A Financial Historical Analysis of General Motors (GM)
Virtually all companies experience financial hardships at one time or another. Yet, rarely has a company fallen as far and as fast as General Motors (GM). When we analyze such a fall, the blame for failure can be attributed to a combination of factors. Unbothered by competition and looming economic threats, GM??™s management thought to coast its way to increasing market share while maintaining its grip on the automotive industry. Rather than imitate their eastern competitors, such as Honda or Toyota, the bureaucratic giant completely ignored cost-cutting initiatives, believing that large profit margins would more than make up for increasing legacy costs (i.e., healthcare and pension obligations to an increasing retiree population) [ (Gearino, 2010) ]. More precisely, its passive labor negotiations proved fatal in conceding to the demands of the United Auto Workers (UAW), when unrealistic contracts were struck in the early 1970s, including the right to retire after 30 years with full pension and benefits. The result: It fell behind its Japanese competitors in innovation, research & development expenditures and patent filings.
Following multiple corporate restructuring attempts in the 1980s, Rick Wagoner took the helm at GM as Chief Executive Officer (CEO) in 2000 (Holstein, 2009). Rather than learn from his predecessor??™s mistakes, Wagoner drove the company into a multitude of potholes. According to John Baldoni, a leadership consultant recognized as one of the world??™s top 25 leadership experts by Top Leadership Gurus International, Wagoner failed to do three things effectively: (1) Resist a non-confrontational culture, (2) Demand creative solutions, and (3) stimulate change in the midst of crisis (Baldoni, 2009). First, Wagoner never challenged the non-confrontational culture at GM, where, according to Baldoni, ???if you went along, you got along.??? In the automotive industry, where urgent million-dollar decisions are made in minutes spurred by the harsh reality of the industry itself, management cannot be successful while nurturing a culture that hinders its practice in a changing world. There must be accountability realized in transparent policies, procedures, and standards, both written and implied. Secondly, Wagoner ???never pushed his people to come up with new ideas that would shake the status quo??? (Baldoni, 2009). This complacency led to inflexible work rules, an unwieldy dealer network, and over-extended brand offerings leaving the company with no flexibility to respond to market changes. Lastly, Wagoner failed to act urgently in the midst of crisis by not putting the right people in place to make the right decisions. GM??™s management relied upon historical performance and outdated data to justify their relaxed position, instead of responding to changing consumer buying patterns. However, not everything Rick Wagoner did was bad. He reenergized the Cadillac and Chevrolet brands with new profitable products, began to spend more on R&D, and pushed hard in adopting Toyota??™s low-cost manufacturing approach. But, it was too late. An economic crisis was brewing in the summer of 2008.
While we have thus far identified some of GM??™s key failures over the past decades, we must conduct a more in-depth analysis of their past ten-year history in order to bring clarity to the situation and better understand why the company filed for bankruptcy on June 1, 2009. This shall not be a timeline per se, but more of a general sketch of relevant bankruptcy indicators, with occasional focused appraisals on certain decisions made by GM management as warranted by their quantitative and/or qualitative impact. Perhaps the most significant event for GM in 2000??”the first year of the time range we have decided to analyze??”was GM??™s decision to phase out its Oldsmobile division, America??™s oldest car brand (Isidore, 2000). This decision was due to a variety of reasons; including the company??™s failure to continually update the once-famous brand, its delayed inclusion into the light-truck segment of the market, and a steady decline of Oldsmobile sales since 1985. But the decision to phase out Oldsmobile??™s production also trimmed thousands of jobs (4,000 in America and 2,000 in Europe) and hundreds of Oldsmobile dealerships throughout America. But this was just one of many indicators of GM??™s downfall (Isidore, 2000).
2001 was another ???restructuring??? year with the continued attrition of its European salaried workforce, totaling 1,500 jobs. Moreover, in 2001 its German subsidiary, Opel, recorded a $456 million dollar loss, attributed to a global shrinking of the car market (Fuchs, 2001). Many other plants were also on the edge of existence. Plans were devised to close other plants across Canada and the U.S., a total of approximately 11, 850 employees taking the hit. Levels of over capacity in the auto industry had developed in the previous boom due to globalised production, and as a result mass redundancies in production facilities and subsidiary concerns were being realized everywhere (Fuchs, 2001). A little due diligence in market forecasting may have prevented this problem of overcapacity??”yet another bankruptcy indicator within GM??™s historical profile.
However, in 2002 GM began to take on an aggressive role in exploiting emerging markets. What seemed to a misguided $251 million dollar acquisition of Daewoo, the insolvent South Korean automaker, turned out to be just the right move to secure a leading position in the Far East (Tierney, 2006). The acquisition brought unexpected synergies including ???expertise in key areas where GM lag[ged], such as the cost and time it takes to develop vehicles??? (Tierney, 2006). GM??™s Asia Pacific division, unfettered by legacy costs and image distortions, were able to explore and capitalize on such transactions by operating with the urgency of a do-or-die mentality, unlike their cohorts in North America. By tapping talent from Daewoo??™s product quality engineers, they began to understand the singular importance of quick efficient execution in slashing production costs and quickening the product development cycle, especially in an Asian market that demanded low-cost small car segments (Tierney, 2006).
2002 also was a strong financial year for GM with record revenue of $186.8 billion, market share gains in three automotive regions, strong operating cash flows, and improved costs performance [ (SEC, 2002) ]. GM??™s strong cash performance, its automotive operations generating approximately $8 billion in cash flow, allowed them to contribute $4.8 billion to its unrealistic U.S pension plan during the year. Additionally, the company??™s U.S. market share increased by 0.2 percentage points from 2001 with SUV sales topping 1.2 million for the calendar year. Wagoner??™s reason for the great success: ???we??™re offering cars and trucks that customers really want to buy??? (Automotive Intelligence News, 2003). Evidently, such an acclaimed strategic perspective proved untrue years later as they continued to heavily market fuel-inefficient models while gas prices exceeded $4.00 a gallon.
