United States House
May 21, 2009
The Obama Administration is abusing bankruptcy law to benefit a
favored constituency, the United Auto Workers union. This threatens
- Without the discipline of a real bankruptcy reorganization,
General Motors and Chrysler may not be able to achieve the reforms
that they need to survive and prosper.
- The restructuring plans announced by both automakers are not
bold enough. To gain a competitive edge, they will have to cut more
dealers loose, put an end to the Byzantine system of work rules
that stifles flexibility, and in general, make deeper cuts.
- Selling Chrysler to a shell corporation for the purpose of
divesting lenders of their rights is a stunning abuse of U.S.
bankruptcy laws that threatens to upend this important resource for
- The "rule of law" means clear, generally applicable laws by
which individuals can organize their affairs and which are applied
consistently, without respect to status. By favoring a union over
creditors with superior rights, the Obama Administration has
violated a fundamental principle of our constitutional
- Striking down contractual rights arbitrarily, merely because
they are inconvenient or expensive to the government, raises the
costs of making and enforcing agreements across the economy.
- Certain industries and businesses will suffer
disproportionately: the automobile industry, heavily unionized
industries, corporations that are faltering or undergoing
reorganization, and already weakened financial institutions.
- This episode of lawlessness began with legislation, the
Emergency Economic Stabilization Act, that many at the time
recognized as an illegally unbounded delegation of power from the
legislative to the executive branch. It was that act which created
the TARP that is now the Administration's slush fund for bailing
out its allies and otherwise upsetting economic expectations. That
outcome should be no surprise; unbridled discretion breeds
- The bankruptcies of Chrysler and soon General Motors are a
microcosm of the lawlessness that threatens our freedom and our
prosperity. With its legislative power, Congress can put an end to
the bailouts and begin the slow process of unwinding those that
entangle us today.
My name is Andrew Grossman. I am Senior Legal Policy Analyst at
The Heritage Foundation. The views I express in this testimony are
my own, and should not be construed as representing any official
position of The Heritage Foundation.
My testimony this afternoon concerns the impact that the abuse
of the bankruptcy system to bail out Chrysler and soon General
Motors will have on the automobile industry, the rule of law, and
the economy. This is an important issue, and I applaud the
Committee for taking the time to address it and consider my
Members of this Committee should focus on three points. First,
that the U.S. auto industry itself has been harmed by the
initiatives of the Bush and Obama Administrations that were meant
to save it. Second, that the Obama Administration's abuse of
bankruptcy to carry out its initiatives will serve as a precedent
for others to sidestep the requirements of America's Chapter 11
reorganization process. The third point is that in rescuing
Chrysler and General Motors, the federal government has trampled
the rule of law in ways that will prolong our current recession
unless Congress acts to rein in the excesses of the
Administration's interventionist policies.
The auto industry, like AIG and like many of the banks now
scrambling to extract themselves from the government's Troubled
Asset Relief Program (TARP), may have been better off had the
federal government followed the will of Congress and declined to
intervene in their troubles. Though this counterfactual is
difficult to prove--we will, of course, never know what would have
happened in some alternative scenario--the major issues left
unaddressed, or only partially addressed, in the government's
reorganization strategy point to this conclusion. So, too, do a
surprising number of indicators.
The Detroit-centered auto industry's collapse was the result of
deep-seated structural problems that have been decades in the
making--not just the recent drop-off in sales.To understand the
extent of these problems, some history is required.
The combined market share of the Big Three U.S. automakers has
been in decline for more than 35 years, since the oil crisis
provided an opening for more fuel-efficient Japanese cars. In the
1980s, with the price of oil down, foreign carmakers gained market
share on the strength of their quality, reliability, and prices,
and quickly muscled in to the profitable luxury segment of the
market. More recently, foreign automakers simply out-innovated
their American competitors, investing heavily in smart,
fuel-efficient vehicles that Detroit is now struggling to
Those failures in management and leadership have been compounded
by bad operational and governmental policy. Years of protectionism,
such as import restrictions, complex fleet requirements, and
regulations that raise costs for foreign producers, shielded the
Big Three from competition in vital markets but allowed their
creative juices to evaporate. Meanwhile, fat years and government
interference allowed the automakers and their workers to put off
restructuring their labor agreements, even as foreign competitors
opened U.S. plants producing cars with fewer workers working at
less cost and achieving greater quality. By 2008, these "legacy
costs" dominated the U.S. automakers' balance sheets, and they
spent $20 to $30 more per hour on labor than their competitors,
even following minor concessions by the unions, and, due to
inflexible work rules, continued to require more hours to produce a
vehicle. Well aware of the writing on the wall, the Big Three and
the United Auto Workers union demonstrated their cynicism in
signing on to untenable labor agreements, under which the companies
lose money on most small car sales, under the assumption that the
taxpayers will eventually shoulder much of the burden.
