Monday, April 6, 2009

Is The Government Trying To Lose Taxpayer Money In Its GM Investment?

...Or the case for Equitable Subordination of the U.S. Treasury's GM Claim

The US Treasury lent $13.4 billion to General Motors on December 31, 2008. The loan documentation (full contract here) is curious in several respects (beyond the obvious dangers to capitalism).

1. Although styled as a secured loan, the document clearly acknowledges that there are numerous other senior security interests ahead of it. Also, normally such documents loudly proclaim the ranking of the debt being created, but this document seems silent on the topic, so most likely it will rank as senior unsecured debt, except for those few assets not otherwise tied down.

2. The other curious things are the recitals, which in this case include the expression of the parties to have GM use the loan proceeds to: (a) develop a viable and competitive business, (b) make energy efficient cars, (c) preserve American jobs, (d) safeguard retiree benefits, (e) make more cars.

While the politics of the recitals is certainly understandable, from a contract perspective, they raise some interesting questions. Acknowledging the need to become viable raises the question of whether GM was insolvent or in the “Zone of Insolvency” at the time of the loan. If so, there are serious implications for the ability of the government to collect on the loan. Suggestions about embarking into Venture Capital Land with untried energy efficient cars, not only smacks of disregarding the company’s duty to all creditors (including retirees), but also of a general breakdown of normal corporate governance. Preserving jobs and retiree benefits is exactly what got GM into the pickle it is in, so this notion runs counter to everything else in the document.

OK, let’s overlook the politics and the vague seniority, to give this document the benefit of a Senior, Partially Secured Loan. What has happened since the loan was made?

1. Treasury gave GM an extension to meet the business plan deadlines.
2. Treasury saw the need to add its own 110% (plus 15% from GM) to back the warranty on new cars

Again, not bad politics, but, their insolvency counsel (now Cadwalader) must be going nuts! Creditors who meddle in the affairs of a corporation are subject to something called Equitable Subordination. This is explicitly part of the Bankruptcy Code in section 510(c) (see statute text here), and allows the judge to throw the debt of certain creditors to the bottom of the stack – in some cases below even the equity!

Collier on Bankruptcy is the most authoritative source, but in very summarized fashion:

1. Equitable Subordination is not part of statutory or case law, but rather part of the equitable powers of the Bankruptcy judge.

2. There is a three pronged test:

a. The creditor must have acted badly
b. The other creditors must have suffered harm
c. Equitable Subordination must not be inconsistent with the Bankruptcy Code

An easy way to meet part (a) of the test is for a lender to exert “actual or effective control” over the company, such as, for example, FIRING THE CEO.

An easy way to meet part (b) of the test is for the lender to force the company do something like: make energy efficient (but unprofitable) cars, preserve American jobs (which they can’t afford), safeguard retiree benefits (which they can’t afford), or better yet, let treasury prime all the unsecured creditors when everyone knows they were already insolvent (fraudulent conveyance).

Part (c) of the test is easiest, the creditor who broke all the rules (Treasury) must pay the ultimate price: their claim is expunged.

Of course all of this legal analysis at 30,000 feet is pointless. Why? Because the only entities who still own GM bonds are: Money Market Mutual Funds (who are already guaranteed by the Treasury, so they don’t care); Banks (who already are under TARP control of the Treasury, so they don’t care); Hedge Funds (who probably paid less than 20% of par, so nobody will feel sorry for them). In fact, maybe Treasury actually wants to be Equitably Subordinated. This is just another way to print money and direct industrial policy! And PLEASE, don't anybody suggest that we aren't going to bankruptcy court.

Big hat tip to Lookout

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Hedge Fund Invest said...

Zero Hedge, equitable subordination is a very involved process to prove in bankruptcy court. I kindasorta know this first hand. The power the Bankruptcy Court has in this situation is not governed by the bankruptcy code, and is often left to the discretion of the judge, usually governed by precedent cases. While equitable subordination might be argued by junior creditors... good luck to them. The gov't aid clearly helped GM avoid bankruptcy at the time. Also, the U.S. Bankruptcy Courts, as a matter of practicality, are not likely to oppose the Dept. of Treasury's wishes/aims/goals.

On another point, fraudulent conveyance... also VERY unlikely. Fraudulent conveyance arguments are usually predicated on one specific party benefiting from a transaction just prior to the filing of a Ch. 11, or when an entity is in the "zone of insolvency." I don't see how the Treasury benefited here, they didn't get any assets from GM other than a claim of the original loan.

Finally, ranking is often clearly spelled out in loan documents, but not necessarily by reference of specific obligations. It is done either contractually (securing or subordinating), or structurally (lending to a solvent subsidiary with EV/assets.)

But then again, I could be wrong.

Anonymous said...

Tyler, wasn't the legal analysis tongue-in-cheek and the post more of a political commentary? GM paper trades in the 10-12% of par range today, so everyone knows it is a call option on a 'friednly' quick reorg rather than an inter-creditor fight.
PS: HDS1 function on Bloomberg on GM corp shows Fidelity with about $500 million of GM paper, wonder what they paid?

Anonymous said...

Nice article. It ranks up there with Treasury, under HP, taking a literal interpretation of tax code so they don't have to consolidate the 79.9% stake in AIG onto its books. FINANCIAL FRAUD.

MAX2205 said...

They also severanced people incurring more liabilities

RichL said...

It would be a long-term survival mistake for the US Government to let the GM plants be dissipated.
One doesn't know the future, but in the past the ability to convert major motor factories to make munitions helped the US to win WW2.

Even though GM, their management, and labor, are inefficient, incompetent, and overpaid, the assets must remain intact in some form in this country.

Would you do anything else???

Lookout said...

Modern bankruptcy is not usually about closing down the assets, but about rearranging the liabilities. First (and this is not easy) right size the factories and the employment/OPEB contracts to form a viable company, and then give the equity to the old debt holders (and/or new money investors).