The filing of Chrysler for Chapter 11 bankruptcy is bound to raise many questions, about how such a situation was ever allowed to come to pass.
Chrysler has been under many managements in the last decade, initially with in-house management, then through the merger with Daimler, and finally as a private company managed by private equity firm Cerberus.
If so many different groups of highly respected managers could not improve things—Chrysler’s market share has fallen from 16% to 11% over the last decade—one must wonder what a court-approved Chapter 11 process can really achieve.
Chrysler’s balance sheet suggests that it has about $52 billion (Rs2.57 trillion) of liabilities, which it hopes to reduce to about $12 billion after the bankruptcy process. The Chapter 11 process will effectively ask various parties to write off nearly $40 billion, excluding the equally large losses to equity shareholders.
Only the very optimistic would expect that a $40 billion write off will happen very quickly. The bankruptcy process is fraught with complications and will not be as smooth as envisaged by the Obama administration. Some creditors will surely believe that liquidation instead of a Chapter 11 reorganization would get them more than the 32 cents per dollar promised by the treasury.
The economic psychology behind the Chapter 11 code is the key to understanding why the court proceedings might take longer than the two month estimate made by the administration and resultantly, what the implications might be for the various stakeholders.
The Chapter 11 code in the US has a strong, pro-incumbent slant and is designed to ensure that firms can continue business as usual. The existing management, which would usually be indebted, is placed in control of the business, while the terms of debt restructuring are worked out. The management naturally represents the equity shareholder, who has the junior most claims on the company. As such, it has the most incentive to keep the company running well as equity shareholders will only recover money after the company is able to pay off all other creditors.
This is in contrast to the case of the UK, where a receiver is appointed to administer the company in bankruptcy and the receiver’s main interest is to recover the dues of his fellow senior creditors, with little concern for better alternative solutions that might benefit other stakeholders as well.
To enable managements to have a breather while they restructure the company, Chapter 11 results in an automatic stay on interest and principal payments and even allows for renegotiation of the various debt contracts. During this period some value is given up by the senior lenders to others. It is hoped that by virtue of allowing the company to live to fight another day, the senior lenders would recover more than they might have under liquidation.
It is, however, this elasticity of bankruptcy law that worries senior lenders and could potentially derail the Chapter 11 process at Chrysler. For example, US law permits new lenders to take priority over existing claims, if it can be proven that the funds so infused will increase the company’s value.
In some cases existing long-tenure lenders fret that by the time earlier lenders are paid off, nothing will be left for them. They may ask for their money back now even if a re-schedulement would be better for the business if they feel that by doing so they would enable someone else to be paid out earlier.
Finally, all lenders worry about free riders, who expect that others will make sacrifices or write downs while they will not. All these concerns of lenders can cause the restructuring process to be prolonged. The court will need to find a balance between all these complex creditor concerns.
In Chrysler, most of the debt holders have had to write down debt by about two thirds (68%). Various investment funds are said to have been holding out. They have expressed the uncharitable view that the alacrity with which the banks fell in line and agreed to this restructuring package has been a quid pro quo for bailouts received by the banks during the financial crisis.
This particular allegation has the potential to complicate the court process because the bankruptcy law needs evidence that creditors are acting in good faith when they vote for a deal. There is speculation that some dissenting creditors will claim that the major banks (JPMorgan, Citibank, Goldman Sachs, etc.), who have benefited from the financial bailout, have had to concede to the terms of the Chrysler deal, especially in the context of the TARP (Troubled Asset Relief Programme) funds they have got.
In addition to lenders and shareholders, the costs of bankruptcy extend to suppliers who lose business, consumers who will not get after sales support and employees who may not invest in upgrading human capital. The United Auto Workers (UAW) have now agreed to cuts in wages, overtime and vacation pay as well as a range of other benefits, in return for 55% of Chrysler stock.
One wishes that the UAW had demonstrated this willingness to negotiate earlier. Ironically a few years ago, it agreed to concessions with GM and Ford, but not with Chrysler, merely because Chrysler was profitable at the time. It is also moot whether a workers union such as the UAW can truly have the same incentives as a standalone shareholder.
It is similarly quite unclear whether auto dealers, many of whom have made major investments in anticipation of a surviving Chrysler, will accept any major adverse changes in their contracts without a prolonged legal battle. Without car finance from Chrysler financial, sales, which are largely driven by loans, could dry up.
These imponderables make it unlikely that Chrysler will emerge from Chapter 11 as quickly as anticipated. The period of uncertainty till then will, likely erode market share and force many suppliers and dealers to exit the business. Given the centrality of the auto industry to the US economy, this can hardly be good news.
When companies as large as Chrysler are forced into Chapter 11, shareholders over a large period of time lose their savings. While post mortems of such situations are considered unfashionable, boards can not be entirely absolved of blame. Chrysler like its sister companies GM and Ford, has had close to 20 years to clean up its act and become leaner and more efficient. That it did not must reflect on its board as well.
The boards of these companies need to be asked some tough questions—how did they vote on the issue of creating fuel efficient cars, why did they continue to tolerate inefficient suppliers, and importantly, why did they cave in repeatedly to auto workers demands? The board of this company should have for the past decade seen the writing on the wall and could have reacted earlier. This appears to have not happened.
The last thing the economically critical auto sector needs is another Lehman like bankruptcy with all its unforeseen consequences. In this context, it is heartening to note that the president, in a Roosevelt-like fashion, has had the courage to take a strong position on this issue.
Given the precarious situation of the economy, president Obama’s leadership in pushing for a quick resolution leaves hope that the participants in the court process will make the sacrifices necessary to return Chrysler to management before the summer is out. Chrysler, has returned from the brink of bankruptcy several times, most notably under Lee Iacocca.
A great company deserves one last chance, hopefully sooner than later.
Govind Sankaranarayanan is CFO, Tata Capital Ltd. He writes on issues related to governance. The views expressed in this column are personal. Write to him at email@example.com