Thus far an inexperienced spectator may find little cause for concern with the financial results of GM that we have described. U.S. market share was increasing, liquidity was on the rise, and with its purchase of Daewoo, GM seemed to have the top spot secured in the Asian Pacific region??”the world??™s largest growing market. Yet, a closer examination of the figures tells another story. To present a case in point we have utilized the scholarship of Nick Beams, an Australian socialist intellectual, to provide a very simple breakdown. According to Beams, in the second quarter of 2003 only $83 million of the company??™s $901 million profit came from the company??™s North American vehicle operations, down from $1.3 billion in 2002. The remainder of its second quarter profits came from the company??™s financial division, General Motors Acceptance Corp. (GMAC) (Beams, 2003). Even there, auto financing was not the big contributor, but rather its home mortgage business, financing more than $72 billion in loans to provide the secret cushion. Thus, although on a sheet of paper GM may have seemed to be turning around, the real story was quite evident: its core business was hiding beneath the shadows of its financial arm. Beams goes on to write, ???faced with over-capacity and with inventories above normal, GM will cut production by 6 percent in the third quarter and expects to lose $150 million on its auto business.??? Situations like these illustrate the inflexible culture that GM??™s management cultivated, hoping to somehow purge the inevitable.
In 2004, GM continued to ignore threats from their external environment by making decisions based on historical data without incorporating current changes in consumer demand. For example, Robert Lutz, GM??™s vice chairman of product development, stated in 2004, ???General Motors Corp. has no plans to try to answer the success of the Toyota Prius, the critically acclaimed gas/electric hybrid car.??? Mr. Lutz??™ suspicion may be partly well-founded, but when there is an escalating social movement within the consumer market desiring to combat climate change, there ought to be a more serious consideration for how that affects future auto design and production. GM correctly assumed that customers would not be willing to pay more for hybrid cars. Yet, a major error on GM??™s part was taking that assumption and blanketing it over the entire consumer market. Lutz states, ???Hybrids are an interesting curiosity and we will do some. But do they make sense at $1.50 a gallon No, they do not??? (Isidore, 2004). The issue??”at least not in 2004??”was primarily not about gas prices; rather, it was about a social movement that demanded cleaner more environmentally-friendly products. Therefore, not surprisingly, GM??™s sales were down 1.3% in 2004 while Toyota??™s sales were up 10.4%. The fourth quarter proved to be difficult for GM. The company only reported net income of $630 million down from $1 billion in 2003??™s fourth quarter. GM??™s European operations, Opel, were a major contributor to this weak performance. The European division alone had a $742 million loss, which is more than three times the loss reported in 2003. Another major contributor to the sluggish performance was retiree benefits. In 2004, GM had 2.5 retirees to every employee (Peters, 2005). According to research by Morgan Stanley, ???pension, health care and other costs for retirees added $1,824 to the price of each vehicle G.M. produced in 2003. By contrast, Toyotas retiree cost per vehicle was only $186, according to Morgan Stanley??? (Peters, 2005). These costs would prove to be detrimental to GM??™s future.
It did not take long for these concerns to be recognized by Wall Street. In 2005, Standard & Poor??™s (S&P) downgraded General Motor??™s debt to junk bond status (Teather, 2005). By this time, the company had accumulated nearly three hundred billion dollars in debt??”half of that burden consisting of pensions and health insurance costs for GM retirees (Teather, 2005). Due to sinking sales, GM??™s management recognized that their only hope to avoid bankruptcy was to reduce the size of the company. The company further initiated a plan designed to shrink the company??™s expenses. In 2005, General Motors announced a three-year plan that would result in the layoffs of thirty thousand workers as well as close twelve US plants (ABC News, 2005). GM reported in the company??™s annual report a $10.4 billion loss primarily due to poor performance in the North American operations.
2006 was a challenging year for GM. To start off the year, the company filed their 2005 10-K two weeks late, because it had erroneously accounted for cash flows from a mortgage subsidiary of GMAC. Furthermore, the company disclosed that its complex accounting relationships with several suppliers were the subject of a criminal probe. The company was also faced with a major dispute with UAW-Delphi, its main parts supplier, over a negotiated buyout of employees??™ health care coverage which had become a crippling burden for them. This was extremely costly to the company and caused GM to increase the company??™s after-tax charge taken in the fourth quarter by $1.3 billion (Isidore, 2000). On April 3, 2006 GM announced a $14 billion deal to sell its majority share in GMAC (ABC News, 2005). In order to generate much needed cash, GM saw the sale as a viable option. GM had a junk bond status for more than a year which negatively affected its ability to raise capital. GM hoped that after selling its majority stake in GMAC??”their finance arm that was subject to a criminal probe of mistaken accounting practices??” the company would return to investment grade status. Overall for the year GM reported in the annual report a $2 billion loss primarily due to losses in the company??™s North American operations. Although this is still a loss, it was a significant improvement over 2003??™s loss of $10.4 billion.
In 2007, GM reported a 90% decline in first quarter profit. One of the main contributors??™ to the decline was continued losses from its now-minority-held finance arm (GMAC). GMAC reported a $2.3 billion loss primarily due to a significant loss at Residential Capital, LLC. GM still had a 49% stake in GMAC and therefore reported a $1.1 billion loss. During this same period, Toyota surpassed GM in first quarter sales of cars and trucks threatening GM??™s reign as the world??™s largest automaker (Komatsu, 2007). GM reported a net loss of $23 million excluding special items. When including special items GM reported a loss of $38.7 billion, which was almost entirely attributable to a non-cash $38.3 billion charge related to the valuation allowance against deferred tax assets. This massive write-down was affected by a decision from management who realized that it was time to come clean and ???write-down the value of its deferred tax assets because it became completely unpredictable as to when the company would actually return to making a profit, and thus use that tax asset against any future tax liability??? (Englund, 2008). Thus, the company made a negative judgment about its ability to successfully perform in the near future; and when executive management is uncertain about its ability to generate after-tax profits they are fully aware that bankruptcy is imminent.
