As several U.S. automakers teeter on the brink of collapse, the prospect of bankruptcy reorganization has become a present-day reality for two of the largest automakers in the U.S. Reorganization would involve plant closures, brand elimination, layoffs, union concessions, reduced dealer networks, asset sales and creditor compromise. What is perhaps less obvious is the part that this codependence will play between the domestic automakers and their suppliers in Detroit’s potential road to recovery. Unless the courts grant “critical vendor” status to many parts suppliers, there are risks of widespread collapse in the supply chain. If the collapse occurs, production lines could be disrupted or shut down because of the automakers’ inability to obtain parts.
After losing tens of billions of dollars, domestic automakers needed a government bailout. By the end of February 2009, General Motors (GM) and Chrysler received $17.4 billion in bailout funding, with requests pending for an additional $21.4 billion (Ford did not utilize bailout funds). Millions of jobs are at risk if the domestic automakers fail—not just at the automakers, but across the complete supply chain. The Center for Automotive Research estimated that nearly three million jobs would be lost if Detroit’s automobile production ceased. Approximately 500,000 people work directly for the domestic automakers, with another 2.5 million being part of the supply chain. In his recent speech to the combined session of Congress, President Obama said:
[W]e are committed to the goal of a retooled, reimagined auto industry that can compete and win. Millions of jobs depend on it. Scores of communities depend on it. And I believe the nation that invented the automobile cannot walk away from it.
Given this industry’s significance to the U.S. economy, its prospect of being eliminated remains small. Aggressive restructuring actions need to be implemented to return the industry to profitability. The forum for these restructurings will either be (1) restructuring out of court, (2) prepackaged bankruptcy or (3) normal bankruptcy proceedings.
Having received initial government funding in December 2008, negotiations have taken place with various constituencies in order to reach an agreement on the terms of an out-of-court restructuring. As part of the bailout, the U.S. government gave GM and Chrysler 60 days to present a comprehensive restructuring plan, and another 45 days to demonstrate significant progress toward becoming profitable. It required that the automakers limit executive compensation, obtain union concessions, agree to debt-for-equity swaps with bondholders and demonstrate viability by March 31, 2009.
However, given the complexity of these negotiations and the skepticism that abounds from Detroit’s decades-long restructuring, gaps among the constituents may not be bridgeable. Chrysler succumbed to the protections of bankruptcy on April 30, 2009, and GM followed suit on June 1, 2009. Both automakers filed for bankruptcy in the Southern District of New York.
If bankruptcy is inevitable for these big players in the automotive industry and others who may file for bankruptcy in the near future, the general consensus seems to be for a prepackaged bankruptcy rather than a traditional unstructured filing. Automobiles are not consumables, and buyers rely on the availability of warranties and parts when making decisions. In a protracted bankruptcy with no certainty of emergence, consumers are likely to switch to automakers that are operating normally. If executed correctly, this type of filing would provide the automakers with the ability to cleanse both their legacy issues and uncompetitive capital structures while allowing them to quickly emerge, thereby easing the minds of the consumer public.
Given that many parts are sole-sourced, addressing Detroit’s supplier base is critical to achieving a successful prepackaged filing. Many suppliers are smaller, independent companies with a heavy reliance on Detroit. GM alone has 21,000 parts suppliers, and it is estimated that the domestic automakers share approximately 70 percent of its suppliers. If existing receivable balances are treated in the normal order of priority, many of these suppliers may collapse from lost working capital, which could jeopardize attempts by the overall industry to reorganize.
The reason that the Bankruptcy Code is helpful to debtors is precisely why it is challenging for creditors and potentially fatal for the automotive industry: Prepetition claims cannot be paid without a plan or separate order of the court, and 11 U.S.C. §101, et seq., requires payment in a specified-priority order. Orders allowing payment of prepetition claims prior to plan approval are uncommon, with first-day critical vendor motions being one possible avenue. If the automakers file, they will need to carefully delineate their creditor pool between critical and noncritical vendors, likely along the lines of sole-source supply, and they will also need to be strong advocates for critical vendor rulings.
