There is a draft of the automobile bailout bill floating around. It is relatively brief—31 pages double-spaced (though remember that the original draft of the big bailout law was only three pages)—and has started to receive blogging attention already (by David Zaring and by Eugene Volokh). I want to focus on one particular provision, namely the proposed seniority of the debt to be issued. (Others can address airplane divestiture (it’s bye, bye jets).) This provision either doesn’t work or is part of an elaborate game of chicken.
Section 11(d) on taxpayer protection provides that “in the case of an eligible automobile manufacturer which received a loan under this Act, any other obligation of such eligible automobile manufacturer shall be subordinate to such loan, and such loan shall be senior and prior to all obligations, liabilities, and debts of the eligible automobile manufacture.” The government wants to take a senior position for its debt (along with warrants, see 11(a)).
As Ford emphasized in the plan it filed in Congress on December 2, 2008, the car companies come to this situation with a deeply embedded pre-existing capital structure. Ford noted that it had roughly $17.5 billion in senior secured debt and another $17.1 billion in public senior unsecured debt. Although I have not seen the covenants, I would be stunned to learn that an effort to issue senior debt would not violate those covenants. (Ford talks through some of this in note 16 to the financial statements attached to its 2007 annual report.) Plus, of course, the way we do secured transactions means that the debtor almost always lacks a mechanism to grant a senior interest to a pre-existing position. That is the precise point of having a senior security interest.
And there may be substantial constitutional limitations on the power of Congress to alter pre-existing security interests under the Bankruptcy Clause of the Constitution. The Supreme Court sidestepped this issue in 1982 in Security Industrial Bank. That case dealt with a new security-interest avoidance provision in the 1978 Bankruptcy Code. Rather than take on what it saw as a difficult question of constitutional authority—has the government taken property without compensation in violation of the Fifth Amendment’s Takings Clause if it strips preexisting security interests?—the Court instead read the statute to apply only on a going forward basis. That meant that no preexisting security interests were covered by the new law. That won’t work here.
We might do well to compare this partial shadow bankruptcy regime called for in the auto bill—what I have called phantom bankruptcies elsewhere—with the rules that would be required in an actual bankruptcy. Section 364 of the Bankruptcy Code sets forth the rules for debtor-in-possession financing. That section requires the bankruptcy judge to march through a hierarchy of potential loan terms for the debtor looking for new money after filing for bankruptcy. We start with unsecured credit given administrative expense status, a nice post-petition perch in most bankruptcy cases, though one that is still junior to pre-petition secured claims. We then turn to secured debt, but that debt needs to look to property not otherwise subject to a lien already or to security interests junior to a prior secured position. That isn’t what the government wants here. Finally, if funding is not forthcoming still, the court is empowered to consider senior secured debt or equal secured debt but that requires that the court find that the pre-existing position of other secured creditors is adequately protected, a bankruptcy term of art.
As all of that suggests, section 364 is pretty tough. In contrast, the bailout bill simply tries to create priority by fiat—finally, a car joke—without taking any steps to ensure that the pre-existing positions of other lenders are protected. That is quite different from the approach that would be taken in bankruptcy, plus it may be tripped up by the Takings Clause.
Were I the feds, how would I fix this? The car bailout bill will create a car czar to manage the loans that the government will make under the bill. The auto bailout bill could require that the czar make the same sort of adequate protection finding that would occur in a bankruptcy proceeding. The existing security interests in car company assets were made with full knowledge that in an actual bankruptcy for General Motors, a bankruptcy judge might be able to subordinate those interests if the statutory standard could be satisfied. Apply the same standard, but just have the car czar do it.
Of course, even on that standard, it is far from a no-brainer to think that the government loans would have senior status. But absent an amendment of the sort that I am suggesting, either we will face some nice constitutional questions on takings of security interests or we are going to play chicken. When the government makes a loan causing a default under the existing covenants, who is going to step forward to accelerate its debts?