For those of you who have followed this blog, you know that I have been very critical of Tata’s acquisition of Jaguar and Land Rover (see Buyer’s Remorse and Tata and Jaguar/Rover Update). As I suggested when the deal was announced:

I think that this deal is destined to fail.

…For Tata, while bold, the deal just doesn’t make much sense. Aside from several luxury brands, an increased global presence, and some notoriety, I’m not sure what Tata gains. For example:

1. Where’s the synergy? Can Tata and Jaguar/LR share components, design, production, dealerships, or management? On its face, the synergies are just not there. But perhaps the investment was made for learning purposes, with Tata hoping to use Jaguar/LR capabilities to improve the quality and/or image of their existing automobiles. Possibly.
2. Can Tata rationalize Jaguar/LR’s production to make them more profitable? Actually, they cannot. They made pledges not to cut staff or close plants. And it’s unlikely that they would be able to reduce costs substantially by sourcing parts and supplies from India.
3. Can Tata right a ship that larger, more experienced, more formidable competitors had been unable to? In Jaguar and Land Rover, Tata is inheriting pieces of the old British Leyland Motors (Jaguar, Rover, Austin, Morris, etc.) that all tolled experienced (and continues to experience) more than 40 years of uncompetitiveness and underperformance. Quite simply, they are inheriting a lot of baggage (see Riding the Elephant for more background on British Leyland). It will be difficult for Tata to overcome this tremendous inertia.

Some analysts have argued that Jaguar and Land Rover were purchased on the cheap (at $2.3B minus $600M that Ford is throwing in to offset pension liabilities), and at the right time – when both Jaguar and Land Rover have a stable of new models about to hit the market (e.g., the Jaguar XF and the Land Rover LRX). These analysts point out that if these new models hit it big, it will make Tata’s acquisition look like a steal. However, this assumes that Tata can revive flagging sales at Jaguar and Land Rover in the middle of a downturn. Likewise, it assumes that Tata, by simply owning the brands, will not dilute their image. Finally, it assumes that the Jaguar and/or Land Rover brands can be revived after years of neglect and consumer dissatisfaction, and that consumers will once again be interested in buying relatively expensive, gas-guzzling cars and SUV’s (especially in the case of LR).

I remain skeptical.

When it became clear later in the year that demand had collapsed in the auto industry I wrote:

And it looks like things will be even tougher [for JLR and Tata] with global demand…slowing quite a bit.

I was therefore not surprised to see an article in this week’s Economist detailing some of the difficulty that Tata has been experiencing with its Jaguar/Rover subsidiary (see Indian Firms’ Foreign Purchases). Although the purpose of the piece was to review (broadly) the history of Indian overseas investment, it provided some perspective into Tata and JLR.

…several of corporate India’s acquisitions now seem ill-advised. The purchase of Jaguar Land Rover (JLR) in 2008, for example, saddled Tata Motors with a prestigious brand, prodigious losses and a $3 billion loan, the last $1 billion of which it managed to refinance on May 27th, days before it fell due. It has had to call on the help of the Tata Group’s holding company, which underwrote its faltering rights issue last year, and the indulgence of India’s biggest state bank, which guaranteed an $840m bond it floated in May. In a recent interview, Ratan Tata, the group’s chairman, admitted that the company bought JLR at an “inopportune time”.

The authors then pose the following questions:

So were these acquisitions fundamentally sound decisions cursed by poor timing?

MY COMMENT: Naw, that doesn’t sound right.

Or were they bad decisions flattered by easy money?

MY COMMENT: Ding, Ding, Ding, Ding – we have a winner.

As we wait for GM to officially declare bankruptcy (see Bondholders Push GM to Brink) and a decision on Opel (Berlin Considers Buyer for GM Unit), I thought I’d share an interesting article from this week’s edition of the Economist on Fiat’s quest to create a global automobile firm (see Marriages Made in Hell).

