In contrast, a bailout fails entirely to address the complexity
of the automakers' problems. Unlike the finely honed tools of
bankruptcy reorganization, a bailout fails to provide any mechanism
(other than money) to restructure debt, repudiate contracts, or
renegotiate labor agreements.
In short, bankruptcy is a solution to the complexity that would
otherwise overwhelm the orderly dissolution or reorganization of an
insolvent firm. And these features are most valuable in large and
complex cases that would be impossible otherwise. Corporations that
have taken advantage of them in Chapter 11 reorganizations include
energy and finance giant Conseco, Delta Airlines, the parent
corporation of United Airlines, telecom giant WorldCom (now MCI),
Texaco, Adelphia Communications, and Global Crossing. Each of these
corporations 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 under the protection of the
bankruptcy process and emerge as viable, competitive
Argument: Renegotiating labor
agreements in bankruptcy would be impossible.
Fact: Chapter 11 provides a
straightforward mechanism, unavailable outside of bankruptcy, to
modify collective bargaining agreements to adapt to economic
Recognizing the great importance of labor relations, the
Bankruptcy Code addresses it specifically. Unlike other contracts,
a business undergoing reorganization cannot simply reject a
collective bargaining agreement. Instead, it must propose
modifications to the agreement that are necessary for it to achieve
a successful reorganization and "assure that all creditors, the
[business] and all of the affected parties are treated fairly and
equitably.' In addition, the business must provide the
union with relevant financial information so that it is able to
evaluate the modified agreement.
The parties must then negotiate in good faith in an attempt to
reach a satisfactory agreement. If that proves impossible, the
bankruptcy court may hold a hearing and allow termination of a
collective bargaining agreement if the union unreasonably rejects
the modified agreement and "the balance of the equities clearly
favors rejection of such agreement.'
Thus, the bankruptcy judge has significant discretion and power
to push the parties toward an agreement that is mutually
acceptable, conforms to economic realities, and ensures that the
business is able to return to profitability. For a company in
Chapter 11, and especially one whose unionized employees enjoy
untenable pay and benefit packages, a reduction in labor expenses
is the likely result. A bailout, in contrast, would likely
provide no new legal authority to achieve this result.
Argument: Automakers' can easily
shrink their dealership networks and consolidate nameplates outside
Fact: Shedding excess dealerships and
nameplates outside of bankruptcy would be protracted and expensive
due to state franchise laws.
According to industry analysts, General Motors needs to shed
nearly 5,000 dealers from its network and eliminate five or six of
its eight domestic brands. Without these changes, the company will
be unable to compete with the likes of Toyota and Honda, which
focus their energies on fewer brands and sell far more cars per
dealer. Ford and Chrysler face the same problem.
Making these changes outside of bankruptcy, however, would
likely prove impossible. Automobile dealers wield enormous
political clout at the state level and have succeeded in winning
passage of tough pro-dealer "franchise' laws in all 50 states.
These laws make it slow and prohibitively expensive for an
automaker to modernize its dealership network and consolidate
redundant brands. Automakers that are already on the brink of
insolvency cannot afford the time and expense that reforming their
sales operations under these laws would involve.
Even making modest changes can be difficult: When General Motors
shut down one underperforming and duplicative brand (Oldsmobile) in
2004, it had to pay dealerships over $1 billion in "financial
assistance' to avoid lawsuits. Four years later, is still embroiled
in litigation from former Oldsmobile dealers who declined to accept
assistance or settle their claims.
Under bankruptcy, however, the automakers would have the
flexibility, free of state franchise laws, to reconsider
contractual obligations and shed those that no longer make economic
sense. Further, an automaker could negotiate new contracts with
remaining dealers to permit more flexibility, such as Internet
sales, integrated inventory management, better customization
programs, and other consumer-driven practices. A bailout, in
contrast, would do nothing to ease the burden of state franchise
laws that keep the Big Three from modernizing their sales
Argument: Restructuring in bankruptcy
would be impossible because sufficient debtor-in-possession (DIP)
financing is not available in the current economic climate.
Fact: DIP financing is available to
firms undergoing restructuring that have strong business plans and
profitable cores, and if it proves necessary, the government could
provide a "lender of last resort' facility without sacrificing the
benefits of a restructuring under 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.
