GM Files for Bankruptcy

GM's Chapter 11 filing caps a decades-long slide, but it should emerge relatively quickly from court with lower labor and debt costs

A once proud and dominant General Motors, which at its peak controlled half the American auto market, filed for bankruptcy court protection on June 1 in an historic act that will see federal taxpayers own 60% of a smaller, reorganized company.

After decades of decline, GM (GM) was finally brought to its knees by the recession and frozen credit markets, forcing the company into the arms of the federal government. But the money the government gave to keep GM upright—$19.4 billion to date and as much as $30.1 billion more down the line—came with big strings. President Barack Obama wanted GM to completely restructure so it could become competitive again. The only way to get the savings the carmaker needed from bondholders and its sprawling dealer network was under the umbrella of court supervision.

With the bankruptcy, GM will get a chance at a new start. Management and its government overseers hope GM can wipe away decades of outsized retiree and labor costs and brand-and-marketing strategy, both of which were designed for an era that had long passed. The result will be a much smaller GM, one that won't even challenge Toyota (TM) for the crown of world's biggest car company. But with far less debt and a reworked labor contract that will get costs closer to foreign-owned auto plants in the U.S., the new GM has a shot at regaining profitability and becoming competitive again. Legendary GM Chairman Alfred Sloan's strategy of selling a "car for every purse and purpose" will still be in place, but the models will be sold through four focused brands—Chevrolet, GMC, Buick, and Cadillac—instead of eight.

The plan is to have the new GM emerge from court protection relatively quickly, perhaps within 60 to 90 days. Meanwhile, some of the weak brands—Hummer, Saab, Saturn, and Pontiac—plus any unwanted assets, such as factories, would stay with the old company, which would be liquidated. All of those brands are already for sale, except for Pontiac, which will be shut down.

Everyone's Banking on a Turnaround

The federal government will hold 60% of the new company's stock in exchange for forgiving all but $9 billion of the loans it extended. Similarly, the governments of Ontario and Canada will loan GM $9.5 billion and will forgive all but $1.7 billion and keep 12% of the stock in the new company. By the time GM is on its feet, the U.S. government will have loaned it about $50 billion. For the U.S. and Canadian governments to recoup their investments, GM's stock value—all but vanished today, to below $1 billion—would need to eventually be worth about $69 billion. Says the Administration official: "I don't know how much we're going to recover. We hope to recover as much as we can."

Bondholders and the United Auto Workers union are also relying on GM to come roaring back. The union agreed to take 17.5% equity in the new GM, stock warrants for an additional 2.5% of the company, plus $2.5 billion in cash and $6.5 billion in preferred stock that pays a $585 million annual dividend—all in place of the $20 billion GM had pledged to the UAW to start a Voluntary Employee Benefits Assn., or VEBA. That entity, which GM set up in an earlier attempt to offload its massive health-care plan for workers and retirees, will pay medical benefits the way a pension fund pays retiree checks. Bondholders, meanwhile, would take 10% of GM's stock and warrants that could eventually give them an additional 15% of the company in exchange for the $27.2 billion of GM debt they hold.

In another twist, GM will be a private company for 6 to 18 months while it reorganizes, a Treasury official said. Its publicly traded stock has been a component of the Dow Jones industrial index for many years.

GM is also getting a new board.

Some current members will stay, but a new majority will be put in place. The government will have input as a major shareholder in the new GM. In another twist, GM will be a private company for 6 to 18 months while it reorganizes, a Treasury official said. Its publicly traded stock has been a component of the Dow Jones industrial index since 1925. Canada and the UAW's health-care trust will each get a seat on the board. A senior Administration official said board members will be picked based on their business background regardless of political affiliation. The Administration and the company are "seeking business leaders and former CEOs," the official said.

For the government, union, or bondholders to get their cash back, GM will have to be successful. Management and Treasury think they have the right plan in place to do that. GM's debt will shrink from well in excess of $60 billion to about $17 billion. Even better, by offloading worker health-care costs to the VEBA trust and seeding it mostly with stock instead of cash, GM has been relieved of paying more than $4 billion a year in medical costs. "Our balance sheet was our greatest weakness," CEO Frederick A. "Fritz" Henderson said in an interview. "We will fix that."