The Big Three are also burdened with obsolete and expensive
business structures. All are top-heavy with management and
bureaucracy, compared to other manufacturing industries. They are
also bogged down by too many nameplates that, due to state
franchising laws, cannot easily be folded into other brands. As of
December, General Motors manufactured and marketed automobiles
under eight brands in the United States, including Chevrolet,
Saturn, Pontiac, and Buick, in a market where few customers
perceive any significant difference among them. Their antiquated
and bloated dealership structures also prevent the Big Three from
instituting modern and more flexible inventory-management practices
and selling cars over the Internet.
In late 2006, shortly before the current economic slowdown, Ford
separated itself from its two domestic rivals. Its new management
team, led by former Boeing executive Alan Mulally, recognized both
that the company needed a top-to-bottom revamp and that, without
extraordinary commitment, this restructuring would probably fare no
better than the many others Ford had undertaken over the decades.
To commit itself to a major, years-long overhaul, Ford mortgaged
its assets to the hilt, raising $23.6 billion to reorganize,
develop new cars and technologies, and free itself of many of the
legacy costs that sapped its competitiveness.
Already weakened by years of bad business decisions, the Big
Three were hit hard by high fuel prices and then the economic
slowdown. Though sales are down across the industry, buyers'
interest in the Big Three's fleets has plummeted. For the first
time in history, Detroit's share of the U.S. market dipped below 50
percent in 2008 and has fallen further since.
Ford, to date, has had the wherewithal and the resources to ride
out the recession and weak auto market. General Motors and
Chrysler, however, have not, and so late last year asked the
federal government to give them the money needed to undertake the
sort of reorganization already well underway at Ford.
The usual process for accomplishing this type of restructuring
is bankruptcy--specifically a Chapter 11 filing. Under Chapter 11,
bankruptcy affords companies that have hit hard times a fresh start
and a chance to reorganize to take better advantage of their
assets. Dire claims that bankruptcy is somehow equivalent to the
end of a business--for example, some claimed that bankruptcy would
imperil the employment of all of an automaker's workers--are simply
incorrect. Instead, the reorganization process provides unique
flexibility to unlock the fundamentally sound productive
capabilities of a faltering business by freeing it of many
obstacles to success, such as unviable contracts, crushing debt,
and poor management. Reorganization is the usual tonic for
businesses, like the Big Three, that need to adjust quickly to new
economic realities but are, at their cores, sound, productive, and
Yet after Congress declined to bail out General Motors and
Chrysler, the Bush Administration and then the Obama Administration
acted to accomplish the same end, drawing on funds that had been
appropriated to shore up financial institutions under the TARP.
Bankruptcy has been, with Chrysler, and probably will be, with
General Motors, a part of this process. As explained further below,
the Obama Administration's Automotive Task Force (ATF) developed a
plan to use several provisions of the bankruptcy code while evading
most of its requirements. In this way, it could bail out Chrysler
and General Motors for far less money than would otherwise be
required--essentially by forcing others to pay for much of
it--without relinquishing its effective control of either company
or forcing favored constituencies, unions chief among them, to
accept serious concessions.
The result is that neither company will go through the full
Chapter 11 restructuring process but only, in the words of various
Administration officials, a "quick dip" or "surgical bankruptcy."
Thus, both will forgo the essential discipline of the Chapter 11
process, its narrow focus on finances and sustainability, that has
made it so successful. Altering or evading this essential focus
reduces the likelihood of achieving the goal: rehabilitating a
business that has suffered financial failure and restoring it to
profitability and, over the longer term, success.
