November 17, 2008
GM: Too Big To File?
Posted by Michelle Harner

The Big Three automakers and a potential government bailout of Detroit have received a great deal of attention during the past week.  (For example, they were the focus of yesterday’s Meet the Press.)  Of the three, General Motors (GM) appears to be the most distressed, losing an estimated $2 billion per month.  Although some suggest that GM should seek bankruptcy protection, others predict dire consequences for the automaker and the overall U.S. economy if a bankruptcy filing occurs.

    

The proposition that a company is too big or too distressed to file for bankruptcy seems illogical on several levels.  Chapter 11 of the U.S. Bankruptcy Code was specifically designed to allow an overleveraged company with a viable business model to reorganize and emerge from bankruptcy as a healthier, more stable business operation.  As the U.S. Supreme Court explained, “‘By permitting reorganization, Congress anticipated that the business would continue to provide jobs, to satisfy creditors’ claims, and to produce a return for its owners. . . .  Congress presumed that the assets of the debtor would be more valuable if used in a rehabilitated business than if ‘sold for scrap.’”  If the sum of a company’s parts is greater than the whole, or if the company’s business model is obsolete, chapter 7 of the Bankruptcy Code provides for an orderly liquidation of the company’s assets.  Under the federal bankruptcy system, a distressed company’s ability to reorganize and survive depends largely on market forces.

    

High-profile companies in the airline, retail, steel, telecommunication, textile and transportation industries have used federal bankruptcy laws to reorganize.  Although first-tier and second-tier suppliers to the automotive industry have filed for bankruptcy, none of the major U.S. OEMs (original equipment manufacturers like General Motors, Ford and Chrysler) have filed.  Chrysler came close in the late 1970s before a government bailout, and the old American Motors Corporation came close in the 1980s before an increased investment by Renault and ultimate acquisition by Chrysler. But if bankruptcy works for the airlines, why not the OEMs?

    

The primary concern with filing a traditional chapter 11 case for any of the OEMs relates to the nature of their products and customers.  End-use consumers remain the primary source of an OEM’s revenues, and consumers are buying a relatively expensive product from the OEM with at least a three- to five-year lifespan.  Consumers are not going to buy a $30,000 Envoy from GM if they question GM’s ability to service the car, manufacture replacement parts and honor the warranties.  In fact, a recent article in the New York Times reports that, in a study of 6,000 consumers, “80 percent of [the respondents] . . . would switch companies if G.M. or Ford filed for bankruptcy protection.”  Consumers do not necessarily have the same long-term investment concerns with airline ticket and clothing purchases.

    

A traditional chapter 11 case for an OEM also could be lengthy, expensive and complex.  The UAW appears reluctant to make additional concessions; consequently, renegotiating GM’s labor contracts could completely consume any bankruptcy case.  GM also would have to develop a feasible business plan in order to satisfy the plan confirmation requirements of chapter 11.  That would take time, and an extended chapter 11 case could further weaken consumer confidence and likely lead to liquidation.

    

So, does that mean the government should bail out GM?  A bailout typically adds more debt to the company’s already overleveraged balance sheet.  That debt can take several forms, including senior debt or preferred stock (the latter is really a hybrid investment; the liquidation preference on the preferred still must be paid before value flows to common shareholders).  A bailout may eliminate GM’s immediate liquidity issues, but it will not fix one of its core problems—its balance sheet.  Likewise, government directives regarding the production of more fuel-efficient cars, executive compensation restrictions, changes in management and the like might produce welcome changes in the industry, but it will not reduce GM’s leverage in the near term.

    

Bankruptcy, on the other hand, could restructure GM’s balance sheet in a meaningful and significant way.  GM could, for example, implement a debt-for-equity exchange and unilaterally reject unprofitable or burdensome contracts in chapter 11—objectives that cannot be accomplished out of court.  But how do you balance these benefits with the obstacles to chapter 11 suggested above?  One potential alternative is a prepackaged chapter 11 case.

    

In a prepackaged chapter 11, the parties work to develop and solicit votes on the company’s plan of reorganization prior to filing the actual chapter 11 case.  This groundwork lends some certainty to, and frequently expedites the timeline of, the bankruptcy.  In GM’s case, these attributes could mitigate the potential damage to consumer confidence and any resulting declines in sales.

    

One remaining issue even in a GM prepackaged bankruptcy case is debtor-in-possession financing, which would be necessary to fund GM’s operations until a bankruptcy plan is approved and implemented.  The debtor-in-possession financing market, like most credit markets at the moment, is effectively closed for business.  Nevertheless, some observers have suggested that the government could extend debtor-in-possession financing to the automotive industry.  Considering the speed with which the government obtained executed term sheets from the country’s nine largest banks under TARP, having the weight of the government behind a GM prepackaged bankruptcy may encourage parties to cooperate more than usual around the negotiating table and facilitate an even quicker restructuring.  A prepackaged bankruptcy also could benefit U.S. taxpayers, particularly when compared to an out-of-court bailout, as debtor-in-possession lenders typically receive enhanced protections under the Bankruptcy Code and payment upon the implementation of the chapter 11 plan.

    

That being said, I am sure other obstacles exist to a GM prepackaged bankruptcy that I have not mentioned or considered, and prepackaged plans can be difficult to negotiate.  Given the current state of affairs and the likely alternatives, however, it certainly seems an option worth exploring.

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