The extraordinary turmoil in the financial markets in recent times has caused many major economies, including the Canadian economy, to enter into a recessionary period. With the financial sector still trying to cope with the shocks of 2007 and 2008, prospects for a full Canadian economic recovery in the near future appear uncertain. Recent decisions by well-established Canadian companies such as Nortel Networks and Masonite International Corporation (a Kohlberg Kravis Roberts & Co. portfolio investment) to file for bankruptcy protection reflect the challenging economic environment through which Canadian businesses must navigate. Moreover, the recent high-profile bankruptcy protection filing by Chrysler LLC and the general turmoil in the automotive industry, foreshadow an increase in the number of distressed companies seeking access to debtor-in-possession (DIP) financings in order to restructure their operations to weather the current economic downturn. However, despite the recent successes of Abitibi-Consolidated Inc., Smurfit-Stone Container Canada Inc., and InterTAN Canada Ltd. (a wholly-owned subsidiary of U.S.-based Circuit City Stores Inc.), to secure DIP financings, the Canadian market for DIP lending remains strained, with only a handful of lenders willing to extend credit on onerous terms and at high interest rates.
What is debtor-in-possession financing?
DIP financing refers to credit financing provided to insolvent debtor companies to enable them to carry on business while operating under formal court protection from their creditors. The need for DIP financing stems from the inability of such financially distressed companies to either obtain trade credit from existing suppliers or to raise fresh funds to finance their day-to-day operations after a filing under the Companies' Creditors Arrangement Act (CCAA). Typically, by the time a company is insolvent, it has not only exhausted credit from existing lenders, but more importantly, it has invariably granted a security interest over all or substantially all of its current and future assets. The lack of unencumbered assets over which new lenders could be granted a first-ranking security interest severely hampers a distressed company's ability to secure new funding, since lenders are understandably reluctant to provide debt financing to an insolvent company in such circumstances. As a result, in order to balance the financing requirements of such troubled companies against the demands of lenders to have a first-ranking security interest over the assets of such companies, Canadian courts are requested, in certain circumstances, to approve "superpriority" DIP financings.
DIP financings have been judicially approved within the statutory framework of the CCAA, which permits certain insolvent companies to negotiate a plan of arrangement or compromise with their creditors during a statutorily imposed "stay period." The stay period under the CCAA allows a company "breathing room" to operate while its lenders' contractual and legal rights and remedies (e.g., collection of interest or principal payments, foreclosure or liquidation of collateral) are rendered temporarily unenforceable.
Negotiations for DIP financings usually occur in the days or weeks leading up to a CCAA filing to ensure that the debtor company will have access to funds in order to sustain its operations during the restructuring period. The need to secure post-filing funds exists because suppliers and creditors have no obligation to advance money or extend credit to a distressed debtor company after it makes a CCAA filing. As a result, once the distressed company files under the CCAA, its lenders will likely terminate any existing financing facilities and its suppliers will generally alter payment terms and require the troubled company to pay for products and services on a "cash-on-delivery" or a "cash-in-advance" basis. Consequently, securing DIP financing prior to a CCAA stay filing ensures that cash will be available to meet the insolvent company's short-term post-filing cash requirements. DIP financing can also function as a means of maintaining supplier and consumer confidence at a time when the fortunes of the insolvent company may hang in the balance. Ultimately, when the restructuring is completed and the debtor company emerges from bankruptcy protection, it will require "exit financing" to retire the DIP facility and resume operations.
Legal status of debtor-in-possession financing in Canada
DIP financing has its origins in American law under Chapter 11 of Title 11 of the U.S. Bankruptcy Code. However, unlike the U.S. Bankruptcy Code, neither the CCAA nor the Bankruptcy and Insolvency Act (BIA) in Canada currently contemplate DIP financings. It should be noted that proposed amendments to both the BIA and CCAA will codify a court's ability to grant security for DIP financings and the factors that a court must consider when asked to approve a DIP financing. However, in the absence of express statutory authority, Canadian courts have invoked their "inherent jurisdiction" to create superpriority charges, giving DIP lenders a superpriority first-ranking security interest. This allows a DIP lender to stand at the front of the line in terms of priority of payment if the restructuring fails and the process shifts into a liquidation and winding-up proceeding.
