Too Big To Fail, Too Big To Bail: A Plan to Save the U.S. Auto Industry

The evaluation of risk may be visualized as a scale on one tray of which is the magnitude of the damage incurred if the risk occurs and on the other the acceptable likelihood of such risk. Clearly a great magnitude of potential damage demands a low level of acceptable risk. The consequences of the failure (by which I mean complete or substantial liquidation) of the U.S. automobile industry presents an intolerable magnitude of damage to the U.S. economy.

The U.S. automobile industry consists of three distinct but highly interconnected segments: (i) the Detroit Three, GM, Ford, and Chrysler; (ii) non U.S. companies that manufacture cars in the U.S.; and (iii) parts suppliers, contract engineers and like businesses which supply and service segments (i) and (ii) and one another (“parts suppliers”). There are also several non U.S. companies which manufacture cars in the U.S. and thousands of parts suppliers, dealerships, and other direct service providers to the auto industry in the U.S.

It is indisputable that a complete failure and liquidation of even one of the Detroit Three will severely damage all the other members of the three industry segments. If all of the Detroit Three failed each of the other two industry segments would be severely damaged and most would likely fail; although the non U.S. companies would ultimately (after a period of months or even years) satisfy U.S. demand at first through imports, a very unhealthy result for the U.S. Some parts suppliers are very heavily dependent on a single auto manufacturer.

By way of example, Delphi is GM’s largest Parts Supplier and receives 37% of its net revenue from sales to GM, (Delphi is itself in Chapter 11 reorganization for four years now). However, the great majority of parts suppliers sell to several auto manufacturers in intense competition with one another. If, say, Chrysler were to fail, it is highly probable that some significant number of its suppliers would also promptly fail causing a shutdown of all or most of the other manufacturers (non U.S. as well as the Detroit Three) while they scramble to replace unavailable essential parts.

This will not be a simple or quick process as most auto parts are not fungible, but rather finely engineered purpose designed objects. So, to continue with the Chrysler example, were Chrysler to fail and take with it some of its suppliers it is probable that will cause GM and the others to shut down, and thereupon, Delphi, among others, will also fail. A short period of time, perhaps only two or three months, without GM orders would probably force a liquidation of Delphi which, in turn, would probably force a bankruptcy of GM from which it may well never emerge.

These interconnected failures will spread contagion through the industry from which few will survive.

The consequences of such a disintegration of the U.S. auto industry will have a profound impact on the U.S. economy and, indeed, globally. According to the Center for Automotive Research (“CAR”), an independent nonprofit analyst of the automotive industry, the auto manufacturers and parts suppliers directly employ over 1,200,000 workers of whom about 240,000 are employed by the Detroit Three and about 115,000 are employed by non U.S. manufacturers. CAR has calculated that the total loss of jobs due to the multiplier effect of the failure of the U.S. auto industry will be about 3 million unemployed.

Other significant indirect effects include a loss of revenue to state and local governments exceeding $150 billion, the transfer of health care costs from auto manufacturers to Medicare, and the transfer of pension costs to the Pension Benefit Guarantee Corporation (“PBGC”). The Detroit Three have $100 billion of healthcare liabilities for retirees, about 40 percent of whom are too young to qualify for Medicare. In addition, the Detroit Three spend almost $13 billion annually on pensions (this amount should be expected to increase in view of current market conditions). The PBGC will be liable for a portion of these benefits if the plans fail.

Further, while the U.S. imported $185 billion in value of automobiles, parts and engines as of September 2008, it also exports $94.6 billion in value of vehicles, or 7% of our total exports. Thus the combination of lost exports and increased imports will have a significant adverse effect on our already serious current account deficit.

At our current 6.5% unemployment rate over 10 million workers are considered to be unemployed. Most prominent economists and employment forecasters expect the unemployment rate to increase in 2009 to 8% to 10%. If a catastrophic failure of the auto sector is added to these 2009 forecasts I can anticipate about 18 million U.S. workers to be unemployed which will drive a rate of about 12%.