A 2008 study showed that on average, Toyota actually pays employees a slightly higher hourly wage than General Motors. GM reported an average hourly wage of $29.78, while Toyota paid about $30 per hour (Associated Press, 2008). The difference lies in the benefit costs each company pays employees. General Motors has much higher benefit costs due to agreements with the United Auto Worker union to pay substantial pension and health care costs not only for current workers, but also the significant number of retirees. The study found General Motor??™s total compensation per hour to be $69 while Toyota??™s was only about $48 (Associated Press, 2008). Rising employee costs combined with a dwindling market share confirmed Wall Street??™s harrowing predictions for the world??™s largest automaker. However, General Motors was not able to shrink operations quickly enough and in late 2008 asked Congress for a governmental assistance. GM argued that without the aid, they would be forced to default on their obligations. Executives made the case that such an action would cause a major collapse of the United States automotive industry. The Federal Government responded by approving a fifty billion dollar investment in GM as well as $2.1 billion in preferred stock and a $6.7 billion loan (David Cho., 2009).
The agreement was contingent on General Motors undergoing a dynamic restructuring plan, which focused on accelerating the company??™s downsizing of operations by gaining major concessions from all major stakeholders (DePamphilis, 2010). Therefore, with available cash running low and car sales steadily declining GM entered bankruptcy on June 1st, 2009, ???with the government providing debtor possession financing during their time in bankruptcy??? (DePamphilis, 2010).
The bankruptcy filing was the fourth-largest bankruptcy in United States history in terms of company assets, which totaled $82.3 billion. In its bankruptcy filing, GM listed $82.3 billion in assets and $172.8 billion in liabilities (DePamphilis, 2010). The move may seem unprecedented for a one hundred year old industrial giant that was a component of the Dow Jones Industrial Average for over eighty years, but to the honest financial analyst the company??™s downfall was not without warning signs (Godt, 2009).
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The Legal Structure of GM??™s Bankruptcy
The federal Bankruptcy Code under Chapter 11 provides the legal structure for the reorganization of General Motors (GM). As the laws contained under the codification of Chapter 11 are quite extensive, we shall limit our discussion to simply those which most directly and significantly affect GM??™s 2009-2013 Plan of Reorganization. To commence a bankruptcy proceeding an entity may either voluntarily file a petition with the court (voluntary petition), or its creditors in hopes of reducing their potential losses may file with the court (involuntary petition). Along with this petition the company must also file a statement of financial affairs providing information about the company??™s current financial position. However, this does not automatically create a bankruptcy case. If the voluntary petition is considered detrimental to the interests of the entity??™s creditor??™s or, in the case of an involuntary petition, there is insufficient evidence indicating the debtor??™s insolvency, the court will likely reject it. Yet, insolvency (i.e., the inability to pay one??™s debts as they come due) per se is not required for a voluntary Chapter 11 petition [ (Newton, 2009) ]. ???As long as there is some indication of financial problems, judges generally will not dismiss the petition??? [ (Newton, 2009) ]. Upon filing a voluntary or an involuntary petition, the debtor typically assumes the identity ???debtor in possession,??? a term that refers to the debtor??™s continual control over the assets of the business while undergoing a reorganization under Chapter 11 [ (Administrative Office of the United States Courts , 2006) ].
If the court accepts the petition, then an automatic stay or order for relief is granted. The automatic stay, which continues until the case is closed or dismissed, is one of the most fundamental protections provided to the debtor. It is a time period ???in which all judgments, collection activities, foreclosures, and repossessions of property are suspended and may not be pursued by the creditors [(including governmental creditors such as the Internal Revenue Service)] on any debt or claim that arose before the filing of the bankruptcy petition??? [ (Administrative Office of the United States Courts , 2006) ]. The stay provides a hedge or a ???breathing spell??? for the company while it tries to negotiate with creditors, stockholders, employees, and other affected parties in resolving its financial difficulties. However, the automatic stay does not preclude the payment of fees to certain professionals during the case. Thus, any outside party appointed by the court may apply to the court for interim compensation and reimbursement payments at intervals of 120 days.
The debtor in possession has the exclusive right to file a plan within the first 120 days after the order for relief is issued, but the creditors get to vote on whether to accept or reject the plan within 180 days of the petition date. An extension to this 120 day period may be granted if deemed appropriate by the Court, limited to an 18 month maximum. Upon expiration of this 120-day exclusive time period, other interested parties, such as the creditors??™ committee or a creditor, may file a plan. This provides a check on the debtor by ensuring timely submission of the proposal, and avoids excessive delays in the case.
Constructing a plan of reorganization is at the heart of the bankruptcy process. To effectively turn the business around it is necessary for the debtor to have a strong Reorganization Plan. However, in preparing a plan the assumption is that the debtor has already conducted a diagnostic review to establish the fact that maintaining the business really is a viable option, because if it is not then the company should be liquidated [ (Newton, 2009) ]. In other words, the plan must provide convincing evidence that it will enable an organization to emerge from bankruptcy as a viable going concern. If not, then it probably will not be accepted by the parties involved.
