Stephen J. Lubben is a law professor at Seton Hall University specializing in "corporate finance, particularly issues concerning corporate debt and financial distress." That alone would make him a man much sought after by business reporters in today's chaotic financial markets. But in July 2007 he also authored the prescient paper "Credit Derivatives and the Future of Chapter 11," in which he theorized that the proliferation of credit default swaps (CDS) could end up reducing creditor willingness to agree to out-of-court corporate restructurings. He suggested that creditors who had bought CDS that would pay out in the event of a bankruptcy would have fewer incentives to agree to deals designed to avoid bankruptcy filings.
As the White House, General Motors and G.M.'s thousands of bondholders negotiate furiously this weekend on a G.M. restructuring agreement before the government's June 1 deadline, the question of whether CDS ensuring against G.M. bond defaults might be throwing a spanner into the works has never been more relevant. On the flip side, bondholders are screaming about what they see as wanton government interference with established bankruptcy tradition and law. One of the early emerging narratives of the new administration has been a brewing showdown between President Obama and hedge fund speculators.
For the last month, Lubben has been presenting his own views on these issues at the blog Credit Slips. Salon caught up with him on Thursday to see if we could get a more layman-friendly explanation of the issues at hand.
Bondholders owning Chrysler and General Motors debt are squealing because, they claim, the Obama administration is strong-arming them into accepting deals that do not respect their rights under settled bankruptcy law. Where do you stand on the question of whether the Obama administration is trampling over the "rule of law"?
I have some concerns, but I think that the thing that most people have focused on is not really a concern. Everyone seems to be focusing on the money going to the unions, but that strikes me as a red herring.
Why is that?
Because there is no indication at all that that money would be available in a normal bankruptcy proceeding. That's money that's coming essentially from the government to new Chrysler and then the new Chrysler is buying labor peace with it. The real issue to me is whether or not the creditors could, in a more normal proceeding, get more than $2 billion, which is the cash that they currently stand to get out of this. That's the actual sales price. It's really all about the sale of a company for $2 billion.
And would even that much cash be available if the government wasn't involved?
Well, that's a fair question. I think we can be be almost certain that if there were someone around who really thought these assets were terribly undervalued, they'd show up in court and complain about the bidding process and say, "I'm willing to put $3 billion on the table." But nobody has done that.
What about the "absolute priority" issue? The bondholders say they should be first in line to get compensated in bankruptcy dealing and the unions are jumping ahead of them with government support. Are they off base?
I think they are. And I don't even think that's their strongest argument. I think they have a stronger argument on the credit bidding issue. But they haven't made that argument -- which we can get to in a second. "Absolute priority" is the bankruptcy rule that senior creditors must be paid in full before people below them get paid anything. Certainly [the bondholders] would have a complaint if the $2 billion were being divided between them and the unions, but the $2 billion isn't being divided between them and the unions. The $2 billion is the only piece that's in the bankruptcy process and it's the only piece that is subject to the absolute priority rule.
So what is the union getting out of this?
They are getting ownership. But the way this is happening is old Chrysler is selling its good assets to new Chrysler for $2 billion. After that sale happens, then new Chrysler is giving the union a note and some ownership interest in exchange for various labor concessions by the union. But that's after the sale, it's not part of the bankruptcy process, it's not something that the debtor -- old Chrysler -- is doing. It's something that new Chrysler is doing. So to my mind it is kind of a distraction at this point. I mean, yes, we know that essentially the government is bailing out the unions through this process, but then again, this is not money that's been taken out of the debtor and given to to the unions in violation of absolute priority -- this is not the debtor's money.
Bloomberg News published an article on Wednesday that quoted hedge fund managers warning that after witnessing what happened in the case of Chrysler, in the future they would be less willing to lend to unionized companies with big pension and medical obligations. The implication being that the unions might be triumphing over the hedge funds in this battle, but in the long run they are going to suffer from higher costs for credit. Is that a likely scenario?
It could happen. The first question that comes to my mind is: Besides the auto industry, what big industries are left with heavy unionization? That's the other reality here. The airlines have already pared down their costs through their union agreements, and the steel industry has already been through its round of bankruptcies. But it could happen. I certainly think that the assumptions that some of these hedge funds may have made when they bought this Chrysler debt were probably proven to be wrong, and they will probably take that into account the next time around, so it is certainly realistic to suggest that in the case of a big company that might be subject to a government buyout, people might be a little wary that [a bankruptcy] might not play out according to the normal rules.
