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Supplemental Testimony Before the ABI Commission To Study the Reform of Chapter 11 Mark Shapiro Managing Director, Barclays Capital My name is Mark Shapiro. I am a Managing Director at Barclays Capital and Head of the Global Restructuring and Finance Group in the Investment Banking Division. I have been a professional working in the bankruptcy area for over 25 years, first as an attorney and most recently as an investment banker. I am the head of the group at Barclays that originates, structures and syndicates debtor-in-possession (“DIP”) loans. Barclays is a substantial participant in the active market for DIP lending. I am therefore familiar with the operation of that market, and the role it plays in the bankruptcy process. Introduction The American Bankruptcy Institute’s Commission to Study the Reform of Chapter 11 (the “Commission”) has asked me to supplement my prior testimony1 to address ways to make the DIP market more efficient and potentially more competitive. The views expressed herein are my personal views and should not be ascribed to Barclays, my employer. Based on my experience in both advising borrowers and providing DIP financing, the starting point of any analysis must be that a company facing the prospect of Chapter 11 should have all of the “tools” that it needs to attract new capital to enable its business to operate during Chapter 11, thereby giving the company the time to reorganize in Chapter 11. These “tools” are used as inducements to provide lenders with an incentive to make a new DIP loan, or conversely, to provide an existing pre-petition lender with the protections needed to extend additional credit in the form of a DIP loan. Each of the provisions viewed as “lender-favorable” in the ongoing DIP discussion has a purpose and underlying value to the lender, and becomes part of the lender’s overall risk-benefit analysis concerning the potential DIP loan. Outright prohibitions of any specific right or protection on the ground that it is “too favorable” to a DIP lender will mean that the lender will be required either to enhance other terms (including pricing) to compensate for the absence of the prohibited provision, or not to make the DIP loan available in the amount and for the duration that a Debtor needs to reorganize. To develop this analysis, I first discuss the functioning of the DIP market generally, including the various interests of the DIP lender and the Debtor. At bottom, a DIP loan is a commercial transaction, and the borrower’s management is best positioned to negotiate the commercial terms. I then turn to the specific provisions that have been considered by the Commission, either at Commission hearings or in other writings and commentary. All of these points are buttressed by the Loan Syndication and Trading Association’s recent DIP study. That study demonstrates that many of the anecdotal impressions about the effects of DIP loans—such as the suggestion that DIP lenders commonly exercise undue control of the Debtor, leading to a rash of liquidations—are not supported by the data. In my view, 1 I previously testified before the Commission at its November 30, 2012, field hearing in Tucson, Arizona, at the ABI Winter Leadership Conference. 1 certain proposals to modify certain provisions of the Bankruptcy Code that address DIP lending must be further refined, and the effect of any revisions carefully considered before any solutions can be proposed and implemented. I. The DIP Market The DIP lending market provides a complex and challenging arena for lenders. Not only must they engage in all analyses that are attendant to a more typical loan to a non-distressed commercial borrower, but they also must understand the legal and financial framework that encompasses a potential borrower in a Chapter 11 case, including the impact of Chapter 11 on the Debtor’s business. Contrary to some remarks at Commission field hearings that DIP loans should be approved easily because they nearly always are repaid, both lender and Debtor decision-making in the DIP market take account of numerous considerations that impact the terms and pricing to which lender and Debtor can agree. The historical repayment rate for DIP loans to other Debtors plays little, if any, role in that process. In this section, I develop some of the most salient lender and Debtor considerations that impact the choice to lend or borrow in the DIP market. A. Lender Considerations in the DIP Market A lender evaluating a potential DIP loan must evaluate several categories of issues before it can be in a position to commit to making a DIP loan. Each and every credit determination must be made on a case-by-case basis, after evaluation, to the extent possible under the circumstances, of the idiosyncratic and specific risks attendant to each potential borrower. Generalized data points—for example, that as a historical matter many DIP loans have in the past been paid back in full—do not provide helpful guidance in making a determination about whether or not to underwrite and fund a specific loan, and if so, how to price that loan. To borrow a phrase, every Debtor is bankrupt in its own way, and before making and pricing a loan to a specific Debtor, the lender must evaluate the risks of lending to this entity. Underwriter and lender considerations span both bankruptcy and non-bankruptcy issues. 