Friday, May 1, 2009

Are Hedge Funds Morally Bankrupt?

President Obama seems to think so. In a speech on Thursday, the President said:


He further stated "it was unacceptable to let a small group of speculators
endanger Chrysler's future by refusing to sacrifice like everyone else."

Now I know that the general perception of "investors and hedge funds," not to mention "speculators" is that they are close to, if not as bad as, the so-called "robber barons" of yesteryear.

Many people will think these firms deserve to lose money, perhaps all of it. Heck, I'm sure that there are some Americans who would like nothing better than to physically take out their anger at the economy on these "speculators" who let greed get the better of them.

I guess it's smart for the President to frame the issue in populist terms. After all, the workers compromised; Daimler, the former owner, compromised; even the private equity firm, Cerberus, compromised! Although the Cerberus part was somehow was left out of the speech.

The other secured lenders were willing to take the deal offered as well. So what's wrong with these "investment firms and hedge funds." How could they possible think they were going to get away with an "unjustified taxpayer-funded bailout?" Why did they think they could get "twice the return that other lenders were getting?" Are they really so greedy and rapacious that they would rather see poor Chrysler employees on line at soup kitchens and living in Hoovervilles while they gleefully liquidate and American icon?

Well, certainly that seems to be the party line among Chrysler, its well paid advisers, the unions, and the Executive Branch, led by the President himself!

It might make a wonderful movie some day, like "It's a Wonderful Life," but it's a fairy tale. In reality, things aren't so clear cut.

Let's examine what has happened and is happening:

  • Chrysler and the President's "Automotive Task Force" tried to arrange a distressed debt exchange. Typically, in such negotiations, the parties know that there is a financial distress and the failure to come to an agreement will lead to a bankruptcy.

Bankruptcy, under Chapter 11, provides companies with protection from their creditors. The company (known as the "Debtor in Possession") doesn't have to pay interest or principal on any debt owed at the start of the case (although, generally, it is necessary to pay some parties to keep the business running) until the end, when the Plan of Reorganization is confirmed.

Bankruptcy also provides the debtor in possession with the opportunity to cancel executable contracts (like leases, long term purchase agreements, etc.).

At the conclusion of the bankruptcy, the pre-petition creditors are given some form of compensation (or nothing, if they are too junior). Compensation can be cash, a future promise to pay cash (in the form of a loan agreement or bond), and/or equity.

One class of creditors that is given special protection under the law is the secured creditors. Under a strict reading of the law, compensation would be paid out based on absolute priority (the priority of payment in a liquidation). Therefore, if the value in the business left at the end of a bankruptcy is less than the secured claims, then the secured creditors receive all the compensation and the unsecured creditors receive nothing.

Secured credit is one of the foundations of American capitalism. Without it, many businesses wouldn't be able to borrow money at all. Other businesses use secured loans to obtain cheaper capital.

If the Chrysler case brought the rights of secured creditors into question, then lending would dry up for some parties and become more expensive for everyone else.

The "investment firms and hedge funds" own a portion of the loans issued under Chrysler's "First Lien Credit Agreement" which was amended and restated on August 3, 2007. The loan under the agreement was initially $10 billion, but has been paid down to the current level of $6.9 billion. This facility (according to the Affidavit of Ronald E. Kolka, Chrysler's CFO) is

(a) secured by a security interest in and first lien on substantially all of Chrysler's assets,including accounts receivable, inventory, equipment, books and records, cash, general intangibles, real property and a pledge of all of the capital stock of each of Chrysler's domestic subsidiaries (other than its charitable subsidiaries) and 65% of all of the capital stock of each of Chrysler's first-tier Foreign Subsidiaries; and (b) guaranteed by certain other Debtors, which guarantees are secured by a first priority lien on substantially all of such Chrysler's respective assets, including a pledge of all of the capital stock of each of its domestic subsidiaries and 65%of all the capital stock of each of its first-tier foreign subsidiaries.

So the owners of those first lien loans should, under absolute priority, be at the front of the line to receive any value from the assets of Chrysler.

  • The first lien secured creditors were initially offered $2.0 billion in cash to pay off the $6.9 billion of that secured debt (roughly 29 cents on the Dollar). This was satisfactory to some of the lenders, but not all. The offer was then increased to $2.25 billion in cash (roughly 33 cents on the Dollar). The "investment firms and hedge funds" refused to accept that offer either.

Now most of the banks (probably all) accepted both the 29 cent offer and the 33 cent offer. They own the same loans as the "investment firms and hedge funds," so why were they willing to compromise?

It might have had something to do with the Government's place in the banking world. First, many of these banks had taken TARP money - so the government owns equity in the institution and those banks are under a microscope. In addition, both the TARP banks and the non-TARP banks rely on the Treasury, the Federal Reserve, and the FDIC (among other Government entities) to conduct their business. The President's Automotive Task Force (and, subsequently, the President) made it very clear that they wanted the exchange to get done, with an implied thread to anyone who stood in their way (and Congress has been pushing for a deal as well).