This level of unemployment has not been experienced since the Great Depression. Indeed the highest unemployment rate experienced in the U.S. since 1948 has been 10.8% in November and December 1982. It seems likely that if these rates were realized the multiplier effect thereof , while incalculable, will create even higher unemployment rates than suggested here and a profound recession the likes of which has not been experienced in the U.S. since the Great Depression. A risk to the well being of the U.S. of this magnitude must be avoided.

The recent testimony to Congress of Messrs. Wagoner, Nardelli and Mulally notwithstanding, it strains credibility that $34 billion injected into these loss-making companies will have a sufficient permanent beneficial effect. The U.S. auto industry suffers from several significant problems: (i) management that has seemed to be “behind the curve” for nearly 30 years (the shortcomings of the Detroit Three management do seem to have diminished in recent years and it may be that for the first time in over three decades U.S. automakers are producing cars that approach the quality and marketability of their non U.S. competitors; (ii) while German and Japanese auto workers now actually earn more than unionized U.S. autoworkers they cost their employers less due to government contribution to health care and pension expense. (This, however, will change due to new labor contract negotiated between the UAW and the Big Three, which would transfer retiree obligations to the UAW, create a two-tier wage structure and make healthcare less costly. The question is whether the Big Three will survive long enough for those benefits to be realized); (iii) the enormous cost of retiree health care borne by U.S. automakers but not by their foreign competitors estimated at $100 billion covering hundreds of thousands of retired workers; (iv) cumbersome work rules dictated by labor contracts that prevent manufacturers from operating plants in the most efficient manner and drive up the labor costs associated with automobile production even when wages are at reasonable levels; (v) most recently, a severe and growing recession in the U.S. which has caused auto sales to plummet to levels not seen since 1994; and (vi) the lack of credit available to potential car buyers due to the current credit crisis.

Any major governmental initiative that does not attempt to effectively address these issues will almost certainly fail in the long term.

One option advocated by purist ideologue market economists and politicians is to do nothing and let the chips fall where they may. The outcome of this approach will most probably be a depression era-like economy, causing untold suffering for millions in the U.S. and worldwide untold suffering and profoundly damaging U.S. stature and influence in the world.

So what is to be done? Recent proposals to grant a $25 or $34billion bailout to the industry seem pathetically inadequate given that the Big Three automakers burned through $17.6 billion in cash in the third quarter alone and have only $41.1 billion in cash on hand as of this date (most of this cash is at Ford). Further, this approach does little or nothing to deal with the long term problems of the industry.

Many responsible economists and observers have suggested that reorganization in bankruptcy under Chapter 11 of the U.S. Bankruptcy Code already provides an adequate framework within which to deal with this growing crisis. Unfortunately the unforeseeable practical aspects of this approach may well likely drive the applicants into a liquidation with the attendant horrors described above. Although provisions of Chapter 11 do exist that would permit the auto manufacturers to reduce labor costs, impose new contracts with more efficient work rules, eliminate pension obligations, eliminate retiree medical benefits, and reduce debt or convert it to equity, it is rare that these powers are invoked in a timetable that is sufficient to meet the needs of the current crisis.

Delphi and United Airlines provide two recent examples where the invocation of these powers devolved into multiyear morasses to the detriment of all stakeholders. Moreover, even if management were bold enough to move on all these fronts with alacrity, and even if labor leadership were bold enough to participate in formulating prompt and realistic solutions, the collateral damage would be severe. The PBGC would be required to pick up the pension liability, to the extent of its guaranteed benefits if plans turn out to be underfunded, retiree medical benefits would be eliminated for hundreds of thousands of employees (which could have a material cost to the Treasury assuming the Health Coverage Tax Credit is reauthorized, thereby providing a 65% subsidy on health care premiums for those affected, unemployment insurance payments would increase markedly, and other damages would occur in the economy). Moreover, unless the reorganization occurred with record speed, it might not occur at all and a destructive liquidation would ensue.

