Bloomberg Law
Free Newsletter Sign Up
Login
BROWSE
Bloomberg Law
Welcome
Login
Advanced Search Go
Free Newsletter Sign Up

A Path to Obtaining Equity Link Debtor-in-Possession Financing

Nov. 18, 2022, 9:00 AM

The primary catalyst to most Chapter 11 bankruptcy filings is an imminent lack of liquidity. Debtor-in-possession financing, which allows a company to continue to operate, is often the most critical and contentious issue presented to a court at the outset of a bankruptcy case.

In exchange for taking the risk of providing liquidity to a bankrupt company, DIP lenders receive, among other things, priority over existing debt, and other claims. Courts frequently approve this type of financing.

In what is a more frequent trend, DIP lenders are seeking the option to participate in the post-reorganization equity of debtors at the outset of the case through the grant of equity. Recent rulings offer guidance on the types of equity linked DIP financing that bankruptcy courts are likely to approve.

How it Works

Cash-strapped debtors are incentivized to accept equity-linked DIP financing because it may reduce the financing’s cash-pay elements. From a lender’s perspective it provides an opportunity to participate in the potentially lucrative post-reorganization equity of the debtors.

However, the post-reorganization equity provided to DIP lenders may reduce the recovery to creditors by taking equity that may otherwise be available to such creditors or investors paying cash for the equity.

Equity-linked DIP financing is not new.

For example, in 2009, equity-linked DIP financings were approved in the bankruptcy cases of General Growth Partners and ION Media Networks, and more recently in 2020 in Avianca and AeroMexico. And on Nov. 2, in Phoenix Services, the US Bankruptcy Court for the District of Delaware approved an uncontested equity-linked DIP financing.

Litigation Trends

However, not all equity-linked DIP financings are created equal. One that provides for a simple conversion of the DIP facility offers flexibility and value to debtors as they formulate a plan of reorganization. As seen in recent examples, equity-linked DIP financing with conversion options at a discount to plan equity value may limit debtors’ flexibility in proposing a plan.

For example, the US Bankruptcy Court for the Southern District of New York in LATAM refused to approve a DIP financing with an equity conversion at a discount to plan value. However, the same court in SAS in September 2022 approved a similar equity conversion despite “misgivings.”

Judge James L. Garrity, in refusing to approve the LATAM deal, highlighted specific concerns with the DIP’s equity conversion feature. He said the discount was not market tested, the debtors could make the election without court oversight, and the election dictated key terms of an eventual plan through such allocation.

The DIP financing was subsequently revised to remove the equity conversion feature and approved.

In perhaps the most aggressive equity-linked DIP financing proposed, the DIP lenders in SAS sought both conversion and tag options for post-reorganization equity.

The call/conversion option was for approximately $700 million of outstanding DIP loans at a post-reorganization total enterprise value strike price (the value of the underlying stock) of $3.2 billion. If the total value exceeded $3.2 billion, the DIP lenders would have the right to convert their DIP loans at a discount.

The tag option allowed the DIP lenders to purchase up to 30% of the post-reorganization equity issued under a plan at the same valuation of other investors. Notably, both the conversion and tag options were terminable at the debtors’ option, but required paying a substantial termination fee.

The court was clearly troubled by the prospect of allocating a specified percentage of post-reorganization equity outside of the plan process.

Judge Michael Wiles, echoing Garrity in LATAM, stated that “decisions about the issuance of equity in the reorganized debtors should be reserved for the plan process and noted that he had ‘flatly denied’ such terms in prior cases.”

Wiles expressed concern not only with the conversion and tag options, but what his decision might mean for future cases, and the opening of a Pandora’s box. He said that “if we have learned anything in the course of administering the Bankruptcy Code, it is that if we open a door by a crack in one case, the door gets pushed open ever wider in succeeding cases.”

Notwithstanding his misgivings, he approved the DIP financing with the conversion and tag options. He noted the similarities to the DIP financing rejected in LATAM¸ and stated he would have a lot of questions about both the legal principles and economics had any party raised an objection.

Outlook

These cases and decisions provide guidance for equity-linked DIP financings. We can say with some degree of confidence that a DIP financing with an equity conversion at the plan valuation will be viewed favorably by courts.

However, the more aggressive equity-linked DIP financings, such as those that include a discount to plan value, may be decided based on the circumstances of the case and whether the parties with an economic interest in the case are contesting the DIP financing. At least one court seems to be inviting such an objection.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Write for Us: Author Guidelines

Author Information

Andrew Minear is an associate in Fried Frank’s Restructuring and Insolvency Department.

Adam L. Shiff is a restructuring and insolvency partner resident at Fried Frank. His practice focuses on all aspects of restructuring, bankruptcy, insolvency and related litigation.