According to the Economist:

The bold attempt by Sergio Marchionne, chief executive of the Fiat Group, to use the crisis that has overwhelmed Detroit to forge a three-way merger between Fiat Auto, Chrysler and General Motors’ European arm, Opel, has been greeted both with admiration (for his chutzpah) and scepticism (about his ability to pull it off). The sceptics say cross-border mergers in the car industry have a poor record and that Mr Marchionne is biting off much more than he can chew.

Assuming Mr Marchionne does get both [Chrysler and Opel] deals done, that is when the hard part will begin. Adam Jonas of Morgan Stanley says that although the three-way combination could make 6m cars and around $100 billion of revenue, he doubts whether it will be able to operate in a fully integrated way like VW or Toyota “for perhaps decades”. He also questions Mr Marchionne’s faith in scale, suggesting it is a function of success rather than prerequisite for it and gives warning that even successful mergers bring with them “many hidden cost burdens (financial and non-financial)” and that these can spiral if things do not go well.

The doubts are rooted in experience. With the partial exception of the alliance formed between Renault and Nissan a decade ago, auto-industry mergers usually go wrong and destroy rather than create value.

Personally, I think it is extremely generous to refer to the Renault and Nissan deal as a success. Let’s just say it hasn’t fallen apart, yet. But that is neither here nor there. The real point is that these types of deals generally fail.

The skepticism detailed in the Economist is entirely consistent with the views I expressed several weeks ago in the post Is Fiat Nuts??:

If it weren’t enough that Fiat is trying to expand on the North American front via its alliance with Chrysler (see Now Introducing Fiat/Chrysler), it now seems as if Fiat wants to simultaneously expand its empire closer to home (via an acquisition of Opel)…

Are they nuts??? It is hard enough to pull off one integration the size of Chrysler, but now they are going to try to pull off two? And to top it all off, we’re talking about foreign integrations, where economic, political, and cultural differences compound the complexity. Frankly, I am surprised that Fiat’s board would give Marchionne the approval to simultaneously attempt both deals. A prudent board would counsel Marchionne to eat one cookie at a time, lest he get indigestion. So much for corporate governance.

“From an engineering and industrial point of view, this is a marriage made in heaven,” [Marchionne] was quoted as telling the Financial Times on Monday.

Or [as I put it at the time] an integration made in hell.

The Economist continues:

The corporate troubleshooter [Marchionne], who, since 2004, has been responsible for a highly successful turnaround at Fiat, has reached the conclusion that volume carmakers will in future need to sell at least 5.5m vehicles a year to be viable. With just over 2m sales last year, Fiat is too small to get there on its own. The choice, he believes, is a stark one: Fiat must be either a nimble hunter or wait to be gobbled up by someone else.

I responded to that specious logic with the following:

I just don’t get it. Why the preoccupation with size? I remain unconvinced that largess is a means to success. Just ask Jurgen Schrempp and the folks at Daimler, who ran around spewing the same nonsense about scale and survival before their acquisition of Chrysler.

Size certainly leads to increased revenues, which helps justify exorbitant managerial pay. But given the organizational complexities that go hand in hand with size, size does not always translate into increased profitability.

In order to truly benefit from size, there must exist extremely large economies of scale and scope. Perhaps such economies (the ability to economize on platforms, dealerships, suppliers, etc.) exist in theory in the auto industry. However, the power of the auto unions, coupled with the structural characteristics of the countries in which Fiat, Chrysler, and Opel operate make capturing synergies very difficult.

Fiat will certainly encounter difficulties when trying to capture synergies based upon economies of scale. But the trouble with Marchionne’s logic does not end there.

The fact remains, there is absolutely nothing wrong (from a strategic perspective) with being the hunted instead of the hunter. Lest we forget, managers act in the capacity of agents for shareholders. As such, they have a fiduciary responsibility to maximize shareholder value. If maximizing shareholder value means selling to a high bidder, then so be it. Shareholders generally end up better off in cases where their firm is the target rather than the acquiror. Moreover, looking only to be the hunter can be self-serving on the part of managers – it helps enrich them, allowing them to build empires and become entrenched along the way, while ultimately destroying shareholder value.

