A New Model for Auto Supplier DIP Financing?

This dynamic has been well chronicled in Tier 1 supplier Collins & Aikman Corp.'s Chapter 11 case, which was filed in Detroit this past May. Initially, a consortium led by the auto industry's top-dog DIP lender, J.P. Morgan Chase & Co., stepped in with a traditional $300 million DIP facility. But the second $150 million of the facility never saw daylight. In June, the bank balked at funding the balance, leaving C&A to face an unenviable predicament: a $4 billion bankruptcy with virtually no cash on hand and no working capital financing. Apparently recognizing the shutdown exposure they would face if C&A was forced to stop production, the OEMs initially funded an emergency $30 million bridge loan in mid-June. But that proved a band-aid measure, as C&A burned through the cash in a matter of days.

The OEMs came to the table once again, but this time with an aggregate $305 million financing package, none of which was funded via a traditional Bankruptcy Code section 364(d)(1) priming DIP loan. The financing, finally approved by the court in August, was comprised of three discreet components: 1) $82.5 million in new loans (secured by junior liens on existing assets and purchase money security interests (PMSIs) on newly acquired capital assets), 2) $82.5 million in temporary agreed price increases, and 3) forgiveness of $140 million in tooling, launch costs and related capital expenditures (all of which were historically C&A's crux to bear).

From the professional's perspective, this creatively sourced, non-bank mode of distressed financing mandated a measurably different approach to the conventional DIP financing negotiation and prosecution process that is worthy of examination, or at least critical observation. Moreover, inasmuch as Detroit continues to give all indications of becoming a Chapter 11 boomtown, other distressed suppliers may look to C&A's facility as a model for future DIP financings.

A New Dynamic

C&A's OEM-sponsored facility had two features that notably impacted the strategic interests and relative bargaining positions of C&A, the creditors' committee, the OEMs, and C&A's senior lenders. First, the facility did not call for any subordination (priming) of existing liens (all advances were secured by junior liens on existing assets and PMSIs in new capital assets acquired via the facility's capex-forgiveness piece), which had the effect of minimizing the bargaining position of C&A's existing secured lenders. Second, the OEMs agreed not to resource while C&A reciprocally deferred its right to reject pre-petition OEM contracts until after the expiration of the facility (as explained below, these reciprocal agreements proved to be sources of contention and posturing down the road for both the creditors' committee and the OEMs).

The first feature ' no priming of existing liens ' was arguably a stroke of strategic brilliance because it significantly reduced the influence of J.P. Morgan and C&A's other senior lenders by practically nullifying their standing to object to the approval of the facility on adequate protection grounds under Bankruptcy Code '364(d)(1). Section 364(d)(1) empowers debtors in possession to obtain financing secured by senior liens on otherwise encumbered estate assets, but only if the debtor can demonstrate tha:t 1) non-priming financing is unavailable; and 2) the existing lienholders' subordinated (primed) liens will be adequately protected. The adequate protection requirement commonly serves as a platform for existing lenders to exert substantial leverage and influence on the terms of the financial covenants, carve-out and other material provisions in the proposed DIP facility. Because the burden of demonstrating adequate protection in connection with approval of a '364(d)(1) loan lies with the debtor-borrower, secured lenders can and frequently do take advantage of their inherent bargaining power.

Adequate protection did not come into play in C&A's case, however, because C&A's facility was pitched for approval under Bankruptcy Code '364(c)(3) as one secured only by junior liens and PMSIs. Thus, the banks, while certainly maintaining a seat at the table, were effectively stripped of any driver's-seat role in the negotiation of the facility (indeed, the professionals involved in the negotiation might paint a different picture of the process, but, ultimately, the absence of a priming lien component speaks for itself here).

The banks were not the only constituency impacted by the prosecution of this unusual financing, In July, the unsecured creditors' committee filed an objection to the second feature mentioned above, the prohibition on re-sourcing during the term of the facility. Specifically, the committee argued that the proposed facility did not, per se, prohibit the OEMs from 'preparing' to re-source (ie, by talking to/evaluating potential replacement suppliers). Additionally, the committee complained that, since the difficulty and expense of transitioning C&A's business to alternate suppliers afforded C&A extraordinary bargaining leverage from the outset, the proposed stay of C&A's right to reject OEM contracts amounted to a poor exercise of C&A's 'business judgment' ' an argument raised in response to C&A's curious reliance on Bankruptcy Code ' 363(b) as a catch-all authority for approval of the facility ' and a surrender of a critical bargaining chip. These points were coupled with a voiced concern that the proposed junior liens would unnecessarily burden C&A's already over-leveraged balance sheet.

