This installment of the Weil Bankruptcy Blog’s series on the ABI Commission Report is the first of two posts that address the Commission’s recommendations relating to postpetition financing. This post covers the Commission’s recommendations with respect to adequate protection and a subsequent post will cover the Commission’s recommendations with respect to certain controversial terms in postpetition financing agreements and the timing of approval for certain other financing terms.
Adequate Protection – Valuation Standard
Fittingly, the Commission started its discussion of adequate protection by addressing the issue it found to be “at the heart of the adequate protection determination”: Valuation.
The Commission observed that section 361 of the Bankruptcy Code, which establishes the possible forms of adequate protection, does not provide a valuation standard by which courts should assess the sufficiency of such adequate protection. Consequently, courts have adopted a variety of standards for this purpose (e.g., liquidation, going concern, and market values). To facilitate greater consistency, the Commission recommended the adoption of a single standard to determine whether a secured creditor’s interest in property of the estate is adequately protected.
The Commission first considered using liquidation value as the standard, but rejected that approach as it generally produces a lower valuation, which would facilitate a debtor’s use of collateral but potentially reduce secured creditor recoveries in the case. The Commission next considered using going concern value as the standard, but rejected that approach too as it generally leads to a higher valuation, which would provide greater protection to secured creditors (perhaps too much protection where the secured creditor does not have an interest in all of the debtor’s assets) but potentially reduce a debtor’s financing and reorganization options. Finally, the Commission agreed that the appropriate standard was the “foreclosure value” of the secured creditor’s interest, which it defined as “the net value that a secured creditor would realize upon a hypothetical, commercially reasonable foreclosure sale of the secured creditor’s collateral under applicable nonbankruptcy law,” measured as of the time of the secured creditor’s request for, or parties’ agreement to provide, adequate protection. Foreclosure value, the Commission concluded, is the appropriate standard because it “is meant to capture … the value that a secured creditor’s state law foreclosure efforts would produce if the automatic stay were lifted or the bankruptcy case had not been filed.” The Commission reasoned that the adoption of this standard is “an integral part of the delicate balance” that it sought to strike between the rights of secured creditors and the reorganizational objectives of the estate.
The Commission, however, was careful to note the flexibility of section 506(a) and made clear that foreclosure value “should not necessarily determine the value of such collateral or the secured creditor’s allowed claim for other purposes in the chapter 11 case.” As an example, the Commission noted its conclusion, presented elsewhere in the report, that a secured creditor is entitled to receive the “reorganization value” of its interest in the debtor’s property in the claims allowance and distribution process at the end of the case.
Adequate Protection – Equity Cushion & Other Recommendations
In the event a bankruptcy court determines that the hypothetical 363 sale of a secured creditor’s collateral would realize net cash value in excess of that collateral’s foreclosure value (a “value differential” in Commission parlance), the Commission recommended that the bankruptcy court should be allowed to find that the secured creditor is adequately protected “in whole or in part” by such value differential. Although the Commission at times used the terms value differential and equity cushion interchangeably, the two terms appear to be distinguishable. Whereas the Commission defined value differential to mean the difference between the 363 sale value and the foreclosure value of collateral, an equity cushion is commonly defined as the difference between the value of collateral and the total amount of claims secured by that collateral. Thus, a value differential could exist even though there is no equity cushion.
Where a value differential serves as adequate protection, the Commission would also have the adequate protection order include a provision that would compel the debtor to sell the collateral (unless the secured creditor elects otherwise) “if the debtor in possession’s reorganization efforts fail, or if the court subsequently finds cause that would support lifting the automatic stay with respect to the secured creditor’s collateral.” The Commission added this protection to reflect “the reality that, if adequate protection is provided based on the reorganization value of the collateral, the secured creditor should have a means of realizing such reorganization value if adequate protection is subsequently proven to insufficiently protect the secured creditor’s interests.” The Commissioners noted that secured creditors could potentially abuse this mechanic by impeding the debtor’s reorganization efforts to trigger their right to force a sale, but determined that such behavior is generally counterproductive for secured creditors and could be contained by the bankruptcy court’s enforcement of its order.
In addition, the Commission recommended (i) that forward cross-collateralization (i.e., securing prepetition debt with postpetition assets) may be used to provide adequate protection, but only to the extent that such cross-collateralization covers a decrease in the value of collateral as of the petition date, (ii) that a secured creditor should receive a priority claim under section 507(b) of the Bankruptcy Code for the foreclosure value at the time of the request for adequate protection (and the Bankruptcy Code should be amended to overturn existing case law holding that a secured creditor must actually be provided with adequate protection to obtain the benefit of section 507(b)), and, finally, (iii) a prohibition on adequate protection in the form of a lien on, or any interest in (including a superpriority claim against), the chapter 5 avoidance actions held by the estate or the proceeds of such actions.
