As Goes General Motors

As of today, General Motors’ market capitalization (the combined value of its shares) is about $16.5 billion. In 2005 alone, GM lost $10.6 billion and by all accounts the losses continue. The positive value of the stock reflects a chance that the company will turn around not an indication that it has. Even so, the company can for some time continue to suffer losses at this or higher levels and still not default on any of its loans. All it need do is borrow from Peter to pay Paul, and GM is doing just that.

In late June, the automaker announced that it would refinance $5.6 billion in loans, a move it described as a "positive action toward additional financial flexibility." This action is "positive," no doubt, for GM managers, employees, and shareholders, each of whom would like to buy time for a reversal of fortune. But no such reversal is guaranteed, or even likely, and thus not every corporate constituent is pleased by the company’s new liquidity. The new loans are secured by collateral that gives the holders priority over GM’s unsecured bonds. Should the company continue its losses and default on its new obligations before it pays off the bonds, the bondholders will be left with little or nothing to collect. In anticipation of such an event, both Standard & Poor’s and Moody’s investor services cut the credit rating of GM bonds, which were already classified as junk. So while GM may consider the refinancing a positive step, the news is not necessarily good.

The General Motors response is straightforward. It has done all it can to survive. It has not only refinanced some of its loans, it has also moved to reduce its workforce and assembly capacity, with the goal of increased efficiency. It has contributed to worker buyouts at Delphi, its largest supplier, in an attempt to prevent labor strife there that could cripple GM production, and it has asked its own workers for concessions. It will introduce new car lines and announced plans to restructure the way it markets its brands. Most recently, it said that it will consider a joint enterprise with competitors Renault and Nissan, a step recommended by GM shareholder Kirk Kerkorian. What more can GM do?

That General Motors may have taken every reasonable step to assure its survival does not imply that it has taken the right steps. Perhaps GM should not attempt to survive. The company’s financial losses have not been visited upon it randomly. Rather the losses have been earned the old fashioned way, through the manufacture of expensive, unpopular products. Of the $10.6 billion in 2005 red ink, $3.4 billion was operating loss, which reflects not debt burden but real resources consumed in excess of revenues received. This is not a problem that can be fixed with new loans. The planned overhaul at General Motors might restore profitability, but given the stiff competition, it might not. GM’s market share—though roughly a quarter of U.S. new vehicles—has fallen and continues to fall. Perhaps the best course for General Motors, then, is to give up any attempt to continue in its current form.

The company might instead voluntarily file a Chapter 11 bankruptcy petition, which would free it from debt payments and permit a rational disposition of its assets. GM’s profitable brands could be retained or sold to competitors, who could also stand behind warranty commitments and assure the availability of parts for current models. The rest of the company would be liquidated piecemeal. Workers would suffer, but fewer might lose their jobs than will be the case if GM holds out until the last penny is spent, when there may be nothing left for anyone to salvage.

Voluntary bankruptcy may seem anathema to corporate management, but almost all corporate bankruptcy cases are voluntary. That is, managers do eventually accept the inevitable and one would expect that the GM managers ultimately will as well. The question is whether they have already waited too long.

They would not be alone if they have. In a just-completed study of large U.S. corporate bankruptcies, Vedran Capkun, Larry Weiss, and I found that in recent years financially distressed companies have waited longer than in the past to file. Thus, by the time today’s financially distressed firms enter bankruptcy they are more heavily indebted than in the past and have burned through more value that might have been rescued with an earlier petition.

Ironically, the likely cause of this change is the greater role creditors now play in the bankruptcy process, formerly dictated by a firm’s management. Creditors are now tough on managers and shareholders once a firm enters bankruptcy, with liquidation a far more common outcome than in the past. As a result, today, few firms that have failed as businesses as well as financially are allowed to reorganize in Chapter 11 and continue as before. The result may be greater returns for creditors from the assets available when a firm enters bankruptcy, but the tougher landing for management and equity has increased management’s incentive to stay out of bankruptcy in the hope of a turnaround, even against all odds and at great cost.

There is an apparent dilemma, then. Leniency yields losses as a result of the bankruptcy process while stricture yields losses in anticipation of that process. There is a solution. The law, or creditors by contract, might make it more difficult for financially distressed firms to stay out of bankruptcy. This could be accomplished if new loans were not permitted to have seniority over (or earlier maturity than) the loans they replaced. Had GM, for example, been unable to refinance its debt with secured loans, refinance would have been unattractive to the lenders, who, like holders of GM’s unsecured bonds, would be left in the unenviable position of general creditor. The lenders, in turn, might have offered new funds only on terms so unfavorable to General Motors that refinance would not be a viable source of liquidity. Bankruptcy might then have been swift and for the better.