1. Commercial Lending Risk-Benefit Analysis As with any commercial loan, a potential DIP lender must perform diligence on the borrower to understand the risk associated with the loan and to generate an appropriate structure and pricing. Importantly, at the time that a Debtor is shopping for a DIP loan, much information about the entity or its operations may be lacking or incomplete. Items that any lender, including a potential DIP lender, considers before extending credit include: (1) Borrower’s operations; (2) Performance by relevant sector; (3) Strength of management; 2 (4) Cash position, cash flow, budget and projected uses, business plan, and related financial metrics; (5) Valuation of the business and risks to valuation; (6) Trading prices and holders of the borrower’s securities and loans; (7) State of the leveraged loan market for syndication; (8) Available collateral and loan-to-value considerations; (9) Structural protections for the loan; and (10) Alternative means to “exit” the loan at maturity, including possible buyers of some or all of the business, in whole or in parts. These considerations do not become irrelevant when the prospective borrower is in financial distress or contemplating reorganization in Chapter 11. Instead, many of these considerations become particularly important in such situations, because financially distressed borrowers may compare unfavorably to non-distressed borrowers along many of these metrics. For example, a financially distressed potential borrower may have poor or declining operational performance, restricted cash flow, low securities and loan trading prices, and little collateral available to secure the loan. Thus many DIP loans will be inherently riskier than the typical commercial loan, and so lenders will need to structure and price the DIP loan to mitigate the risk and lead the lender to extend credit. 2. Bankruptcy Considerations in DIP Lending Risk-Benefit Analysis In addition to the risk-benefit considerations that any commercial lender considers before extending credit, a potential DIP lender also must evaluate specific issues involved when lending to a Debtor in Chapter 11, which include: (1) Borrower’s ability to execute business plan while functioning as a Debtor-InPossession, including impact on liquidity; (2) Opposition by/negotiations with creditors or other parties in interest, including any pre-petition lenders and the creditors’ committee; (3) Necessity of court approval/ongoing court involvement in the lending relationship; (4) Costs of administering the Chapter 11 case (i.e. professional fees); (5) Rights to take action following an event of default; (6) Prospects for successful reorganization/sale as a going concern versus risk of liquidation; 3 (7) Length of case/timing for repayment of the DIP loan; (8) Availability of exit financing/additional funding; and (9) Potential enhanced exposure to litigation risk arising out of the bankruptcy environment. These additional considerations combine to create significant “tail-risk” in making a DIP loan. If a Debtor is unable to exit bankruptcy successfully as originally contemplated by the DIP lender—or if other unforeseen events occur during bankruptcy, such as the Debtor losing control of its case to a committee or trustee—the DIP lender faces the risk that its DIP Loan could trade below par or even not be repaid in full. These risks all cannot be fully assessed at the time that a lender is asked to commit to—or “underwrite”—a DIP loan, due to the prospect of unforeseen events or unfulfilled expectations, requiring the lender to make a decision on limited information. These considerations all create risks for the DIP underwriter and lender, though, even if they may not come to pass in any given case. 3. DIP Loan Timing When a Debtor is in financial distress and/or in a Chapter 11 case, the potential DIP underwriter/lender often must perform a substantial amount of work in a very short amount of time. Most Debtors need their DIP loan to be fully committed prior to filing for Chapter 11 to ensure a reasonable certainty of funding in Chapter 11. Since most financial institutions that underwrite DIP loans do not want to hold most (or all) of a loan to which they are committing, the lender must sell or “syndicate” the loans to third-party purchasers after the commitment has been made. Generally speaking, lenders need approximately three weeks to perform their due diligence and related tasks associated with reaching a decision on whether or not to commit to making a DIP loan. However, before a lender will commit the significant resources necessary to evaluate properly a Debtor for a possible DIP loan, it must have an initial level of comfort that it will be able to sell the loans successfully on the terms to which it has committed and that it will be appropriately compensated. 