Section 1123 of the Bankruptcy Code contains the mandatory and discretionary provisions of a Chapter 11 plan. A Chapter 11 plan must specify the various classes to be treated??”unsecured creditors, secured creditors, employees, equity holders, etc.??”along with each class??™s respective treatment. Because there is the temptation to misappropriate the distribution of ownership in the new reorganized entity, one of the most important bankruptcy laws is the ranking of unsecured claims. Hence, ???the Bankruptcy Reform Act identifies several types of unsecured liabilities that have priority and must be paid in full before other unsecured debts are settled??? [ (Joe B. Hoyle, 2011) ]:
1.) Having one of the primary priorities in Section 507??™s priority ranking are claims for administrative expenses. These disbursements include all trustee expenses and external consultation fees incurred through the employment of attorneys, accountants, and the like. This priority ranking induces these essential parties to assist the debtor in developing a viable plan for restructuring, having a better assurance that there services will not be for naught.
2.) Post petition claims arising before issuance of an order for relief, during the so-called ???gap period.??? Generally, these claims are rare in voluntary cases where the petition and order for relief are issued in conjunction. As GM??™s filing was a voluntary petition, to be touched upon later, we need not address the effect of an involuntary petition.
3.) Wage claims of employees during the 180 days preceding the filing of a petition up to $10,950 per individual. However, this does not include officers??™ salaries. This priority ranking is ???designed to prevent employees from being too heavily penalized by the company??™s problems and encourages them to continue working until the bankruptcy issue is settled???(Joe B. Hoyle, 2011).
4.) Unsecured claims for contributions to an employee benefit plan earned during the 180 days preceding the filing of a petition with, again, a $10,950 limitation per individual. The $10,950 limitation may be reduced by certain specified payments, based upon a complex formula.
5.) Customer deposits (limited to $2,425) to acquire property or services that the debtor never provided. These are purchasers who prepaid their purchases with deposits, but never actually intended to be creditors, actually expecting something in return upon a later date.
6.) Unsecured claims of government units, primarily income and property taxes.
7.) General (unsecured) creditors
8.) Preferred stockholders
9.) Common Stockholders
However, some creditors may have already obtained various levels of security for themselves. The creditor may have attached a mortgage lien or security interest to specified assets, such as inventory or various types of equipment, to secure their loan in case of default. If the debtor does encounter financial hardship and as a result cannot pay the loan, ???the [secured] creditor has the right to force the sale of the pledged property with the proceeds being used to satisfy all or part of the obligation??? [ (Joe B. Hoyle, 2011) ]. On the other hand, a creditor who does not obtain the pledge of some form of collateral sacrifices the security of their investment, because they have no legal right to go after the assets of the debtor. Rather, these so-called unsecured creditors are given lower priority; being entitled to only those funds that remain after all secured claims have been settled. This puts the unsecured creditor in a much more vulnerable position, because even in the best of situations they may receive only a fraction of what they originally gave, incurring significant losses.
A reorganization plan typically contains other provisions which may (1) propose changes in the company??™s operations (2) outline plans for generating additional monetary resources (e.g., a $50 billion loan from the U.S. government) (3) suggest plans for changes in company management, and (4) highlight arrangements to settle the debts of the company that existed when the order for relief was entered. The last-mentioned provision deserves some explanation, as it frequently is the primary focus in the acceptance and confirmation decision. We will first discuss the traditional, although inefficient, process, and then a recent quite quick and efficient, yet debated, development.
A large portion of the traditional method has already been explained. Here, we shall only provide a brief summary of the traditional reorganization plan acceptance and confirmation process. To begin, the debtor in possession draws up a plan of reorganization that identifies and deals with each class of creditors and equity holders. The plan is then described in a written disclosure statement, which upon the court??™s approval is mailed to all creditors and equity security holders. The disclosure statement must provide adequate information concerning the affairs of the debtor??”sufficient to enable the creditors and stockholders to make an educated judgment about the plan. This written statement generally cannot be solicited to the creditors until the court approves of it. When or if accepted the debtor can begin to request acceptances of the plan, as creditors may likewise solicit rejections. Each class of claims and interests has the opportunity to accept or reject the proposed plan. Under Section 1126(c) of the Bankruptcy Code, to be accepted by a class of claims, a plan must be accepted by creditors that hold at least two-thirds in amount and more than one-half in number of the allowed claims in the class. Furthermore, if there are impaired classes of claims, the court cannot confirm a plan unless it has been accepted by at least one class of non-insiders (e.g., trade creditors) who hold impaired claims. Acceptance of a plan by a class of interests, such as shareholders, requires acceptance by holders of at least two-thirds in amount of the allowed interests of such class that actually voted on the plan.
In order for a court to confirm a plan, the court must ensure that (1) the plan has been proposed in good faith, (2) the plan is feasible (i.e., not likely to be followed by chapter 7 liquidation), (3) the claims of certain creditors have been satisfied in accordance with the Bankruptcy Code, and (4) each class has accepted the plan or are unimpaired by it [ (Robert A. Mann, 2010) ]. However, the Court, having generally the last say, may confirm the plan without being accepted by all impaired classes, ???by determining that the plan does not discriminate unfairly and that it is fair and equitable??? [ (Robert A. Mann, 2010) ]. This is called a cram-down. But one will most definitely ask how the courts construe ???fair and equitable??? Are there certain objective tests on the basis of which a logical judgment is made, or is there a quantitative threshold that each creditor is entitled to According to Mann & Roberts, the authors of the University??™s of Akron??™s designated Business Law text, fair and equitable carries a different meaning, one can say, for the secured and the unsecured creditor:
Fair and equitable??? with respect to secured creditors requires that (1) they either retain their security interest and receive deferred cash payments, the present value of which is at least equal to their claims, or (2) they realize the ???indubitable equivalent??? of their claims. Fair and equitable with respect to unsecured creditors means that such creditors are to receive property of value equivalent to the full amount of their claim or that no junior claim or interest is to receive anything. [In summary,] with respect to a class of interests, a plan is fair and equitable if the holders receive full value or if no junior interest receives anything at all.