Given the deep-seated nature of these companies' problems--how
long they have persisted, how much they cut to the core of their
businesses--it is obvious that meek efforts will not suffice. Yet,
aside from the billions of taxpayer dollars being committed to
them, meekness, rather than discipline, buttressed by tough talk
characterizes the Obama Administration's approach. The result is
that heavily touted reforms are less aggressive than could be
expected in an ordinary bankruptcy reorganization. This imperils
One example is the rationalization of dealer networks. Both
General Motors and Chrysler recently announced plans to sever their
ties with some of their dealerships. Chrysler, relying on a
provision of bankruptcy law that allows the setting aside of
contracts, will drop 800 of its dealers, about a quarter of its
total network, leaving about 2500. General Motors, meanwhile,
notified 1,100 of is 6,000 dealers that their contracts will not be
renewed next year; it hopes to cut another 900 to 1,300 dealers
over the next few years, reducing its total to 3,600 to 4,000.
Further reductions could come from attrition and consolidation.
These are, unambiguously, steps necessary to the survival of
both automakers, but there is a real question as to whether they
are enough. Even with the cuts, neither company will come close to
matching Toyota's much-envied statistic of 1,100 car sales per
dealer, per year, on average. If it meets its most aggressive
goals, General Motors will still have, relative to that standard,
an excess of 1,800 dealers. The result is that overhead and
marketing expenses will remain too high, that dealers in some
markets may face cannibalizing competition from cross-town rivals,
and that many dealers will not be able to invest the money
necessary to improve customer experience.
If the economy, and car sales, recover, both companies will find
it tough to make further cuts. Outside of bankruptcy, both will be,
once again, subject to restrictive state franchising laws that
heavily penalize closures. For example, 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 and is still, 4 years later,
embroiled in litigation from former Oldsmobile dealers who declined
to accept assistance or settle their claims. The costs could be
even greater for cutting loose multiple-brand dealers.
There is also concern about which dealers are being cut and
whether they are the right ones to go. As wards of the state, both
automakers face intense pressure to make decisions that reduce
political friction, rather than those that maximize economic gain.
It would be difficult to believe, considering the ATF's deep
involvement in both companies' plans, as well as the power of
certain Members of Congress, that no political pressure was brought
to bear and that all decisions were made entirely on the
Unfortunately, such pressure, and such doubt, will accompany
every decision made by General Motors and Chrysler in the months
ahead. Some, for example, speculate that General Motors and
Chrysler threw their support behind President Obama's new emissions
and fuel efficiency standards at the behest of his
Administration. No doubt politics played some role in
transforming the automakers' former intransigence on the issue.
As with dealers, both companies have begun the process of
culling underperforming brands from their stables to reduce
expenses and improve focus. Again, this is a necessary step, but
questions remain as to whether it is enough. Does Chrysler need
both the Chrysler brand and Dodge? And while General Motors was
right to retire Pontiac, and Cadillac maintains its allure, does it
need Chevrolet, Buick, and GMC, or do further opportunities to cut
brands, and costs, exist? These questions could be answered in a
regular Chapter 11 case, but outside of that context, there's
little to guide the inquiry. Some industry analysts, however, have
maintained for years that these extra brands only add costs and
distraction, not value.
And once again, trimming brands in future years will be a
difficult, expensive effort, due to the same state laws that make
it hard to cut loose dealers. Efficiencies forgone now, during
restructuring, may not be available in the future.
Labor is another area where the concessions made, though a big
step in the right direction, may be insufficient to put General
Motors and Chrysler on a level playing field with their
competitors. At this moment, General Motors is locked in
negotiations with the United Auto Workers, but Chrysler completed a
deal with the union shortly before it entered bankruptcy. The new
agreement will, in theory, eventually put hourly costs in line with
those of the foreign automakers, known as "transplants," who build
cars in the United States. It also trims benefits a bit (e.g.,
vision, dental, prescriptions for Viagra), reforms overtime
calculations, and consolidates some skilled trades to reduce the
complexity of work rules.
Some issues, however, were not fully addressed by the new
agreement. Current employees, for example, will not be asked to
take cuts in their base wage rates until at least 2011, if at all.
At that point, the company and the union will enter into binding
arbitration with the stated goal of equalizing "all-in" hourly
wages with those of the transplant automakers. That agreement could
potentially push equalization even further into the future; if auto
sales have recovered by then, Chrysler may not be in a position to
demand that its workers accept more cuts. The agreement also
requires the automaker to continue making payments to the union-run
Voluntary Employee Beneficiary Association (VEBA) that provides
health benefits to retirees and their families. Those payments will
total $9.2 billion. benefits for laid-off workers will also remain
unusually generous. Some workers will be eligible to receive
payments covering 50 percent or more of their gross pay for up to 2
years after being laid off. Given the need to shrink operations,
this stands to be a significant expense.