Thus, the committee expressed a fear of re-sourcing as its overarching concern in the case and illuminated the vulnerability of a financing scheme that, while perhaps a necessary evil, was wholly dependent upon non-bank lenders-by-default who, at least to the extent of the non-cash portions of the facility, were not necessarily predisposed to C&A's continuation as a going concern. This subtle perversion of the baseline DIP lender motivation ' increased likelihood of recovery via preservation of the borrower's going concern value ' is what makes C&A's OEM-sourced financing so potentially treacherous. Consider the event of a forced C&A shutdown/liquidation, in which a default on the non-cash components of the OEM-sourced DIP facility would likely expose the OEM's to the costs of a short-term cessation of final assembly operations pending supplier transition (the OEMs generally acquire inventory on a just-in-time basis), but little more. Conversely, if bank lenders had provided the entire $305 million as traditional loans, a shutdown might be substantially more costly (at least to the extent of cash advances beyond $82.5 million).

As the Sept. 30 expiration of the facility approached, certain of the participating OEMs postured for the possibility of C&A's shutdown and/or rejection of their supply agreements by filing motions styled as 'contingent' requests for relief from stay to repossess tooling ' contingent, that is, upon C&A's failure to obtain new financing or negotiate extension of the material terms of the existing financing. J.P. Morgan, among others, objected, pointing out that determination of bailment, ownership or lien rights in automotive tooling would mandate extensive discovery and litigation of elaborate legal issues. Indeed, J.P. Morgan's position is potentially a strong one, and could prove significant. An order sustaining the objection (if this squabble ever gets that far) might establish a milestone precedent for tooling repo disputes in future supplier cases that would put the OEMs in the strategically unenviable position of being unable to re-source without significant assembly interruption and expense. Thus, a judicial conclusion to these contingent relief from stay motions might chill prospects for similar OEM-sponsored DIP financings in future supplier cases.

Lessons Learned and Things to Come

Is C&A's OEM-sponsored deal indicative of some kind of trend? Maybe, maybe not. C&A's package appears to be unique, at least for the time being, insofar as the OEMs themselves, rather than their various lending subsidiaries, are the actual lenders. Moreover, the bulk of recent Chapter 11 automotive debtors have obtained some level of bank financing (a good chunk of it coming from J.P. Morgan, which, according to The Bankruptcy Insider, has committed $2.9 billion to distressed auto/aerospace companies in the last 5 years, including $1.5 billion of Delphi's record-breaking $4.6 billion facility). But a few Tier 1 debtors have obtained financing from the OEM's lending arms. For example, GM Tier 1 suppliers Trim Trends Co. and Jacobs Industries, Inc. both turned to GMAC Commercial Finance for support in their Chapter 11 cases. In any event, the OEM's are likely to continue to function only as lenders of last resort (in Trim Trends' case, GMAC came into the picture only after the company's pre-petition lenders declined to fund a roll-up DIP).

Conclusion

So, what can be gleaned from C&A's financing odyssey? In sum, C&A's approach to DIP financing may have established a modified set of ground rules in auto supplier cases for the 'players' and their respective professionals. In future cases, will the OEM's emerge as the primary shot-callers and wield the balance of negotiating muscle? Will debtors and committees be aligned, but only to the extent of a desire to leverage shutdown threats and tooling lien fights to their mutual advantage? Ultimately, only time will yield answers to these questions.

But one thing is clear: The OEMs have tipped their respective hands by threatening relief from stay to repossess C&A's tooling. In October, just as the OEM-sponsored DIP expired, C&A was negotiating extensions of the pricing concessions and other critical terms of the facility with the participating OEMs. Presumptively, these deals will close and everything will be hunky-dory, at least for some defined period of time. Regardless of how C&A's particular situation pans out, however, the OEM's have made it known that, if need be, they might just be willing to bite the bullet in a shutdown scenario and go the re-sourcing route.

Without any reservation, it is safe to say that insolvency crisis facing the U.S. auto industry ' from myriad Tier 2 suppliers right up to the legacy-burdened OEMs ' has become the cause c'l'bre of the professional restructuring community, and for objectively good reason. In this year alone, at least eight parts makers (among them, Collins & Aikman Corp., Meridian Automotive Systems, Inc., Tower Automotive, Inc., Jernberg Industries, Inc., Harvard Industries, Inc., Jacobs Industries, Inc., and Delphi Corp.) filed for Chapter 11 relief. And many industry experts believe that these cases represent merely a harbinger of even bigger things to come. See, eg, Whiteman L: GM Could Seize the Opportunity. TheDeal.com (Oct. 10, 2005) (reporting that Bank of America Securities LLC analyst Ronald Tadross raised the odds of a GM bankruptcy from 10% to 30% following Delphi's Chapter 11 filing); Benson MD, Houdek TA: Automotive OEM and Tier 1 Consolidation ' Tip of the Iceberg. (Stout Risius Ross, Inc. Client Advisory) (2005); Houlihan, Lokey, Howard & Zukin, Inc.: Automotive Supplier Quarterly Update at 1 (Second Quarter 2005).

