The Impact of the Credit Crisis on DIP Financing

For reasons discussed below, from the debtor's perspective (to the extent it has any negotiating leverage), a take-out DIP only should be used if the debtor can obtain more favorable terms under the DIP facility than its prepetition facility, or if it is likely that a priming fight will ensue. A debtor only can obtain a priming DIP if it can demonstrate that it is unable to obtain financing on another basis (e.g., an unsecured loan with administrative expense priority or non-priming) and either the existing secured creditors consent to the priming or the debtor establishes that existing secured creditors are adequately protected against diminution in value of their collateral as a result of the priming DIP. A debtor should prefer a priming DIP over a take-out DIP, if the terms of the existing facility are favorable, or there are perfection issues associated with the prepetition collateral. In addition, if a debtor agrees to a take-out DIP, its emergence hurdle becomes that much greater because the DIP loan must be repaid in full in cash prior to the debtor's emergence from Chapter 11. By elevating the debtor's prepetition secured debt to post-petition debt, the debtor will be required to obtain sufficient exit financing to repay the upsized facility. Moreover, the additional leverage could put pressure on the debtor's ability to confirm a plan.

Second, DIP lenders are granted super-priority administrative expense claim status in the debtor's Chapter 11 proceeding ' in addition to a prohibition against other constituencies obtaining pari passu status. This means that a DIP lender is repaid in full in cash prior to any other constituency, subject to certain agreed upon carve-outs such as the debtor's, and any official committee's professionals' fees and expenses.

Third, any court-approved protections granted to a DIP lender are not subject to revocation or reversal so long as the bankruptcy court finds that the DIP loan was advanced by the lenders in good faith.

Fourth, a debtor's expenses usually are substantially reduced once it files for Chapter 11 protection, because it is prohibited from paying current interest or amortization on its prepetition unsecured debt, and in certain cases, other large cash outflows such as minimum funding contributions to defined benefit plans. This should provide the debtor with additional cushion to satisfy its post-petition debt service obligations.

Lastly, DIP loans usually impose numerous onerous covenants and conditions on the debtor, such as: 1) requiring that net proceeds from approved asset sales be used to first repay outstanding debt under the DIP, and terminate commitments, 2) conservative advance rates in connection with asset-based facilities, 3) frequent and detailed financial reporting, 4) tight financial covenants, such as minimum EBITDAR and liquidity tests, 5) requiring the debtor to operate within an agreed upon budget, 6) imposing strict limitations on the use of loan proceeds, including capping capital expenditure programs, and 7) requiring the debtor to appoint and retain a chief restructuring officer acceptable to the lenders. Moreover, it is customary for a DIP order to grant the DIP lenders relief from the automatic stay to exercise remedies without further court approval upon the occurrence of an event of default, subject to prior written notice to the borrower.

As global markets gyrated throughout the past year, coupled with the precipitous decline in collateral and asset values, the market's perception that DIP loans are secure investments has become seriously undermined, notwithstanding the legal protections described above. A principal concern was that debtors would be forced to liquidate as opposed to reorganize, and default rates among DIP loans would increase dramatically. As a result, many commercial lenders, and corporate debt investors ' including traditional DIP lenders ' disappeared from the market.

In response to the limited capital supply for DIP loans, not only have rates widened to unprecedented levels (exceeding 100% increases over last year's rates), but other costs (such as LIBOR floors), original issue discount and fees (administration and placement) also have increased dramatically. In addition, many recent DIP loans provided even greater lender influence over the debtor and the progress of the bankruptcy proceeding than seen in recent bankruptcy cycles. For example, recent DIP loans have included milestone covenants for asset sales or required that a plan of reorganization, on terms acceptable to the lender, be confirmed within a specified period.