There will be pain for many workers, dealers, and creditors, though. If the bankruptcy court agrees with management's plan, GM's bondholders would take a big haircut even if the company's stock has some value; the steep discount on their holdings remains the biggest hurdle to a fast reorganization. While GM has greatly reduced its workforce, about one-third of GM's remaining 54,000 factory workers could still lose their jobs since the company plans to close 11 more plants, though the workers will likely be bought out and sent into retirement. And if GM's stock doesn't do well, the UAW will have to further cut medical benefits for workers covered by the union's own trust. On the retail front, GM also plans to get rid of 1,600 of its 4,800 dealers by the end of 2010.

A 50%-plus share at its peak

The reason all those the moves are necessary is because GM's business model was broken for years. Agreements at the bargaining table to pay generous health-care and retirement benefits cost the company of billions of dollars that could have gone into new models, investments in new technology, and marketing. And the need to fund those big workforce obligations—along with restrictions on the company's ability to cut workers or make its factories more flexible—required management to fight for every bit of market share. If sales dropped too far—regardless of whether they were producing a profit—the company feared it wouldn't be able to generate the cash to cover its huge fixed costs.

The "zero percent" showroom wars GM waged in recent years drove auto sales to historic highs but in fact reflected the sickness of GM's structure. The company had too many plants because union contracts all but forbade layoffs. Even if workers had no work, they made 95% of their pay while idled. So GM was loath to close plants. Management figured if it was going to pay money for rebates to keep sales up or for furlough pay, it may as well keep sales going.

GM's market share losses have been an ongoing problem since its share of the U.S. market peaked at more than 50% in 1962. Since then, numerous GM CEOs and marketing executives have sworn they would stop the slide, but there were only a few periods when the company held ground. GM had close to a 30% share at the start of the decade but just 19.1% so far this year. GM says it can hold 18.5% in the next few years, but analysts expect it to be more like 14% to 17%. Wherever it is, GM will have to be sized to meet that share profitably. Says Henderson: "We'll have capacity at the right levels."

GM's dealer network was equally problematic. Dealer franchise laws in nearly every state make it easy for dealers to sue if GM gets rid of a brand. The company's decision in 2000 to close Oldsmobile cost it some $2 billion.

So GM wound up spreading its resources thin, often designing models as Saturns or Pontiacs when they would have been better suited to a stronger brand like Chevrolet. The weakling brands also siphoned marketing cash. Plus, GM's dealers average 400 to 500 sales a year in a decent car market, while a good Toyota or Honda dealer could triple that level. That gave competitors higher profits to upgrade showrooms, retain better staff, and take better care of customers. GM's bloated dealer force was losing the battle on the showroom floor.

Partnerships around the globe

Bankruptcy allows GM to break dealer franchise contracts and ditch brands. GM will now be able to spend $1 billion a year to market Chevy, up from $600 million in a typical year. And Cadillac's budget can grow about 50%, to $300 million, says Mark LaNeve, GM's vice-president for North American sales and marketing. That should match the Toyota and Lexus brand budgets in the U.S., he says.

Developing new models will be a simpler affair as well. GMC won't cost much, because its trucks and SUVs will continue to be upscale versions of those sold by Chevy. That may sound like a variation on GM's old brand-straddling theme, but in fairness, GMC's higher pricing shows that it works. Thomas Stephens, GM's new senior vice-president for product development, says he can now use global products and technology to feed Buick and give it a full line of cars and SUVs. Sold together in a showroom with GMC, it will be a higher-priced corporate mate of Chevy.

GM plans to still be able to use the compact and midsize cars engineered in Germany by its Adam Opel unit, Henderson said in an interview done before GM sold a majority stake to Canadian parts maker Magna International (MGA) and its Russian financier Sberbank (SBER.RTS) on May 29. Cash terms weren't disclosed, but Magna will hold 20%, GM keeps 35%, Sberbank gets 35%, and workers will hold the remain 10%. Henderson said in that interview that GM will keep the rights to use the car platforms and engines developed by Opel. It may cut deals to jointly develop them in the future.

