Published November 5, 2013, Los Angeles Daily Journal – Few words can describe the unmitigated disaster that nearly befell our country last month when a New York bankruptcy judge was set to rule on one of the most explosive cases before the judiciary. The ruling could have inflicted untold damage on our fragile economy, sending scores of citizens into the financial abyss, and disrupting business relationships central to our continued viability. Yet, by the narrowest of chances, the matter settled on Oct. 21 after several failed mediation attempts and a hotly contested trial.

What was at issue was whether General Motors had fraudulently diverted hundreds of millions of dollars away from the bankruptcy court in an effort to shield assets from the insolvency process and give a group of the company’s important creditors preferential treatment. The trial centered around whether GM secretly made a deal with a collection of hedge funds who owned $1.3 billion in bonds after the bankruptcy proceedings were initiated, and then backdated the agreement to before the date of the bankruptcy filing.

The mischief was discovered by a trust representing GM’s unsecured creditors in 2012, who filed a lawsuit in the bankruptcy court where GM’s insolvency proceedings were initiated. The matter was assigned to Judge Robert Gerber, the same judge who presided over GM restructuring proceedings and who ultimately approved the pre-packaged bankruptcy that enabled the automaker to shed billions in debt.

The case, formally known as Motors Liquidation Company CUG Trust v. Appaloosa Investment Ltd, et al., sought to set aside the deal with the hedge funds and claw back the $450 million in cash that was transferred away from bankrupt the company as part of the transaction. Yet, the real question was whether the alleged act of dishonesty would give the bankruptcy court cause to set aside the entire bankruptcy proceeding — an event that would have catastrophic implications.

GM’s 2009 Chapter 11 filing was the fourth largest in U.S. history, behind Lehman Brothers, Washington Mutual and WorldCom, and sought to rid the company of billions in debt. At the time of filing, GM stated that it had $82 billion in assets and $173 billion in debt. The pre-packaged bankruptcy filing allowed the company to sell off its best assets to “new” GM, leaving the remainder of the old company to be liquidated for the benefit of creditors.

Setting aside the bankruptcy would saddle new GM with billions in debt, and reinstate obligations long considered to be voided — events that would cast long shadows over our current recovery. Not only would GM immediately become financially strapped, but uncertainty would shudder throughout the economy. For instance, legitimate questions would surface about whether the 1,200 GM dealers who were terminated in the bankruptcy proceeding would be automatically reinstated, or whether the tens of thousands of GM retirees would have their retirement benefits returned.

To be sure, the threat of collapse was acutely understood. As Judge Gerber stated upon learning of the hedge fund deal: “When I heard about that, it wasn’t just a surprise, it was a shock … The bottom line is, is that this matter is huge … There was a lack of disclosure to the court on the matter with the potential to injure [GM] creditors to the extent of hundreds of millions, if not billions of dollars.”

What caused the hedge fund deal to be cut in the first place is actually quite interesting. In 2006, believing that GM was headed toward bankruptcy, Fortress Investment Group began buying bonds at a steep discount that were issued by GM Nova Scotia Finance Co., a subsidiary of GM Canada. Other hedge funds soon joined in, and by June 2009 four hedge funds owned $1.3 billion in the Canadian company’s bonds.

As GM began preparing its restructuring package, it realized that the hedge funds were in a position to force GM Canada into bankruptcy, an event that would greatly impact GM’s planned bankruptcy in the U.S. If the Canadian unit was forced into bankruptcy in Canada, the chances of GM having an expedited bankruptcy in the U.S. would evaporate.

On Friday, May 29, 2009 — three days before the June 1 deadline given to GM by the U.S. Treasury — representatives from GM and the hedge funds met in New York at the offices of GM’s lawyers to negotiate a deal that would keep GM Canada out of bankruptcy. GM needed the hedge funds to waive the $1.3 billion owed to them under the Canadian bonds, and the bond holders used every ounce of leverage they had.

After negotiating through the weekend, a deal was finally struck: The hedge funds would waive the $1.3 billion owed, and GM would transfer $450 million to GM Canada, of which $367 million would be given to the bond holders, and the hedge funds would be entitled to submit a claim to the U.S. bankruptcy court in the amount of $2.67 billion.

The problem, however, was that the deal was allegedly consummated after the actual bankruptcy filing. The lawsuit by the creditors trust claims that the bankruptcy was filed on June 1, 2009, at 7:57 a.m., but that the hedge fund deal was not completed until  later that morning. The creditors claim that metadata shows that the agreement was not finalized until 10:37 a.m. — two hours and 40 minutes after the bankruptcy filing — making it a post-petition transaction that would require bankruptcy court approval. The failure to obtain the approval would vitiate the agreement, and could reopen the entire bankruptcy proceeding.

GM appeared to be concerned about the claim. While it stated that it considered the lawsuit to be meritless, at the same time it filed documents with U.S. Securities and Exchange Commission that its exposure to the lawsuit could be as much as $918 million. Some believe that number to be woefully understated.

After the case proceeded to trial, and while the parties were awaiting Judge Gerber’s decision, a settlement was reached that avoided the tremendous uncertainty associated with a court ruling. Under the terms of the deal, new GM will pay the hedge funds $50 million cash, and the funds will reduce their claims in the bankruptcy court from $2.67 billion to $1.55 billion.

The settlement appears to be a windfall to the bondholders. They bought $1.3 billion in bonds at a steep discount, and received $367 million in June 2009, with an additional $50 million to be paid now. In addition, they will be entitled to make a claim in the bankruptcy court for $1.55 billion, which is reported to be paid out in stock in new GM.

While the deal with the bondholders is indeed rich, it avoids a calamity of epic proportions. Reopening the bankruptcy — a very possible outcome — would have threatened the viability of the reconstituted GM, and initiated a firestorm of litigation throughout the nation. For all concerned, we can rest easy knowing that this is one disaster that was thankfully averted.