The preceding statement unambiguously supplies the judicial ammunition for all classes of claims who end up being sacrificed in the bankruptcy process. It specifies a strict mechanical adherence to the codified priority ranking that debtors must follow, not only for the sake of the bondholder, but for the investor community at large. For, if bondholders are disregarded, what then is the motivation for investment Who then does the investor community turn to for protection and justice These are questions that must be answered as later on they provide the crux of our research on the results of GM??™s bankruptcy.
Lastly, after confirmation, the plan binds the debtor and any creditor of the debtor. The debtor is discharged of all its prepetition debts. For the most part, this is the extent of the traditional procedure of Chapter 11 reorganization. A brief analysis of a recent development which circumvents this process will now be presented.
As a plan of reorganization often takes months, and even years to get approval of all stakeholders, many distressed entities have recently opted for a Section 363 sale of all or a portion of their assets. So-called because of its designation in the Bankruptcy Code, a Section 363 sale invites a prospective buyer and a Chapter 11 debtor or seller to negotiate an asset purchase agreement for approval by the court [ (Stevens, 2004) ]. If approved, the buyer can buy clean assets, free of all prior liens and claims, and thus avoid the battle between classes of competing creditors that frequently occur when Plans of Reorganization are filed. However, to get the highest possible return to creditors the Court will require a competitive bidding process.
Section 363 sale mechanics include an initial bidder, often called the ???Stalking Horse???, who fully negotiates a purchase agreement with the bank and then files with the court. The ???Stalking Horse??? obtains certain benefits including a breakup fee, expense reimbursements, and protective advantages over other competitive bidders. Once a Stalking Horse bid is accepted by the court, then the search for a higher bidder begins. This is usually done on a given day in a virtual auction format [ (Stevens, 2004) ]. The highest and best bid??”that is, that which provides the highest return to creditors??”will be selected. This Section 363 sale is a fast, efficient, and effective means of reorganizing a distressed business.
However, with quickness and efficiency come the risks of overly gross creditor loss and the deprivation of adequate protection. A 363 sale requires only the approval of the Bankruptcy Judge unlike the plan of reorganization which, as described above, must be approved by a substantial number of creditors and meet other requirements in order to be ???confirmed.??? Moreover, the 363 sale does not require the preparation and submission of a disclosure statement adequately informing investors of the debtor??™s intentions, nor a detailed ranking listing and outlining the debtor??™s proposed treatment of its various classes of creditors. Furthermore, the plan offers statutory protections for creditors and ???greater emphasis on valuation and feasibility of the post-sale business operations made possible by the sale??? [ (Rasmussen, 2009) ]. These highlighted differences between a 363 sale and a plan of re-organization establishes a convenient platform for our next subject: the results of the General Motors Chapter 11 Bankruptcy.
The Results of GM??™s Reorganization
General Motors Corporation and three domestic subsidiaries filed a voluntary petition for protection of Chapter 11 on June 1, 2009 in the US Bankruptcy Court for the Southern District of New York. Bankruptcy Judge Robert Gerber called the bankruptcy filing, ???the only available means to preserve the continuation of GM??™s business.??? This, of course, was made possible by the overly generous $50 million stimulus loan given to them by the United States government. Without this federal aid, the debtor GM would most likely have had to file under the auspices of Chapter 7-liquidation, as was admittedly confessed within their 2008 annual report.
In fact, Deloitte & Touche, the auditors of GM, in typical accounting language expressed ???substantial doubt??? as to the viability of the Detroit-based behemoth in its 2008 audit report. The report also ???raised the possibility that GM would have to liquidate its operations if its loan request were denied??? (Bunkley, 2009). As was mentioned earlier, before a debtor can establish the fact that turning the business around is a viable option it is necessary that they conduct a diagnostic review of their operations. Here, GM filed a Viability Plan with the Treasury department in February of 2009, despite their auditor??™s expressed substantial doubt as to its ability to continue as a going concern (Bunkley, 2009). The company??™s Viability Plan relied in large part upon assumptions and analyses developed by the company. If these assumptions and analyses proved to be incorrect their Viability Plan would probably not be successful and they would not be able to continue as a going concern. Furthermore, as was expressly admitted in their 2008 annual 10-K report, the execution of their Viability Plan relied almost solely upon their ability to obtain financing from the U.S. Government. Stated in their 2008 10-K report are these words:
Even if our progress under the Viability Plan is certified under the UST [U.S. Treasury] Loan Agreement and our debt restructuring is successful, our indebtedness and other obligations will continue to be significant. If the current economic environment does not improve we are not likely to generate sufficient cash flows from operations to satisfy our obligations as they come due, and as a result we would need additional funding, which may be difficult to obtain.
These words convey insoluble contingencies regarding GM??™s ability to operate profitably in the future. In short, GM??™s Viability Plan was simply not possible. It rather should have been termed a ???Wish-Plan.??? The company??™s future not only relied upon massive financial aid, but upon surgical debt restructurings that could only be implemented at the expense of bankruptcy law. Therefore, we observe GM??™s 2009 bankruptcy filing as really more of a forced bankruptcy, one in which the U.S. (United States) Government was not so much concerned with whether GM was independently able to operate profitably in the future but rather how much federal aid was going to be necessary to enable a politically motivated solution.