Given that DIP financing in Canada is a judicially created tool, the courts have formulated their own approach to approving DIP facilities. Although the approach is fact-specific and will vary on a case-by-case basis, existing judicial decisions suggest that a superpriority DIP financing will generally be approved where all or substantially all of the existing secured creditors consent or acquiesce to the DIP financing, or where it can be demonstrated that existing secured creditors whose security interests are being "primed" or subordinated, will not be materially prejudiced by the DIP financing. The court will also consider the importance of the business to the economic and social fabric of the community.
The proposed amendments to both the BIA and CCAA seek to codify the existing judicial guidelines concerning the approval of DIP financing for insolvent debtors. Like the judicial guidelines specified above, the proposed amendments will require courts to consider factors such as whether any creditor would be materially prejudiced as a result of the financing, whether the debtor's management has the confidence of its major creditors and whether the loan would enhance the prospects of a viable restructuring. Features of debtor-in-possession financing
The primary incentive for a lender to provide DIP financing is that it allows lenders to charge higher rates with spreads comparable to other distressed debt instruments and collect a variety of fees for arranging a DIP loan. The higher spreads and fees associated with DIP loans are intended to compensate the DIP lender for the greater implicit default risk and monitoring costs associated with managing distressed loans. It should be noted, however, that the losses associated with defaults on DIP loans are often not as severe as other distressed debt instruments, due to a DIP loan's superpriority status.
Court-approved DIP loans also give the DIP lender a first-ranking security interest over the assets of the distressed debtor company by subordinating the interests of other creditors, including pre-filing bank lenders. The superpriority feature of DIP loans greatly reduces a DIP lender's exposure to the debtor company's default risk by enabling the DIP lender to realize a priority recovery in the event of a liquidation. However, despite their superpriority status, DIP loans generally still rank behind certain statutory liens such as purchase-money security interests, unpaid wages and vacation pay claims up to a certain amount, and other court-ordered charges in favour of the debtor company's advisors, directors and officers. The superpriority feature of a DIP loan often encourages existing secured creditors to provide fresh DIP funds in what is known as "defensive DIP lending," in order for these existing lenders to protect their pre-filing loans and existing priority status over the collateral of the troubled company. In addition, defensive DIP lending also allows existing creditors that have extended DIP funds to have significant control over the debtor company's operations during the restructuring period.
Moreover, the credit agreements under which DIP loans are structured often incorporate a higher number of affirmative and negative covenants, permitting the lender to closely monitor the debtor company. Affirmative covenants typically require debtors to prepare more frequent and detailed financial reports and allow lenders to examine company books and conduct physical inventory checks. Negative covenants, on the other hand, restrict specified payments and distributions, operating activities, capital expenditures and disposition of assets. Negative covenants also prohibit a debtor company from granting liens over its assets in favour of other creditors. Overall, the affirmative and negative covenants, together with the detailed reporting requirements, enable the lender to monitor the debtor company more closely than it could under traditional secured loans, thus providing the DIP lender with a significant degree of control over the operations of the debtor company and increasing the likelihood of timely repayment.
The continuing deterioration in the Canadian economic outlook, combined with high corporate debt levels amassed under more favourable credit conditions, suggests that the number of distressed companies that will require funds to restructure and reposition their operations will likely increase. Accordingly, the number of companies requiring DIP financings, and the opportunities for lenders to provide DIP loans is expected to rise in the coming months. The tight credit conditions due to the continuing global credit crunch, however, suggest that the market for DIP financings will remain strained, as distressed companies continue to face a challenging lending environment characterized by few DIP lenders, wide spreads and high fees.