But Opel's sale shows just how different GM is becoming. While Chevy is growing in Eastern Europe, Opel is GM's major player on the Continent. With a minority stake in Opel, GM's European business will be much like its Shanghai-GM operation in China, which is 50%-owned by Chinese carmaker SAIC. GM is becoming more and more reliant on joint ventures and partners with others to build and sell cars around the globe.

Speed is key

Of course, all this depends on GM getting a federal bankruptcy judge to agree to its plan. Crosstown rival Chrysler filed its own Chapter 11 proceeding on Apr. 30. Those court proceedings have moved smoothly, with Italy's Fiat Auto apparently set to take over the new Chrysler, while the old company's assets will be liquidated.

Like Chrysler, GM will be split by selling good assets to the new shareholders using Section 363 of the bankruptcy code. The idea was hatched late last year by turnaround expert Jay Alix and attorney Martin Bienenstock of Dewey & LeBoeuf. They figured that if they could get key creditors and the UAW to agree to a new structure before filing for Chapter 11 protection, they could split the company in two and keep the good assets and get the new company out of court fast. The fear all along—expressed by deposed GM Chairman and CEO G. Richard Wagoner Jr.—was that if GM were in court too long, buyers would flee, and the company's revenue would fall too fast for a restructuring to have a chance.

Alix and Bienenstock proposed the idea to GM management in November of last year and then to GM's board in December. Both bought into the idea, but only if they couldn't accomplish what the company needed outside of court, say sources involved with creating the strategy. When the Obama Administration's auto task force came on the scene in February, GM advisers pitched them on the 363 sale and a more traditional prepackaged bankruptcy in which terms would be negotiated with all parties in advance, but GM would remain one company. That was shot down by treasury.

President Obama's auto task force, headed by former private equity executive Steve Rattner and erstwhile United Steelworkers negotiator Ron Bloom, took to the the idea as a better way to ditch liabilities such as dealers, brands, and debt.

The 363 sale proposal gained steam among the key players because it was a way to show that a new GM was being created. It could be presented to the public, much as Treasury is doing now, that GM is getting a fresh start, it will emerge from bankruptcy quickly, so no one should fear buying the company's cars. One sticking point between Treasury and former Chairman G. Richard Wagoner Jr. was his public opposition to bankruptcy. That played at least some part in the administration's decision to fire him, though mostly they needed a scalp to show the public.

Once the task force decided on the 363 sale as the likely outcome, Bienenstock told its members that GM was loaded with too much debt. Even the bankruptcy scenarios would leave the company burdened with borrowings. GM would just replace bond and union debt with Treasury loans. Treasury officials agreed and in April decided they would have to take a major stake in GM rather than just lend the company billions and leave the debt on the balance sheet, say sources involved with the restructuring. The task force and its advisers reckoned they would have a better chance of seeing GM succeed if it were stripped of debt. Then the government may be able to get its investment back by taking equity in a healthy company rather than loaning to one that's heavily in debt.

But while the Obama Administration clearly expects GM's bankruptcy to be similarly speedy, it will be more complex. That's because Chrysler had a smaller group of creditors who agreed to a deal in advance. GM has thousands of bondholders who are likely to oppose the breakup. Treasury officials said 54% of GM's bondholders agreed to accept the exchange and hence will not fight the 363 sale or restructuring plan in court. But others could put up resistance.

Even a minority of bondholders can delay the process, says S. David Cohen, a professor at Pace University School of Law. Creditors get to vote only on the final restructuring plan, Cohen says. But the 363 sale gets done before the restructuring plan is submitted to the bankruptcy judge. Since splitting GM in two through the 363 sale accomplishes most of the company's reorganization, some creditors might hire counsel to fight it if they don't feel they are being treated fairly. They may think that once the sale is done and it restructures the company, voting against the reorganization plan would be futile. So they may pitch their fight early in the bankruptcy process by fighting the 363 sale.

"Some creditors would oppose the 363 because it gets you a long way toward the restructuring plan," Cohen says. "I can see counsel opposing this on grounds that it does an end run around creditors' voting rights." While they may fight, Cohen says they will have a tough time proving that the 363 sale is not in GM's best interest.

If GM is able to move through court relatively quickly, it may defy those who predicted catastrophe for such a massive bankruptcy. The company will still face a horribly slumping economy, and it will have to fight its own battered image. But if American consumers give the new GM a look, it could finally emerge a winner.

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