If Marchionne is truly interested in acquiring Chrysler and Opel because he believes it is better to be the hunter than the hunted, then we must question his motivation. It could be, as I pointed out in my previous post (Is Fiat Nuts??), that:

Marchionne, aided by a board of directors that he has in his back pocket, is engaging in a form of empire building whereby his own personal interests in building the world’s second largest automaker are taking precedence over the best interests of Fiat’s long-term health and prosperity.

Nevertheless, for those of you interested, I encourage you to read the entire Economist piece. It provides a nice perspective on the proposed three-way deal. That said however, it still came across as if the authors believe that the Fiat/Chrysler/Opel deal makes strategic sense, and that if anyone could pull off such a deal, it is Mr. Marchionne.

I am less sanguine. My stance toward Fiat/Chrysler/Opel therefore remains: Guilty until proven innocent.

Now that we are largely out of Q1 earnings season, it might be helpful to take stock of the health of the corporate sector. By many accounts, Q1 earnings were better than expected. The better-than-expected earnings has led some to suggest that economic recovery might be right around the corner – you know, “green shoots” and all (see First Quarter Shows Hint of Recovery). A deeper look at those earnings, however, reveals that they are not all that they are cracked up to be.

It is true that many firms reported earnings that were better than analyst expectations. However, this stylized fact is not necessarily indicative of a recovery in corporate earnings, for the following reasons:

1. Analyst expectations were unrealistically low. Many companies hedged when giving guidance, preparing analysts for the absolute worst. Some companies even refused to give guidance, leaving analysts to founder with their projections.
2. Earnings were down 30% or so from a year-ago level, and nearly 90% over the past two years (see S&P Earnings Decline). No sugar coating it. This was a horrible quarter.
3. Corporations were able to report better-than-expected earnings in large part because they engaged in greater-than-expected cost cutting (see Is Cost Cutting Throat Slitting, ht Anuja). Although cost cutting through layoffs and slashing expenditures can increase earnings in the near term, they can be deleterious in the long run. For example, reducing R&D budgets today can result in a compromised product pipeline down the road. Although cutting costs is the natural (and rational) response to economic malaise, the question remains whether companies cut costs by too much. And it’s not just the firm-specific consequences, cost cutting has systemic implications as well. Many analysts are overlooking the higher order effects of layoffs and capital expenditure reductions on the broader economy. This manifests as the dreaded negative feedback loop – fewer jobs leads to reduced consumer spending which then reduces demand for firms’ products resulting in decreased corporate profits leading to fewer jobs (wash, rinse, repeat).

The key then to the future of corporate profitability lies in whether you believe corporate earnings have bottomed out and will now begin to increase from a lower base, or whether you believe that there is still substantial downside risk that increasing unemployment and decreased consumer spending will continue to put a crimp in profitability. Given the nearly 40% rally in equity markets over the past several months, market participants clearly believe the former. I fear that the latter might be more representative.

All this makes me wonder whether the current rally has legs…

I’ve been tied up with end of year meetings, graduation, and conference travel lately. This has kept me from posting as regularly as I might like. But I did get to see Hillary Clinton speak at NYU’s commencement last week (see Clinton Gives NYU Commencement Speech).

I quite liked Hillary’s speech, but then again, I’m a sucker for idealistic, inspirational graduation messages. Between you and me, I also enjoy the pomp and circumstance, and the pageantry of the day. And as much as we academics like to complain that graduation ceremonies are long, boring, and suck up otherwise productive hours from a day, a good speaker or two can go a long way toward making the experience worthwhile.

A good set of commencement speeches never fail to remind me why I got into the education business in the first place – to learn, to discover, to share, to teach, and to inspire. Needless to say, I came away from the NYU commencement ceremony feeling reinvigorated and reassured about our academic mission (despite the economic challenges).

So now that I’ve had all the inspiration I can take for one week, let’s switch gears to something not quite as uplifting – the impending bankruptcy of GM (see GM Doesn’t See Deal Before Deadline). According to the NY Times:

With a week remaining before the expiration of a tender offer to its bondholders, General Motors said Tuesday that it did not expect to reach an agreement with the United Automobile Workers and others before bondholders decide.