You said earlier you think the bondholders might have a more justified complaint on the issue of "credit bidding." How does that work?
I view credit bidding as a check against what the lenders are complaining about. If you really think the debtor is selling out the company for cheap -- too cheap -- then the secure lender always has a right to put down that loan and take the company. I think that's an important check against a debtor sticking it to its secured creditors, and I think that the Obama administration probably hasn't been sensitive enough to that. The argument is that the smaller bondholders are not able to credit bid, because the big banks who own most of the bonds are all controlled by the government and they are stopping them from credit bidding.
Which may or may not be true.
Yeah, we don't know if that is true or not. But the administration could have been a little more transparent about that part of it. Was the decision to vote for the Chrysler plan by Chase and Citibank and so forth an influenced decision? Or was it made as a business decision within those institutions?
The bankruptcy judge, so far, has overruled all the bondholder complaints. But on Thursday we learned that a group representing Indiana teacher pension funds was challenging the sale. What is their argument?
They have a lot of arguments and they are kind of throwing them all against the wall and seeing if any of them stick. Their most serious one is that this is a constitutional violation and it amounts to a "taking" under the Fifth Amendment of the Constitution, which holds that government can't take property without due compensation.
Is this a typical thing to see in a bankruptcy case?
What do you think of their argument?
The constitutional argument strikes me as being based on an erroneous view of the transaction, to the extent that they think that value is being diverted to the unions, because the value that is going to the unions was never in the debtor to begin with. Secondly they also have a constitutional argument about the way the debtor wants to apply a section of the bankruptcy code -- Section 363 -- and if their argument were true, then several other provisions of the bankruptcy code would also be unconstitutional, and that just can't be so.
Is the fact the judge did not grant them an emergency stay indicative of how he is likely to rule?
It at least gives us an impression of his first take on the issue, so unless he changes his mind after reading their papers more closely ... Of course it's not going to be totally up to him. The district court can also decide part of this because the Indiana bondholders have also filed a motion to withdraw the case from the bankruptcy court up to the Southern District of New York.
Let's talk about credit default swaps. Back in July 2007, you wrote a prescient paper warning that the proliferation of credit default swaps might mess with standard bankruptcy procedures. This has become a hugely controversial topic -- this idea that by insuring against a bond default, bondholders actually have an interest in forcing a bankruptcy rather than agreeing to an out-of-court restructuring. Do you see evidence of this in the cases of Chrysler and G.M.?
My understanding is that there hasn't been much of it in Chrysler, but a substantial piece of the G.M. bonds are held by people who also have credit default swap protection. This could lead to a scenario where people are not willing to work out problems, because they will only get paid on their credit default swaps if the company files for bankruptcy. So the protected creditors become standoffish because they want to trigger a default and get their payouts, which basically undermine the negotiations to try to avoid bankruptcy.
Treasury Secretary Timothy Geithner has proposed new regulations for derivatives. Would that help in cases like these?
To the extent that derivative regulations require more transparency, it could help us. If when you were doing a workout you knew what a given bank's CDS position was, that would be helpful, although most regulation that I have seen discussed so far would not require that degree of transparency. The notion that a bank would have to disclose its specific position in a different company has thus far not really been discussed, but it might not be a bad idea. I think the general feeling is that out-of-court workouts are better than just running every company through Chapter 11, which has a variety of social costs.
The last line of your 2007 paper reads as follows: "The growth of credit derivatives raises many important questions, and bears close inspection as the market develops, but in the short term bankruptcy scholars and professionals should avoid the temptation to overreact to a market that may ultimately mature and self-correct without our aid." Do you feel like revisiting that line in light of the events of the last 18 months?
All things considered, looking back at that article now, I had foresight in seeing that credit default swaps would be a big issue but I was perhaps more optimistic than I am today. I think the credit default swap market had its chance, but it's going to have to pay the consequences, which means it's going to have to be subjected to some degree of reasonable regulation. Obviously, what is "reasonable" will be the key.