Zywicki on Chrysler and The Rule of Law

Josh Wright —  14 May 2009

My colleague Todd Zywicki has a must read op-ed in the WSJ.  Here’s an excerpt:

The Obama administration’s behavior in the Chrysler bankruptcy is a profound challenge to the rule of law. Secured creditors — entitled to first priority payment under the “absolute priority rule” — have been browbeaten by an American president into accepting only 30 cents on the dollar of their claims. Meanwhile, the United Auto Workers union, holding junior creditor claims, will get about 50 cents on the dollar.

The absolute priority rule is a linchpin of bankruptcy law. By preserving the substantive property and contract rights of creditors, it ensures that bankruptcy is used primarily as a procedural mechanism for the efficient resolution of financial distress. Chapter 11 promotes economic efficiency by reorganizing viable but financially distressed firms, i.e., firms that are worth more alive than dead.

Violating absolute priority undermines this commitment by introducing questions of redistribution into the process. It enables the rights of senior creditors to be plundered in order to benefit the rights of junior creditors.

Go read the whole thing.

5 responses to Zywicki on Chrysler and The Rule of Law


    Asness is full of baloney — he put his money into high-risk investment which predictably exploded and which would return far below 0.30 if the government wasn’t involved. If he had someone lined up willing to say, “yes, I can repay better than the government can,” I’d be willing to listen. As is, he’s just grandstanding to get more than 0.30 from taxpayers for his failed investment.

    The point about “whose money is it anyway” is relevant, but it ignores the central issue here: in a free market, this company would be liquidated for far below 0.30. I’m not going to listen to anyone complain about “unfairness” when the government is stepping in to give them money, far more than the free market would.

    But even in this unusual context, Obama’s plan isn’t that unusual. Were I buying a company, I’d torpedo the senior creditors — who have NO interest in the future of the company and are purely deadweight — in favor of the union, which has an interest in the future of the company and an incentive to make it profitable again. Indeed, the unions have ample groups to complain that the deal is unfair to them.


    I think Max and Thom both make good points, but it’s instructive that neither post provides support for Zywicki’s “rule of law” point. It’s not like the Administration is overruling the bankruptcy judge. One may have issues with the U.S. acting like a sovereign wealth fund and using its money for policy goals. (By the way, I think the policy goal here is not “payoff to the union” but rather “best chance of ongoing viability.”) One may argue that the Administration is violating the rules of capitalism. But is it not “a profound challenge to the rule of law,” and the administration is not violating absolute priority. Does Zywicki think the creditors would get a better deal through a liquidation?


    There are MASSIVE differences between Max Kennerly’s Buffett hypo and what Obama did with Chrysler.

    First, when a private financier makes demands on senior creditors as a condition to providing financing, it does so to ensure that it gets repaid. It says to the senior creditors, “I’ll lend money here if you give up your seniority in my favor so that I get my money back.” Here, the Obama administration said to senior creditors, “You must give up your seniority NOT to me (so that I get repaid my money) but to junior creditors to whom I owe a political debt.” The messing around with the seniority system was not at all designed to guarantee the government’s repayment. It does not make it more likely that the government will be repaid. Instead, it rewards a group to which the President is politically beholden.

    A second important difference in the Obama and Buffett scenarios is that Buffett, when he does this sort of thing, is investing HIS OWN MONEY (or money received from investors, to whom he owes a fiduciary duty to maximize gains) in order to make a profit. When the government starts acting as a business player (financier), its goal is not profit maximization, and the decisionmakers are not spending their own (or their investors’) money. The potential for mischief is massive.

    IMHO, the best thing out there on this Chrysler disgrace is this letter from hedge fund manager, Clifford Asness, who didn’t take too kindly to the President chiding hedge fund managers for refusing to steal from their clients in order to win our popular President’s favor. Money quotes:

    When hedge funds, pension funds, mutual funds, and individuals, including very sweet grandmothers, lend their money they expect to get it back. However, they know, or should know, they take the risk of not being paid back. But if such a bad event happens, it usually does not result in a complete loss. A firm in bankruptcy still has assets. It’s not always a pretty process. Bankruptcy court is about figuring out how to most fairly divvy up the remaining assets based on who is owed what and whose contracts come first.

    The process already has built-in partial protections for employees and pensions, and can set lenders’ contracts aside in order to help the company survive, all of which are the rules of the game lenders know before they lend. But, without this recovery process nobody would lend to risky borrowers. Essentially, lenders accept less than shareholders (means bonds return less than stocks) in good times only because they get more than shareholders in bad times.

    The above is how it works in America, or how it’s supposed to work. The President and his team sought to avoid having Chrysler go through this process, proposing their own plan for reorganizing the company and partially paying off Chrysler’s creditors. Some bondholders thought this plan unfair. Specifically, they thought it unfairly favored the United Auto Workers, and unfairly paid bondholders less than they would get in bankruptcy court. So, they said no to the plan and decided, as is their right, to take their chances in the bankruptcy process. But, as his quotes above show, the President thought they were being unpatriotic or worse.

    Let’s be clear, it is the job and obligation of all investment managers, including hedge fund managers, to get their clients the most return they can. They are allowed to be charitable with their own money, and many are spectacularly so, but if they give away their clients’ money to share in the “sacrifice,” they are stealing. Clients of hedge funds include, among others, pension funds of all kinds of workers, unionized and not.

    The managers have a fiduciary obligation to look after their clients’ money as best they can, not to support the President, nor to oppose him, nor otherwise advance their personal political views. That’s how the system works. If you hired an investment professional and he could preserve more of your money in a financial disaster, but instead he decided to spend it on the UAW so you could “share in the sacrifice,” you would not be happy.


    The President’s attempted diktat takes money from bondholders and gives it to a labor union that delivers money and votes for him.


    If Obama had jumped as President into an on-going bankruptcy and ordered the senior creditors get trashed more than junior creditors, we’d have a real problem.

    That’s not what happened. The US is exercising no more power than it’s entitled to as the financier of the restructuring.

    Replace “Obama” with “Buffett” and run these same facts. An insolvent company and its creditors try to engineer a deal with an outside financier, who demands X cuts from senior creditors and Y from junior creditors. It is not at all surprising that the outside financier will try and attack the senior creditors first, since the outside financier wants as senior a claim as possible, and the senior creditors are the primary obstacle both to the outside financier’s priority and the later profitability of the company.

    Everyone agrees to the new plan except for a handful of senior creditors, so the company goes into bankruptcy.

    The bankruptcy judge then looks carefully at the deal, maybe plays with it a little bit, and then, upon the advice of the Debtor, the Creditors’ Committee (which is run by the same majority of senior creditors), and the U.S. Trustee, and with objections solely from the handful of unhappy senior creditors, orders everyone to adopt the plan, and thereby orders the objecting senior creditors to play along.

    That, in a nutshell, is what happened here and what happens in every major bankruptcy. I wonder if Zywicki can name a single major bankruptcy in which the senior creditors fared better than the junior creditors. (Excluding, of course, those situations where the senior creditors themselves provide debtor-in-possession or post-bankruptcy reorganization financing, which is not the case here.)


    I wonder how concerned Professors Zywicki and Wright were when they were on the staff at the FTC, an agency that violates the rule of law in just about every way imaginable on a daily basis.