G.M. is trying to persuade the holders of $27 billion in unsecured notes to exchange them for about 41 cents on the dollar. It must receive tenders for 90 percent of its bonds in order for the offer to be successful and avoid a bankruptcy filing.

Many analysts believe that the offer, which expires May 26, will fail and that G.M. will seek Chapter 11 protection.

But we knew that already.

And we wait…

As I mentioned in a recent post Legal Issues Affecting Chrysler:

…the dissident lenders have a valid complaint. Unfortunately, they are swimming upstream. They are not only in the minority among Chrysler’s creditors in opposing the Fiat deal, but in the minority among their own class of creditors (the total group of first lien holders including the likes of Citigroup and JP Morgan).

Sure enough, a few days later, many of Chrysler’s dissident lenders dropped their opposition to the Fiat/Chrysler deal (see Chrysler Lenders Drop Opposition). According to the Washington Post:

The small but staunch lenders group that stood against the sale of Chrysler disbanded Friday, removing the only major obstacle in the Obama administration’s plan to quickly restructure the automaker in bankruptcy court.

The breakup of the organized opposition improves the government’s odds of getting Chrysler out of bankruptcy quickly and could portend a similar road for General Motors should it also be forced to file for protection.

Now that Chrysler’s dissident lenders have caved, it is becoming increasingly likely that Chrysler’s bankruptcy will be a surgical one after all, contrary to my initial expectations (see Chrysler Bankruptcy: Anything but Surgical). I did not anticipate that the dissident lenders would so quickly reach their legal fee threshold.

…the legal costs…were a factor in dropping the public objection.

Irrespective of their financial wherewithal, dropping their opposition to the deal was probably a wise decision on the part of dissident creditors. They saw the writing on the wall. They weren’t going to win. And it’s no fun taking on the federal government, …even in the best of circumstances.

But now the question becomes: What does this all mean for GM?

Several weeks ago, in an Op-Ed for Advertising Age (subscription only, see GM and Chrysler: Finally a Sensible Approach or Ad Age Op-Ed for background) I wrote:

Should Chrysler go bankrupt (a likely outcome), the federal government gets to play a strong hand against GM. Allowing Chrysler to go bankrupt should be enough to wake up GM’s creditors and the UAW to the reality that US taxpayers will not support them indefinitely. It therefore acts as a signal to GM that the Obama administration is serious.

Sure enough, in a press conference held today, Fritz Henderson, CEO of GM, admitted that keeping GM out of bankruptcy will be difficult (see GM CEO Says Tasks are Large). From the Associated Press:

Bankruptcy protection for the biggest U.S. automaker is becoming more probable with a deadline just over two weeks away, the company’s top executive told reporters Monday.

General Motors Corp. CEO Fritz Henderson is still holding out hope that the company can restructure without court protection, but he says the tasks to complete before a June 1 government-imposed deadline are large.

“Certainly the task that we have in front of us is large,” Henderson said during a conference call to update the company’s restructuring efforts. “There is still an opportunity and still a chance for it to be done outside of a court process.”

…the company must reach concessionary agreements with unions, persuade thousands of bondholders to exchange $27 billion in debt for 10 percent of GM’s stock, cut thousands of dealers, close plants and lay off more salaried workers.

Of all stakeholders, the largest impediment to an out-of-court restructuring will come from GM’s bondholders, as was the case with Chrysler (although in Chrysler’s case there were only bank lenders, not bondholders). According to the Associated Press:

GM cannot modify its stock exchange offer to bondholders because the company has been told by the Treasury Department that it cannot go above 10 percent of the company’s equity, Henderson said.

A committee representing the bondholders has counteroffered seeking a 58 percent ownership stake.

Here we go again. As with Chrysler, the senior creditors want one thing, and the government wants something else. So does the federal government get GM bondholders to accept a massive haircut of the type that they were effectively able to cram down the throats of Chrysler’s lenders?

