July 24, 2017

By: Michael Brandess and Luke Smith

 


 

A written tour of business bankruptcy and its alternatives.

Editors’ Note:  we started this series (click here to start reading from the beginning) with a broad overview of business bankruptcy and its alternatives.  Our last few installments have focused on explaining how a creditor can, when its customer files bankruptcy, collect as much as possible on what it is owed (read about How To Protect Your Claim and about Priorities). In this installment, we turn to how distressed companies seek liquidity in the bankruptcy context: DIP Financing and Cash Collateral Motions.

 

Chapter 11 is expensive.  There is a seeming irony here in that a company that files for bankruptcy often does not have the cash to do so. How, then, does such a company file bankruptcy? And, what is the true cost of obtaining bankruptcy financing?

 

Obtaining Permission to Use “Cash Collateral”

Most businesses of any real size have some sort of outside debt financing. This commonly takes the form of a line of credit with a bank or other lender.  Often, these lines of credit are secured by substantially all of the assets of the borrower.

All assets means just that—all assets, including cash and receivables. The Bankruptcy Code dictates that a company in bankruptcy cannot use the cash collateral of a secured creditor without either (i) the consent of that secured creditor; or (ii) the approval of the bankruptcy court over the secured creditor’s objection. As a practical matter, a secured creditor will only agree to allow its cash collateral to be used if it can extract certain concessions in return; something that the debtor cannot agree to without court approval.

What all this means is that even if a would-be Chapter 11 debtor has enough cash to satisfy administrative costs (such as professionals and ongoing business expenses), it has to file a motion to use that cash. Such a motion is commonly filed at the very beginning of a Chapter 11 case on an emergency basis.  The motion is usually accompanied by a proposed budget.

 

DIP Financing

Even assuming the use of cash collateral, companies that are about to file bankruptcy are often cash poor.  So what is a company to do when it needs money to operate during bankruptcy and to pay the extraordinary administrative case expenses, but doesn’t have the funds?  The answer is borrow it.

But who would loan to a company about to file bankruptcy?  As counterintuitive as the answer may seem to appear at first blush, the answer is plenty of parties.  Some potential sources include:

  • Institutional banks – lenders who loaned the debtor funds prepetition can be a reliable source of debtor in possession financing.  They are familiar with the debtor and its operations and are in a strong position to assess potential risks to their collateral.  Moreover, they commonly want to prevent a new DIP lender from coming in to “prime” them.

 

  • Bridge lenders – lenders who see distressed businesses as an opportunity to charge a higher interest rate can also be a source of post-petition funds.  However, the interest rates often make it difficult for an already unhealthy business to successfully emerge from chapter 11.

 

  • Asset purchasers - A private equity fund or other interested bidder can provide post-petition funds in order to finance a sale and acquire assets free and clear of all liens and encumbrances.  The DIP loan can then be “credit bid” at auction.

Debtors can borrow money on an unsecured basis in the ordinary course of business without obtaining court approval, and such loans are allowable as an administrative expense.  As a practical matter such loans occur when a vendor provides post-petition credit terms. A lender making a cash loan, however, typically will not do so on the mere basis of getting an administrative expense claim.

A debtor that wants to borrow money out of the ordinary course of business or on a secured basis must get court approval to do so.  And, the hoop that a debtor must jump through in order to obtain such approval depends on the lien priority that the debtor wants to grant the would-be DIP lender. Bankruptcy Code §364 governs this.  To obtain unsecured credit outside of the ordinary course of business, the DIP must first seek and obtain the consent of the court after notice and a hearing.

If the DIP is unable to obtain unsecured credit, then, after notice and hearing, the court may authorize the DIP to obtain credit backed by a superpriority administrative expense claim, a secured lien on unencumbered property of the estate, or a junior lien on already encumbered property of the estate.

If, and only if, the DIP is unable to obtain credit by any of the means listed above, the court may authorize post-petition financing secured by a first-priority lien on property of the estate that is already encumbered (a “priming lien”), provided there is adequate protection for the holder of the lien being primed.  Such relief is rare.

In any case, DIP lenders generally extract as many protections as they can before subjecting themselves to the risks attendant in bankruptcy financing.  These lender-friendly provisions are often rebutted not by the DIP itself, who does not have proper leverage to negotiate with a DIP lender, but instead by creditors’ committees, the U.S. Trustee or even the bankruptcy court.

