The Examiners: Make DIP Financing More Restructuring-Friendly

If you could make one change to the bankruptcy code, what would it be?

Much has changed in the paradigm Congress envisioned when it created Chapter 11 in 1978 as a vehicle for reorganizing ailing enterprises. The balance of power among debtors, secured creditors and unsecured creditors classified in the 1978 code—what some would call a relatively level playing field and others a pro-debtor field—has changed. Control of the Chapter 11 process has shifted in favor of secured lenders; some say too much so, and others say just enough to be fair. A third camp, relying on survey data, say if the shift is real, it is certainly not as dramatic as popular opinion would have you believe.

The enhanced influence wielded by secured creditors in Chapter 11 cases is due in large part to changes in the manner in which companies today are financed outside of Chapter 11. Most notable among those changes is the fact that a typical Chapter 11 debtor has significantly more secured debt today than it had in 1978. Many companies file for Chapter 11 protection today with few, if any, unencumbered assets available to provide the basis for debtor-in-possession financing from any source other than the prepetition secured lender. In practical terms, this means that continued operation in Chapter 11—let alone a successful reorganization—is often impossible without the prepetition secured lender’s consent.

With no equity cushion in existing collateral and with no unencumbered assets to provide “adequate protection” against diminution in the value of a secured lender’s collateral, a Chapter 11 debtor is beholden to its secured lender to use the lender’s cash collateral or permit priming DIP financing to fund the debtor’s Chapter 11 case. Indeed, at the outset of cases in these circumstances, there is often little to no real competition to provide DIP financing (other than by the existing secured lenders). The result too often is DIP financing incorporating conditions that the 1978 code never even contemplated, including rollups, strict timing milestones, prepayment penalties, liens on estate avoidance actions, waivers of unsecured creditors’ rights to challenge the validity of the lender’s liens and waivers of collateral surcharge rights under section 506(c) of the bankruptcy code. Given this backdrop, it is not surprising that more companies that enter Chapter 11 proceed directly to an orderly liquidation of their assets by means of a section 363 asset sale.

The code needs changes to ensure that funding is more readily available on terms that support a more predictable and orderly Chapter 11 process that maximizes value of the enterprise and more fairly allocates the costs of a Chapter 11 case. There is no one change that could accomplish this objective. A careful balancing of a collection of changes is needed. They include changes to, among others, the extent of the 506(c) surcharge of secured creditor collateral and the terms and conditions that can be included in DIP financings (e.g., limiting the ability of DIP lenders to force sales on timetables that do not maximize value for the estate, limiting rollups that are not rationally related to the benefit conferred by the financing and prohibiting waivers of 506(c) surcharge rights).

Paul Leake is a partner in Jones Day’s New York office and the global practice leader of the firm’s business restructuring and reorganization practice.