As more and more of the industry's Tier 1 and 2 players progress towards or work through major restructurings, the availability of financing for ongoing operations has become a critical concern, especially in the face of high materials costs and unusually burdensome OEM traditions (like requiring suppliers to bear crushing tooling and other ramp-up capital expenditures for months or even years in advance of new product launches). Within these parameters, bank financing is not always a given.

Collins & Aikman Corp.

This dynamic has been well chronicled in Tier 1 supplier Collins & Aikman Corp.'s Chapter 11 case, which was filed in Detroit this past May. Initially, a consortium led by the auto industry's top-dog DIP lender, J.P. Morgan Chase & Co., stepped in with a traditional $300 million DIP facility. But the second $150 million of the facility never saw daylight. In June, the bank balked at funding the balance, leaving C&A to face an unenviable predicament: a $4 billion bankruptcy with virtually no cash on hand and no working capital financing. Apparently recognizing the shutdown exposure they would face if C&A was forced to stop production, the OEMs initially funded an emergency $30 million bridge loan in mid-June. But that proved a band-aid measure, as C&A burned through the cash in a matter of days.

The OEMs came to the table once again, but this time with an aggregate $305 million financing package, none of which was funded via a traditional Bankruptcy Code section 364(d)(1) priming DIP loan. The financing, finally approved by the court in August, was comprised of three discreet components: 1) $82.5 million in new loans (secured by junior liens on existing assets and purchase money security interests (PMSIs) on newly acquired capital assets), 2) $82.5 million in temporary agreed price increases, and 3) forgiveness of $140 million in tooling, launch costs and related capital expenditures (all of which were historically C&A's crux to bear).

From the professional's perspective, this creatively sourced, non-bank mode of distressed financing mandated a measurably different approach to the conventional DIP financing negotiation and prosecution process that is worthy of examination, or at least critical observation. Moreover, inasmuch as Detroit continues to give all indications of becoming a Chapter 11 boomtown, other distressed suppliers may look to C&A's facility as a model for future DIP financings.

A New Dynamic

C&A's OEM-sponsored facility had two features that notably impacted the strategic interests and relative bargaining positions of C&A, the creditors' committee, the OEMs, and C&A's senior lenders. First, the facility did not call for any subordination (priming) of existing liens (all advances were secured by junior liens on existing assets and PMSIs in new capital assets acquired via the facility's capex-forgiveness piece), which had the effect of minimizing the bargaining position of C&A's existing secured lenders. Second, the OEMs agreed not to resource while C&A reciprocally deferred its right to reject pre-petition OEM contracts until after the expiration of the facility (as explained below, these reciprocal agreements proved to be sources of contention and posturing down the road for both the creditors' committee and the OEMs).

The first feature ' no priming of existing liens ' was arguably a stroke of strategic brilliance because it significantly reduced the influence of J.P. Morgan and C&A's other senior lenders by practically nullifying their standing to object to the approval of the facility on adequate protection grounds under Bankruptcy Code '364(d)(1). Section 364(d)(1) empowers debtors in possession to obtain financing secured by senior liens on otherwise encumbered estate assets, but only if the debtor can demonstrate tha:t 1) non-priming financing is unavailable; and 2) the existing lienholders' subordinated (primed) liens will be adequately protected. The adequate protection requirement commonly serves as a platform for existing lenders to exert substantial leverage and influence on the terms of the financial covenants, carve-out and other material provisions in the proposed DIP facility. Because the burden of demonstrating adequate protection in connection with approval of a '364(d)(1) loan lies with the debtor-borrower, secured lenders can and frequently do take advantage of their inherent bargaining power.

Adequate protection did not come into play in C&A's case, however, because C&A's facility was pitched for approval under Bankruptcy Code '364(c)(3) as one secured only by junior liens and PMSIs. Thus, the banks, while certainly maintaining a seat at the table, were effectively stripped of any driver's-seat role in the negotiation of the facility (indeed, the professionals involved in the negotiation might paint a different picture of the process, but, ultimately, the absence of a priming lien component speaks for itself here).