4. DIP Lenders’ Capital Considerations When a lender provides a commitment letter to make a DIP loan, it must have the funds ready and available to lend—which means there is a charge against its capital. In this regard, the lender has committed (subject to the conditions contained in the commitment) in every sense to the DIP loan as soon as it issues a commitment letter. If capital has been committed to Borrower A, it means that the same capital is unavailable to potential Borrower B. Accordingly, when a DIP lender commits to making a loan, basic economics require it to collect a corresponding underwriting fee for the commitment, which is usually 2% to 4% of the commitment. The fee compensates the lender for the unavailability of the committed capital and the risk in committing to the loan, since the underwriter “owns” the loan on the agreed terms. This dynamic makes it difficult, if not impossible, to run an “auction” after a commitment letter has been entered—that is, an auction similar to the way assets commonly are sold under section 363—because once the commitment fee has been paid, it is difficult for another lender (that would require a similar commitment fee, for the same reasons described above) to compete economically. That said, 4 there is no reason why a Debtor, prior to signing a commitment letter with a DIP lender, cannot and should not shop for the most favorable terms available. 5. DIP Loan Underwriting and Market Considerations When a lender underwrites a committed loan, that lender has committed to make the entire amount of the loan and, if the lender ultimately is unable to syndicate the loan, it will be held by the lender on its own books, tying up substantial capital. The risk that a lender will be unable to syndicate and remain committed to the entire loan amount is a very real one, as the very tight credit markets in the wake of the financial crisis demonstrated—with billions of dollars of leveraged loans that could not be syndicated. Magnifying these concerns, the potential syndication market for DIP loans is only a small subset of the overall leveraged loan market, because approximately 80% of typical leveraged loan investors (mutual funds and CLOs) either do not purchase DIP loans or only have small pools of capital allocated to DIP loans. 6. DIP Loan Pricing Some have posited that DIP loans are “overpriced” because historically they have rarely resulted in losses to lenders. However, the uncertainty, risks, need for a commitment, potential illiquidity and considerations outlined above necessarily factor into DIP loan pricing. Before making a DIP loan, the lender must evaluate the borrower on a particularized basis, often with incomplete information, and knowing that it must commit under severe time constraints and later seek to syndicate the loan to a (relatively) small secondary market. Moreover, the pricing of a DIP loan must also cover the tail-risk, albeit small, of potential trading (i.e., mark to market) or actual losses on that loan. Past performance, as they say, provides no assurance of future results. And the pricing of DIP loans typically reflects the market’s best assessment of the risk associated with making this type of specialized loan to this particular Debtor—including the types of tailrisks described above, which by their nature involve a high degree of uncertainty. B. Debtor Considerations in the DIP Market The Debtor-In-Possession, through its management, is charged with using its business judgment to protect and maximize the value of the estate for the benefit of creditors and other constituencies. This duty requires the Debtor to assess various factors when deciding whether to enter the DIP loan market and negotiating and entering into a particular DIP loan. As with the potential DIP lender, the Debtor must consider economic issues in negotiating and entering into a DIP loan, including interest rate, fees, availability, covenants and restrictive provisions, among other terms. The lender will negotiate these terms based on its assessment of the various risks discussed above, and the factors that most often impact pricing of the loan include the collateral that secures the loan, the liquidity and free cash flow of the company, where other debt securities are trading in the market and how competitive a process the company can run. A Debtor also must consider its long-term business goals and related strategic considerations. In this regard, it may not wish to engage in a contentious