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Monday, April 7, 2014

Comedy in Tragedy: The Daily Show on GM Liabilities




I LOVE The Daily Show. It's one of the only two shows that I ever watch (the second being Colbert Nation). Last week, Jon Stewart discussed how the post-bankruptcy GM is immune from liabilities related to accidents caused by vehicles made by pre-bankruptcy GM. The automaker's fledgling CEO Mary Bara led the recall of approximately 2.6 million vehicles with faulty ignition switches. This defect is linked to at least 13 deaths, which is especially controversial because GM has known about this since 2005. The automaker purportedly decided against fixing the problem then because it would take too long and cost too much money (WSJ). 




Let's recall a teeny tiny fact about the time-frame of the initial discovery of the ignition issue: the GM and Ford downgrade from Investment Grade to High Yield! Remember that mess in 2005? GM and Ford, which were considered bellwether bonds making up the second and third largest issuers of the bond market. This was right after the Fed had raised short-term rates and GM had failed to get healthcare concessions from its unions. 

"The GM downgrade could cause disruptions in the market for junk bonds, partially because many funds that are limited to investment-grade assets will be forced to sell GM's bonds." WSJ

So cost of capital for GM went from around 5% to around 11% for corporate debt. There was a huge sell-off in the bond market and then Kerkorian started bidding for GM stock, which had languished from $40 in the beginning of 2005, at $31. 

I'm sure that GM management at the time was like, "Eh. We have to pay more than double to borrow money, our unions want way more in healthcare benefits than we can afford, and, oh, we may now have an activist shareholder hovering over our shoulders. We're selling a record number of vehicles because we started this vicious employee discount cycle to offset our dwindling market share, and we need to keep selling. Let's hold off on making changes to this ignition thing until we're super duper sure about what we're going to do." Not that it absolves anyone of wrongdoing, but it gives us some context as to the turbid morass that the company was in at the time. 


Okay, so let's get to the liabilities from ignition device defects, why, according to bankruptcy law, new GM doesn't necessarily have a legal obligation to compensate consumers for the malfunctions, and what can possibly be done about it. 

When I heard Stewart talk about GM negotiating the release of former liabilities as part of its bankruptcy plan, he made it sound as if such releases are abnormal. In fact, a Chapter 11 filing is puissant precisely because it gives the company a new life line by extricating itself, at least partially, of the heavy burdens of debt and liabilities. If you'd like to know more about the history and impact of liabilities releases on financial renewal in America, check out this ABI podcast with Harvey Miller.

When a corporation files for bankruptcy protection, a reorganization plan, which has to be approved by the judge, details recuperation of the company's assets for all stakeholders. BUT, all stakeholders aren't created equally. For example, in GM's case, if a bank lends specifically for the a new plant and the plant serves as collateral, more than likely, in a simplified case, the bank will get that plant in a bankruptcy filing. This arrangement makes the bank a secured lender. 

Then, there are unsecured lenders, those who lend to GM without having explicit collateral. There are many levels of unsecured lenders, which can get kind of complicated. But the process of a restructuring involves figuring out which lender has dibs on which assets, and then distributing those assets accordingly. 

Obviously, consumers of the product can also have claims in a bankruptcy proceeding, especially in cases such as warranties, gift certificates or pre-orders. So what happens in the case where stakeholders at the time of the bankruptcy don't know they're going to have claims? That is, they didn't know they had a faulty switch until now in a car that was purchased back before the bankruptcy filing? There is precedence for such a situation in the Epstein v. Official Committee of Unsecured Estate of Piper Aircraft. Here's a quick summary: 

"Piper has been manufacturing and distributing general aviation aircraft and spare parts throughout the United States and abroad since 1937.

On July 1, 1991, Piper filed a voluntary petition under Chapter 11 of Bankruptcy Code in the United States Bankruptcy Court for the Southern District of Florida. Piper's plan of reorganization contemplated finding a purchaser of substantially all of its assets or obtaining investments from outside sources, with the proceeds of such transactions serving to fund distributions to creditors.

On July 12, 1993, Epstein filed a proof of claim on behalf of the Future Claimants in the approximate amount of $100,000,000. The claim was based on statistical assumptions regarding the number of persons likely to suffer, after the confirmation of a reorganization plan, personal injury or property damage caused by Piper's pre-confirmation manufacture, sale, design, distribution or support of aircraft and spare parts." 58 F. 3d 1537

The most relevant aspect of this case decision is that these Future Claimants are considered tort victims. The problem is that tort claims do not take priority over secured claims, meaning that they're in the same category as unsecured claims. LexisNexis

So, let's do a simplified hypothetical example. The bank lends GM $80 for the plant. Then, GM issues unsecured bonds that get purchased by mutual funds and insurance agencies with a notional amount of $100. Total GM debt is $180. GM files for bankruptcy and sells its plant and other assets for $100. Of that amount, $80 goes to the bank because it was a secured lender. There's only $20 left over for ALL unsecured bondholders plus any future claimants of tort cases. The trustee sets aside $10 for future claimants and distributes $10 to the rest of the unsecured holders. 