'Defensive Debt'

As discussed above, the second type of DIP loan is a “defensive debt” arranged by the debtor's prepetition secured creditor group. This group's motivation for extending fresh capital to the debtor includes ensuring the group does not lose control of its collateral and recovery prospects to a new money lender seeking to prime its prepetition debt. In addition, given the current state of the capital markets and the significant costs associated with reorganizing in Chapter 11, defensive DIPs are being advanced by the debtor's creditors with a view to acquiring the debtor through a loan-to-own strategy, where either the DIP or the prepetition secured facility becomes converted into a significant equity stake in the reorganized debtor or the lenders credit bid for substantially all of the debtor's assets in a 363 sale transaction. Defensive DIP lenders employing loan-to-own strategies through the provision of the DIP loan usually do so through a full or partial roll-up structure. By “rolling up” the prepetition secured loan, the defensive DIP lender creates a higher threshold for the debtor to reorganize because the DIP loan (including the rolled-up portion) needs to be repaid in full in order for the debtor to emerge from Chapter 11. Given the lenders' position in the debtor's capital structure, their control over the asset sale process should give them an advantage over other potential bidders in an auction of the debtor's assets. From the lenders' perspective, even if they are not the winning bidder at the auction, the documentation in a loan-to-own strategy usually would entitle the lenders to a break-up fee and expense reimbursement, in addition to requiring that the DIP loan be repaid in full upon consummation of the sale.

Aside from the desire to employ a loan-to-own strategy, a defensive DIP is sometimes necessary if either the prepetition lender group is the only lender willing to finance to the debtor, or if the debtor does not have sufficient liquidity to raise financing from a third-party lender. Liquidation of the group's collateral usually is the worst outcome because going-concern values are rarely achieved in a liquidation, as opposed to an ordinary sale. In addition to the foregoing, by providing the debtor with fresh capital, the existing creditor group can require the debtor to admit to the validity, extent, and priority of the lender's prepetition liens.

Conclusion

The availability of DIP financing is critical to the reorganization process, because, in addition to providing the debtor liquidity with which to operate, it also signals to the debtor's customers and employees that the debtor likely will remain a going concern. In addition, vendors are likely to restore trade credit post-petition, further enhancing the debtor's liquidity. Although some new money lenders are still in the DIP market, debtors continue to find obtaining DIP financing a challenge. The increasing likelihood that asset sales will either fall through or not yield as much as anticipated, or that Chapter 11 cases will convert to Chapter 7 liquidations, likely will continue to limit the availability of DIP financing in the near term. Nevertheless, as robust pricing continues to filter through the marketplace, and lenders become more comfortable with the prospects for the broader economy, those participating in the DIP market may find themselves able to achieve substantial returns for the risk involved. As with all cycles, as capital begins to filter back into the marketplace, more pressure will be put on pricing and structure, and a reversion to the mean likely will occur.

Michael H. Torkin is a partner at Shearman & Sterling LLP in the Bankruptcy & Restructuring Group. He advises companies on out-of-court restructurings and Chapter 11 reorganizations, acquirers of distressed businesses, and boards of directors of financially distressed companies. He also represents private equity investors in connection with M&A transactions and general corporate matters. Danielle B. Kalish is an associate in the firm's Bankruptcy & Restructuring Group.

Corporate and consumer spending have continued to decline since the second half of 2008. As a result, many highly leveraged companies have continued to face severe liquidity constraints as cash flow continues to decline, and borrowing bases for asset-based facilities decrease. Prior to the global credit pandemic, a company in default or that faced a near-term covenant breach could either obtain relief through waivers and amendments, or refinancings. As the availability of credit shrank, the latter choice was no longer a viable solution. Moreover, a byproduct of the frozen credit markets was the unexpected contraction of available debtor-in-possession financing (DIP financing). Historically, DIP financings have had the lowest default rates among commercial loans, and until the recent market disruption, only two significant DIP loans had defaulted, and only one of those resulting in a sub-par recovery. As a practical matter, access to DIP financing usually is the pivotal aspect of a company's ability to restructure in Chapter 11. Without access to capital, companies with performance issues that might otherwise have filed for Chapter 11 protection (or at least should have) could not, while companies with imminent maturity defaults or severe liquidity crises filed for Chapter 11 protection with limited liquidity, resulting in quick sales or liquidations. In the United States, the most notable liquidation victims were some of the country's largest retailers, including Circuit City and Linens 'n Things.

