The American Bankruptcy Institute Commission to Study the Reform of Chapter 11 (the “Commission”) issued its 400-page Final Report and Recommendations (the “Report”) on Dec. 8, 2014. The Report recommends a variety of changes to Chapter 11 of the Bankruptcy Code. In this Alert, we discuss the Report’s recommendations on debtor-in-possession (“DIP”) financing, which, if enacted, could have a significant impact on both prepetition secured lenders and DIP lenders.1
Background on DIP Financing
Many Chapter 11 debtors require DIP financing to operate in bankruptcy. DIP lenders — who often are also the debtor’s prepetition secured lenders — traditionally receive certain inducements, concessions and protections in exchange for making these postpetition loans. For example, prepetition lenders who offer DIP financing often seek:
- Concessions regarding: (1) the validity or enforceability of prepetition liens; and (2) the amount of the lender’s prepetition claims;2
- Inclusion of deadlines to achieve case milestones (e.g., deadlines for the sale of the business or the filing of a disclosure statement and plan);
- The ability to convert prepetition secured debt into DIP financing through a so-called “roll-up”;
- Liens on avoidance actions and their proceeds; and
- Waivers of certain of the debtor’s rights against the lender’s collateral under the Bankruptcy Code.3
These concessions and protections can set the tone for the entire Chapter 11 case. The Commission apparently believes that the pervasive use by DIP lenders of these provisions has tipped the Chapter 11
- For additional discussions of the Report’s recommendations with respect to adequate protection, see our Dec. 22, 2014 Alert, “Priming DIPs: The New Normal?,” and be on the lookout for our forthcoming publications on cross-collateralization restrictions and intercreditor agreements (including the Report’s recommendation to override certain provisions in intercreditor agreements restricting a junior secured creditor’s ability to provide DIP financing).
- This is particularly so where there could be a dispute about the amount of the lender’s prepetition claim, such as when the lender asserts that it is entitled to a make-whole or prepayment premium.
scales too far in favor of DIP lenders and has recommended several ways to scale back or eliminate many of these protections.
Limitations on Interim DIP Orders
Debtors and lenders often seek interim approval of DIP financing from the bankruptcy court within the first few days of the case, with final approval following several weeks later.4 The Commission was particularly concerned about debtors acceding on an interim basis to DIP lender demands for what the Commission deems “permissible extraordinary financing provisions,” including requiring: (1) the debtor to perform milestones, benchmarks or other tasks (described further in “No Case Milestones in the First 60 Days,” below); (2) that the debtor make representations regarding the validity and extent of a creditor’s liens on the debtor’s property; and (3) that the DIP lender’s prepetition secured debt be rolled up into the postpetition facility (described further in “Limitations on Roll-Ups of Prepetition Debt,” below). The Commission stated that the danger in permitting such “permissible extraordinary financing provisions” in interim financing orders is that parties-in-interest “may not have sufficient time or information to accurately assess the import of such provisions and the impact they may have on the case.”5
Thus, the Report recommends that bankruptcy courts should not approve these “permissible extraordinary financing provisions” in an interim order.6 This recommendation is particularly troubling for secured lenders who are asked at the outset of a case to immediately consent to the use of their cash collateral and/or to provide additional financing. For example, secured lenders often seek agreement with a debtor early in the case on the validity of their prepetition liens and the amount of their prepetition claims to ensure that a debtor will not use the lender’s own cash collateral or proceeds of a DIP loan to litigate with the lender over those matters.7
If enacted, these recommendations could increase the risk profile for DIP lending because these lender protections will not be available upon entry of an interim order when initial advances are made to the debtor. In other words, the protections would not be available until entry of a final order — long after the DIP loan has already been made. To counter this loss of protection, prospective DIP lenders may well seek additional, or other, protections such as higher interest rates to compensate them for the uncertainty and the litigation risk they may face on their prepetition claims.
No Case Milestones in the First 60 Days
DIP lenders sometimes will insist that a debtor agree to establish case milestones to ensure that the debtor remains focused on implementation of its exit strategy. Milestones encourage a debtor to exit bankruptcy quickly to avoid the substantial administrative costs associated with an extended stay in Chapter 11, as well as to minimize the impact of the negative perception of bankruptcy to customers,
- 11 U.S.C. § 364(d). Under Federal Rule of Bankruptcy Procedure 4001(c), a final hearing on a motion to obtain postpetition financing requires at least 14 days’ notice. Thus, debtors generally seek entry of an interim financing order at the “first day hearings,” after which a portion of the financing may be provided, and a final financing order, which may include incremental amounts of financing at least 14 days after the motion is filed, by which time the committee of unsecured creditors usually has been appointed and has had time to analyze the proposed financing.
- Report, at 81.
- Report, at 80.
- Note that while a debtor’s stipulations are typically binding on the debtor when the interim financing order is entered by the bankruptcy court, the creditor’s committee and other parties-in-interest are given time to object to the lender’s claims and liens before the stipulations become binding on them as well.
suppliers and other essential constituents. In recent years, more sales have been conducted and plans filed and/or confirmed in the very early stages of Chapter 11 cases as the use of milestones has become more prevalent.