Amongst the many pitfalls of a Chapter 11 filing is the likelihood of a “consumer strike.” Would you buy a new car from a company in “bankruptcy” with no assurance of a reliable warranty or of future parts availability? This problem alone will likely eventually destroy the U.S. industry and no doubt accounts for Mr. Wagoner’s refusal to publicly acknowledge even planning for the contingency.

The only solution that seems to us likely to succeed in balancing the risk scale is the creation of a new legal regime for companies whose survival is critical to the national interest. Probably a new chapter of the bankruptcy laws designed to reorganize and restructure the industry in a manner that will substantially increase the odds of long term survival and avoid a short or medium term crisis.

It is foreseeable that if Congress were to enact such a regime it may well never again be utilized.

I would suggest the following key components of such a reorganization regime. (It is probably best to never refer to such a regime as a “bankruptcy”). First the formation by statute of a committee to determine whether a company is critical to the national interest with a charge to make such determination promptly—30 days after application for such status by a company seems adequate. In order to meet this standard, the company would have to demonstrate not only that it was at risk of failure over the near term, but that its failure would have such a dramatic effect on the economy, taken as a whole, that the national interest required that it have access to this new form of reorganization. The members of such Commission should probably include the Secretaries of the Treasury, Commerce and Labor, a representative of the most affected labor union, the Speaker and Minority Leader of the House (or a designee), the Majority and Minority Leaders of the Senate (or a designee), and perhaps others such as the Executive Director of the PBGC.

If the Commission designates a company applying for relief under this new regime, then a special “Reorganization Panel” presided over by a three judge panel chosen from sitting bankruptcy judges by the U.S. Court of Appeals in the jurisdiction of the filing (as is currently the case in choosing Bankruptcy Appellate Panels) would come into session with the statutory authority necessary to structure a solution. The Reorganization Panel will then employ a Trustee to administer the reorganization who in turn will require expert assistance from lawyers, industry experts and others. This mechanism is substantially similar to the approach that has previously been taken in many large complex bankruptcy reorganizations. The Reorganization Panel will require extraordinary powers to effectively achieve the desired results without having to deal with the numerous legal challenges inevitable in such a complex proceeding and the probable impossibility in today’s capital markets of arranging debtor-in-possession (“DIP”) financing at the required scale.

The crux of the reorganization will require (i) a mechanism to facilitate DIP financing, either backed by the Treasury or borrowed directly from the Treasury, typically it is possible to structure the DIP in a manner that eliminates or reduces risk thus the ultimate cost to tax payers is likely to be smaller than the available alternatives; (ii) a stream-lined process to restructure debt on the balance sheet; (iii) reduction or elimination of pension obligations; (iv) reduction or elimination of retiree medical coverage; (v) restructuring of labor contracts to bring all work rules, wages, and benefits to levels that can sustain a business that will be competitive in the industry; and (vi) the appointment by the Panel of 5 new members to the Company’s board of directors for a period of 5 to 10 years.

Perhaps each of these objectives may be accomplished under current provisions of the bankruptcy code. The problem is one of timing—the patient in this instance will die on the table as the operation is being performed. The solution to the timing issue is a combination of changes affecting substantive rights, and procedural rights. While the arcane details of the changes required are beyond the scope of this article, essentially, the new provisions would allow the Trustee to make the changes to debt, labor costs, work rules, benefits, post retirement benefits, and any other financial drag on the ability of the business to be financially viable. A hearing would be held within thirty days after the filing of the case at which the Trustee would put on the case as to the need for the changes being proposed, and the viability of the entity.

One of the most important features of this proposal is that it will separate the work required to return the company to a viable and competitive state from the work required to allocate value among those stakeholders who are adversely affected by the reorganization. By providing two simple forms of “plan currency” (one class of debt and one class of common stock), valuation issues can be minimized and stakeholders will have a fair opportunity to assert rights to appropriate compensation for the concessions that they have made in the reorganization. While one might argue that expedited process does not provide sufficient opportunity to litigate over issues such as reduction of creditor debt, retiree medical expenses, pension obligations, work rules, and the like, that is, in fact, precisely the point of the proposal. A surviving company can compensate employees, retirees, and the creditors for at least some of their loss, a liquidated company cannot. During this period the Panel and the Trustee would be expected to take steps necessary to continue normal operations as once common under the “doctrine of necessity.”