  • The "Investment Firms and Hedge Funds" that refused to give in had less to fear from the Government, so they could exercise their fiduciary responsibilities. Even so, they were willing to agree to 60 cents on the Dollar (although there was a story on Bloomberg that they were willing to take $2.5 billion, or 36 cents on the Dollar).
One fact that is often forgotten when discussing "Wall Street" and "Hedge Funds" in particular, is who actually owns the assets that they manage. While the investor base varies, among the largest players are pension funds, insurance companies, and endowments (universities like Yale and Harvard have been active investors in these funds for over a decade). So losses by these funds impacts the public through the financial stability of the institutions supporting their pensions, life insurance, etc.
So, back to the President's argument. Let's look at it one piece at a time:

  • The unions compromised - But they were unsecured creditors being offered more than the offer to the first lien secured creditors. They couldn't hope for a better deal.
  • Major financial institutions compromised - but, as I discussed above, they were given an offer they couldn't refuse.
  • Daimler agreed to give up its stake - They owned equity and had loaned money against a second lien. They weren't getting anything if the first lien was cut to 33 cents! I don't know enough about their liability in relation to the pension plan, but as former owners, there was probably a case against them to fund the pension.

Well, the pressure didn't work on the holdouts (they owned approximately 15 percent of the loan). Chrysler has filed for bankruptcy.

The Chrysler team, led by President Obama, is trying to do a "surgical bankruptcy" from which they hope to emerge in 60 days. The plan is:

(a) Chrysler will transfer substantially all of its operation assets to New Chrysler; and (b) in exchange for those assets,New Chrysler will assume certain liabilities of Chrysler and pay Chrysler $2 billion in cash.Prior to the Closing Date, (a) Fiat will contribute to New Chrysler access to competitive fuel efficient vehicle platforms, certain technology, distribution capabilities in key growth markets and substantial cost saving opportunities; and (b) New Chrysler will issue approximately 55%,8% and 2% of the Membership Interests in New Chrysler to a new VEBA, the U.S. Treasury and the Canadian government, respectively. After the "Fiat Transaction", a subsidiary of Fiat will own 20% of the equity of New Chrysler, with the right to acquire additional 31% of NewChrysler's Membership Interests under certain circumstances.

So the union's pension plan will own 55%, Fiat will own 20%, the US will own 8%, Canada will own 2%, and there's 15% unaccounted for. All that will be left for the creditors will be the $2 billion in cash and whatever assets are left behind (except for any assumed liabilities, which are most likely trade and employee related) - after the lawyers, consultants, and investment bankers are paid out of the estate for their services during the bankruptcy.

To implement this plan, Chrysler will file a motion for a 363(b) sale to New Chrysler, which will be the "stalking horse" bidder in the sale process.

Our friend at the Distressed Debt Investing blog has looked at the documents and provides an interesting analysis - including the observation that the CFO stated an incorrect price in his Affidavit (he said the first tier loan debt is trading at 15 cents on the Dollar - it's actually, according to the blogger, 25.25 bid and 27.25 offer). His two posts are here and here and include links to the documents with an analysis.

Over at the Bankruptcy Litigation Blog, Steve Jakubowski points out that there are several hurdles for a rapid 363(b) sale. He cites a 2002 paper co-written by Chrysler's primary bankruptcy attorney, Corinne Ball discussing these hurdles. Here is an updated version of that article from 2007.

In that article, she states:

The most common justifications for a Section 363 Sale, which is typically much faster than a Plan Sale, are that the value of the assets involved will rapidly deteriorate or that the seller urgently needs the cash from the sale to continue its remaining businesses and avoid a liquidation, which, in either case, will lead to a lower recovery by creditors. See, e.g., In re Trans World Airlines, Inc., et al., No. 01-00056 (PJW), 2001 WL 1820326, at *4 (Bankr. D.Del. Apr. 2, 2001) ("TWA had no other strategic transaction available to it and had no offer for value to which it could turn. Nor could TWA rely on its self-help plan because TWA was unable to procure adequate capital infusion to implement that plan. Its only alternative was a free fall chapter 11 filing with the high likelihood of a piecemeal liquidation of the enterprise.")

Well, they've created an "urgent" need through the terms of the DIP being offered by the Treasury (here is a copy of the Term Sheet - it was part of the Exhibit to the declaration by the advisor from Capstone, Robert Manzo). The DIP loan is partially contingent on the filing of the petition for the 363(b) sale must be filed by Monday May 4th, the hearing on the petition to take place on or before May 9th, all bids related to the auction are to be received by May 20th, the lead bid must be determined by May 29th, the hearing on the motion to approve the sale must be held by June 1st, and the transaction must close by June 27, 2009 (see Schedule 5). Failure to comply with that schedule will constitute a default of the DIP agreement.

We'll get to find out how Judge Gonzalez enjoys having a proverbial gun to his head. To me, this could easily be construed as a sub rosa reorganization, violating the Section 1129(b)(2)(A) since substantially all of the assets are being sold without a full reorganization process (and the value of any operating improvements that could be made under the protection of Chapter 11 will accrue to the owners of NewChrysler, not the pre-petition creditors).

There could also be an argument made as to whether the union, Fiat, the US Treasury, and the Canadian entity are acting in "good faith." This could particularly be argued in connection with the promotion of the VEBA claim above that of the first lien lenders.

I don't know if the DIP lender, particularly the Government, will be given the right to create a crisis situation justifying the sale. If not, getting past the legal precedent of Lionel, Braniff, Iridium, and this case from the Southern District of Texas.

This is going to be a very interesting case, and it starts in 2 3/4 hours!

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