Comments

[Dan McGuire]

Preventing companies from replacing unsecured facilities with secured facilities would have a disastrous impact on scads of companies that do not belong in bankruptcy. It would cut off a vital part of the capital markets to many companies that, while not financially strong enough to meet their cash needs based on the credit available on an unsecured basis, are not anywhere near the zone of insolvency. The rise in “liquidations” results in large part from removal of inappropriate leverage previously granted to equity holders in the form of the new value exception. Now that the absolute priority rule actually applies, liquidating chapter 11 cases are more common because they are often the best way to realize value for creditors. I put liquidations in quotation marks because a great deal of liquidating chapter 11 cases result in a going concern sale, so the business of the debtor does in fact “continue as before” only with ownership changing hands from those who steered the company into chapter 11. A stand alone chapter 11 plan is not inherently superior to a liquidating chapter 11 via a section 363 sale.
If unsecured creditors aren’t happy with an insolvent company staying out of chapter 11, they can avail themselves of section 303(a). If they’re getting paid, they cannot file an involuntary and remain subject to risk in a chapter 11 if the secured debt equals or exceeds the value of the company. If they don’t like that risk, they don’t need to extend credit.
As for GM in particular, while many share the view that chapter 11 seems inevitable, history suggests it might not be a good idea to bet against Kirk Kerkorian.

[BobRasmussen]

Nobody forced the bondholders to buy the bonds, so let's not shed too many tears for them. GM's capital structure, in effect, gave managers a real option to attempt a restructuring outside of bankruptcy, and folks bought the bonds with this in mind (and presumably priced). This capital structure may have a been a sensible way to allocate control rights at the time of the lending decision. While your data suggest more restructuring outside of bankruptcy, it is unclear whether, on the whole, it is cheaper to restructure outside of bankruptcy or inside of bankruptcy. One should measure from before financial distress until its resolution. Also, one cannot look only at companies that file for bankruptcy because one would omit those cases where the exercise of the option outside of bankruptcy turned the fortunes of the company around.

That said, it is indeed possible that the capital structure under which GM operates is not the best we can do. Going forward, it may well be that the debt market is indeed evolving in this area. The rise of second liens, especially silent second liens, takes away the real option that you identify. Given the continuing evolution that we see in financing, my default would be to let the market participants attempt solutions (bankruptcy is certainly a foreseeable risk) rather than have the government attempt to ban certain types of transactions.

[Barry Adler]

No tears shed here, and I don't disagree with a word Bob says. (Though I do wonder why he was saying them in the middle of the night, I thank him and Dan for responding to my post.) My point was to focus on the potential inefficiency of what's going on. At the time of issue, the bondholders may not have anticipated the new era of Chapter 11 (which Chicagoans Rasmussen and Baird have so well documented) and the incentives it creates. As Bob says, the market may evolve or has evolved to address the situation, and the courts have as well (though dubiously) through the "deepening insolvency" tort. My suggestion that the bankruptcy law might intervene was intended to be provocative and I would not in any case favor any more than a default rule anyway.

[Frederick Hamilton]

I grew up in the birthplace of GM. Flint, Michigan. I have followed closely the GM fortunes and loss thereof over the years.

Years ago Ben Wattenberg had a great documentary show about hugh failed corporations in America as he took a walk through the graveyard and pointed to the tombstones of Anaconda Copper, Studebaker, et al.

GM will survive or fail not based on the federal bankruptcy code. It will fail or survive (prosper?) based on the world automotive market and whether they can profitably compete. Products consumers want to buy at prices that allow GM to post a profit. You can't fool mother nature and you can't fool market forces.

All the bankruptcy code will do is define the feeding frenzy of the vultures circling overhead. Should GM go down, the consequences may be severe. Feds picking up the retirement costs at a big loss to the individual retiree. Nationwide depression, doubtful, but possible. Will GM be allowed to go down? aka Chrysler bailout by the feds.

Wattenberg's walk through the graveyard of corporate America may continue with GM. My gut tells me GM will survive based on the monies involved with people like Kerkorian. Apparently Nissan and Renault were on their death bed only to be revived by Carlos Ghosn. Time will tell. Again, if GM does go down many people will get hurt badly.

[Kimball Corson]

Uh Oh. When bankruptcy specialists start writing about General Motors (and so goes the country), we know we are in trouble. I will now read Barry's article to find out why.

[Kimball Corson]

Barry writes, "The General Motors response is straightforward. It has done all it can to survive . . ." noting that virtually all financial recourses have been perused.

But I say, how about a cheap hot car with good mileage, great sex appeal and designed to last for twenty years without pieces falling off of it like crumbs dropping from feeding toddler. One of these well done might just save the Company. The world awaits just such a car. Too, I am sure that, buried in the bowels of GM, there is just the person who could pull it off.