Work rules also remain a barrier to competitiveness. The
agreement does make some significant improvements to these
Byzantine arrangements that govern nearly every facet of automobile
production, but they will still reduce flexibility and efficiency,
while imposing a bureaucratic, union-mediated process on all
employer-employee relations that is expensive, time-consuming, and
morale-sapping--for both sides. A better, though perhaps unlikely,
outcome would have been scrapping plant-level work rules in favor
of the more flexible approach taken at New United Motor
Manufacturing (NUMMI), a Toyota and General Motors joint venture in
California that regularly wins awards for its innovation and
productivity. That approach is based on the one used at all of
Toyota's facilities and is similar to those employed by other
transplant automakers. This shortcoming alone leaves Chrysler, and
almost certainly General Motors under its forthcoming agreement, at
a major competitive disadvantage.
Also detrimental to General Motors and Chrysler is the
difficulty that they will have accessing capital and debt markets.
Lenders know how to deal with bankruptcy--it's a well understood
risk of doing business. But the tough measures employed by the
Obama Administration to cram down debt on behalf of the automakers
were unprecedented and will naturally make lenders reluctant to do
business with these companies, for fear they could suffer the same
fate. Even secured and senior creditors, those
who forgo higher interest rates to protect themselves against
risks, suffered large, unexpected losses. So nothing that either
company can offer, no special status or security measure, can fully
assuage lenders' fears that, in an economic downturn, they could be
forced to accept far less than the true value of their holdings. At
best, if General Motors and Chrysler have access to debt markets at
all, they will have to pay dearly for the privilege. At worst, even
high rates and tough covenants will not be enough to attract
Impaired access to debt and capital will stymie future
restructuring, investment, and growth, reducing the likelihood that
either company will fully rebound and, beyond that, prosper. There
is the risk that this will lead to further government intervention,
using taxpayer funds; rather than the lender of last resort, the
federal government could become the first, and only, option.
Finally, there is the stigma of having accepted government
funds. For months, auto executives asserted that consumers would
not purchase cars manufactured by a company in bankruptcy. Poll
after poll, however, showed that fear to be overblown, especially
as consumers came to know more about the restructuring process.
Meanwhile, as auto sales plummeted, General Motors and Chrysler
lost the most, as Ford, the holdout, snatched their market share.
There is a stigma to taking taxpayer dollars that, according to
polls, is far worse than any attached to filing for bankruptcy.
Fully 72 percent of those surveyed nationwide say they are more
likely to purchase a Ford product because the company has not taken
government money. A Rasmussen poll found that 88 percent of
Americans would prefer to buy a car from an automaker not receiving
government aid. And many articles published in newspapers
and online have quoted individuals once devoted to GM brands or
Chrysler (known as "Mopar" fans, after the company's auto-parts
division) whose loyalty is now defunct--or shifted to Ford.
These downsides prove--as much as is possible at this time--that
aggressive government intervention has had a negative effect on
both Chrysler and General Motors, relative to the usual
alternative, a regular bankruptcy, even one with some degree of
debtor-in-possession financing provided by or (even better) merely
guaranteed by the federal government. There is every reason to
believe that unexceptional bankruptcies, though taking longer and
demanding greater sacrifice, would have left both companies on
firmer competitive footing. But for mostly political reasons, that
is not what the Obama Administration chose to do. That it chose,
however, to rely on portions of the bankruptcy code to implement
its bailout plan raises concerns that it may have, in the process,
altered that body of law.
Specifically, the Obama Administration's abuse of bankruptcy to
carry out its initiatives could serve as a precedent for others to
sidestep the requirements of the Chapter 11 reorganization process,
thereby undermining what has been an extraordinarily successful
tool to turn around troubled enterprises.
America's Chapter 11 process has been a model for the rest of
the world. As one recent article describes, China's new bankruptcy
law, its first, allows for reorganization of insolvent businesses
and the "cramdown" of their debts, very closely tracking the U.S.
