LIBOR and Bankruptcy in the Current Market

How do these issues associated with LIBOR impact reorganizations and bankruptcies? The combination of an increased amount of distress, particularly in certain industries, the volatility of the credit markets, and a rapidly changing LIBOR rate have resulted in certain unique behaviors and circumstances in recent months, many of which are expected to continue for a period of time.

Investors demanding LIBOR floors to guarantee minimum returns. Investors are now concerned that with LIBOR providing a less predictable metric, that floors need to be instituted to assure minimum returns.

LIBOR spreads increase as banks perceive risk to be greater or increasing and LIBOR spreads decrease as funds become available as risk is perceived to be lower, all of which is happening in time frames that are more compressed than in past history. The spread between the rates that banks charge and LIBOR have increased, while LIBOR still remains low. Banks are still able to generate acceptable levels of return in many cases.

The supply of funds for debtors in possession 'DIP' financing and exit financing has decreased. Additionally, the yield premiums over LIBOR for DIP loans have widened.

In some cases, DIP financing will not be available at all, resulting in the need to 'break apart' companies and sell lines or business or individual subsidiaries or assets individually, where, in a liquid financing market, the company may have been able to restructure and exit from bankruptcy or avoid bankruptcy altogether.

DIP loans may be provided by existing creditors more than in the past. Additionally, new parties are participating in the process of providing DIP loans, including hedge fund investors and private equity firms that are currently holding equity interests in the company that file for bankruptcy protection.

The cost of exit from bankruptcy increases as LIBOR and spreads increase, making exit difficult or impossible. The increased cost
of exit may delay exit substantially, which can also impede the company's ability to deliver its balance sheet, reduce its costs, and implement plans for improvement.

Current loan agreements may include covenants and amortization schedules that cannot be met, but banks may not be willing to amend existing agreements. 'New money' may be provided under dramatically different terms than as previously provided.

Business bankruptcies for corporations with assets of at least $100 million have tripled in the first quarter of 2008 as compared to that of the prior year. With tightened DIP and exit financing sources, debtor companies may have much more limited options. At the same time, the flow of 'large' Chapter 11 filings is minimal, causing the marketplace to speculate on when the market will actually 'turn.'

Cases in Point

There have been several examples of situations involving companies in distress or that have filed Chapter 11 where some of these situations have taken place. Each is unique and may or may not have occurred in another type of financing market:

Delphi: The court approved plan of reorganization was obtained, but the financing markets have changed dramatically since that approval as a result of the increased length of time to obtain exit financing.

Quebecor World USA: DIP loan priced at a LIBOR premium higher than that which was available one year prior. The $1 billion debtor-in-possession facility consisted of a $600 million term loan and a $400 million revolving credit facility, due July 23, 2009.

Buffets Inc.: The $85 million DIP loan for Buffets was structured with a LIBOR floor with a rate of 725 basis points above LIBOR and specified a minimum LIBOR of 4% and a maximum of 5%.

Deep Ocean Expeditions LLC: The scientific exploration company filed for Chapter 11 in the U.S. Bankruptcy Court for the Western District of Washington in Seattle on May 28 after financing was not available for the refitting of its 183-foot ship, the MV Alucia.

What It Means

How does this all play out for the restructuring and bankruptcy environments? Lenders continue to be discriminating in the issuance of new loans, and are monitoring their existing credits closely. In some cases, they are reducing the amount of credit available to a borrower based on current performance. In the cases of distressed companies or those in bankruptcy, there have been multiple situations where, due to lack of available financing, Chapter 11 bankruptcies have been converted to Chapter 7, companies have been dismantled and sold off by line or business or subsidiary, and, in some cases, the company product disposed of via liquidation.

Clearly, the time frame in which decisions are made must be shortened as long-term assumptions may not be valid nor predictable. The 'transaction' cost and time frame for a restructuring may be increased as compared to that of pre-second quarter 2007. Constituents with differing goals and objectives will be involved with discussions in which they previously did not have an interest. Disputes may be more prevalent as the expected outcomes of a restructuring may not be available or easy to obtain, along with the impact of stresses caused by the tightened availability of financing. Although the form of transactions, the availability of capital and financing are unique to each situation, the impact of macroeconomic factors will continue to be the most prominent driver of the restructuring and bankruptcy environments.

Editor's Note: At press time, the Bankers' Association (BBA) disclosed a variety of changes to the governance of LIBOR at it its annual conference and issued a paper calling for views on further changes. The changes to date include:

• Tighter scrutiny of the rates contributed by banks into the setting mechanism, so that any discrepancies in the rates would have to be justified by individual contributing banks;
• Wider membership of the Foreign Exchange and Money Markets Committee, the independent body overseeing the process; and
• Increasing the numbers of contributors to some of the rate-setting panels.

The BBA also stated that it would accept input on whether 'the historically transparent rate-setting mechanism is stigmatizing contributors and whether a second rate-fixing process for U.S. dollar LIBOR might be set after the U.S. market opening.'

Jeff J. Marwil, a member of this newsletter's board of Editors, is a partner in and Co-Chair of the national Restructuring and Insolvency practice of Winston & Strawn LLP. He concentrates on the representation of hedge funds in distress and hedge fund investors, including fund of fund investors.

Distressed companies and those in bankruptcy nearly always require some amount of loans to fund their recovery, exit from bankruptcy, or sale. What happens when those loans are not available, too expensive, or too risky in the eyes of the capital market? Combine that with volatility in The London Interbank Offer Rate, 'LIBOR,' the rate at which money is lent to other banks, and the terms, in particular, interest rates, that are offered to these distressed borrowers, are constantly in change. While LIBOR is recognized as the foundation of pricing of products internationally, recent issues have arisen, causing additional erosion of the confidence in the financing market. The integrity of LIBOR has been addressed in recent months, specifically pointing to certain financial institutions' possible misrepresentation of borrowing costs as a method of minimizing their respective losses during the crisis in the financial markets. It is unclear if the capital markets consider these issues a 'crisis' in terms of the LIBOR benchmark calculation, or if the identified problems are considered to be resolved.