On July 5, 2009 an order was entered approving the sale of most of GM??™s assets to a new and independent company (now known as General Motors Company) under Section 363 of the Bankruptcy Code. GM??™s sale of assets to the New GM quickly gained the approval of the US Treasury, the UAW (United Auto Workers), and a substantial portion of their unsecured bondholders (Court Documents and Claims Register, 2009). Section 363 allowed the company to sell desirable assets to the new company and leave behind undesirable assets in the old company. It also allowed the new company to form very quickly by allowing them to avoid a long bankruptcy process. According to University of Michigan bankruptcy law professor John Pottow, ???A 363 sale was intended to let a company in reorganization quickly sell units not central to its core business.??? Going against this original purpose of section 363 GM sold profitable core assets to the new company. The new GM includes the best and most profitable parts of the company: Chevrolet, Buick, GMC and Cadillac brands and plants [ (Reed 2009) ]. The company left behind the unprofitable brands of Saturn, Hummer, and Pontiac [ (Reed 2009) ].
A Section 363 sale normally accumulates an accretion of cash for the bankrupt estate, which should distribute the proceeds to creditors according to the priority of their claims [ (Lowe, 2009) ]. In other words, a 363 sale ought not to direct the distribution of the sale proceeds among various stakeholders. However, that??™s not exactly what occurred in this case. In lieu of cash, unsecured bondholders were given a ten percent equity stake in the new GM, while another unsecured creditor, the United Auto Workers Union (UAW), received a larger equity stake (approximately 17 percent) in the new GM as well as ownership of other debt [ (Lowe, 2009) ]. This unequal distribution clearly violated the priority ranking established under bankruptcy law that was elaborated upon in the preceding discussion. The justification may very well be that this is an extremely unique and delicate case (i.e., a sui generis); one that effects the employment of thousands of individuals. Yet, to justify circumvention of bankruptcy jurisprudence dies the death of a thousand qualifications. Barry E. Adler, Bernard Petrie Professor of Law and Business at New York University, wrote that the ???price of this achievement [i.e., the ability of the Courts to resolve all of the bankruptcy complexities and issues in such a brief period of time] was unnecessarily high because the cases [referring to both the Chrysler and GM bankruptcy] established or buttressed precedent for the disregard of creditor rights??? [ (Adler, 2010) ]. In other words, the ripple effect of disregarding bankruptcy law in all likelihood will extend to the discouragement of creditors to invest in union dominated firms. Moreover, the risk of impaired trust of foreigners in the U.S legal system, especially as pertaining to investments in U.S. instruments, is a risk that we suspect will in time be realized in enhanced investor abuse.
Yet, the legacy of General Motor??™s bankruptcy involves other fundamental concerns that are not commonly known. One, in implementing a 363 sale instead of a reorganization plan, stakeholders were deprived of the protections embodied in Chapter 11??™s confirmation rules. Two, many 363 sales, such as this one, are guised in ???innocent clothing??™, but in reality are alternative full-blown reorganization attempts. This enables the debtor to circumvent the Bankruptcy Code??™s strict plan confirmation rules. And lastly and most importantly, the courts blindingly allowed distributional norms??”settled way back in the foundational case of Northern Pacific Railway Co. v. Boyd??”to be bypassed in favor of the unsecured UAW! In Boyd there was a collusive effort between secured bondholders and shareholders to squeeze out the unsecured creditors. The trial court overruled the unsecured creditors??™ objection, but the Supreme Court reversed that decision. The Justice of that case, Joseph Lamar, concluded that:
If the value of the road justified the issuance of stock in exchange for old shares, the creditors were entitled to the benefit of that value, whether it was present or prospective, for dividends or only for purposes of control.? In either event it was a right of property out of which the creditors were entitled to be paid before the stockholders could retain it for any purpose whatever.
This conclusion does not, as claimed, require the impossible, and make it necessary to pay an unsecured creditor in cash as a condition of stockholders retaining an interest in the reorganized company.? ? His interest can be preserved by the issuance, on equitable terms, of income bonds or preferred stock.? If he declines a fair offer, he is left to protect himself as any other creditor of a judgment debtor; and, having refused to come into a just reorganization, could not thereafter be heard in a court of equity to attack it.?
In summary, the court in totally abandoning legal precedent and equitable law is positively resurrecting the abuse of equity entitlements. It is relatively immaterial how reorganizational value is captured, whether it??™s via a 363 sale or a plan, but what is material is preserving the core principle of ???fair and equitable??? treatment of stakeholders. This understanding brings meaning to the idea of ???secured creditor,??? it injects certainty into the markets and rightfully encourages confident investment.
GM??™s former debt structure was heavily encumbered with unsecured public bond debt, to the tune of $27 billion (Tabb, 2010). The reorganization allowed GM to reduce liabilities by $93.4 billion, which was a forty-four percent decrease in total liabilities (Reed 2009). Bondholders representing fifty-four percent of GM??™s unsecured bonds agreed to exchange their debt for a ten percent equity stake in the new company, plus warrants for possibly an additional fifteen percent (The White House, 2009). Unlike the stricter two-thirds requirement of a traditional chapter 11 plan, GM was permitted to proceed with a mere majority vote??”most of voters being big institutional investors and individuals.
The United Auto Workers Union also agreed to concessions. The agreement allowed General Motors to establish an independent trust in extinguishment of the company??™s twenty billion dollar obligation to the UAW to pay future retiree health care costs (Smith, 2009). The UAW health care fund received nine billion dollars in cash and preferred stock along with a 17.5 percent stake in the new company (Hirschey, 2009). In addition to bondholders and the United Auto Workers Union, the United States Treasury now owns sixty percent of the new General Motors Corporation (Smith, 2009). The United State??™s shares came as a result of the significant financial support the country provided (via taxpayer money) to GM. In total, the U.S. provided GM nearly $50 billion in loans and stimulus monies (GM to Repay $2.1B of Government??™s Investment, 2010). The Canadian and Ontario governments decided to lend GM 9.5 billion dollars in exchange for a 12 percent stake in the new company (Tuohey 2009). They received 1.7 billion dollars in debt and preferred stock in the new company (Tuohey 2009). Investors who held common shares in GM were not entitled to anything.