Its success can also be judged in statistical terms. A recent
article from Elizabeth Warren and Jay Lawrence Westbrook analyzes
data from thousands of bankruptcy cases involving both small and
large businesses. They found that, among companies that,
entering bankruptcy, had a plausible chance of reorganizing,
between 65 percent and 72 percent were able to confirm a
reorganization plan to exit bankruptcy. And the rate is likely higher
for larger firms. This is an encouraging statistic,
considering that all of these businesses had reached the point of
insolvency or illiquidity at the time that they entered
Warren and Westbrook also found that bankruptcy proceeds at a
quick pace in most cases; the typical case is resolved in about 9
months. While firm size is a factor, larger
businesses only took an average of 4 months longer than smaller
businesses. And by 24 months, they report, nearly all
cases were resolved.
They summarize their findings thusly:
These data expose the heart of the efficiency question: is
successful reorganization a rarity, available in a relatively small
number of cases? Are the benefits of Chapter 11 achieved only at
the expense of long delays? Our data...show that confirmation rates
jumped to two-thirds or more among larger debtors, debtors that
were able to survive the first nine months in bankruptcy, and
debtors who at least proposed a plan to reorganize. The data reveal
that the cases--both those that exit the system and those that
confirm plans of reorganization--moved at a lively pace.
Those conclusions, however, describe a system that is premised
on maximizing the value of an enterprise for (in the case of
insolvency) the benefit of its creditors, who wield great control
over the process. That is the system that the Obama Administration
opted to circumvent.
In a normal case, a business files for bankruptcy and then has
an "exclusivity period" of up to 18 months during which it can
prepare a reorganization plan to present to its creditors. That
plan, under Section 1129 of the Bankruptcy Code, must adhere to the
"absolute priority rule," which simply mandates that senior
creditors, such as those with security interests (like a mortgage
or a car loan), are paid off before junior creditors. Further,
creditors who, under the plan, are not paid in full and are slated
to receive less than they would in a Chapter 7 liquidation--that
is, when the assets of the business are sold off--have a chance to
vote, as a class, on whether to accept or reject it.
Taken together, these rules protect creditors' contractual
rights and ensure that bankruptcy law is used to promote economic
efficiency, rather than for more nefarious purposes, such as
enriching favored creditors at the expense of others. This is
important because, within bankruptcy, a business has extraordinary
power to accept or reject contracts, alter the terms of its debt,
and even dismiss debt altogether. Without these rules, bankruptcy
could easily be misused to defraud lenders and other creditors.
But Chrysler, which filed for bankruptcy on April 30, will never
file a plan subject to the approval of impaired creditors. Though
it is taking advantage of bankruptcy to exit contracts, such as
with some dealers, and cram down its debt, it gets to skip the
requirements of Chapter 11 reorganization thanks to a combination
of aggressive lawyering, coercion, and intimidation, all courtesy
of the Obama Administration.
The means to evading the law is a provision of the Bankruptcy
Code, Section 363(b), which allows the sale of assets of the
bankruptcy estate. Relying on that provision, the government
arranged a sham sale of nearly the entire company to a newly
created "Chrysler" capitalized by the government. The price? $2
billion, all of which would go to secured creditors for senior debt
worth $6.9 billion, for a recovery of just 29 cents on the dollar.
Meanwhile, one junior debtor, the UAW-administered VEBA, was slated
to receive 43 cents on the dollar for its unsecured $11 billion
claim, as well as 55 percent of the new Chrysler. In a typical case
where senior debt-holders were not paid in full, the UAW, along
with other junior creditors, would receive nothing.
In effect, the Administration used Section 363(b) to accomplish
a sub rosa reorganization of Chrysler, financed in part by
Chrysler's former senior debtors. It then transferred a large
portion of that value, along with added value from additional
bailout funds, to the UAW and Fiat, which is investing some
technology, but no money, in its new joint venture with
This is exactly the kind of abuse--stealing from one party to
give to another--that the bankruptcy code was designed to
This is not the first time that Section 363(b) has been used to
sell essentially an entire company or its "crown jewel" assets,
though it is certainly the most prominent. Courts have been
justifiably wary of the practice and carefully scrutinized
transactions to ensure that the law was not being abused. In an
early case employing this legal "innovation," the Fifth Circuit
rejected it outright, writing:
[T]he district court was not authorized by Sec. 363(b) to
approve the [transaction]. In any future attempts to specify the
terms whereby a reorganization plan is to be adopted, the parties
and the district court must scale the hurdles erected in Chapter
11. See e.g. 11 U.S.C. Sec. 1125 (disclosure requirements); id.
Sec. 1126 (voting); id. Sec. 1129(a)(7) (best interest of creditors
test); id. Sec. 1129(b)(2)(B) (absolute priority rule). Were this
transaction approved, and considering the properties proposed to be
transferred, little would remain save fixed based equipment and
little prospect or occasion for further reorganization. These
considerations reinforce our view that this is in fact a
A more recent case stated the concern with Section 363(b) sales
even more plainly: "The reason sub rosa plans are prohibited is
based on a fear that a debtor-in-possession will enter into
transactions that will, in effect, short circuit the requirements
of Chapter 11 for confirmation of a reorganization plan."