'New Money' Lenders

A question commonly asked about DIP financing is who would advance funds to a company seeking Chapter 11 protection and why. The question is answered by dividing the types of DIP lenders into two distinct categories, and explaining their motivations for making the loan. Generally, there are two types of DIP lenders ' “new money” lenders and a lender group composed of the debtor's prepetition secured lenders ' commonly referred to as a “defensive” DIP. As discussed below, a sharp contrast exists between the motivation of a “new money” lender and a defensive DIP lender. A new money lender's incentive to underwrite a DIP generally is premised upon the lender earning significant commitment fees, underwriting fees, as well as interest margin on what historically has been the securest form of commercial lending. DIP loans usually are considered safe investments for several reasons, some of which are practical, and others are rooted in protections afforded to DIP lenders under the Bankruptcy Code. First, DIP loans usually are secured by a first lien over all of the debtor's assets, including assets that were encumbered prepetition. Granting a DIP lender a first priority lien is generally accomplished in two ways ' by refinancing the debtor's prepetition secured facility, usually with incremental availability (a “take-out” DIP) or through a “priming” DIP.

For reasons discussed below, from the debtor's perspective (to the extent it has any negotiating leverage), a take-out DIP only should be used if the debtor can obtain more favorable terms under the DIP facility than its prepetition facility, or if it is likely that a priming fight will ensue. A debtor only can obtain a priming DIP if it can demonstrate that it is unable to obtain financing on another basis (e.g., an unsecured loan with administrative expense priority or non-priming) and either the existing secured creditors consent to the priming or the debtor establishes that existing secured creditors are adequately protected against diminution in value of their collateral as a result of the priming DIP. A debtor should prefer a priming DIP over a take-out DIP, if the terms of the existing facility are favorable, or there are perfection issues associated with the prepetition collateral. In addition, if a debtor agrees to a take-out DIP, its emergence hurdle becomes that much greater because the DIP loan must be repaid in full in cash prior to the debtor's emergence from Chapter 11. By elevating the debtor's prepetition secured debt to post-petition debt, the debtor will be required to obtain sufficient exit financing to repay the upsized facility. Moreover, the additional leverage could put pressure on the debtor's ability to confirm a plan.

Second, DIP lenders are granted super-priority administrative expense claim status in the debtor's Chapter 11 proceeding ' in addition to a prohibition against other constituencies obtaining pari passu status. This means that a DIP lender is repaid in full in cash prior to any other constituency, subject to certain agreed upon carve-outs such as the debtor's, and any official committee's professionals' fees and expenses.

Third, any court-approved protections granted to a DIP lender are not subject to revocation or reversal so long as the bankruptcy court finds that the DIP loan was advanced by the lenders in good faith.

Fourth, a debtor's expenses usually are substantially reduced once it files for Chapter 11 protection, because it is prohibited from paying current interest or amortization on its prepetition unsecured debt, and in certain cases, other large cash outflows such as minimum funding contributions to defined benefit plans. This should provide the debtor with additional cushion to satisfy its post-petition debt service obligations.

Lastly, DIP loans usually impose numerous onerous covenants and conditions on the debtor, such as: 1) requiring that net proceeds from approved asset sales be used to first repay outstanding debt under the DIP, and terminate commitments, 2) conservative advance rates in connection with asset-based facilities, 3) frequent and detailed financial reporting, 4) tight financial covenants, such as minimum EBITDAR and liquidity tests, 5) requiring the debtor to operate within an agreed upon budget, 6) imposing strict limitations on the use of loan proceeds, including capping capital expenditure programs, and 7) requiring the debtor to appoint and retain a chief restructuring officer acceptable to the lenders. Moreover, it is customary for a DIP order to grant the DIP lenders relief from the automatic stay to exercise remedies without further court approval upon the occurrence of an event of default, subject to prior written notice to the borrower.

