The Devilish Details of Detroit’s Deal

Thom Lambert —  10 December 2008

There are some pretty scary devils in the details of this Detroit bailout legislation. This WSJ article provides some specifics.

Under the terms of the draft legislation, “the government would receive warrants for stock equivalent to at least 20% of the loans any company receives.” Let’s put that in perspective. General Motors is seeking around $10 billion in short-term loans, so the legislation would give the government the option to buy a $2 billion stake in GM. GM’s market capitalization — the market value of its outstanding stock — is currently around $3 billion. If the government were to exercise its option today, it would pay GM $2 billion (thereby enhancing GM’s value by that amount) and would receive $2 billion worth of newly issued stock in a (now) $5 billion company. Thus, the government would end up owning 40% of GM.

A 40% holder of a corporation’s voting securities usually has effective control of the corporation. Indeed, the American Law Insitute’s Principles of Corporate Governance presume that a holder of at least 25% of voting securities is a controlling shareholder. While the draft bailout legislation doesn’t specify if the stock taken by the government will be voting or non-voting, it’s likely that the warrants provided in the legislation will give the feds a tremendous amount of control over the automakers.

Besides the control that comes with equity, the draft bailout legislation provides for the feds to take direct day-to-day control of the companies via an “auto czar,” who would “act as a kind of trustee with authority to bring together labor, management, creditors and parts suppliers to negotiate a restructuring plan” and would have authority “to review any transaction or contract valued at more than $25 million.” (UPDATE: This figure has apparently been raised to $100 million in the current draft of the legislation.)

The bailout legislation also includes some specific dictates. While the loans are outstanding, recipients may not pay dividends to stockholders or bonuses to senior executives, and they’re barred from participating in legal challenges to state laws designed to impose limits on greenhouse-gas emissions. (UPDATE: The bar on legal challenges may be lifted.) In addition, they must “analyze whether excess production capacity could be used to make trains and buses for public transit authorities.”

A few comments on this Faustian bargain…er, bailout deal:

The equity stake. Anyone who believes that giving the feds a large equity interest in the automakers will improve the business lot of those companies is on glue. Politicians are experts at winning popularity contests. They are not experts at creating shareholder value. If they have an equity stake that gives them a high degree of control over the automakers, they’ll push those companies to do popular things, regardless of the bottom line effect.

If anyone doubts this prediction, I’d point him or her to Fannie Mae and Freddie Mac. Consider these remarks from bailout negotiator Barney Frank (from a 2003 hearing on the financial soundness of Fannie and Freddie):

[I]n my view, the two government sponsored enterprises we are talking about here, Fannie Mae and Freddie Mac, are not in a crisis. … [W]e have got a system that I think has worked very well to help housing. The high cost of housing is one of the great social bombs of this country. I would rank it second to the inadequacy of our health delivery system as a problem that afflicts many, many Americans. We have gotten recent reports about the difficulty here. Fannie Mae and Freddie Mac have played a very useful role in helping make housing more affordable, both in general through leveraging the mortgage market, and in particular, they have a mission that this Congress has given them in return for some of the arrangements which are of some benefit to them to focus on affordable housing, and that is what I am concerned about here. I believe that we, as the Federal Government, have probably done too little rather than too much to push them to meet the goals of affordable housing and to set reasonable goals.

As I explained here, Congress used various carrots to push “private” Fannie and Freddie to ignore business considerations in favor of pursuing a social agenda. In doing so, it created a guaranteed buyer for unwise subprime mortgages and Alt-A (or “liars'”) loans, thereby encouraging private lenders to make them, knowing they could quickly sell them to Fan/Fred, a “greater fool.” The result has been disastrous. Do we really want to turn GM and Ford into Genny Mae and Fordy Mac? I think not.

The auto czar. Today’s WSJ describes this person’s role as follows: “He or she would bring together labor, management, creditors and parts suppliers to negotiate a long-term restructuring plan. The czar could pull back the loans if the companies don’t negotiate in good faith. And if a company and its stakeholders can’t agree on a plan, the czar would be required to recommend one, including the possibility of a Chapter 11 bankruptcy reorganization.”

This looks a heckuva lot like the judge in a bankruptcy reorganization, no? Oh wait. There’s one crucial difference. In bankruptcy, labor contracts would be on the table as a matter of right. Under this plan, the automakers would presumably have to get the unions to agree to open up the contracts for renegotiation, and it’s the automakers, not the unions, that get smacked if they fail to renegotiate. The automakers would have far less ability to procure the sorts of concessions they need to bring their costs down to the level of competing foreign car manufacturers who operate in right-to-work states.

Of course, there are a couple of other arguments in favor of “bankruptcy lite” under an auto czar: (1) it’ll be hard to get debtor-in-possession loans in the current credit crunch, and (2) people won’t buy cars from a car company in bankruptcy. I don’t find these arguments all that persuasive. With respect to the first, why not have the government withhold its bailout until it’s clear that debtor-in-possession loans are impossible to attain? With respect to the second, are consumers really less likely to buy cars from companies in bankruptcy reorganization–doing the housecleaning that will return them to viability–than to buy from companies that keep running to Congress, complaining about their dire straits and begging for a handout lest they fail? C’mon.

The specific dictates. Now here’s where I get a little cynical. If an automaker has a good faith, legally plausible argument that the Clean Air Act (or other federal statute) bars states from adopting certain emission standards, and the automaker’s business (and thus its shareholders) will be benefited by abrogation of those state standards, then shouldn’t the automaker be permitted to ensure that the states follow the law that Congress passed? If Congress wants the state standards implemented, then it should amend the Clean Air Act to ensure that that outcome is achieved. It can certainly do so if it wants, but it’ll have to take a little political heat. It would rather have a free lunch.

More generally, if Congress believes that there are significant externalities created by fuel consumption and that we should restructure the automotive industry to reduce fuel demands, then grow a pair and do the honest thing: tax fuel consumption at a level reflecting the external costs, and let industry adjust. Congress doesn’t want to do that, of course, because it wants to mask the true cost of its social agenda. (By the way, this sort of effort to get a political free lunch is exactly what damned Fannie and Freddie. Congress wanted cheap housing, but it didn’t want to pay for subsidies, so it pushed Fannie and Freddie to make disastrous business decisions.)

The bailout legislation’s ban on dividends and bonuses is what we might call a legal Spencer Pratt — it looks good on first glance, but it’s ultimately a dumb and pointless annoyance. The dividend ban greatly hampers Detroit’s ability to raise private capital. It will be pretty tough to raise money by selling stock that pays no dividend. The bonus ban prevents the firms from adopting performance-based incentive compensation, precisely the sort of compensation scheme Detroit may need to attract the best executive talent and to encourage its current executives to do the hard work necessary to turn the companies around.

Thom Lambert

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I am a law professor at the University of Missouri Law School. I teach antitrust law, business organizations, and contracts. My scholarship focuses on regulatory theory, with a particular emphasis on antitrust.