That court went on to state:
[W]hether a particular settlement's distribution scheme complies
with the Code's priority scheme must be the most important factor
for the bankruptcy court to consider when determining whether a
settlement is "fair and equitable" under Rule 9019 [concerning the
settlement of controversies within classes]. The court must be
certain that parties to a settlement have not employed a settlement
as a means to avoid the priority strictures of the Bankruptcy
Any court examining the Chrysler transaction would be compelled
to reach the opposite conclusion. It is difficult to argue that
what Chrysler is undergoing at present is not a reorganization. The
Treasury, in fact, refers to the transaction as a "restructuring
initiative" and to the new shell company as "the reorganized
Chrysler." Further, it describes the time period
after the transaction as part of a "restructuring period."
Even more clearly, the transaction, unlike a sale to an established
entity such as another company, had no economic substance. Finally,
the distribution is hardly "fair and equitable;" it upends the
Code's priority scheme, with junior creditors faring better than
those holding senior claims.
In short, the entire point of using Section 363(b) was to force
a very unfavorable plan on (understandably) recalcitrant secured
creditors in violation of their contractual and property
Lawyers justified the sale using much the same language as was
employed in support of the Section 363(b) sale of Lehman Brother's
brokerage unit, just after its parent had filed for bankruptcy, to
Barclays Capital. They argued that Chrysler would precipitously
decline in value, wreaking havoc throughout the supplier base, and
that only a quick sale could prevent that end. Unlike in the case
of Lehman, however, there was little evidence to support this
claim, just hand-waving.
Under the Bankruptcy Code, creditors can object to a proposed
sale. But reminiscent of the Sherlock Holmes tale about "the dog
that didn't bark," banks that held the bulk of Chrysler's senior
debt, and that were also TARP recipients and so subject to close
scrutiny and regulation by the Treasury, declined to do so. Though
an anonymous Administration aide told reporters that the White
House forbade the use of TARP as leverage over these banks, other
creditors saw early on in negotiations that TARP recipients were
more willing than non-TARP parties to cut a deal on unfavorable
terms. The implication is that, whether they
were explicitly ordered to or not, these banks were coerced into
supporting the government-backed proposal.
And there were threats, too, after about 20 creditors banded
together to form the "Chrysler Non-TARP Lenders Group" and
challenge the Section 363(b) sale. This was just days after
President Obama had put pressure on those who had rejected the
Administration's previous offer, publicly blaming "investment firms
and hedge funds" for Chrysler's bankruptcy, claiming that by
rejecting the government's deal, they had "decided to hold out
for...a taxpayer-funded bailout" and were "hoping that everybody
else would make sacrifices, and they would have to make none."
(In reality, the hold-outs had offered a compromise plan under
which they would receive 60 cents on the dollar, about the same as
the UAW.) The group, representing teachers unions, pension funds,
and school endowments, among others, moved to delay the sale, and
the judge agreed to hold a hearing. But the effort would quickly
fizzle, as members deserted the group in the face of death threats,
criticism from lawmakers, and according to one prominent attorney,
threats from the administration:
One of my clients," [attorney Tom ] Lauria told [radio] host
Frank Beckmann, "was directly threatened by the White House and in
essence compelled to withdraw its opposition to the deal under
threat that the full force of the White House press corps would
destroy its reputation if it continued to fight."
After suffering days of abuse, the group folded, ending the
leading objection to the sale.
According to news reports, General Motors will follow a similar
course at the end of this month, with an anticipated Section 363(b)
sale to a new entity that would initially be owned by the federal
government. Secured lenders would be paid 28 cents on
the dollar, while holders of the company's $27 billion in unsecured
bonds would receive a 10 percent stake in the new company. The UAW,
meanwhile, would receive $10 billion in cash and up to a 39 percent
stake in the "new" General Motors in exchange for its $20 billion
in unsecured debt--a far better payout than those to secured
lenders and similarly situated bond holders. The government is also
expected to take a big ownership stake.