process with its prepetition lender (through a priming fight) at the beginning of the Chapter 11 case because a 5 priming fight is often difficult to win and, more importantly, the Debtor would not have access to new financing during the priming litigation. Instead, the Debtor often prefers to secure and obtain DIP financing as early as possible in order to finance its Chapter 11, despite the limitations that may be imposed on its negotiating position. Deference usually is given to the Debtor’s business judgment in these commercial decisions. However, the system depends on the proposition that in negotiating a DIP loan, as in making other business choices, the Debtor’s management is seeking to maximize the overall value of the business enterprise, with a view toward the interests of all of its stakeholders. As a practical matter, based on the experience of many restructuring professionals, it is commonly the case that a Debtor’s management and board delay addressing its economic distress. Debtors that fail to address the need to engage in bankruptcy planning until the last minute may not have the time to engage a process through which a third-party lender can conduct the diligence necessary to extend post-petition credit (as mentioned above, the diligence process typically lasts at least three weeks). Because the pre-petition lender already will have a comprehensive understanding of the Debtor’s business (and will in many cases have a lien on substantially all of the Debtor’s assets), Debtors often are left with little practical choice but to rely on the pre-petition lender for bankruptcy financing. This reality means that a Debtor will have a reduced ability to negotiate the terms of its DIP loan because only its pre-petition lender is willing to make the loan. II. The Focus on Common DIP Provisions Will Not Increase DIP Loan Efficiency or Competitiveness In field hearings and publications, members of the Commission have focused on common DIP provisions, suggesting that certain of these terms are overly onerous and oppressive and impair the Debtor’s ability to reorganize. Commission members have suggested that changes to these provisions will remedy the perceived lack of DIP loan efficiency and competition in the DIP market. However, changes to these provisions will not achieve either of those goals. A. Common DIP Provisions The provisions that Commission members have identified as onerous or oppressive include: (1) roll ups (the payment of a pre-petition debts with the proceeds of post-petition DIP loans); (2) milestones (provisions that require the Debtor to accomplish something by a date certain or trigger an event of default); (3) cross collateralization (the practice of securing prepetition debt with post-petition collateral); (4) influence on management (including provisions involving lender-approved CROs); (5) liens on avoidance actions (provisions that immediately grant to the post-petition secured creditor liens on the Debtor’s claims and causes of action arising under Chapter 5 of the Bankruptcy Code); (6) binding determinations regarding the validity or perfection of liens; (7) waivers of sections 506(c) or 552(b) (provisions that seek to waive, without notice, whatever rights the estate may have under Bankruptcy Code Section 506(c) to surcharge collateral and/or rights concerning the equities of the case exception under section 552(b)); and (8) prepayment penalties. 6 Relatedly and for a similar reason, Ken Klee and Rich Levin recently made specific proposals either to limit or—in many cases—completely prohibit certain similar provisions.2 On the whole, Klee and Levin view priming problems and DIP provisions as leading to a lack of competition for DIP loans before and during the bankruptcy case. As such, they propose to (1) prohibit approval of roll up provisions except as noted below, (2) limit interim DIP financing to the funds necessary to operate during interim period, (3) prohibit prepayment penalties in DIP agreements, and (4) require that DIP loans not unduly restrict Debtor’s ability to refinance, including not allowing a Debtor to incur reasonable expenses to encourage DIP bidding. Klee and Levin view roll ups as an undue exercise of lender control and limitation on the Debtor’s reorganization options. They therefore propose to prohibit all roll ups, except to the extent (1) the collateral is receivables and/or inventory, (2) rolled-up debt provides incremental liquidity to the Debtor and is in the best interest of the Debtor’s estate, and (3) the amount of the rolled-up debt is limited to the value of the pre-petition collateral. Similarly, Klee and Levin believe that milestones, particularly with respect to the plan and sale processes, have led to a proliferation of quick section 363 sales and preclude the Debtor from finding alternative business plans, potentially leading to lower asset valuations. They propose prohibiting