Friday, June 5, 2009

Could the Indiana Pensioners Have Prevailed in Chrysler?

As I write this, the United States Court of Appeals for the Second Circuit is hearing the appeal of the Indiana Pensioners to Judge Gonzalez's ruling to allow for the 363(b) sale of substantially all of Chrysler's assets to NewChrysler.

As I mentioned in an earlier post, I believe the logic laid out in Judge Gonzalez's opinion was well reasoned, but I believe the conclusion is wrong, but the Judge could only rule on the evidence presented to him.

Now, I'm not saying that Judge Gonzalez should have concluded differently, but it would have required him to ask the parties to come back with more information.

Judge Gonzalez's opinion relied on three key assumptions, both of which, I believe, could have been challenged if the Indiana Pensioners had brought in additional experts. The three assumptions that I am referring to are:

  1. That Chrysler is a wasting asset;

  2. That the value being paid by NewChrysler for substantially all of the Estate's assets is fair ; and

  3. That the consideration being provided to the Union through the VEBA is being paid by NewChrysler and, thus, didn't violate the priority of claims against the estate.

Let me discuss how these key assumptions could have been challenged (I have not seen anything indicating that these arguments were used):

Chrysler as a Wasting Asset

It was imperative for the parties favoring the sale to convince the Judge that Chrysler is a wasting asset in bankruptcy and that it was urgent that the business be sold immediately to maximize the value to the Debtor's estate. The Lionel case stated that "The rule we adopt requires that a judge determining a Sec. 363(b) application expressly find from the evidence presented before him at the hearing a good business reason to grant such an application."

Further, the Lionel opinion stated:

In fashioning its findings, a bankruptcy judge must not blindly follow the hue and cry of the most vocal special interest groups; rather, he should consider all salient factors pertaining to the proceeding and, accordingly, act to further the diverse interests of the debtor, creditors and equity holders, alike. He might, for example, look to such relevant factors as the proportionate value of the asset to the estate as a whole, the amount of elapsed time since the filing, the likelihood that a plan of reorganization will be proposed and confirmed in the near future, the effect of the proposed disposition on future plans of reorganization, the proceeds to be obtained from the disposition vis-a-vis any appraisals of the property, which of the alternatives of use, sale or lease the proposal envisions and, most importantly perhaps, whether the asset is increasing or decreasing in value. This list is not intended to be exclusive, but merely to provide guidance to the bankruptcy judge.

The Court stated that "a debtor applying under Sec. 363(b) carries the burden of demonstrating that a use, sale or lease out of the ordinary course of business will aid the debtor's reorganization" but that an objecting party "is required to produce some evidence respecting its objections."

I am not aware of any real challenge to the Debtor's position (other than the inclusion of some of the articles showing that Chrysler was actually performing reasonably well while in bankruptcy included in some of the objections filed by the dealers, and which I pointed out here and here).

I believe that the Indiana Pensioners could have engaged an expert who could have, at least, created doubt about the Debtor's assertion that there was a "good business reason" to rush through the 363(b) process because:

  • There is no evidence that consumers would be unwilling to purchase a vehicle from a company undergoing reorganization through bankruptcy - and the President's promise to support warranties and to fund a successful exit was sufficient to insure that Chrysler's sales would not be impaired by the process (in fact, Chrysler's sales in May seem to have been little effected by the bankruptcy - there have been increased liquidation sales by dealers who are being dropped, but production has been shut down, limiting the availability of specific vehicles in particular markets).

  • The shut down of Chrysler's facilities was partly due to a need to balance inventories. It seems that there was also a desire to provide the appearance that, without the close of the planned transaction, those plants would not be restarted. Since the funding for the running of those facilities would be provided by the DIP, the Judge would have to determine whether the coercive elements of the DIP proposal were in the best interests of the Estate.

  • Fiat's deadline of June 15th was clear, however, given that they were obtaining, initially, 20%, and eventually 35% of NewCo (and access to Chrysler's dealer network) without any expenditure of cash - but simply for the contribution of know-how, it seems unlikely that Fiat would walk away from the transaction if it were properly managed.
Fairness of Compensation

The Debtor engaged Greenhill & Co., LLC to opine on the fairness of the transaction. Greenhill based its opinion on the premise that, without the transaction (remember, the Government stated that it wouldn't continue to provide funds to Chrysler unless it was to support an approved plan), Chrysler would have to liquidate; and the $2 billion was within the range that Capstone estimated could be realized in a liquidation. Greenhill specifically stated:

We have not made any independent valuation or appraisal of the assets or the liabilities of the Company, or concerning the solvency or fair value of the Company, nor have we been furnished with any appraisals, except for the Liquidation Proceeds Analysis. In particular, we do not express any opinion as to the value of any asset of the Company, whether at current prices or in the future.