These high-profile precedents threaten to change the nature of
bankruptcy for businesses carrying heavy debt loads. Professor Mark
Roe, of Harvard Law School, described this risk in a recent
[I]f the current deal becomes a strong bankruptcy court
precedent, it'd throw priorities into question generally, because
the tactics are easily imitated even without the government as the
major player. In Chapter 11 reorganizations going forward, if a
coalition of creditors and insiders can convince a judge to use the
same structure as the Chrysler judge has provisionally approved,
they can freeze out a creditor group who then couldn't call on any
of bankruptcy law's normal protections.
Insiders alone, as well, might wish to take advantage of this
technique to keep their hold on the business, while dropping debt.
Rather than persevere the rigor and discipline of the current
bankruptcy system, and its inconvenient insistence on fair
treatment of creditors, businesses will have another option:
arrange a sham sale to a shell company, wiping out debts and other
obligations in the process.
If this practice becomes more prevalent, it threatens to disrupt
both lending and capital investment across the economy. This
consequence is discussed further below.
Just as bad, it promises poor results. Businesses will be washed
of their debt, but without realizing the efficiency gains of a
real, profits-focused reorganization. Managers regularly
overestimate their ability to turn around a failing business, and
creditor control in bankruptcy provides an important check on this
tendency. Cutting creditors out of the picture will only lead to
more business failures, as firms opt to take the easy way out.
Congress should, the next time it takes up bankruptcy reform,
study the use, or misuse, of Section 363(b) sales to evade the
requirements of the bankruptcy code and frustrate the principles of
fairness and rule of law on which it is premised.
It is appropriate here to discuss the rule of law, because in
rescuing Chrysler and General Motors, the federal government has
trampled it in ways that will hurt our economy.
The "rule of law" means clear, generally applicable laws by
which individuals can organize their affairs and which are applied
consistently, without respect to status. This was something that
the Framers of the U.S. Constitution took very seriously. In three
separate clauses of the Constitution--the Contracts Clause, the
prohibition on bills of attainder (i.e., legislation that punishes
particular individuals, as if they had been convicted of a crime),
and the prohibition on ex post facto laws (i.e., criminal
laws that apply retroactively)--they sought to limit the power of
the government they were creating and of the states to intervene in
James Madison, for one, understood that the temptation to do so
would be irresistible otherwise. His explanation in Federalist No.
44 is worth repeating:
Our own experience has taught us,
nevertheless, that additional fences against these dangers ought
not to be omitted. Very properly, therefore, have the convention
added this constitutional bulwark in favor of personal security and
private rights; and I am much deceived if they have not, in so
doing, as faithfully consulted the genuine sentiments as the
undoubted interests of their constituents. The sober people of
America are weary of the fluctuating policy which has directed the
public councils. They have seen with regret and indignation that
sudden changes and legislative interferences, in cases affecting
personal rights, become jobs in the hands of enterprising and
influential speculators, and snares to the more-industrious and
less informed part of the community. They have seen, too, that one
legislative interference is but the first link of a long chain of
repetitions, every subsequent interference being naturally produced
by the effects of the preceding. They very rightly infer,
therefore, that some thorough reform is wanting, which will banish
speculations on public measures, inspire a general prudence and
industry, and give a regular course to the business of society.
In this view, the consistent application of law is the
assumption behind every other clause of the Constitution, the
principle, without which, none life, liberty, and the pursuit of
happiness could be secure. It is, thus, a prerequisite to due
process and protection against the arbitrary exercise of
power--that is, tyranny.
When the rule of law is cast aside, for whatever seemingly
pragmatic reason, it impairs the machinery of private ordering,
such as contractual rights, that are at the core of our economic
freedom and prosperity. The broad enforceability of contracts,
tempered by several narrow doctrines of abrogation, makes it
possible to conduct economic affairs with strong assurance that
other parties will keep their promises or be held liable for
failing to do so. In this way, people are able to order their
affairs, in employment contracts, insurance contracts, service
agreements, and the myriad of other contractual agreements that
make modern life possible.
Striking down contractual rights arbitrarily, merely because
they are inconvenient or expensive to the government, raises the
costs of making and enforcing agreements across the economy by
reducing the certainty of all agreements. Madison himself described
the slippery slope that would result: The more the legislative or
executive branch interferes in private affairs, the more who will
demand that it interfere in their affairs, to their advantage, and
the less the role private agreements will play in economic life. It
is, in effect, a tax on contracting, for more contracts will
require a lawyer's hand in drafting to avoid government abrogation.