As global markets gyrated throughout the past year, coupled with the precipitous decline in collateral and asset values, the market's perception that DIP loans are secure investments has become seriously undermined, notwithstanding the legal protections described above. A principal concern was that debtors would be forced to liquidate as opposed to reorganize, and default rates among DIP loans would increase dramatically. As a result, many commercial lenders, and corporate debt investors ' including traditional DIP lenders ' disappeared from the market.

In response to the limited capital supply for DIP loans, not only have rates widened to unprecedented levels (exceeding 100% increases over last year's rates), but other costs (such as LIBOR floors), original issue discount and fees (administration and placement) also have increased dramatically. In addition, many recent DIP loans provided even greater lender influence over the debtor and the progress of the bankruptcy proceeding than seen in recent bankruptcy cycles. For example, recent DIP loans have included milestone covenants for asset sales or required that a plan of reorganization, on terms acceptable to the lender, be confirmed within a specified period.

'Defensive Debt'

As discussed above, the second type of DIP loan is a “defensive debt” arranged by the debtor's prepetition secured creditor group. This group's motivation for extending fresh capital to the debtor includes ensuring the group does not lose control of its collateral and recovery prospects to a new money lender seeking to prime its prepetition debt. In addition, given the current state of the capital markets and the significant costs associated with reorganizing in Chapter 11, defensive DIPs are being advanced by the debtor's creditors with a view to acquiring the debtor through a loan-to-own strategy, where either the DIP or the prepetition secured facility becomes converted into a significant equity stake in the reorganized debtor or the lenders credit bid for substantially all of the debtor's assets in a 363 sale transaction. Defensive DIP lenders employing loan-to-own strategies through the provision of the DIP loan usually do so through a full or partial roll-up structure. By “rolling up” the prepetition secured loan, the defensive DIP lender creates a higher threshold for the debtor to reorganize because the DIP loan (including the rolled-up portion) needs to be repaid in full in order for the debtor to emerge from Chapter 11. Given the lenders' position in the debtor's capital structure, their control over the asset sale process should give them an advantage over other potential bidders in an auction of the debtor's assets. From the lenders' perspective, even if they are not the winning bidder at the auction, the documentation in a loan-to-own strategy usually would entitle the lenders to a break-up fee and expense reimbursement, in addition to requiring that the DIP loan be repaid in full upon consummation of the sale.

Aside from the desire to employ a loan-to-own strategy, a defensive DIP is sometimes necessary if either the prepetition lender group is the only lender willing to finance to the debtor, or if the debtor does not have sufficient liquidity to raise financing from a third-party lender. Liquidation of the group's collateral usually is the worst outcome because going-concern values are rarely achieved in a liquidation, as opposed to an ordinary sale. In addition to the foregoing, by providing the debtor with fresh capital, the existing creditor group can require the debtor to admit to the validity, extent, and priority of the lender's prepetition liens.

Conclusion

The availability of DIP financing is critical to the reorganization process, because, in addition to providing the debtor liquidity with which to operate, it also signals to the debtor's customers and employees that the debtor likely will remain a going concern. In addition, vendors are likely to restore trade credit post-petition, further enhancing the debtor's liquidity. Although some new money lenders are still in the DIP market, debtors continue to find obtaining DIP financing a challenge. The increasing likelihood that asset sales will either fall through or not yield as much as anticipated, or that Chapter 11 cases will convert to Chapter 7 liquidations, likely will continue to limit the availability of DIP financing in the near term. Nevertheless, as robust pricing continues to filter through the marketplace, and lenders become more comfortable with the prospects for the broader economy, those participating in the DIP market may find themselves able to achieve substantial returns for the risk involved. As with all cycles, as capital begins to filter back into the marketplace, more pressure will be put on pricing and structure, and a reversion to the mean likely will occur.

Michael H. Torkin is a partner at Shearman & Sterling LLP in the Bankruptcy & Restructuring Group. He advises companies on out-of-court restructurings and Chapter 11 reorganizations, acquirers of distressed businesses, and boards of directors of financially distressed companies. He also represents private equity investors in connection with M&A transactions and general corporate matters. Danielle B. Kalish is an associate in the firm's Bankruptcy & Restructuring Group.