Is the U.S. a Country Where the Rule of Law Rules?

President Obama seems to be taking lessons from Vladimir Putin: If you don’t like the result the law requires, ignore it; political connections should dictate results. The U.S. Bankruptcy Code delineates how creditors stack up in court. You don’t have to be a lawyer to understand the basics. The more senior the debt, the better off a creditor is when a company is forced to seek protection under Chapter 11 of the Bankruptcy Code. If a debtor’s assets are insufficient to cover all claims, the Code calls for strict prioritizing of the claims. Secured creditors are entitled to payment of their claims before junior claims can expect any payment. However, as lead negotiator in Chrysler’s attempt to settle its claims out of court, President Obama demanded all secured creditors forego their rights and submit to his demands. His settlement proposal (demand?) was to provide benefits to unsecured claims before the secured creditors’ claims were settled. Bloomberg reported that the U.S. government, as a secured creditor, would receive an equity stake of approximately 25% in a reorganized Chrysler.

As a former law professor, one might expect President Obama to understand and accept the law. However, three possible explanations for the President’s demands come to mind: he does not understand the Bankruptcy Code (and he should get competent legal counsel); he is just posturing as a negotiator on behalf of his secured position and on behalf of a group of unsecured creditors (an employee benefit trust); or he considers his position to be above the law.

Bloomberg News quoted President Obama as stating that a “small group of speculators” (i.e. “bad guys”) demanded that everyone else needed to “make sacrifices and they would have to make none.” President Obama must also know, then, the price at which the speculators bought their pieces of senior debt, specifically that they must have paid less than 32.6 cents per dollar of face amount, since that was the President’s last reported offer to them. Never mind that they probably paid more than that, and under the indenture contract, they were promised 100 cents on the dollar by Chrysler.

Meanwhile, under the President’s proposal, unsecured claims arising from employee benefit promises were offered equity in the reorganized Chrysler. Granted, in many Chapter 11 proceedings I have analyzed, strict priority of claims was often not applied; unsecured creditors usually received some equity in the reorganized company, but unsatisfied claims of secured creditors shared in a similar arrangement. Such arrangements, though, have been overseen and approved by a bankruptcy judge, not dictated by one creditor (in this case, the Federal Government), which President Obama has taken on the role to represent.

The holdout group is reportedly a minority group, as other secured creditors were willing to accept the President’s offer. One can readily understand the admittedly weaker negotiating position of a number of those secured creditors. They happen to include banks in which the Federal Government has invested TARP funds appropriated by Congress. The expectations are that much (if not most/all) of that preferred stock issued to the Government will be soon converted into voting common stock. One should not begrudge the President his leverage over those secured creditors to accept his offer.

However, the “speculators” also have a fiduciary duty to their investors to get the best deal they can. If they think that a bankruptcy judge offers them a better alternative, then it is their right (and duty) to avail themselves of it. As Mr. Bill Frezza points out on RealClearMarkets.com, their submission to a publicity campaign launched by the President could lead to a host of unintended, undesirable consequences. Unless, that is, we wish to abandon the rule of law.

Bob Decker, CFA

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