This is where Chrysler’s situation and GM’s situation diverge.

Although the debt restructuring problems they both face are the same in theory, in the case of Chrysler, it was much easier for the federal government to get Chrysler’s lenders to accept a haircut because the majority of its first lien debt sat with banks that accepted TARP money (e.g., Citigroup and JP Morgan). The government could therefore exert tremendous influence over these lenders.

Not so in the case of GM. GM’s bondholders are a much more diffuse bunch with disparate interests. Moreover, the government has much less of a direct influence over GM’s bondholders.

GM is obviously a much larger organization than Chrysler. So sorting out the details in bankruptcy will therefore be more complex. Nevertheless, be prepared for a longer, more drawn out, more complex negotiation with bondholders for GM than for Chrysler, unless the Obama administration can find some way to effectively use outcomes of the Chrysler case to convince GM’s bondholders to take their medicine outside the court system (e.g., by demonstrating the triumph of the “fresh start” provision over the the “absolute priority” rule – see Legal Issues Affecting Chrysler).

Steve Jakubowski is at it again (see Chrysler Bankruptcy: Anything but Surgical for background). In Steve’s latest post (Will the Absolute Priority Rule Kill the Sale?) he gets right to the heart of the matter:

When does the “absolute priority rule”…which establishes a hierarchy of recovery rights among creditor classes take a back seat to the “fresh start” rehabilitative policy of chapter 11?

Chrysler is arguing that it should be permitted to move forward with the Fiat deal as a means of getting a “fresh start” of the kind that bankruptcy law was designed to allow. The dissenting lenders, by contrast, are arguing that they deserve priority as first lien holders, that their claims should take precedence above all others, and that they should be allowed to liquidate Chrysler if they feel that is in the best interest of the first lien holders.

Steve writes:

Chrysler’s argument is essentially that it’s a “dead man walking”… [and] that if the “sale” doesn’t close on the accelerated timetable proposed, it will wither on the vine, resulting in “a rapid and severe loss of value.” …the transaction should be approved because, first, Old Chrysler is receiving “fair consideration” in the transaction and, second, Chrysler’s going concern value will be preserved, jobs will be retained, and an extensive network of independent dealers and suppliers will live to see another day.

Is that enough to approve the Fiat deal over the objections of the dissident lenders? According to Steve:

Surprisingly, though, Chrysler’s opening memorandum doesn’t squarely address the issue laid bare in my previous post and in the preliminary objection of the dissident lenders; that is, why isn’t the proposed transaction a sub rosa plan of the kind prohibited under the law of the Second Circuit?…Chrysler’s opening memorandum of law…[also] does not address the important question of why, absent the consent of the dissident lenders, 65% of the equity in New Chrysler should go to junior creditors in satisfaction of their respective claims against Old Chrysler while the claims of senior dissenting lenders go unpaid?

By sub rosa, Steve is referring to a Latin term meaning secret or covert. In essence, the dissident lenders are arguing that the government, in conjunction with Fiat and the rest of Chrysler’s creditors, are trying to run an end around, making a deal that neither respects their rights nor makes them whole. Moreover, the dissident lenders feel that the deal has been crammed down their throats in a less than transparent way.

In my opinion, the dissident lenders have a valid complaint. Unfortunately, they are swimming upstream. They are not only in the minority among Chrysler’s creditors in opposing the Fiat deal, but in the minority among their own class of creditors (the total group of first lien holders including the likes of Citigroup and JP Morgan).

Given the incentives of the various interested parties (e.g., the auto union, the US government, Chrysler’s suppliers, Chrysler’s dealers) and their status as junior creditors, it is no surprise that junior creditors would support the Fiat deal. But why, you might ask, would various of the first lien holders agree to a substantial haircut when it is possible that they might be better off liquidating Chrysler? Because the majority of the debt held by first lien holders resides with banks that accepted TARP money. And the federal government can exert a tremendous amount of influence over these creditors. This is the krux of the objection of the dissident lenders.