A few years later, it turns out that there are $100 of tort cases related to pre-petition design of cars. New GM pays off those victims in full. What happens? If you held an unsecured bond and 10 got cents on the dollar, you'd be pretty upset since the tort victims, whose claims were at the same level as yours, got more than you did. 

The problem here is deeper than it initially seems. If we assume that future tort victims have similar priority as unsecured claimants, then we can't justly pay them more. We also can't require the new GM to compensate the tort victims because that would be changing the rules after the deal has been done. That is, since the new GM has different shareholders, the new shareholders bought the stock assuming that they weren't liable for future claimants any more than for unsecured bondholders. Changing that would cause buyers to lose trust in the system. (Here's a Pepper Hamilton article for more). 

The current law obviously isn't the answer, however. Loyola University's Law Journal describes the issue in more detail: 

"Allowing the debtor to escape liability for wrongful prepetition conduct frustrates the goal of deterring wrongful conduct by the debtor and others in the future. Under Piper, a tortfeasor may escape financial responsibility by simply filing for the protection of the bankruptcy court."

Is there a solution? There have been many offered in the legal field. Future damages that result from pre-petition issues could be considered claims in the bankruptcy court. There can be a cap on those claims and the judge can decide on a case-by-case basis. 

Another solution may be to put an actual dollar amount estimate to future claims and considering them secured debt so that they receive a portion of what's due to the secured guys. Here, the secured debtors end up paying for the victims (you know, the lender for the plant). 

Another answer could be explicitly requiring the new shareholders to pay for the mistakes of the old GM, maybe with a cap, so that the new shareholders know what to expect. 

Lastly, there could possibly be a claw-back using the fraudulent conveyance argument from previous shareholders, which may be the most fair, but also the most difficult to prove and execute. 

See Mr. Stewart, the problem here isn't simply a matter of whether or not the injured ought to be compensated; it's a problem of who pays for it and ensuring that the decision is the most just solution available. 


5 comments:

  1. Weren't GM secured creditors impaired as well in a negotiated deal? Regardless going to take a hit then...

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    Replies
    1. GM's secured creditors weren't impaired. Secured creditors made up a relatively small number of total creditors, and secured bond holders were mostly the US and Canadian governments.

      Chrysler secured creditors were impaired in favor of the UAW receiving 40 cents on the dollar, which resulted in major consternation in the bond market.
      http://www.nationalaffairs.com/publications/detail/the-auto-bailout-and-the-rule-of-law

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  2. I came across your page here earlier this year when this issue was getting a lot of attention. At the time I was in a bankruptcy and restructuring course with a professor who had played a central role in the original GM bankruptcy proceedings. Something that came up in our class discussion of this issue, which was almost entirely ignored in the early media coverage (the Stewart piece is a perfect example), is the fact that New GM expressly assumed "all liabilities to third parties for death, personal injury, or other injury to persons … which arise directly out of accidents" in the Master Sale and Purchase Agreement. So I don't think the bankruptcy issue raised was ever whether personal injury/wrongful death plaintiffs would have claims against New GM--New GM had assumed those liabilities in the 363 sale. Rather, the question was whether economic-loss plaintiffs (e.g. someone whose Old GM car was worth $10k before the defect was discovered but is now worth $9k, and wants to sue New GM for the loss in value) would have claims against New GM.

    Knowing this, another question comes to mind, namely, why would New GM voluntarily assume liability for these personal injury claims? I think the answer is that they needed to assume these liabilities to maintain a strong brand moving forward. If the news was filled with stories about GM car owners being injured by their defective cars and going uncompensated, it would become a serious drag on sales (because few customers would make any distinction between the "New GM" cars currently for sale and the "Old GM" cars that were ruining people's lives).

    Perhaps this is another potential solution to the problem you identify of corporations improperly avoiding liability for pre-petition activities through bankruptcy--if the main point of reorganization is to maintain going-concern value, and if that value is hurt by not assuming certain important liabilities in bankruptcy, then this will serve as a check on the problem. It is a market-driven solution, and, at least in the case of large, visible corporations, it seems like it works.

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  3. Thomas, thank you so much for sharing your knowledge! I had no idea that GM expressly assumed all liabilities which arise out of accidents. That's interesting that you think they assumed the liabilities to maintain a strong brand. I wonder if that's a common practice.

    Your possible solution for handling pre-petition liabilities, that of expressly assuming them, is a fantastic one. I agree that it is a market driven solution and really works in favor of new shareholders too since they would want to make sure that the brand remains strong.

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