Adequate Protection – Observations
Adopting a single valuation standard for determining adequate protection would promote consistency of judicial outcomes, which is generally beneficial to all parties in interest. Whether or not adopting foreclosure value as that standard successfully strikes the “delicate balance” that the Commission sought is another matter. Foreclosure values are typically lower, which would make it easier for debtors to establish the adequate protection necessary to access secured creditors’ cash collateral and to secure postpetition financing on a priming basis. Yet, this benefit for debtors may leave secured creditors worse off than they are today as they would invariably lose negotiating leverage early in the case and may risk diminished recoveries as debtors layer-on more senior postpetition debt.
Depending on how the foreclosure standard is applied, prepetition lenders that took “blanket liens” to secure loans underwritten on the basis of the borrower’s revenue or cash flow may be at particular risk because the spread between the foreclosure value and the 363 sale value (i.e., the equity cushion/value differential) could be larger and, therefore, more easily primed. But courts could also apply that standard to find that, under such circumstances, a “commercially reasonable foreclosure sale” would produce a valuation closer to a going concern value, providing more protection. Moreover, to the extent that a secured creditor is adequately protected by the value differential/equity cushion, that creditor would be able to compel a sale if the debtor’s reorganization efforts “fail” or there is cause to lift the stay. If, however, there is a significant amount of senior, priming debt that must also be repaid from sale proceeds, this protection may be cold comfort for a secured creditor.
Additionally, easier access to cash collateral and postpetition financing on a priming basis may allow junior creditors or equity holders to extend postpetition financing (possibly on below-market terms) simply to extend the debtor’s chapter 11 case with the hope that market conditions improve to the point that their junior claims or interests are back in-the-money. Should value continue to drop, the secured creditors would take the hit because junior claims or interests were already out-of-the-money. At the same time, because the secured creditor would be “adequately protected,” its cash collateral may also be used to pay the costs of restructuring. In essence, junior creditors or equity holders can purchase a risk-free option, the costs of which are borne by the prepetition secured lenders. Although this strategy is not new, it becomes much easier to implement if the Commission’s recommendations are adopted.
Adequate Protection – Market Perspective
The Commission’s report was released on December 8, 2014 and it didn’t take long for the secured lending community to voice concerns about the potentially negative consequences of the recommendations for postpetition financing. The reaction was such that, on February 4, 2015, the co-chairs of the Commission, Messrs. Robert Keach and Albert Togut, issued a response here to a “minority of critics” and argued that “[t]he Commission’s recommendations, taken as a whole (rather than cherry-picked), are decidedly lender-friendly.”
With respect to the recommendation on adequate protection, Messrs. Keach and Togut noted the “critical” distinction between foreclosure value and liquidation value and underscored the flexibility of foreclosure value, stating that:
Depending on the scope of the secured lender’s rights in collateral and the types of collateral covered, “foreclosure value” could lie on a continuum between “forced-sale value” and going concern value (in the case of a creditor with an all assets lien on collateral located in a single state, for example).
They went on to argue that the adoption of a valuation standard based on the amount a secured creditor would realize upon foreclosure under applicable non-bankruptcy law “is consistent with the entire purpose of adequate protection” because adequate protection is intended to protect a secured creditor from loss of value due to the stay on its right to foreclose under non-bankruptcy law. Therefore, adopting foreclosure value as the standard allows “the debtor to use cash collateral and/or to finance its case, while at the same time providing protection of the secured lender’s rights (and expected return) under state law.”
Messrs. Keach and Togut further respond to critics by touting the Commission’s recommendations regarding a secured creditor’s right, under certain circumstances, to compel a 363 sale if adequately protected by an equity cushion/value differential and a secured creditor’s right to receive reorganization value up to the full amount of its allowed claim under a plan or 363 sale. They argue that these “safeguards” ensure that secured creditors will not suffer diminished recoveries due to the Commission’s “proposed clarification” on the valuation standard adequate protection.
The arguments put forward by the Commission, as further explained by Messrs. Keach and Togut, may have a certain intellectual appeal, but they do not necessarily support a conclusion that the Commission’s recommendations on adequate protection are “lender-friendly.” The concerns raised above (and by secured lending community) likely remain and secured creditors should continue to be focused on the reform process as it develops.