As explained by the Associated Press (see Chrysler Files for Bankruptcy):

…a group of funds identifying themselves as 20 of Chrysler’s “non-TARP lenders” released a statement saying they had been sidelined during negotiations between lenders and the government. The group, which said it holds $1 billion in Chrysler debt, complained that the four banks were “obviously conflicted” because they had accepted money from the government’s Troubled Asset Relief Program while they had not gotten TARP money.

Fascinating stuff. And kudos to Steve on a wonderful legal analysis of this complex problem! Please do visit his post Will the Absolute Priority Rule Kill the Sale? to read the full story.

If it weren’t enough that Fiat is trying to expand on the North American front via its alliance with Chrysler (see Now Introducing Fiat/Chrysler), it now seems as if Fiat wants to simultaneously expand its empire closer to home (via an acquisition of Opel). According to various media reports, Fiat is likely to make an attempt to acquire Opel, GM’s European arm (see Fiat Turns to Opel or Fiat Aims for Opel Deal). From the Wall Street Journal:

Fiat SpA Chief Executive Sergio Marchionne is stepping up his plan to acquire a majority stake in General Motors Corp.’s German unit Opel, the next phase of his ambitious campaign to forge one of the world’s biggest auto makers by crafting a three-way alliance among Fiat, Chrysler and Opel.

Mr. Marchionne is expected to meet senior German government officials in Berlin on Monday, according to people familiar with the matter, in an attempt to get support for a potential alliance with Opel. Mr. Marchionne signed a partnership with Chrysler LLC in Washington last week.

Fiat’s board of directors met Sunday and authorized Mr. Marchionne to seek a potential merger between Fiat and GM’s European operations, including Opel and its U.K. unit Vauxhall, according to a statement issued by Fiat on Sunday.

My Comment: Are they nuts??? It is hard enough to pull off one integration the size of Chrysler, but now they are going to try to pull off two? And to top it all off, we’re talking about foreign integrations, where economic, political, and cultural differences compound the complexity. Frankly, I am surprised that Fiat’s board would give Marchionne the approval to simultaneously attempt both deals. A prudent board would counsel Marchionne to eat one cookie at a time, lest he get indigestion. So much for corporate governance.

From the Associated Press:

Marchionne’s proposal is part of a Fiat plan to put together the biggest European auto maker and the world’s No. 2.

Marchionne reckons that the only automakers to survive the crisis will need to be able to churn out between 5 and 6 million vehicles a year.

“From an engineering and industrial point of view, this is a marriage made in heaven,” he was quoted as telling the Financial Times on Monday.

My Comment: Or an integration made in hell. I just don’t get it. Why the preoccupation with size? I remain unconvinced that largess is a means to success. Just ask Jurgen Schrempp and the folks at Daimler, who ran around spewing the same nonsense about scale and survival before their acquisition of Chrysler.

Size certainly leads to increased revenues, which helps justify exorbitant managerial pay. But given the organizational complexities that go hand in hand with size, size does not always translate into increased profitability.

In order to truly benefit from size, there must exist extremely large economies of scale and scope. Perhaps such economies (the ability to economize on platforms, dealerships, suppliers, etc.) exist in theory in the auto industry. However, the power of the auto unions, coupled with the structural characteristics of the countries in which Fiat, Chrysler, and Opel operate make capturing synergies very difficult. As reported in the WSJ:

Mr. Marchionne has suggested that closing down plants isn’t a realistic option in Europe, where many workers are shielded by contracts that make it costly for companies to lay off workers.

My comment: This is a microcosm of the problems that Fiat would likely face in any deal with Chrysler (which would be 55% owned by the auto union), and especially with Opel (given European/German labor law).

Good thing Fiat doesn’t intend to put any of its own capital at risk in either deal:

Fiat is also likely to seek government aid from Berlin to prop up the potential alliance while Fiat retools Opel’s operations, according to a person familiar with the matter. Fiat, which is saddled with €6.6 billion, or $8.8 billion, in debt, doesn’t have the money to finance potential partners.