And where that is unavoidable, parties may decline to contract at
all, costing the U.S. economy the surplus of their avoided
transaction, while others may alter the terms of their agreements
to reduce risk but also reward. Still others may shift their
business to foreign shores that show greater respect for the rule
We can predict who will suffer these consequences. The
automakers, surely, will have only limited access to financial
markets for years to come and pay usurious rates when they are able
to borrow. Sadly, Ford will probably suffer the same fate, if to a
slightly lesser degree, because the mere fact of its present
solvency is not enough to guarantee that lenders' rights will not
be gutted at some point in the future.
Quite perversely--or quite appropriately, depending on one's
point of view--unionized industries may also see their cost of
capital rise, hampering growth and hiring. The Obama
Administration's transparent favoritism toward its political
supporters in the United Auto Workers Union may lead other unions
to demand the same: hefty payouts and ownership stakes in exchange
for halfhearted concessions. Lenders know now that the
Administration is unable to resist such entreaties. As one hedge
fund manager observed, "The obvious [lesson] is: Don't lend to a
company with big legacy liabilities, or demand a much higher rate
of interest because you may be leapfrogged in bankruptcy."
Perhaps the most affected will be faltering corporations and
those undergoing reorganization--that is, the enterprises with the
greatest need for capital. Lending money to a nearly insolvent
company is risky enough, but that risk is magnified when bankruptcy
ceases to recognize priorities or recognize valid liens. With
private capital unavailable, larger corporations in dire straits
will turn to the government for aid--more bailouts--or collapse due
to undercapitalization, at an enormous cost to the economy. As
Warren Buffet opined, "[I]f priorities don't mean anything that's
going to disrupt lending practices in the future."
Professor Todd Zywicki offers an observation on this point: "Mr.
Obama may have helped save the jobs of thousands of union workers
whose dues, in part, engineered his election. But what about the
untold number of job losses in the future caused by trampling the
sanctity of contracts today?"
Financial institutions--enterprises that the federal government
has already spent billions to strengthen--will also be affected.
Many hold debt in domestic corporations that could be subject to
government rescue, rendering their obligations uncertain. It is
that uncertainty which transforms loans into impossible-to-value
toxic assets and blows holes in balance sheets across the
Finally, there are the investors, from pension funds and school
endowments to families building nest eggs for their future. General
Motors bonds, like the debt of other long-lived corporations, has
been long regarded as a refuge from the turmoil of equity markets.
The once-safe investment held directly by millions of individuals
and indirectly, though funds and pensions, by far more, are now at
risk, which will be reflected in those assets' values.
The effects of abrogating the rule of law are broad and deep.
They can be witnessed first-hand in any nation where contracts are
unenforceable and the government's rule is arbitrary and absolute.
They are also evident in the prosperity of nations:
[Economists Rafael La Porta, Florencio Lopez-de-Silanes, Andrei
Shleifer, and Robert Vishny (LLSV)] documented empirically that
legal rules protecting investors vary systematically among legal
traditions or origins, with the laws of common law countries
(originating in English law) being more protective of outside
investors than the laws of civil law (originating in Roman law) and
particularly French civil law countries. LLSV then used legal
origins of commercial laws as an instrument for legal rules in a
two stage procedure, where the second stage explained financial
development. The evidence showed that legal investor protection is
a strong predictor of financial development.
Empirical studies also show that the rule of law has an impact
on civil society, affecting such disparate variables as
entrepreneurship, military conscription, and government control of
In sum, continued disregard of this fundamental principle
threatens severe consequences.
This episode of lawlessness began with legislation, the
Emergency Economic Stabilization Act, that many at the time
recognized as an illegally unbounded delegation of power from the
legislative to the executive branch. It was that act which
created the TARP that is now the Administration's slush fund for
bailing out its allies and otherwise upsetting economic
expectations. That outcome should be no surprise;
unbridled discretion breeds unchecked power.
What began with Congress can end with it, too. It is time to
stop the economic adventurism that marked the last months of George
W. Bush's Administration and the first of President Obama's. The
bankruptcies of Chrysler and soon General Motors are a microcosm of
the lawlessness that threatens our freedom and our prosperity. With
its legislative power, Congress can put an end to the bailouts and
begin the slow process of unwinding those that entangle us