Nevertheless, the Commission recommends that no DIP financing should be approved that “is subject to milestones, benchmarks, or other provisions that require the trustee [or debtor] to perform certain tasks or satisfy certain conditions within 60 days after the petition date or date of the order for relief.”8 The Report defines “milestones, benchmarks, or other provisions” as those that “relate in a material or significant way to the debtor’s operations” during its bankruptcy case, including deadlines for conducting an auction, closing a sale,9 or filing a disclosure statement and plan.10
The Commission believes that by limiting these milestones in the first two months of the case, the debtor will have more time to conduct robust auctions, explore restructuring alternatives, take advantage of market changes that could lead to better financing terms, and wait out cyclical or seasonal changes in the debtor’s business.11 While it is possible that longer stays in Chapter 11 might achieve some of these objectives, it is also possible that implementation of the proposed 60-day moratorium on milestones in DIP financings could have the opposite effect. Longer Chapter 11 cases may result in lower enterprise values; increased administrative expenses (particularly for professionals) that generally must be paid in full under a plan of reorganization; additional uncertainty on the part of vendors, suppliers and customers; and increased DIP financing costs. Thus, rather than enhancing the estate’s prospects and creditor recoveries through robust processes that seek the highest bidders and lowest financing, the Commission’s proposed change may decrease the value of the debtor’s business, make DIP financing harder to obtain (which could result in more liquidations rather than reorganizations or going-concern sales) and ultimately reduce recoveries for creditors.
Limitations on Roll-Ups of Prepetition Debt
Prepetition lenders often seek to “roll-up” their prepetition debt in order to convert some or all of their prepetition secured debt into postpetition secured debt, which often enjoys additional protections and benefits (e.g., a more senior claim priority, a broader collateral base, etc.).12
The Commission sees a potential for abuse when a prepetition lender can improve its claim priority or obtain a larger collateral base, particularly if the putative DIP loan does not provide much new cash to the estate.13 The Report thus recommends that no roll-up of prepetition debt into a DIP facility should
- Report, at 73, 79-80. The Report also recommends that the debtor put together a “valuation information package” (“VIP”) that will include tax returns, annual financials, independent appraisals of the debtor’s assets, and recent business plans or projections shared with prepetition existing or potential investors. Report, at 45. The Report further recommends that any motion to approve DIP financing filed within 60 days after the petition should include a list of the information included in the VIP, and that parties-in-interest may request a copy of the VIP for a “proper purpose,” which they can receive if they execute a confidentiality agreement and, in certain instances, agree to restrict their trading activity. Id.
- We will provide a more complete discussion of the Report’s recommendations on sales in Chapter 11, including its recommendation that sales be prohibited in the first 60 days of the debtor’s bankruptcy case except in certain circumstances, in a forthcoming Alert.
- Report, at 80. The Report clarifies that payment of scheduled loan amounts, loan covenants, reporting requirements and compliance with a budget would not be affected by its recommendation as long as such markers were not “disguised milestones or benchmarks.”
- Report, at 87.
- While the Commission uses the term “roll-up” to refer to any situation in which proceeds of postpetition financing are used to pay off prepetition debt, bankruptcy practitioners generally view roll-ups as the use of DIP financing proceeds to repay the DIP lender’s own prepetition debt.
- Report, at 77-78.
be permitted unless the bankruptcy court finds that the proposed DIP financing is in the best interests of the debtor’s estate and:
- The DIP facility is provided by new lenders who do not directly or indirectly hold the prepetition debt that will be paid down; or
- The DIP lender “repays the prepetition facility in cash, extends substantial new credit to the debtor, and provides more financing on better terms than alternative facilities offered to the debtor.”14
Further, if one or more of the DIP lenders is also a prepetition lender, and prepetition debt is being refinanced by or rolled up into the DIP facility, the roll-up cannot be effectuated until entry of the final financing order (rather than the interim order).15
While the Commission’s stated goal is to make DIP financing more readily available to debtors, the proposed limitation on roll-ups could have the opposite effect for a debtor’s prepetition lenders, who may wish to provide DIP financing to protect their prepetition investment. Absent the ability to roll-up their prepetition debt, prepetition secured lenders likely will view DIP lending as a less attractive opportunity.16 Moreover, without the realistic opportunity to provide future DIP financing, lenders may make prepetition financing more expensive for borrowers. Neither result appears to be consistent with the Commission’s objectives. While potential DIP lenders outside the existing capital structure may welcome certain of these changes, these lenders may be more interested in quickly realizing a return on their investment, rather than working to stabilize and optimize the debtor’s operations on a long-term basis.