My comment: Great, so let’s take stock. Fiat almost went bankrupt in 2004. It took a massive debt restructuring to rescue them from the brink. Now, after only a few short years of operating as a quasi-healthy automobile manufacturer, they want to take on two near-bankrupt companies that would nearly triple their current size, …and do it simultaneously. They have very little cash available to make capital investments. And to top it all off, they still have nearly $9 Billion worth of debt they need to service on their own.

I am left to conclude that there only are few plausible explanations for such a set of maneuvers:

1. Fiat is trying to acquire assets in a down market, when valuations are cheap. In so doing, they can take advantage of governments that do not want to be in the position of running large automobile manufacturers. They are thereby engaging in a low risk/high reward strategy in which they are trying to acquire access to products/brands/markets for next to nothing in the off-chance that they can magically make the Fiat/Chrysler/Opel combination work. Given that they will put very little capital at risk up front, if the deals fail, so be it.
2. Marchionne is trying to create another automobile firm that is too-big-to-fail, but in the process, too-big-to-succeed.
3. Marchionne, aided by a board of directors that he has in his back pocket, is engaging in a form of empire building whereby his own personal interests in building the world’s second largest automaker are taking precedence over the best interests of Fiat’s long-term health and prosperity.

Fiat’s stock reacted positively to the deal announcement, which suggests that shareholders favor the first explanation. However, Fiat should not underestimate the potential to get bogged down in such a strategy and get stuck with a money pit.

In addition, given the histories of similarly troubled super-sized deals (e.g., DaimlerChrysler, RenaultNissan) and a preponderence of evidence to the contrary, I remain skeptical of what’s behind door #1.

With Chrysler now in bankruptcy, our attention will turn to whether Obama’s promise of a short and surgical bankruptcy, coupled with an alliance agreement with Fiat, will ultimately be realized. Steve Jakubowski has presented some interesting legal analysis of the Chrysler bankruptcy (see Assessing the Financial Carnage and Testing the Limits of 363 – ht CalculatedRisk).

Although Steve analyzes the bankruptcy from a legal perspective, there are some interesting strategic dilemmas that emerge. For example, Steve went through the legal filings to piece together Chrysler’s balance sheet and financial standing. He points out:

• The claims of the top 50 unsecured creditors total $730 million, with total trade at about $1.5 billion.
• The claims of the senior secured lenders total $6.9 billion.
• The USA is owed $4 billion, secured by a third priority lien.
• Cerberus and Damiler AG are owed $2 billion secured by a second priority lien.
• An additional approximately $8.5 billion is owed to the VEBA funds that were designed to cover the costs of unionized retiree health benefits.

This raises an interesting set of questions. For example, why would the secured lenders be willing to take $2 billion to settle their claims? After all, they are technically first in line (after the DIP financier). Moreover, they feel that the federal government tried to cram down a Fiat deal in which unsecured creditors have been unduly favored over secured creditors. They argue that in liquidation they might be better off trying to recoup their money. Assuming Chrysler’s assets still have some value (which the truck, minivan, and Jeep lines probably do), they might be right. So to a certain extent I cannot blame them for not backing down.

By contrast, Chrysler’s representatives maintain that the secured creditors are likely to recover very little in the event of liquidation. As Steve points out:

In the end, however, the matter will be determined by the opinion testimony elicited from the parties’ opposing experts (with Houlihan Lokey’s Eric Siegert representing the dissenting lenders and Capstone Advisory Group’s Robert Manzo, who prepared this 166 page first day affidavit / expert report, representing Chrysler).  Notably, Manzo concludes in his affidavit (pp. 26-27) that:

Based on the Liquidation Analysis, the First Lien holders are expected to recover between 9% and 38% of their claims, on a net present value basis, [which] translates into a range of between $654 million and $2.6 billion.  It is my professional opinion that given the market developments subsequent to this analysis, coupled with the limited success of other OEM effort to move individual car lines, the First Lien holders would likely recover at the low end of this range as part of any liquidation of the Company. The U.S. Treasury is only expected to recover between 3% and 6% of its claims.