DIP orders from limiting any statutory rights granted to Debtors by the Bankruptcy Code, such as requiring defined, agreed periods for the Debtor to file a disclosure statement and a plan and to solicit acceptances. They also propose implementing a minimum time before a section 363 hearing may occur, setting a minimum maturity date for DIP loans that mirrors the sale hearing threshold (to foreclose the possibility of circumventing sale threshold), and prohibiting provisions allowing DIP loans to mature or accelerate simply on account of 363 sales not closing within 60 days of the sale order. Klee and Levin also propose to prohibit a number of other common provisions such as cross collateralization, CROs, liens on avoidance actions (although they may concede some discretion to allow DIP lenders’ liens to be satisfied from proceeds and to allow DIP lenders that extend new loans post-petition to secure loans by liens on collateral that is freed by avoidance actions), waivers of sections 506(c)/552(b), and prepayment penalties. All of these proposals and the Commission’s focus on these types of DIP loan provisions miss the point. B. Changes to These Provisions Will Not Achieve Efficiency or Competition As an initial matter, and as discussed earlier, the raw data does not support the anecdotal impression that the rise of DIP loans with roll ups of pre-petition debt and control provisions with tight milestones have led to the proliferation of quick sales or liquidations in Chapter 11. When the LSTA sought to test this proposition, it found that while all but a few of the DIP loans in its DIP study included such provisions, only about 25% of the cases had (i) converted to Chapter 7, (ii) involved section 363 sales of all of the Debtors’ assets, and/or (iii) involved confirmation of liquidating plans. And of that subset of cases, only 38% (i.e., less than 10% of the total sample) involved a roll up, refuting the idea the roll ups are fundamentally bridges to 2 Kenneth N. Klee & Richard Levin, Rethinking Chapter 11, 21 J. BANKR. L. & PRAC. 5 (2012). 7 sales. Moreover, the proposals to address this anecdotal problem fail to apprehend the role that such provisions play and the effects of prohibiting or restricting them. The provisions that Klee and Levin seek to limit or prohibit are often the direct consequences of the financial health—or lack thereof—of the Debtor. Given the LSTA’s data and the commercial reality confronting a debtor in poor financial health, I believe that the current DIP financing regime, which affords bankruptcy courts the discretion to approve many of the provisions that Klee and Levin take issue with after adequate disclosure and based on the facts of a particular case, functions fairly well in the overwhelming majority of cases. Outside of bankruptcy, secured lenders are entitled to full repayment or to foreclose on their collateral. Allowing a Debtor to roll up pre-petition debt in appropriate circumstances can often induce lenders to lend more capital, or lend on more favorable terms, than would be the case without the roll up. Since roll ups typically are only permitted when the pre-petition debt is fully secured by the value of the collateral, they do not convert unsecured debt to secured debt and do not alter the economic distributions among creditors. These provisions are designed to increase the prospects of full repayment to those pre-petition lenders who are willing to extend additional credit to the Debtor, or who are willing to permit a third party to consensually “prime” their collateral, and to provide greater certainty of full repayment to those lenders. To fund the cost of the Debtor’s post-bankruptcy activities, those lenders require some comfort that the Debtor is taking all steps necessary to improve its value and maximize recovery. Many of the above-mentioned provisions are used when a Debtor seeks funding from a pre-petition lender. When the Debtor approaches its pre-petition lenders for DIP financing, their existing loans are at risk and their collateral is at stake. These provisions simply (and rationally) provide that if the Debtor is going to take the pre-petition lender’s money now in the form of a DIP loan, the Debtor will not later use that money in litigation against the lender. For example, roll ups remove the threat of a cram down, and lien determinations prohibit later challenges to liens when the pre-petition lender extended DIP financing on the assumption that its earlier liens were secure. In view of the tail-risk associated with making a DIP loan, it is wholly appropriate for a DIP lender to place substantial value on these types of provisions, which serve to mitigate that risk. Similarly, the appointment of an independent CRO mitigates risk to all constituents in the bankruptcy. This somewhat less common DIP provision often supplements the management team’s capability and provides the Debtor