November 20, 2008
The Government as Controlling Creditor
Posted by Michelle Harner

Creditors have long imposed conditions and restrictions on their corporate borrowers; it is the price a company pays for doing business with borrowed money.  Recently, creditors have increasingly tightened the reins on corporate borrowers, particularly those in financial distress.  In the latter context, creditors typically require frequent financial reports; tight financial covenants; veto or consent rights with respect to a variety of business decisions, including asset dispositions and acquisitions and management compensation; and the retention of financial or restructuring professionals, which may include the appointment of a Chief Restructuring Officer acceptable to the creditor.  In addition, some creditors obtain the right to elect one or more directors or to place an observer on the board under certain circumstances.


Creditor control is not a new development, but the practice has garnered recent attention as academics and practitioners discuss the changing dynamics in corporate restructurings and the increase in corporate liquidations.  (See Fred Tung's recent post here; other related articles here, here and here.)   A recent study suggests that a distressed company with secured or oversecured creditors is more likely to restructure through a sale process than a company with little or no secured debt.  This finding is consistent with the proposition that creditors utilize control rights to exit a distressed credit as quickly and efficiently (with respect to their own interests) as possible.  Some commentators also suggest that creditors utilize control rights to acquire the distressed company—the so-called “loan-to-own” strategy.


Now, I do not think the U.S. government wants to “nationalize” the automotive industry at the end of the day by becoming the principle shareholder of one or more of the “Big Three,” but its proposed strategy for addressing the distress in Detroit takes creditor control to new levels.  In explaining the proposed $25 billion bailout for General Motors, Ford and Chrysler, Rep. Barney Frank said:  “[T]hey will get the $25 billion if the bill passes, with a lot of conditions.  No dividends can be paid, no bonuses for people over $200,000 and some other things.  [And] they would have to prepare and file by March 31 a plan that shows how they plan to get much more efficient and to get cars that can be marketed.”


Rep. Frank further explained, “[T]he federal government would be in the first position to be paid.  We will come ahead of the debt holders, the shareholders, etc. . . . If, on March 31, the president does not believe that [their proposed plans are] going to get them the viability with energy efficiency [sic] cars, they have to repay the loans; they get no more money.”  Rep. Frank left open the possibility of additional loans if the March 31 plans show sufficient progress.


Several aspects of this proposed $25 billion bailout are interesting and unique.  First, I would like to understand better how the government will obtain what amounts to a super-priority lien on the automakers’ assets to ensure payment ahead of all other creditors.  For example, recent reports suggest that General Motors has approximately $20 billion of unencumbered assets.  If these reports are accurate, those assets could serve as collateral for any government loan.  The pertinent issues then would revolve around valuation of the collateral, the amount of the loan and maintenance of the collateral during the loan term.  If the reports are inaccurate, or the amount of unencumbered assets is insufficient to support the necessary loan, the issues are more troubling.  The U.S. Bankruptcy Code authorizes a bankruptcy court to grant super-priority status to postpetition lenders under certain circumstances; nevertheless, the indication from hearings before the Senate Banking Committee is that the Big Three and proponents of the bailout are not open to bankruptcy options.  Theoretically, other creditors could agree to subordination (or to a waiver of any relevant negative covenants against asset pledges or the like), or options for structural subordination could be explored, but again, that does not appear to be contemplated by the proposed bailout.


Second, the March 31 restructuring plan requirement, although it makes facially good sense from a policy perspective, makes the proposed loan look very similar to debtor-in-possession financing, with one major caveat.  The government, rather than a bankruptcy court, is deciding whether the restructuring plan is feasible and whether additional super-priority loans will be extended.  Finally, again, absent severe arm-twisting to get existing creditors and contract parties to modify their rights against the automakers on a voluntary basis, I do not see how the Big Three realistically can propose a plan for long-term sustainability (see my prior post on a GM bankruptcy).


Certainly, elements of the proposed auto bailout are similar to those invoked by the government under TARP for financial institutions.  The similarity may be intentional as lawmakers try to tap the $700 billion relief package to fund the auto bailout.  Control covenants are a part of the TARP preferred stock agreements.  The proposed auto bailout, however, seems to push the envelope even further.  And although I have many questions about how the government would implement and monitor the bailout, the most pressing are various “what ifs?”  What if the government determines the March 31 plan is not feasible and the companies have no ability to repay the loans?  What if the government approves the March 31 plan and loans additional money—does the government continue to act as the ultimate decision maker for the automotive industry?  What if the government gets it wrong and after several subsequent loans (and substantial additional non-government debt being added to the companies’ balance sheets), the automakers fail--what happens?  Is the government now acting in a fiduciary role?  I do not know the answers to any of these questions, but it certainly will be interesting to observe.


Notably, Senate leaders elected to cancel today’s vote on the proposed auto bailout, so no definitive answers likely will be forthcoming this week.

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