No DIP Liens or Claims on Avoidance Actions or Proceeds
DIP lenders often seek a lien on avoidance actions (e.g., preference and fraudulent conveyance actions) or proceeds thereof.17 The Commission, however, believes that a DIP lender has other means to secure its DIP financing, and that avoidance actions and the proceeds thereof may be a principal source of returns for general unsecured creditors.18
Thus, the Commission recommends that a court should not approve DIP financing that grants a lien on or claim to the estate’s avoidance actions or the proceeds of such actions.19 Implementation of this proposal would remove from the reach of DIP lenders a potentially significant source of collateral, thus either reducing the appeal of providing DIP financing or requiring debtors to pay higher interest rates to compensate for the DIP lender’s increased risk profile.
- While the second prong of the above-mentioned test would still allow a prepetition lender to roll-up its debt into the DIP facility, it is unclear what constitutes “substantial new credit” or “better terms.”
- Debtors are often receptive to granting liens on avoidance actions to lenders because a lender who will either provide exit financing under a plan or ultimately own the business through a credit bid will be less likely to actually sue the recipients of such preferences and fraudulent conveyances (who are usually the company’s existing vendors and customers) than a Chapter 7 trustee or creditor’s committee that has no incentive to keep vendors and customers happy.
- Report, at 78.
- Report, at 73. As discussed in “Priming DIPs: The New Normal?,” the Commission’s recommendations may allow liens on avoidance actions or proceeds as adequate protection for prepetition lenders where other methods of adequate protection have failed.
No Waivers of Certain of the Debtor’s Rights Under the Bankruptcy Code
There are two waivers that prepetition lenders who offer DIP financing typically attempt to obtain from a lender:
- Section 506(c) Waiver. Under Section 506(c), the debtor can surcharge or recover from a prepetition secured lenders’ collateral the “reasonable, necessary costs and expenses of preserving, or disposing of,” such collateral, provided such expenses directly benefit the secured lenders or the collateral.20
- Section 552(b) Equities of the Case Waiver. As a general rule, Section 552(a) of the Bankruptcy Code invalidates after-acquired property clauses in prepetition security agreements after the petition date.21 Section 552(b) of the Bankruptcy Code provides an exception to the general rule for liens attaching to proceeds of prepetition collateral (as well as certain types of rent). This exception to the general rule, however, has its own exception, which provides that a court may limit or even eliminate the secured lender’s lien in proceeds under 552(b) “based on the equities of the case.”22
Lenders often seek waivers of the debtor’s rights under Sections 506(c) and 552(b) in the DIP documents. The Commission believes a debtor should not be permitted to waive either protection.23
DIP lenders generally provide a limited carve-out for payment of a debtor’s professional expenses and certain administrative claims or unsecured claims in exchange for a waiver of the debtor’s Section 506(c) right to surcharge the lender’s prepetition collateral. The Commission, however, felt that the debtor often has little power to negotiate the carve-out and the waiver often affected other stakeholders as well.24 The Commission also believes that debtors “should not be able to waive, or enter into any agreement affecting, a court’s ability to limit or alter a secured creditor’s interest in the debtor’s or the estate’s property based on the equities of the case under section 552(b) of the Bankruptcy Code.”25
The Commission’s recommendations to prohibit these waivers, when coupled with its other recommendations, would further erode prepetition lenders’ incentives to provide DIP financing. Rather than foster a more robust market for DIP financing options for debtors, this has the potential to reduce the availability of DIP financing from prepetition lenders.
The Commission’s proposed changes regarding DIP financing collectively represent a dramatic departure from the protections currently afforded to lenders. Enactment of these proposals likely will make DIP
- Report, at 227. Such expenses may include expenses related to maintaining and preserving collateral, operating the business and, in some jurisdictions, even the debtor’s attorney’s fees.
- In concept, this is supposed to provide the debtor access to unencumbered cash with which to fund its case, thus improving its chances of a successful reorganization.
- “The principal purpose of the equities of the case exception is to prevent secured creditors from reaping unjust benefits from an increase in the value of collateral during a bankruptcy case resulting from the debtor’s use of other assets of the estate, or from the investment of non- estate assets.” Toso v. Bank of Stockton (In re Toso), 2007 WL 7540985, at *13 (B.A.P. 9th Cir. Jan. 10, 2007).
- Report, at 226, 230.
- Report, at 230.
- Report, at 230. The Commission also declined to adopt a federal definition of the term “proceeds,” instead leaving that definition to state law. financing less attractive to the debtor’s prepetition lenders who may be the debtor’s sole potential source of DIP financing. Further, the lack of “traditional” DIP protections could cause lenders to hesitate before lending to distressed companies or force those companies to provide other forms of protection, such as higher interest rates or more expansive make-whole provisions. Enactment could also lead to longer and more expensive cases, particularly if expedited sale or plan processes are no longer permitted, which could erode recoveries for junior and unsecured creditors.
While some of these changes, particularly when coupled with the Commission’s recommendations concerning adequate protection, may make it easier for new lenders to provide DIP financing, such new DIP lenders may only be interested in opportunistically seeking returns and not providing meaningful opportunities for the reorganization of the debtor’s business. Though the Commission’s recommendations are likely to take several years to be implemented, if ever, lenders to distressed companies should be mindful of these potential changes in making their current credit decisions.