 

Procedural Issues

Courts are typically concerned in the context of cash collateral and/or DIP financing motions that (1) they lack time to properly review and develop an understanding of the issues; and (2) creditors and creditors’ committees don’t have an opportunity to review the arrangement, even though it can have a substantial impact on potential creditor recoveries.

The Bankruptcy Code provides guidance concerning post-petition financing agreements and the protections afforded to secured creditors. Specifically, Bankruptcy Rules 4001(b) and (c) provide for the interim use of cash collateral and DIP financing, respectively.  In other words, a debtor can receive court approval for the temporary use of cash without binding itself to final terms or denying other parties in interest (such as a creditors’ committee) a chance to weigh in. Rule 4001 provides for an interim hearing at the beginning of the case, followed by a full hearing at least 15 days later. At the interim hearing, the court may authorize DIP financing and/or cash collateral use only to the extent necessary to avoid irreparable harm pending a final hearing. This is often necessary for a DIP to make payroll, pay for post-petition goods or services, or otherwise maintain the DIP’s value as a going concern.

Even within the framework of Rule 4001, courts have expressed concern over the content of DIP financing and cash collateral orders. In his letter to the Delaware Bar, Bankruptcy Judge Peter J. Walsh outlined unfavorable provisions that should be excluded from interim DIP and cash collateral motions such as:

  • provisions that are “just too verbose and cover unnecessary matters;”
  • provisions that incorporate specific sections of underlying loan documents without a statement of the sections’ import;
  • provisions that state the court has examined all of the underlying loan documents or that it approves of their terms;
  • lengthy recitations of fact concerning the relationship between the debtor and the lender (and suggesting instead the use of stipulations);
  • statements that parties in interest have been afforded “sufficient and adequate notice” (and suggesting that the order recite that the hearing is being held pursuant to Bankruptcy Rule 4001(c)(2) and listing the parties to whom notice was given);
  • provisions that grant the lender a lien on avoidance actions;
  • any attempt to limit the committee’s right to challenge a lender’s pre-petition position to less than 60 days (and in most cases to less than 90 days) or to not grant committee counsel a carve-out; and
  • provisions that expressly or by their terms have the effect of divesting a debtor of any discretion in formulating a plan.

Many other courts have established local rules or other written guidance along the same lines, such as the requirement is that specific provisions (such as cross collateralization, §506(c) waivers, lien on avoidance actions, etc.) be identified in a motion, so the judge does not inadvertently miss them. For an example of such local rules, see Delaware Local Rule 4001-2(a)(ii).

 

Bedrock Planning Steps

The DIP’s first steps when contemplating post-petition financing should come as soon as a bankruptcy filing proves likely.  Pre-filing (if possible), debtors should begin their due diligence of existing loan documents and cash flow needs.

The development of an initial budget is also essential to obtaining court authority for post-petition financing. Likewise, lenders require budgets to ensure that cash is spent prudently and with an eye towards repaying the lender in full (with interest). Post-filing, unsecured creditors must also scrutinize budgets and planned expenditures for any excessive spending, such as high interest rates or unnecessary expenditures.

Next, the court must assess the overall structure and proposed use of post-petition funds.  This is where the court will scrutinize the many lender-friendly protections insisted upon by the post-petition lender. For instance–how much of the liquidity injection is truly “new money” as opposed to a rollup of prepetition debt? What protections are being granted to DIP financiers, such as adequate protection liens or superpriority administrative expense claims, that may affect the lender’s rights relative to other creditors? Is there more than one lender, or tiers of lenders, providing first- and second-priority DIP financing? Do the debtors even need DIP financing, or could their going concern be preserved through use of cash collateral alone?

Answering these questions will prove essential for a debtor to pay for the privilege of financing its bankruptcy case.

 

To read other installments in this series, click here

 


 

Michael Brandess is a partner at Sugar Felsenthal Grais & Hammer LLP’s Chicago office. He is ranked AV® Preeminent™ by Martindale.com and has been listed as a Rising Star by Super Lawyers magazine for the past two years. Michael was named the Emerging Leader of the Year by the Turnaround Management Association’s Chicago/Midwest chapter in 2015. Luke Smith is set be begin his restructuring career in Chicago the fall of 2017.



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