In addition to slashing the company??™s debt, General Motor??™s restructuring plan outlined an aggressive approach to reduce operating expenses. The main focus of the plan was to reduce the size of the company so that it could focus on core brands. This led to the decision to close more than a dozen factories and reduce the company??™s dealership network by forty percent (Smith, 2009). Employee-related costs were one of the most visible areas in which General Motors needed to make cuts. Foreign competitors were producing high quality vehicles while keeping their overall employee compensation costs significantly lower than GM??™s. General Motors worked with the United Auto Workers Union to develop a compensation structure that would freeze employee compensation while reducing retiree medical benefits (White, 2010). The new plan reduced new hire??™s starting hourly wage to $14 per hour (White, 2010). These significant wage reductions were necessary to make the new General Motors Corporation cost-competitive against foreign companies. Previous to the company??™s decline, it agreed to labor contracts that offered employees??™ rich benefit packages. These types of benefit packages made it nearly impossible for GM to compete with their foreign adversaries. As a result of the organization??™s cost cutting measures, GM was able to reduce their break-even point nearly forty percent, from sixteen million vehicle sales annually to ten million (The White House, 2009).
Although General Motor??™s bankruptcy plan significantly lowered their break-even point, the company needed to find a way to produce vehicles that consumers found appealing. General Motor??™s felt the best way to achieve this goal was to focus on producing fuel-efficient vehicles. The company??™s restructuring plan boasted that twenty-two of twenty-four new vehicle launches before 2012 would be ???fuel-efficient cars and crossovers??? (General Motors Corporation, 2008). Although fuel-efficient vehicles are becoming a trend in the auto industry, there were significant concerns that GM may have fallen too far behind competitors to compete in this market. In addition to focusing on fuel-efficiency, General Motor??™s plan involved concentrating on its Chevrolet, Cadillac and Buick brands as well as the company??™s GMC truck brand (General Motors Corporation, 2008).
In summary, we applaud the good natured intentions of the Obama Administration to preserve such a key company in the U.S. automotive industry. We are even willing to admit that well-founded arguments can be constructed defending the federal government??™s interjection into the free capitalist market in 2008. The slippery slope of implications and what-if scenarios, although notoriously vague, may have an adequate force of truth. However, circumvention of the Bankruptcy Code cannot be defended. Chapter 11 protections are intrinsically valuable to the investor community, both nationally and globally. These are not mere opinions but experiential realities realized in the thousands of bondholders who lost almost everything. Time will tell whether GM??™s bankruptcy sets precedent for future so-called reorganizations.
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William Smith Condemns GM??™s Bankruptcy
Almost every leading law academic has disapproved of the GM bankruptcy case. The Chapter 11 case has been criticized by most finance-oriented media outlets??”from Ralph Nader??™s published statement in Brietbart to William Smith??™s remark in BusinessWeek. Why What precisely occurred in the GM Bankruptcy that calls for such hostile remarks Was it something that we may pinpoint to one specific event, or is the matter more complicated
Before we attempt to respond to such questions we ought to set forth the credibility of these critics who disapprove of the GM bankruptcy case. The individuals that we will mention throughout our discussion are not first-year law students ignorantly voicing their newly acquired wisdom. Rather, they are the one??™s leading some of the best corporate law and investment firms of the nation. For example, William B. Smith is the founder and Chief Executive Officer (CEO) of Smith Asset Management, Inc., SAM Advisors LLC, and SAM Capital Partners, LLC. Mr. Smith examines and invests in equity and debt securities of publicly traded companies that are in the midst of restructuring. This employment gives him an extensive understanding of the legal implications involved in corporate restructurings which enables him to make accurate judgments on the fairness of various debt restructurings. Other well-qualified critics, such as professors Ralph Brubaker and Charles J. Tabb of the University of Illinois, have spent hundreds of hours researching the vast literature concerning the development of bankruptcy jurisprudence in the context of GM??™s bankruptcy. They all arrive at one general conclusion: the GM reorganization was simply not fair. And when many experts end up repeatedly arriving at one conclusion, there is an extremely legitimate dilemma that must be given due credence.
Generally, the arguments given in mainstream media are vague, and when closely examined, inaccurate. They typically amount to a statement that the government ???should??? prefer investors over unions. What occurred in the GM bankruptcy was not the mere violation of a traditional policy consideration; it was the breach of the rule of law. And we understand the answer to be much more complex than that. It features both a deep politically-motivated cause and a disheartening ripple effect. Accordingly, to understand why bankruptcy law professionals, such as William Smith, are so opposed to the government??™s handling of GM??™s reorganization, we investigate (1) the evolution of Absolute Priority under the Bankruptcy Reform Act of 1978, (2) the courts??™ violation of the ???unfair discrimination??? standard in GM (short for, ???The GM Bankruptcy Case???), and finally (3) the effects, both short-term and long-term, of circumventing bankruptcy jurisprudence.
I. The Evolution of Absolute Priority under the Bankruptcy Reform Act of 1978
Before we analyze the legal issues of GM??™s reorganization we need to know the relevant facts pertaining to GM??™s ???reorganization.??? GM??™s sale of assets was not a cash sale. Rather, through a credit bid of secured debt most of GM??™s assets were transferred to a new entity whose capital structure had already been divided among GM??™s creditor??™s, with a much larger allocation (about 7.5 %) of New GM stock and warrants going to UAW (United Auto Workers) retirees than to GM??™s other unsecured creditors. This is what bankruptcy law professionals term a ???pre-packaged??? bankruptcy: quick, efficient, and predetermined. In fact, GM rocketed through chapter 11 in just thirty-nine days! The problem is that in effecting this reorganization GM openly disregarded substantive and procedural rules that govern reorganizations when it gave bondholders a smaller allocation (i.e., 10 percent) of the new entity??™s ownership than the UAW (United Auto Workers), who received a 17.5 percent stake. But we are anticipating.