The banks were not the only constituency impacted by the prosecution of this unusual financing, In July, the unsecured creditors' committee filed an objection to the second feature mentioned above, the prohibition on re-sourcing during the term of the facility. Specifically, the committee argued that the proposed facility did not, per se, prohibit the OEMs from 'preparing' to re-source (ie, by talking to/evaluating potential replacement suppliers). Additionally, the committee complained that, since the difficulty and expense of transitioning C&A's business to alternate suppliers afforded C&A extraordinary bargaining leverage from the outset, the proposed stay of C&A's right to reject OEM contracts amounted to a poor exercise of C&A's 'business judgment' ' an argument raised in response to C&A's curious reliance on Bankruptcy Code ' 363(b) as a catch-all authority for approval of the facility ' and a surrender of a critical bargaining chip. These points were coupled with a voiced concern that the proposed junior liens would unnecessarily burden C&A's already over-leveraged balance sheet.

Thus, the committee expressed a fear of re-sourcing as its overarching concern in the case and illuminated the vulnerability of a financing scheme that, while perhaps a necessary evil, was wholly dependent upon non-bank lenders-by-default who, at least to the extent of the non-cash portions of the facility, were not necessarily predisposed to C&A's continuation as a going concern. This subtle perversion of the baseline DIP lender motivation ' increased likelihood of recovery via preservation of the borrower's going concern value ' is what makes C&A's OEM-sourced financing so potentially treacherous. Consider the event of a forced C&A shutdown/liquidation, in which a default on the non-cash components of the OEM-sourced DIP facility would likely expose the OEM's to the costs of a short-term cessation of final assembly operations pending supplier transition (the OEMs generally acquire inventory on a just-in-time basis), but little more. Conversely, if bank lenders had provided the entire $305 million as traditional loans, a shutdown might be substantially more costly (at least to the extent of cash advances beyond $82.5 million).

As the Sept. 30 expiration of the facility approached, certain of the participating OEMs postured for the possibility of C&A's shutdown and/or rejection of their supply agreements by filing motions styled as 'contingent' requests for relief from stay to repossess tooling ' contingent, that is, upon C&A's failure to obtain new financing or negotiate extension of the material terms of the existing financing. J.P. Morgan, among others, objected, pointing out that determination of bailment, ownership or lien rights in automotive tooling would mandate extensive discovery and litigation of elaborate legal issues. Indeed, J.P. Morgan's position is potentially a strong one, and could prove significant. An order sustaining the objection (if this squabble ever gets that far) might establish a milestone precedent for tooling repo disputes in future supplier cases that would put the OEMs in the strategically unenviable position of being unable to re-source without significant assembly interruption and expense. Thus, a judicial conclusion to these contingent relief from stay motions might chill prospects for similar OEM-sponsored DIP financings in future supplier cases.

Lessons Learned and Things to Come

Is C&A's OEM-sponsored deal indicative of some kind of trend? Maybe, maybe not. C&A's package appears to be unique, at least for the time being, insofar as the OEMs themselves, rather than their various lending subsidiaries, are the actual lenders. Moreover, the bulk of recent Chapter 11 automotive debtors have obtained some level of bank financing (a good chunk of it coming from J.P. Morgan, which, according to The Bankruptcy Insider, has committed $2.9 billion to distressed auto/aerospace companies in the last 5 years, including $1.5 billion of Delphi's record-breaking $4.6 billion facility). But a few Tier 1 debtors have obtained financing from the OEM's lending arms. For example, GM Tier 1 suppliers Trim Trends Co. and Jacobs Industries, Inc. both turned to GMAC Commercial Finance for support in their Chapter 11 cases. In any event, the OEM's are likely to continue to function only as lenders of last resort (in Trim Trends' case, GMAC came into the picture only after the company's pre-petition lenders declined to fund a roll-up DIP).

Conclusion

So, what can be gleaned from C&A's financing odyssey? In sum, C&A's approach to DIP financing may have established a modified set of ground rules in auto supplier cases for the 'players' and their respective professionals. In future cases, will the OEM's emerge as the primary shot-callers and wield the balance of negotiating muscle? Will debtors and committees be aligned, but only to the extent of a desire to leverage shutdown threats and tooling lien fights to their mutual advantage? Ultimately, only time will yield answers to these questions.

But one thing is clear: The OEMs have tipped their respective hands by threatening relief from stay to repossess C&A's tooling. In October, just as the OEM-sponsored DIP expired, C&A was negotiating extensions of the pricing concessions and other critical terms of the facility with the participating OEMs. Presumptively, these deals will close and everything will be hunky-dory, at least for some defined period of time. Regardless of how C&A's particular situation pans out, however, the OEM's have made it known that, if need be, they might just be willing to bite the bullet in a shutdown scenario and go the re-sourcing route.