Since Chrysler obviously favors the Fiat deal, it is not a surprise that they “believe” that the first lien holders are making a mistake. I am not so sure I agree with that position, as again, I think there might be a bit more value in Chrysler’s products and brands.

Another interesting point that comes out of Steve’s analysis is that the US government is third in line, after the bank lenders and Cerberus/Daimler. Therefore, in liquidation, it is unclear that the taxpayer would receive much in return. But that begs the question, is it better to get nothing in return for a $4 Billion loan, or lend invest an additional $6 Billion to support a Fiat deal (putting the taxpayer $10 Billion in the hole) with the prospect of still getting nothing in return? And under the Fiat scenario, the federal government’s claim would only be in equity, meaning that in the event of future bankruptcy, the taxpayer will be among the first to get wiped out. So again, it’s unclear to me that the Fiat deal is in the best interests of the taxpayer.

Now I am not a legal expert, but Steve makes some interesting points with respect to the role of the judge in cases such as these. He writes:

In concluding that the debtor…should be sold outside of the context of a reorganization plan, he [the judge] asks:

• Is there evidence of a need for speed?
• What is the business justification?
• Is the case sufficiently mature to assure due process?
• Is the proposed APA sufficiently straightforward to facilitate competitive bids or is the purchaser the only potential interested party?
• Have the assets been aggressively marketed in an active market?
• Are the fiduciaries that control the debtor truly disinterested?
• Does the proposed sale include all of a debtor’s assets and does it include the “crown jewel” (noting that “the likelihood of approval of the § 363 sale is inversely proportional to the percentage of the value of the debtor’s assets that are to be sold”)?
• What extraordinary protections does the purchaser want?
• How burdensome would it be to propose the sale as part of confirmation of a chapter 11 plan?
• Who will benefit from the sale?
• Are special adequate protection measures necessary and possible?
• Was the hearing a true adversary presentation?  Is the integrity of the bankruptcy process protected?
• What other factors apply to the case at hand that tip the balance or that overweigh the evaluative factors set forth above?

The most interesting question to me is the one about “Are the fiduciaries that control the debtor truly disinterested?” In this case the fiduciary that controls the debtor is the federal government since it is my understanding that it will act as a the trustee. On that basis, since the government is both creditor and trustee, how can it be disinterested??

Also, another interesting consideration is whether the Fiat deal unduly favors the auto union, and Chrysler’s retirees, vis-a-vis secured creditors. Again, I am not a legal expert, so it is not entirely crystal clear to me which claims comes first in bankruptcy (secured creditor claims or VEBA claims), although if I am not mistaken, the claims of the auto union should be unsecured claims and therefore junior to secured creditors. Either way, a 55% ownership stake in Chrysler for the union seemed a bit rich to me.

Steve concludes by reminding readers:

never forget that in litigation, nothing is guaranteed.  Indeed, much depends on the judge drawn.  The judge overseeing this case is Judge Arthur Gonzalez, who proved…that he will adhere to what he believes the law requires, even if the financial markets turn upside down because of it.

So, who will win?  Really, only the true speculator and/or holder of Chrysler credit default swaps will (and perhaps Fiat if they–unlike their predecessors–can make it work), as my first post on the financial carnage at Chrysler demonstrates.  My guess is that after much briefing, discovery, and expedited litigation over the next 60 days, Judge Gonzalez will show enough angst to worry both sides that they stand to lose, thus resulting in a compromise that settles the matter and allows the transaction to go forward.  But with all Chrysler plants and operations now idled pending a final sale, the pressure to get the deal consummated and return people to work will be so overwhelming that it’s hard to imagine Judge Gonzalez not approving the transaction in some form that’s acceptable to everyone (except perhaps the dissenting lenders).

Steve claims that there is chance that Fiat might be a winner if they can make this deal work. As I’ve written before, I view Fiat’s chances of success as a low probability event (see Fiasco for Fiat or Now Introducing Fiat/Chrysler).

Irrespective of the outcome, one thing is certain: This is going to be a fascinating showdown – one that is extremely complex from both a legal and strategic perspective.