DIP Financing Issues and AlternativesCorporate & Finance Alert
(David W. Marston)
April 7, 2009
In every financially struggling company, management has two critical imperatives: call off those ravenous dogs (i.e., the company’s unpaid creditors) and somehow, somewhere, find new cash.
Fortunately, Chapter 11 of the Bankruptcy Code (“Code”) directly addresses both of these issues, with potent provisions that can be summarized in just four words: “automatic stay” and “DIP financing.” To get the benefit of those two life preservers, a hard-pressed company simply needs to file a petition for relief under Chapter 11 of the Code, thereby initiating a “reorganization” bankruptcy.
Upon filing of the petition, the automatic stay provision in Section 362(a) of the Code calls off the dogs--instantly. It stops the creditors in their tracks. It bars virtually all collection activity, lawsuits, and general harassment by creditors, and it is in fact automatic. Without any court hearing or judge’s order, the stay is created by the simple act of the bankruptcy clerk stamping the Chapter 11 petition with the time/date stamp, indicating that it has been officially filed. The stay binds creditors before they are even aware of its existence, and there are criminal penalties for intentional violations of it.
With the creditors at bay, the next step is to find new cash to keep the company’s doors open. Until the current financial markets meltdown, that was also a fairly straightforward process. Section 364 of the Code provides for debtor-in-possession financing (“DIP financing”). DIP loans have a super-priority administrative claim in the bankruptcy, which means the DIP lender is the first creditor repaid upon confirmation of a Plan. Indeed, the terms of DIP loans have historically been so attractive that the DIP lender was often the debtor’s old bank--the same bank that was getting stiffed on its previous loans to the company, before the company filed its Chapter 11 petition.
For banks that understood the risks and rewards, DIP financing was, for decades, very good business indeed. Sterling National Bank, for example, began aggressively making DIP loans in the 1970s. In a recent interview with Investment Dealers’ Digest, Sterling Chairman Louis Cappelli stated: “We never lost one penny in Chapter 11 financings in all of those years.”
And if DIP loans were attractive business for the banks, they were also vital to Chapter 11 debtors, providing the essential liquidity to allow time for reorganization or sale of the company.
That was then.
Post-meltdown, DIP loans have become an endangered species. They still have super-priority status and all of the other attractive features provided by the Code, but many suddenly risk-averse banks are now reluctant to lend into a legal proceeding that has the word “bankruptcy” on the first page of the pleadings (even if it is a “reorganization” bankruptcy). In today’s economy, the limited number of banks willing to make DIP loans will demand increased interest rates and higher fees, significantly shorter loan terms, and other provisions that will make the DIP financing much less debtor-friendly. Nevertheless, as the risk:reward calculus of DIP loans is more widely understood, it seems likely that alternative sources of capital will step up to provide DIP financing in situations where banks are unwilling to make new loans and/or extend old ones.
This paper will look at the current DIP financing climate, analyze what today’s DIP loan practices mean for the future of Chapter 11 reorganizations, and suggest strategies that companies may use to get Chapter 11 protections and benefits in an environment where DIP loans may be scarce at best.
Current DIP Financing Climate. First, as American Home Mortgage Investment Corp. (“AHM”) learned in August 2008, debtors that are lucky enough to amend and/or extend existing DIP loans are going to pay a high price for the amendment. The interest rate on AHM’s $35 million DIP financing jumped from LIBOR plus 300 basis points to LIBOR plus 1,200 basis points, and a total of $750,000.00 in new amendment fees was also part of the package approved by the U.S. Bankruptcy Court for the District of Delaware.
Second, the terms of recent DIP loans, which historically have generally run 12-18 months, have been are cut to 2-6 months. While there is no theoretical limit on extensions and renewals, in practice the short-term DIP loans will generate pressure for quick asset sales or even liquidation, rather than following the traditional--and often lengthy--Chapter 11 reorganization model.
Finally, even unencumbered collateral does not support the level of DIP financing that it once did. Lenders who once lent 85 cents for every dollar of A/R now may cap their loan ratios at 50 cents. The advance rate against inventory, once typically 50%, is now often just 25%, and even less in retail and other sectors deemed to be more risky.