Some economists have suggested that if DIP financing proves
impossible to arrange solely because of the current lending
environment and not because of the structure of the loans or the
underlying business case for them, the federal government could
play a modest role as a lender of last resort. Proponents of this
idea, including Luigi Zingales of the University of Chicago and
Edward Altman of New York University's Stern School of Business,
explain that operating this mechanism through a conduit, such as by
providing a carefully structured loan guarantee to experienced DIP
lenders, would distort the lending and DIP oversight process only
minimally. This option would be superior to a
non-bankruptcy bailout because it would provide greater protection
(bankruptcy's "super-priority') to taxpayers, would do more to
force the automakers to reform their operations while providing
them greater flexibility to do so, and would be more likely to
At present, however, this option is unnecessary, and it may
prove, in the end, ill-advised. Rather than act now, Congress
should adopt a wait-and-see attitude and then consider whether to
intervene in DIP financing in the new year if, after an automaker
files for bankruptcy, it is unable to arrange financing. Before
enacting such a policy, Congress should consider the precedent it
would set and whether it would too greatly entangle the government
in this sector of the economy. Further, it may be that DIP
financing is unnecessary and that any automakers entering
bankruptcy could liquidate some or all of their assets to parties
that have greater access to capital. In this way, these valuable
assets would be reallocated to businesses in a better position to
use them to their potential.
Argument: Consumers would shun the
vehicles of a company in bankruptcy, causing its sales to
Fact: There is no evidence that
consumers are shunning the Big Three today, despite their
well-publicized economic woes, and automakers undergoing
reorganization could boost consumer confidence with third-party
warranties, insurance, and transparency.
After two straight months of front-page stories on the Detroit
automakers' woes, consumers are no doubt well aware that General
Motors and Chrysler face insolvency and bankruptcy. And while auto
sales fell sharply last month across the entire industry, General
Motors' and Chrysler's declines were on par with those experienced
by other automakers, given their fleets. There is little reason to
believe, then, that a formal bankruptcy filing (which would
actually provide these companies a measure of protection from going
out of business) would deter consumers.
Further, automakers have several mechanisms at their disposal to
boost consumer confidence. The first is simply their commitment to
their customers. Surely, the Big Three are able to get out the
message that they are on the path to recovery, expect to remain in
business for a long time, and will honor all warranties.
Second, an automaker in bankruptcy could also purchase
third-party insurance to guarantee its warranties against any risk
of default. Automakers could also offer third-party-backed
warranties on new cars. These types of warranties are already
available on the market and are typically purchased along with used
cars, so consumers understand what they are and how they
Third, transparency will increase public and consumer confidence
in the automakers. Instead of appearing before Congress to testify
about their companies' woeful performance and poor prospects, the
automakers' executives should be talking clearly about where their
companies are, where they need to wind up, and how to get there.
Having clear goals and benchmarks, such as reorganization targets
and emergence from bankruptcy protection, will help the public
understand that progress has been made.
Finally, there is no reason to believe that consumers would be
more assured by an infusion of government money in the form of a
bailout that leaves in place the same failed business model that
led to the industry's current crisis.
Argument: General Motors and Chrysler
can be turned around outside of bankruptcy without putting taxpayer
dollars at risk.
Fact: If these companies can be
repaired, bankruptcy is the best (and possibly the only) way to do
Industry analysts and economists project that a bailout-style
approach to turning around the automakers would cost in the
neighborhood of $150 billion, far more than the $25-$34 billion
that the automakers are now seeking from Congress. And for all that
money, there is no guarantee that a bailout would effectively
return these companies to profitability or that taxpayers would not
suffer losses if the companies file for bankruptcy down the road or
Congress forgives the debt.
In contrast, 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.
Any deviation from this neutral standard reduces the chance that a
business will successfully reorganize and remain viable over the
Bankruptcy Law Exists for a Reason
With recent job losses across the economy, lawmakers are
understandably nervous to subject themselves to the charge that
they have allowed further business failures, and more job losses,
to occur on their watch. But this charge is easily rebutted, for it
misunderstands the role of bankruptcy law in revitalizing
businesses. Properly understood, reorganization in bankruptcy
represents the best chance for General Motors and Chrysler to
survive and prosper.
Andrew M. Grossman is
Senior Legal Policy Analyst in the Center for Legal and Judicial
Studies at The Heritage Foundation.
Further, analysis shows that the auto industry's projections, even
given their faulty assumptions, are overblown due to the type of
economic model employed. See James Sherk, "UAW Workers Actually
Cost the Big Three Automakers $70 an Hour,' Heritage Foundation
WebMemo No. 2163, December 8, 2008, at http://www.heritage.org/Research/Economy/wm2162.cfm.
U.S.C. § 1113(b) (2008).
U.S.C. § 1113(c)(3) (2008).
Daniel Keating, "Why the Bankruptcy Reform Act Left Legacy Labor
Costs Alone,' Missouri Law Review, Vol. 71 (2006),
Edward Altman, testimony Before the House Committee on Financial
Services, December 5, 2008, at
Joshua Rauh and Luigi Zingales, "Bankruptcy to Save GM,' The
Chicago Tribune, November 23, 2008, at http://faculty.chicagogsb.edu/luigi.zingales/research/PSp
(December 9, 2008).
See, e.g., Zandi, Testimony before the Senate Banking Committee,
December 4, 2008 (calling the requested $34 billion in loans
"[in]sufficient for them to avoid bankruptcy at some point in the
next two years' and estimating that "they would ultimately need $75
billion to $125 billion').