I am unaware of any other circumstance where an investment bank issued a fairness opinion in which it did not perform its own valuation analysis. That doesn't mean that it never happens; I've just never seen it.

The Liquidation Proceeds Analysis was prepared by Capstone and is presented in the Declaration of the witness from Capstone, Robert Manzo and the associated exhibit. This analysis stated that the proceeds to the First-Lien Lenders in a liquidation of the assets ranged from $763 million to $2.947 billion (which were, for some reason, discounted to a present value of between $654 million and $2.605 billion).

Mr. Manzo provided a revised Declaration on May 20th to support his testimony (and a further Declaration on May 26th to clarify some issues) that concluded the recoveries to the First-Lien Lenders in a liquidation had declined since his initial analysis to between negative $407 million and $1.378 billion (which, again for some reason, were discounted to a range of N/A to $1.218 billion).

Judge Gonzalez specifically noted that "This testimony, which is unrebutted, is that the $2 billion NewChrysler is paying for the Debtors’ assets exceeds the value that the First-Lien Lenders could recover in an immediate liquidation."

Had the Indiana Pensioners employed a valuation expert, I KNOW that doubt could have been raised about Capstone's estimates based on MY expert opinion and review of the caveats of the Capstone report. Since Chrysler is a private company, I was (and am) unable to perform an independent analysis of Chrysler's value, my opinion is based on the following:

  • The Affidavit of the CFO stated that the book value of Chrysler's assets at December 31, 2008 was $39.3 billion. It seems unlikely to me that the assets would only be worth 5% of book value;

  • The valuation appears to have the costs of an orderly liquidation, while the values for some of the assets appear to be based on forced liquidation. For example, finished vehicles are estimated to provide recoveries of only 25% to 35% of cost. To put that in perspective, if you assume that Chrysler's gross margins are 10% (they are probably greater than that given that their EBITDA was effectively $0 in 2008 - per Exhibit A to Manzo's declaration) and the dealer margin assumed in the Manufacturer's Suggested Retail Price ("MSRP"), this means that a vehicle costing $18,000 to manufacture, with an MSRP of $22,222 would be liquidated for values ranging from $4,500 to $6,300 (discounts from MSRP of 71.65% to 79.75% - a very good deal, right?). The low value is explained as being due to the lack of warranties (although a property/casualty insurer would probably sell the Estate a 5 year 50,000 mile warranty for each car in the fleet of inventory at much less than $10k per car). There are other such assumptions that could be challenged by an expert;

  • The value that would be fair to the First Lien Lenders would only START at the liquidation value of the assets they were secured against. The proposed transaction values the 55% of equity (fully diluted) allocated to the VEBA at $4.25 billion (they are also receiving a note with a value of $4.587 billion and $1.5 billion in cash). Now the structure of the VEBA's position is complicated by the implied call option held by the Treasury Department on any valuation realized above $4.25 billion (increasing at 9% annually), however, this short call option would mean that 55% of the equity would be worth more than $4.25 billion. The implied value for the entire equity of NewChrysler is, therefore, $7.73 billion. Assuming that Fiat's know how is worth the implied $2.7 billion associated with their 35% (assuming the requirements associated with increasing their initial 20% position occur) , that the assumed debt and the equity of the US and Canada are supported by cash or other assets (although the assets transferred from Chrysler are the only other assets in NewChrysler), and the $1.5 billion paid to the VEBA is somehow outside NewChrysler - That would leave $6.837 billion of value not accounted for on the asset side of NewChrysler's balance sheet. The Debtor's plan, therefore, itself values the transferred assets at least $4.25 billion (or 99.1% of the First Lien debt - that is being paid only 28.9%).

In my opinion, that raises serious doubt as to the fairness of the $2.0 billion in compensation.

Priority of Claims

Judge Gonzalez states in his opinion that the $10.337 billion ($4.25 billion value of the equity stake, loan to NewCo valued at $4.587 billion, and $1.5 billion of cash) paid to the VEBA is a deal negotiated, effectively, by NewChrysler and, thus, does not violate priority.

