How Chapter 11 Bankruptcy Impacts the Automotive Industry Thesis

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¶ … Auto Industry

On June 1, 2009, General Motors became the second-largest industrial bankruptcy case in history. Contrary to consumers' views about bankruptcy, GM executives portrayed the move as "an unprecedented opportunity to reverse decades of decline" (King & Terlep, 2009). The case illustrated how Chapter 11 bankruptcy protection can be utilized by ailing companies to re-organize their businesses and salvage their companies. President Obama predicted that GM would emerge from Chapter 11 as a "stronger and more competitive company" within months. Indeed, GM exited bankruptcy only a few weeks later in July (CBS, 2009).

The use of Chapter 11 in the automobile industry is contentious for a number of reasons, but has been deemed necessary by management. Reorganization under Chapter 11 allows automakers to rid debts, break burdensome contracts and shed liabilities. The legal framework for the GM bankruptcy was set by the prior Chrysler bankruptcy. It should be noted, however, that the legacy liabilities these automakers have sought to shed via Chapter 11 are not the only issues these companies face. This paper will analyze the issue of Chapter 11 with respect to how it impacts the automobile industry. While it is expected that reorganization will yield some benefits, but Chapter 11 alone will not address the major strategic issues that these firms face.

Chapter 11

Chapter 11 bankruptcy can be filed by either the debtor or a creditor. Under the statute, the debtor must file a schedule of assets and liabilities, of income and expenditures and of contracts and obligations (UScourts.gov, 2009). The debtor is required to file a reorganization plan that the creditors and the court can examine. Once the reorganization is approved, the plan can be executed.

Section 363 of the bankruptcy code allows for the execution of virtually any asset sale or transaction that has been approved by the bankruptcy courts (Cornell University, no date). Application of section 363 is at the discretion of the bankruptcy court. The judge can approve of a 363 sale if it is deemed necessary to the survival on the company (Morath, 2009). In the case of General Motors, its assets were sold to a new operating company. The stock was removed from New York Stock Exchange and the company is now owned by the existing bondholders, a UAW health care fund and the U.S. And Canadian governments. The argument for this sale was that the company would have been liquidated had the sale not been allowed. As such, the judge allowed the sale under Section 363 in order to save the company.

The Automakers

To understand the benefits of Chapter 11 reorganization of the automakers, some background is required on the factors that drove the companies to bankruptcy. Each of the big three automakers in the United States arose in an era without international competition. Over time, the industry consolidated into the three giants, each with strong market shares. These companies met demand through massive investment in plants and personnel.

Foreign competition arrived in the North American automobile market and was able to compete aggressively against the big three. Companies such as Toyota had stronger manufacturing systems, lower cost structures and better inventory control, which allowed them to produce superior automobiles and sell them for less, compared to the American automakers. The competitive disadvantage of the American automakers resulted in declining sales. With declining sales came declining margins as the competitive intensity of the industry increased. The combination of the two compromised profitability.

The inability of U.S. automakers to keep pace with the changes in their own industry became their undoing (Taylor, 2009). In recent years, the U.S. automakers have struggled to turn a profit. General Motors has not done so since 2004; Ford has not done so since 2005 and Chrysler since before it became owned by Cerberus in 2007 (MSN Moneycentral, 2009). The companies focused their energies on producing larger vehicles, and consequently their sales were hit hard by recent increases in oil prices and a dramatic shift in consumers' tastes (Wharton School, 2008).

Along with slumping sales, legacy liabilities have contributed to the financial woes of the automakers. At their peak, the big three automakers employed tens of thousands of people, a situation which has led to them having hundreds of thousands of retirees today. The lucrative pension plans negotiated with union leaders in the 1950s and 1960s, combined with the skyrocketing costs of providing health care for all of these pensioners, has combined to leave the automakers with massive liabilities not share by their competitors. Retiree health care liabilities alone for the big three amounted to $114 billion prior to the reorganization (Koenig, 2009). These assets have left the automakers in the position of spending $20-30 more per hour on labor costs than their competitors, and with work rules that require them to spend more hours per vehicle as well (Grossman, 2008). This cost disadvantage, which derives largely from the massive pension obligations, makes the automakers vulnerable to price competition. Given that the industry traditionally competes on both price and technological advantage, the U.S. automakers are in a difficult competitive position. Shedding these legacy costs would, theoretically, allow the automakers to sell their products at competitive prices profitably.

Chapter 11

An analysis of GM's financials reveals the problem posed by the legacy liabilities. According to the company's 2008 Form 10-K the company had automotive sales of $147 billion and automotive cost of sales of $149 billion, the latter figure including the legacy liabilities that were built into the per hour labor cost figure. The company was losing money on every vehicle it sold.

The primary benefit of Chapter 11 reorganization then was to shed some of these liabilities and break contracts in order to restore operating profitability to the company. Under GM's reorganization, its key ongoing assets were sold to a new operating company. Chrysler's reorganization took the same form. The new company would have fewer assets, as those to be liquidated were left with the old company. The Chrysler bankruptcy cleared the path for GM, in part because the bankruptcy judge essentially shut down the creditors' objections to the restructuring (CBS, 2009). The use of Section 363 was instrumental. Asset sales under 363 are common in large scale bankruptcies because they allow for the preservation of the company. The case of the automakers, in particular GM, was influenced by the federal government's desire to keep these companies afloat in some form.

There were three key decisions in the GM case that illustrate how the Chapter 11 bankruptcy filing and asset sale under Section 363 allowed the automakers to restructure and theoretically emerge from bankruptcy in a stronger competitive position. The first was with respect to the debtor's motion for approval of the sales of its assets, assignment of contracts and entry into a UAW retiree settlement (U.S. Bankruptcy Court, 2009). This motion laid the framework for the agreement. The use of 363 was allowed, in particular because GM had negotiated with the United Auto Workers to protect some of the key retiree benefits. The old contractual obligations to the UAW with respect to the retirement plan were reworked. As a result of the reorganization, the UAW is now responsible for the plan's administration, and in exchange has received a substantial ownership stake in the reorganized General Motors.

The second key element that allowed for the invocation of Section 363 was the involvement of the federal government. That the U.S. And Canadian governments backed the asset sale (as majority and minority owners of the new GM entity respectively) guaranteed the survival of the firm. The judge was able then to weigh the merits of a General Motors that had not turned a profit in five years, was losing tremendous amounts of money and was insolvent vs. A General Motors whose existence was essentially guaranteed by the U.S. taxpayers. The near certainty that the company as previously constituted would need to be liquidated in its entirety, plus the fact that major creditors and the UAW were accounted for in the deal, convinced the judge to allow the asset sales under Section 363 (Ibid).

The new GM post asset-sale is a company that is owned by two major governments and a handful of major creditors. All of the "good" assets were sold to the new company. What was left behind is a shell company consisting of "bad" assets, plants to be closed and minor creditors not invited to the restructuring. The old General Motors then will be liquidated, with the proceeds going to the remaining creditors, who do not receive nearly as much of the company as those who were allowed by buy into the new General Motors. In essence, the asset sale that came about as a result of the bankruptcy protection served two important functions -- to allow GM to separate assets it would like to keep from those it would like to jettison, and to do the same with its creditors. The residual creditors receive little for their investment, which was part… [END OF PREVIEW]

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