Concurrent with these concerns is the observation that use of the LIBOR system may not be as desirable as it once was. Regardless, the system still is one that is distinct and separate from the system used by The Federal Reserve Board to set interest rates.

LIBOR and Bankruptcies

How do these issues associated with LIBOR impact reorganizations and bankruptcies? The combination of an increased amount of distress, particularly in certain industries, the volatility of the credit markets, and a rapidly changing LIBOR rate have resulted in certain unique behaviors and circumstances in recent months, many of which are expected to continue for a period of time.

Investors demanding LIBOR floors to guarantee minimum returns. Investors are now concerned that with LIBOR providing a less predictable metric, that floors need to be instituted to assure minimum returns.

LIBOR spreads increase as banks perceive risk to be greater or increasing and LIBOR spreads decrease as funds become available as risk is perceived to be lower, all of which is happening in time frames that are more compressed than in past history. The spread between the rates that banks charge and LIBOR have increased, while LIBOR still remains low. Banks are still able to generate acceptable levels of return in many cases.

The supply of funds for debtors in possession 'DIP' financing and exit financing has decreased. Additionally, the yield premiums over LIBOR for DIP loans have widened.

In some cases, DIP financing will not be available at all, resulting in the need to 'break apart' companies and sell lines or business or individual subsidiaries or assets individually, where, in a liquid financing market, the company may have been able to restructure and exit from bankruptcy or avoid bankruptcy altogether.

DIP loans may be provided by existing creditors more than in the past. Additionally, new parties are participating in the process of providing DIP loans, including hedge fund investors and private equity firms that are currently holding equity interests in the company that file for bankruptcy protection.

The cost of exit from bankruptcy increases as LIBOR and spreads increase, making exit difficult or impossible. The increased cost
of exit may delay exit substantially, which can also impede the company's ability to deliver its balance sheet, reduce its costs, and implement plans for improvement.

Current loan agreements may include covenants and amortization schedules that cannot be met, but banks may not be willing to amend existing agreements. 'New money' may be provided under dramatically different terms than as previously provided.

Business bankruptcies for corporations with assets of at least $100 million have tripled in the first quarter of 2008 as compared to that of the prior year. With tightened DIP and exit financing sources, debtor companies may have much more limited options. At the same time, the flow of 'large' Chapter 11 filings is minimal, causing the marketplace to speculate on when the market will actually 'turn.'

Cases in Point

There have been several examples of situations involving companies in distress or that have filed Chapter 11 where some of these situations have taken place. Each is unique and may or may not have occurred in another type of financing market:

Delphi: The court approved plan of reorganization was obtained, but the financing markets have changed dramatically since that approval as a result of the increased length of time to obtain exit financing.

Quebecor World USA: DIP loan priced at a LIBOR premium higher than that which was available one year prior. The $1 billion debtor-in-possession facility consisted of a $600 million term loan and a $400 million revolving credit facility, due July 23, 2009.

Buffets Inc.: The $85 million DIP loan for Buffets was structured with a LIBOR floor with a rate of 725 basis points above LIBOR and specified a minimum LIBOR of 4% and a maximum of 5%.

Deep Ocean Expeditions LLC: The scientific exploration company filed for Chapter 11 in the U.S. Bankruptcy Court for the Western District of Washington in Seattle on May 28 after financing was not available for the refitting of its 183-foot ship, the MV Alucia.

What It Means

How does this all play out for the restructuring and bankruptcy environments? Lenders continue to be discriminating in the issuance of new loans, and are monitoring their existing credits closely. In some cases, they are reducing the amount of credit available to a borrower based on current performance. In the cases of distressed companies or those in bankruptcy, there have been multiple situations where, due to lack of available financing, Chapter 11 bankruptcies have been converted to Chapter 7, companies have been dismantled and sold off by line or business or subsidiary, and, in some cases, the company product disposed of via liquidation.

Clearly, the time frame in which decisions are made must be shortened as long-term assumptions may not be valid nor predictable. The 'transaction' cost and time frame for a restructuring may be increased as compared to that of pre-second quarter 2007. Constituents with differing goals and objectives will be involved with discussions in which they previously did not have an interest. Disputes may be more prevalent as the expected outcomes of a restructuring may not be available or easy to obtain, along with the impact of stresses caused by the tightened availability of financing. Although the form of transactions, the availability of capital and financing are unique to each situation, the impact of macroeconomic factors will continue to be the most prominent driver of the restructuring and bankruptcy environments.

Editor's Note: At press time, the Bankers' Association (BBA) disclosed a variety of changes to the governance of LIBOR at it its annual conference and issued a paper calling for views on further changes. The changes to date include:

• Tighter scrutiny of the rates contributed by banks into the setting mechanism, so that any discrepancies in the rates would have to be justified by individual contributing banks;
• Wider membership of the Foreign Exchange and Money Markets Committee, the independent body overseeing the process; and
• Increasing the numbers of contributors to some of the rate-setting panels.

The BBA also stated that it would accept input on whether 'the historically transparent rate-setting mechanism is stigmatizing contributors and whether a second rate-fixing process for U.S. dollar LIBOR might be set after the U.S. market opening.'

Jeff J. Marwil, a member of this newsletter's board of Editors, is a partner in and Co-Chair of the national Restructuring and Insolvency practice of Winston & Strawn LLP. He concentrates on the representation of hedge funds in distress and hedge fund investors, including fund of fund investors.