I had argued that Chrysler should have taken this position in this post.

An extremely powerful argument could be made against this position, however. The basis of that argument is "what value does NewChrysler get for the $10.337 billion?"

Hiring a work force in place has SOME value, but not anywhere near $10 billion! There were changes in work rules, and the Union gave up their right to strike for five years, but what is that worth? Heck, the work rules in the Union contract were written in a different era and have no business in the 21st century, yet a worker can still have six unexcused absences before the company can even START the process of firing them. To put that in perspective, I've never had (or heard of any friends who had) a job where they could skip work with no excuse for one day, PERIOD! Certainly, if I had to have an unexcused absence, I wouldn't necessarily be fired, but my employer would have the option.

In fact, the $10.337 billion is a settlement of a liability owed by the Estate. Even if the Union failed to forgive their claim against the Estate, that claim is made worthless by the low payment for Chrysler's assets.

The payment to the VEBA is clearly a violation of priority. Now it is not unusual for the final resolution of a case to provide compensation in a manner inconsistent with absolute priority, but the SCALE of this violation is beyond absurd.

White & Case apparently challenged the Manzo violation only by bringing up his personal compensation (and, thus, his stake in coming up with the result he did - by the way, according to the testimony, Capstone will receive a $17 million success fee and Manzo's allocation will be $10 million). The Judge countered this argument by pointing out that nobody contested the hiring of Capstone, and their compensation arrangement was disclosed prior to the order allowing for their retention.

White & Case is an excellent law firm. I suspect the only reason that no experts were engaged was for lack of resources. The Indiana Pensioners had less than $25 million invested in their position and may not have been willing to risk the costs of employing an expert (which could be expensive).

Had experts been employed, I believe the sale would have been delayed, a more reasonable deal would have been negotiated and Chrysler would have emerged.

One nagging question is "why were the secured lenders in Chrysler targeted, but not the General Motors secured lenders (who are unimpaired under that plan)?"

Maybe we'll know someday.

Sphere: Related Content
Digg this
Delicious Bookmark this on Delicious

Subscribe in a reader


Anonymous said...

Very good analysis, although I disagree with your conclusion. To date, there have been no countervailing opinions concerning the value of the assets in questions, or any credible challenge to the process of determining that value. Indeed, all of the credible positions I have seen with respect to the valuation conclude that the Capstone revised estimate may in fact be generous (due to the vast majority of the assets being plant and equipment which is both antiquated and potentially a liability do to years of manufacturing waste by-products.

Having a book value grossly out of whack with a market value is not all that uncommon, especially since Cerebus "purchased" Chrysler just a few years ago. The debt assumed as part of the purchase price would elevate the basis Cerebus had in assets, which would have been allocated in a reasonable way across the asset base - with a portion even being attributable to "goodwill" which, by the way would be accounted for as an asset on the books of the company, and part of that $39B.

The penultimate question then is the 1) the validity of the process of valuation (and, as I have said, no one has yet provided an alternative process or result) and 2) whether the UAW interest in NEW Chrysler was an arms length transaction, or a subterfuge to give priority to unsecured claim in OLD Chrysler. Part of that will depend on the opinions of the other investors in NEW Chrysler (US, Canada, Fiat) as to whether they would be investors, but for the new labor deal. I would suggest the answer is no, and hence the issue is moot.

Lawrence D. Loeb said...

Thank you for your comment.

I would appreciate it if you could further explain why you believe the UAW interest is an arms length transaction by NewChrysler (instead of a payment by the Chrysler estate).

What asset is being created with that purchase?

Would you really pay, what is effectively, a signing bonus of $10.337 billion to hire the UAW with the modified contract?

If so, can you please hire me? You would be more generous than anyone I've ever worked for!

I'm not sure why you put Cerberus' purchase of Chrysler in quotes, but the value of the assets would have been, potentially, increased at the sale date.

Subsequently, if there was an impairment in the value of the assets that was not reflected through depreciation or amortization (or, if appropriate, depletion), then the auditors would require Chrysler to write down the value of the assets and recognize the expense on their income statement.

Your seem to be arguing that Chrysler's December 31, 2008 financials (a mere four months prior to the bankruptcy) should reflect a write down of up to $37 billion?