One may posit a quite valid inquiry: If a majority of the bondholders agreed to the plan GM offered to allocate the ownership of its new entity, then what??™s really the big problem In other words, what??™s so undemocratic about a majority vote To answer this we must understand two things. (1) There was a reason why GM filed for bankruptcy in New York rather than in Detroit, where it conducts most of its business. Legal experts argue that GM wanted to run away from local suppliers, creditors, and employees, to make it tougher for them to file claims and otherwise actively participate in the case. (2) But more significantly, GM??™s offer to the bondholders basically amounted to a take-it-or-leave-it ultimatum: Go along with our proposal or be left holding the undesirable assets of Old GM??”with very little value at all. Thus, they had no other better alternative. In fact, the bondholders committee expressly communicated this when in response to GM??™s offer they said in a statement, ???While the committee continues to remain troubled by preferential treatment that the UAW [United Auto Workers] VEBA [Voluntary Employee Beneficiary Association] is receiving compared to the bondholder class??”rejecting this offer in the expectation that the bondholders will do better in a litigated outcome was a risk the committee is unwilling to take.??? Furthermore, GM??™s SEC filing on the Treasury offer said that ???if these statements of support are not received, the amount of common equity and warrants that it would issue by New GM to Old GM [i.e., the bondholders] would be substantially reduced or eliminated.??? Therefore, the lack of a better alternative and the prospect of an even worse treatment was the reason why GM??™s bondholders accepted the unfair treatment.
This can readily be discerned when examined in the historical context of a series of Supreme Court decisions in the late 1800s and early 1900s, wherein we find the basis for chapter 11??™s codification of creditors??™ priority rights in corporate reorganizations. The origin of the Absolute Priority Rule of Chapter 11-Reorganization is founded in the financially distressed railroad companies of the late 1800s who could not pay off their immense construction costs. The railroads lacked a sound capital structure, issuing dozens of investment securities with miles of track and other assets attached as collateral. In the case of insolvency (i.e., the inability to pay one??™s debts as they come due), they were stranded with an insoluble dilemma. A chapter 7 cash sale was impossible, for (1) the tracks were too costly for any individual or group of individuals to buy in foreclosure and (2) the railroads had to keep running. Thus, the practice of corporate reorganizations was born. The necessitated reorganization remedy that evolved from this peculiar situation is quoted by Brubaker & Tabb:
Using old equitable forms which were designed to convert the properties of an insolvent debtor into cash for distribution among its creditors, [the federal courts] evolved a proceeding which achieved the opposite results of preserving the properties intact and of readjusting the debts of the insolvent debtor. The form of the procedures, briefly, was??¦a judicial sale of that property to the creditors free of the old debts; and its conveyance by the creditors to a new company formed for the purpose of carrying on the enterprise.
The railroads continued to operate as ???their owners and secured creditors created a new capital structure;??? accomplished through ???equity receiverships.??? In summary, the secured creditors and stockholders of the railroad entity would develop a plan to reorganize, carefully foreclose the railroad??™s assets, transfer the foreclosed assets to a newly created entity, and then issue new debt and equity securities to satisfy the old debt.
With this creative remedy came an alliance between bondholders and stockholders. Shareholders would use their management expertise to run the operations of the railroad and ???bondholders would initiate equity receiverships with the goal of a judicial sale of the road pursuant to the bondholders??™ mortgage.??? Old equity holders would then typically contribute funds to the new entity and in return receive new equity securities valued at a specified price. However, with the development of this alliance unsecured creditors were often completely disregarded as ???foreclosure removed from the reach of the unsecured creditors all property that could have been used to satisfy their claims.??? This neglecting of unsecured creditors resulted in an intricate legal battle in the courts over the proper allocation of interests in the new entity in order to satisfy creditor priority rights. The terrain on which these battles were contested was over the meaning of the terms ???fair and equitable.??? The basic argument was, ???why should shareholders take anything when we receive nothing??? The answer was determined in Northern Pacific Railway Co. v. Boyd.
Boyd was an unsecured creditor of the Northern Pacific Railroad. The Railroad declared that it was not liable, because all of its property had been transferred to the Northern Pacific Railway. Boyd then went after the Railway, which defended itself by stating it had purchased its assets ???via a bona fide receivership [the entity designated with the responsibility to run the business during the reorganization].??? However, the courts were not so sympathetic. They saw the receivership sale as an engineered scheme between bondholders and stockholders to transfer the company??™s old assets to a new company??”that is, a sale to themselves??”thereby ???cramming out??? the in-between unsecured debtors. The court concluded that such a sale cannot disregard the claim of a nonassenting creditor. In the words of the Supreme Court:
[I]f purposely or unintentionally a single creditor was not paid, or provided for in the reorganization, he could assert his superior rights against the subordinate interests of the old stockholders in the property transferred to the new company.
Despite this ruling, absolute priority continued to suffer many circumventing attempts by corporate lawyers. It was not until Case v. Los Angeles Lumber Products Co. (1939) that the Court actually accentuated the absolute priority law to the esteemed standard it deserves, especially in a democratic country operating under a constitution steeped in the notion of unconditional justice. The fact pattern of the case goes something like this: the debtor had liabilities of $3.8 million with a subsidiary (an asset) valued at $830,000. The reorganization plan was to discard the old securities and issue ne