Section 105(a) of the Code offers one possible solution to payments, and this section is often the legal basis applied by the courts to assign “critical” status to a vendor, enabling payment outside the normal order of priority. The "doctrine of necessity" often complements §105(a) in reorganization cases. This doctrine requires that the payment of critical vendors provide for a greater overall recovery to the remaining creditors, on the basis that absent such payments, the reorganization would fail, with the estate suffering substantial harm.
Whether a vendor is “critical” depends on its impact to the debtor. If deemed absolutely necessary for the success of the debtor, then it could be classed as a “critical vendor.” A vendor is not deemed to be critical merely because it will not supply products or services to a debtor: The court must be convinced that there is no alternative source of supply at reasonably similar pricing for these products or services. Texas bankruptcy courts recently established a three-part test to determine whether a vendor is critical. See In re Co-Serv LLC, 273 B.R. 487, 497 (Bankr. N.D. Tex. 2003); In re Mirant Corp., 296 B.R. 427 (Bankr. N.D. Tex. 2003):
(1) Does the debtor have a critical need to deal with the creditor?
(2) If the debtor does not deal with this specific creditor is there:
(a) probability of harm; or
(b) loss of economic benefit to the estate’s value disproportionate to the payment required?
(3) Is payment the only practical or legal solution to the logjam?
If the answer is “yes,” then the vendor could be ruled as critical. It was also concluded that §105(a) alone could not justify application of the doctrine of necessity. In Co-Serv, the trustee’s obligation to protect the going-concern value of the debtor, pursuant to §1107(a), provided the “bridge” that was necessary to allow application of the doctrine of necessity through §105(a).
The courts are not always willing to support critical-vendor status, carve-outs and other forms of priority order treatment. In the Kmart bankruptcy in Illinois (See In re Kmart Corp., 359 F.3d 866 (7th Cir. 2004)), the Seventh Circuit affirmed a district court decision by denying the validity of the bankruptcy court’s critical-vendor order. Specifically, it held that the bankruptcy court could not create statutory authority contrary to the explicit priority scheme of the Code based on §105(a). Id. at 869-71. It characterized the doctrine of necessity as “just a fancy name for a power to depart from the Code.” Id. at 871.
The Kmart ruling was not an outright rejection of the critical-vendor concept, but it will make it harder for the automakers to apply for these concessions. In addition to the §105 limitation, the Kmart-suggested compliance with heightened procedural and evidentiary standards is necessary before any payment can be deemed critical. The decision could also affect the timing of critical-vendor motions, as the Seventh Circuit expressed concern with expedited approvals because they fail to give advanced notice to affected creditors. Even if the apparent justification for critical-vendor payments exists, other creditors are entitled to adequate notice and an opportunity for a hearing as a prerequisite to granting such relief. These delays may lead to the collapse of smaller automaker vendors that do not have sufficient working capital to withstand their receivables being frozen and/or deemed ineligible. The position of Detroit’s critical suppliers will also be impacted by certain changes made in 2005 amendments to the Bankruptcy Code:
(1) Payment priorities were adjusted so that the value of ordinary-course supplies provided by vendors within 20 days of the bankruptcy filing would be given priority ahead of general unsecured claims. However, this change has little benefit to the working-capital needs of Detroit’s suppliers since they would still have to participate in the proof-of-claim process while not being paid until the end of the case. In a prepackaged bankruptcy, this timing may be short—but fatal—to the suppliers and the automakers.
(2) Amendments to the Code also included the expansion of reclamation rights to 45 days. Suppliers now have the right to recover any goods that had been supplied within the 45-day period prior to their customers filing. This sounds helpful, but in reality, there are numerous barriers that prevent this from happening expeditiously. Even if the reclamation process is successful, there are still costs to prosecute these claims and to recover the goods.
The courts usually determine specific categories of critical vendors rather than make rulings on a vendor-by-vendor basis. Given the codependence between the domestic automakers and parts suppliers, it would seem likely that the debtors would seek to class as many of their parts suppliers as possible as critical vendors to be paid in the ordinary course. This would provide for the least disruption to production, thereby maximizing the opportunity for the domestic automakers to successfully reorganize.