Bankruptcy lenders are dangling conditions to their loans to distressed businesses, intervening in reorganization in order to maximize their leverage in Chapter 11 cases.
Lenders adding terms to debtor-in-possession (DIP) loans—such as a promise to wrap up bankruptcy by a certain amount of time and setting who-gets-paid-first priority—has always existed. But data shows the practice has accelerated in recent years and fights over such loans have continued during the pandemic as the number of bankruptcies spiked.
Teligent Inc., Rockall Energy Holdings, and Latam Airlines Group are among the bankrupt companies whose reorganization plan has drawn unsecured creditors’ ire.
Such terms are part of the long-term transformation of DIP loan that unsecured creditors argue can sometimes go too far in favoring lenders over other stakeholders.
DIP lenders also often take priority in getting repaid in bankruptcy proceedings, tempting pre-bankruptcy lenders to roll up what they’re owed into a new DIP loan. That would have the effect of pushing other senior creditors further back in the queue of creditors waiting to be repaid.
The loan-condition changes have occurred because capital structures have become much more complex and businesses have become overly debt ridden, said Robert Feinstein of Pachulski Stang Ziehl & Jones LLP. Getting DIP loans from new third-party lenders also have become more rare, he said.
“So what that ultimately means is there’s no competition for DIP loans,” Feinstein said. “Lenders get to say what they want and what they do, and it’s resulted in just generally the cases being run for the benefit of lenders,” Feinstein said.
DIP lenders have steadily been increasing their control of Chapter 11 cases, according to a study by Kenneth Ayotte and Jared Ellias, who teach bankruptcy law at UC Berkeley School of Law and UC Hastings College of the Law, respectively.
Only 10% of DIP loans in their data sample between 1995 and 2000 required management to implement a specific transaction. But that figure had risen to 57% in the five-year period between 2010 to 2015, the study found.
But for creditors, even a DIP loan with onerous terms is usually still a better alternative to liquidation, said Jeff Anapolsky, an adjunct professor teaching corporate financial restructuring at Rice Business School.
Debtors are required by code to conduct a robust process in searching for a DIP loan, and bankruptcy courts are required to oversee a thorough DIP loan process, he said.
If other creditors dislike the debtor’s DIP loan option, they can propose an alternative loan with better terms, Anapolsky said. “Given the amount of debt capital out there seeking good investment opportunities, I disagree that competition for DIP loans is in short supply,” Anapolsky said.
Over the last 30 years, debtors have been implementing specific transactions that have been negotiated with their existing creditors before filing for bankruptcy, said Elias.
Common demands by pre-bankruptcy lenders, such as shortened time frames for bankruptcy proceedings, can make it harder for other creditors to generate enough information to make a counter loan offer or get a real handle on the debtor, he said.
“The information-producing function of bankruptcy law is diminished when companies sort of run through bankruptcy very quickly and they implement an agreement they reached not with all creditors but with a subset of creditors,” Ellias said.
These “debtor-in-possession” loans are meant to allow debtors to use the funding in ways to maximize their bankruptcy case. But contingent DIP loans can instead put lenders in the driver’s seat of bankruptcy cases, Feinstein said.
“It’s called lender-in-possession. And I think the lender-in-possession concept has been really a result of things that have developed over the last 15 to 20 years,” Feinstein said.
Bankruptcy law is meant to encourage lending out money to debtors for reorganization to try to salvage value, said University of Texas bankruptcy professor Jay Westbrook. That policy isn’t necessarily a bad thing and makes modern reorganization possible, but there can be drawbacks, he said.
“I think of a lot of these things as being like fire. It can burn down your house or cook your meal,” Westbrook said.
DIP Loan Friction
DIP loans can be subject to abuse because the financing can be important for a debtor’s viability and terms are powerful, said Anthony Casey, a business and corporate bankruptcy professor at the University of Chicago Law School.
DIP loans with strict requirements for the debtor made appearances in early pandemic bankruptcies, such as Neiman Marcus Group Inc. and J. Crew Group.
But as bankruptcy filings subside—they’ve reached historic lows last year—the strings attached to DIP loans haven’t abated.
In the Chapter 11 of oil and natural gas explorer Rockall Energy Holdings, an unsecured creditors committee said the secured parties that provided the DIP loan would roll up $34 million in prepetition debt through their new loan terms. The parties will also recover $1.1 million in fees and costs, the committee said,
Unsecured creditors could only get paid if Rockall can sell assets for a high price within a 65-day sale timeline, the committee said.
The terms “completely disenfranchises unsecured creditors,” it said.
The DIP loan “goes far beyond simple financing and attempts to effectuate near total control by the prepetition secured parties over the administration and outcome of these cases,” the committee said.
In another example, a creditor of 4E Brands Northamerica LLC complained about a DIP loan from 4E’s parent company. The loan would insulate the parent from its own liability for damages and shift costs to the debtor’s estate, the creditor said.
Creditors can ask judges to reject conditioned DIP loans. Judges rarely fully reject DIP loans, according to Wei Wang, a bankruptcy professor at Smith School of Business at Queen’s University.
But judges on occasion push back on stringent DIP loan terms. Judge James L. Garrity of the U.S. Bankruptcy Court for the Southern District of New York in September 2020 initially refused to approve a $2.45 billion DIP loan from Latam Airlines’ shareholders in the company’s Chapter 11.
The terms allowed Latam Airlines to repay existing shareholders with discounted stock. It also required that only a reorganization plan approved by the company could be confirmed in the bankruptcy.
Garrity later approved the loan after lenders changed the terms.
Improving the market and bringing more confidence to pricing and terms of DIP loans would be a “huge improvement,” Casey said.
To make the DIP loan market more competitive, bankruptcy courts could allow a time at the outset of a case for others to offer a short-term DIP loan without required milestones, Ayotte and Ellias suggest in their paper.
Such a solution may not work because it doesn’t solve “information asymmetry” that exists between pre-existing lenders and other creditors, Casey said. It also doesn’t improve the DIP loan market, he said.
If a debtor doesn’t run a robust process in seeking a DIP loan before filing for bankruptcy, a court should require the debtor to do so post-petition, Anapolsky said. Whatever due diligence information that was shared with the proposed DIP lender should also be made available to potential competitors to enable them to submit alternative proposals, he added.
“Competing term sheets, not legal objections, are the best way to convince an aggressive DIP lender to revise its proposal to be more debtor-friendly,” Anapolsky said. “Since DIP loans are typically approved on an interim basis, which is usually 30 days, other parties get a chance to propose alternatives before final approval.”
It may be unavoidable that those with more information about the distressed business are more willing to make such loans because of their pre-bankruptcy relationship, Casey said.
“The market for DIP loans will never be perfect,” Casey said. “There will always be asymmetric information and time pressure. But what is the alternative?”