The Trustee would propose a new capital structure, replacing all existing debt and equity. The new debt and equity instruments would then be held in trust for a reasonable period necessary to permit all aggrieved persons, including employees, retirees, financial creditors, the PBGC, and any other party who was adversely affected by the reorganization to have an opportunity to litigate for their fair share of the new capital, based on traditional bankruptcy principles concerning the distribution of value. While I do not underestimate the legal challenges to such a regime, what I am suggesting is a process broadly similar to rights and procedures frequently provided to aggrieved parties in bankruptcy proceedings and under plans of reorganization, albeit after years of wrangling.

I envision that the legislation would include an absolute assurance that the ultimate plan will honor all legitimate claims of trade creditors so as not to endanger parts suppliers as well as a post reorganization structure that will place car purchasers warranty claims in a reasonably and secure senior position. The Trustee must have the ability to impose an emergency labor contract which would include mandated forbearance from striking or other workplace actions by labor unions for three years – thereafter normal labor-management bargaining and the potential for strikes would automatically be reinstated.

The Trustee should have the power to eliminate certain legacy costs such as retiree health care and pension liabilities on an expedited basis. The pension component may perhaps not result in significant PGBC liability, to the extent that, as it now appears, the automakers plans are reasonably well funded. Moreover, whatever loss the PBGC might suffer from this scenario would necessarily be lower than the loss it would suffer if the catastrophe scenario were allowed to play out. Similarly, the worst case result of the exercise of these powers for labor and employees will be far more favorable than the results of a Chapter 7 liquidation. Each of the actions proposed to be taken by the Trustee will require approval of the Panel.

Other provisions regarding new management and governance, at least during the period in which the debt and equity in the reorganized company remains subject to competing claims, must be provided. It is envisioned that traditional bankruptcy principles such as the absolute priority rule, would continue to govern the disposition of the “plan currency.” Thus, while it is doubtful that any value would be retained by shareholders in such a reorganization, whether or not value was retained would depend on the application of bankruptcy principles to the competing claims for plan currency made by employees, creditors, and shareholders.

While no legal regime quite like this has ever been enacted, several precedents exist in current law that provide some analogies for dealing with problems deemed to be in the national interest. For example, in 1963, in the context of disputes between railroads and railroad workers that put the nation’s transportation system in jeopardy, there was a Joint Resolution of Congress creating an Arbitration Board to impose, after both sides made their cases, binding terms and conditions on the employment relationship between railroads and their employees for a three year period, after which the parties returned to their rights under the Railway Labor Act. In other circumstances, Congress has authorized an arbitration panel to impose common terms and conditions of employment on diverse labor groups in a context in which rail mergers have occurred. Shortly after September 11, 2001, Congress created the Air Transportation Stabilization Board, which offered emergency grants on loans to the airline industry under specified terms and conditions.

It may well be that even after the Trustee’s utilization of its extraordinary powers an additional capital infusion into the applicant will be necessary to insure its viability. The Panel should have the authority to create a capital structure that will enable the company to raise such funding in the capital markets; but if that should prove impossible, then and only then, the Treasury should be empowered by the enabling legislation to loan funds to or buy preferred stock from the company; these investments by Treasury should at some point be saleable in the capital markets thus returning some or all of the funds to the taxpayers (and perhaps even a profit). Obviously, Congress will impose some limit on this authority similar to the limits in the TARP.

Many details of a wide-ranging plan of this nature must be synthesized, but I suggest that precedents for these provisions are to be found in existing law and procedure and historical precedent. In any event, extraordinary times and risks demand extraordinary and bold measures.