[GARY]

Perhaps the GM Executives will follow the lead of the great textile firm Dan River. The Bankruptcy Court got rid of all unsecured bonds and all share holders. It then allowed the "executives" of Dan River to issue new stock to themselves. A few months out of reorganization Dan River was sold to an Indian company for about 20 million or so more than secured debt. The 20 million was paid to the "executives" for their shares. Not a bad way to screw the investors is it?
Gary

[Barry Adler]

In response to Gary's posting, executives of a debtor in bankruptcy are not permitted merely to issue shares to themselves, they have to buy them with new contributions of capital. This said, unless the new contributions are tested by the market, distributions at the expense of junior creditors is possible, of course. This is why the Supreme Court has required some sort of market test in cases of new contributions.

[GARY]

I am not certain how they did it, but Dan River management ended up with a large percentage of shares in the reorganized corporation.

I think it was done through a Key Employee Benefit Plan that pre-existed filing. Dan River also called it an employee retention plan. The 3rd amended plan eliminated the Key Employee benefit package which included stock options as low as $0.05 per share that were issued when the shares were selling for about that price. The final plan put the Key Employee benefit package into the reorganized company as an executory contract. They bought shares for less than a dime per share and the new owner paid as I recall about $100.00 per share.

3rd Amended Plan
Ҥ5.5
(b) Benefits Provided to Executives and Certain Key Employees. To the
extent the Debtors maintained on the Filing Date any incentive plans for executives and certain key employees that provided for, among other things, the grant of stock options, restricted stock, stock appreciation rights or other performance-based awards, such incentive plans will be deemed to be rejected and terminated in their entirety as of the Filing Date and, with respect to eligible officers and employees, will be replaced by the Long Term Incentive Plan provided by section 7.6 of this Plan. The incentive plans that shall be terminated pursuant to this section include, without limitation, the Dan River Inc. Management Incentive Plan, the Dan River Inc. 2000 Long-Term Incentive Plan, the Dan River Inc. 1997 Stock Incentive Plan, the Dan River Inc. 1997 Stock Plan for Outside Directors, and the Dan River Inc. 2003 Long-Term Incentive Plan; provided, however, that the termination of the incentive plans pursuant to this section shall not impact any
benefits to which any officer or key employee is entitled pursuant to any key employee retention plan that has previously been approved by the Bankruptcy Court, and any such key employee retention plan shall continue to be in full force and effect except as such key employee retention plan may be modified by the Long Term Incentive Plan provided by section 7.6 of this Plan.”

Final Plan
“5.5 Compensation and Benefit Programs. Unless such obligations are the subject of a
motion filed by the Debtors on or prior to the Effective Date that would provide for treatment different than that provided by this paragraph, all savings plans, retirement plans, health care plans, severance plans, performance-based incentive plans, retention plans, vacation plans, workers’ compensation programs, and life, disability, directors’ and officers’ liability and other insurance plans, whether or not qualified under ERISA, shall be deemed and treated as executory contracts and shall, on the Effective Date, be deemed assumed by the Debtors in accordance with sections 365(a) and 1123(b)(2) of the Bankruptcy Code and shall continue as obligations of the Reorganized Debtors in accordance with the terms of such plans, as modified and amended to date including, without limitation, as modified and amended by orders (if any) of the Bankruptcy Court entered in the Bankruptcy Case.”

Gary

[Joan A. Conway, CPA (unauthorized use after 10/15/06)]

The whole is worth more than the sum-of-its parts, an argument for "liquidating Chapter 11 Cases, Section 363, but then I don't pretend to know or practice bankruptcy law:"

I believe if executives could remember who did what and act like an oversight committee concerning the marketing fees that were paid to create a demand for GM products, then the benefits of freeloading would not continue over its costs, nor would the Bankruptcy's Code of business ethics be breached as to loyalty and duty.

If GM can't protect its turf and foreign autos fill the office parks, then the raison d'etat is a social structure, where executives move up the ladder, have headhunters offering new opportunities for higher positions, and gain access to big perks, but little else.

Why have a market test on new contributions of capital, if GM is unable to adapt with speed and ease to global challenges in the auto industry that it has probably paid top dollar to obtain?

[Michael F. Martin]

I bet if they were using better accounting management systems than they could be manufacturing at lower cost more cars that customers actually wanted to buy. Accounting management systems are the only variable that you see a difference in comparing GM to Toyota. Toyota also manufactures here in the U.S. Toyota has the same issues with tracking and adjusting to customer demand. Toyota has basically the same labor, capital, and raw materials costs (averaged over a long period) as GM. By process of elimination, management accounting must be the difference.