Who is making DIP loans currently? Often, it is still the existing secured pre-petition lender, and these new loans have been dubbed “defensive DIPs.” The rationale is that the new DIP financing will give the lender more influence in the overall reorganization procedure, and possibly even improve its pre-petition position.
Implications for Future Chapter 11 Reorganizations. With DIP financing becoming both scarce and restrictive, the ability of debtors to arrange standalone reorganizations is significantly diminished. There is simply not enough time; the successful Chapter 11 reorganization of Piper Aircraft Corporation, for example, took four years (and the company was able to continue manufacturing and selling airplanes through the entire reorganization). But with the current constraints on DIP financing terms, debtors will be pressured to auction assets much faster than that. That was what happened with Sharper Image, the high-end retailer. After filing for reorganization in February 2008, Sharper Image obtained a $60 million DIP loan from Wells Fargo, with a six-month term. The company initially sought to do a standalone reorganization, but by May 2008, it had sold its intellectual property for $49 million in a bankruptcy auction, and given up on the reorganization.
The Sharper Image experience may become the common model. Even when DIP financing is obtained, it is likely to be a “bridge” to an expeditious—and opportunistic—Section 363 asset sale, or even a liquidation. Not exactly a bridge to nowhere, but certainly not a bridge to the traditional Chapter 11 destinations: reorganization, or sale of the whole company.
And if the DIP financing is taking the debtor to a different place, the Chapter 11 journey is also likely to be less pleasant. Here’s why: As a consequence of the proliferation of leveraged loans and securitizations in recent years, holders of corporate debt have shifted from traditional corporate bank lenders to hedge funds and other investors. Considering this development, a Morgan Stanley analyst stated: “The involvement of hedge funds and Collateralized Loan Obligations [in the bankruptcy reorganization process] shapes our expectation that the bankruptcy process will be contentious relative to the clubby democratic-type negotiations involving commercial banks’ workout groups in the past.”
Strategies. Anticipating that DIP financing will be insufficient or unavailable, companies may emulate the newspaper publisher Tribune Co., which in December 2008 filed a “preemptive” Chapter 11 petition after negotiating a multimillion-dollar, non-DIP, financing with Barclays Capital. Similarly, Nortel Networks Corp. filed for bankruptcy protection in January 2009, even though it still had a whopping $2.4 billion in cash reserves, in effect providing its own debtor-in-possession financing. In both cases, the debtors’ use of their cash will be subject to the requirements of Code Section 363 governing cash collateral, but at least they have sidestepped the current uncertainties of DIP financing.
Faced with the increased expense of current DIP financing, some companies have discovered more attractive non-traditional DIP financing sources. Frontier Airlines Holdings, Inc., for example, had secured a $75 million DIP financing commitment from Perseus LLC, a merchant bank and private equity fund management company. But then several members of its Unsecured Creditors Committee in the Chapter 11 offered a more attractive package.
“After a careful examination of this offer against the offer Perseus provided last week,” Frontier CEO Sean Menke said, “we believe this new agreement offers immediate access to greater liquidity under more favorable terms.”
Finally, DIP lenders may be more willing to provide financing if their fees are kept secret, and a December 2008 ruling in the United States Bankruptcy Court for the District of Delaware permitted precisely that. In the Tribune Company Chapter 11, the Court ruled that “…the calculation of fees for the postpetition financing involved a proprietary methodology developed by the DIP lender…” and that satisfied the “confidential commercial information” requirement of Section 107(b) of the Bankruptcy Code.
Conclusion. Even in the current distressed economic environment, the DIP finance provisions of the Bankruptcy Code create extremely attractive---and secure--loan opportunities. If commercial banks opt not to pursue these opportunities, other lenders undoubtedly will. In the short term, these lenders may demand speedy asset sales and/or liquidations to repay their DIP financing. But over time, it seems likely that past practices, where Chapter 11 typically produced a profitable reorganized operating company, will return.
Because everyone makes more money that way.
Should you have any questions regarding your own situation, please contact David W. Marston of our Corporate Department or your Gibbons attorney.
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