with an officer who typically possesses prior Chapter 11 experience. This is a positive step for all constituents and often contributes to a more efficient Chapter 11 case. Other provisions, such as milestones, are tailored to the particular Debtor. Milestones regarding sales, for example, generally are found in defensive DIP loans in which funding is given to a Debtor with a deteriorating business and rising costs from the bankruptcy. There may be a limit on how much new capital can be raised and whether the Debtor will have sufficient capital and time to reorganize. The longer the sale process or plan process takes to be consummated, the smaller the asset recovery value will be. Therefore, rational lending practice dictates that the DIP lenders condition their lending on the Debtor’s pursuit of a prompt realization of value. Having milestones that accelerate a Chapter 11 case, by requiring specific dates by which a plan and disclosure statement must be filed, often is in the best interest of both 8 the lenders and the Debtor—a shorter Chapter 11 case generally leads to less impact on the business, greater and earlier certainty of exit, and lower professional fees. Milestones may be particularly helpful to all constituents when the business is deteriorating or the Debtor’s ability to raise new capital is limited and a short Chapter 11 case is all the Debtor can fund. Moreover, if the business is healthy when these milestones occur, the Debtor may always refinance the DIP loan with a new DIP loan if it is cannot satisfy the milestones. Milestones, rollups, appointment of a CRO or limiting the Debtor’s ability to fight with the DIP lender as a condition to financing are simply prudent lending practices. These provisions lower the DIP lender’s risk, resulting in better terms for Debtors. Complete prohibitions on such provisions will necessarily be factored into terms and pricing and may have the unintended consequence of increasing DIP pricing and fees or, in some cases, cause the lender to not make any DIP financing available (or at the least, a smaller quantum available). The Commission should consider these points before its members suggest blanket prohibitions, especially when the empirical data do not show that DIP loan provisions lead to quick sales and liquidations on the scale that has been suggested. The economic reality is that most companies enter Chapter 11 with few, if any, unencumbered assets available to provide the basis for additional financing or a true working capital, “new money” DIP credit facility. The next section will address how to foster competition among DIP lenders in that environment. III. Areas for Improvement and Fostering Competition Among DIP Lenders A. Mandatory “Shopping” Period Rather than regulating the provisions of DIP facilities and DIP financing orders that are designed to reduce the risk of loss by the lender, the focus should be shifted to pre-bankruptcy planning in an effort to promote the prospect that companies will properly shop for a DIP loan before the situation becomes dire. The Debtor should be required to complete some DIP work pre-petition by imposing, for example, a requirement that the Debtor demonstrate at any interim hearing seeking the approval of a DIP loan that it commenced the search for a DIP loan at least 45 days prior to the filing of its petition, absent exigent circumstances. The “exigent circumstances” standard should be a difficult exception to satisfy (i.e. unexpected emergencies). The Debtor should demonstrate that it actively shopped a loan and that at least three lenders other than the pre-petition lenders were provided the opportunity to provide a new DIP loan and had sufficient time to analyze the borrower’s credit. A demonstration of such shopping would be particularly useful before roll ups and liens on avoidance actions were granted. B. Time between “Interim” and “Final” Orders The Code could be revised to require that a Final Order, absent exigent circumstances, not be entered prior to 30 days after the Interim Order is entered. Relatedly, the Debtor should be permitted to pay reasonable work fees and expenses to third party prospective lenders, notwithstanding any limitations in DIP loan agreements for reasonable and necessary expenses, if the Debtor believes in good faith and following consultation with the Unsecured Creditors 9 Committee that alternative DIP financing on improved terms could be obtained prior to the entry of the Final Order. C. Roll Ups The Commission should seek to introduce the concepts of proportionality or cause for the approval of a roll up. For example, the Code could limit a roll up to a certain percentage of prepetition debt, or mandate a certain amount of additional liquidity be provided that is proportionate to the amount of pre-petition debt being rolled up, or require a Debtor to demonstrate that absent the roll-up, the Debtor has no alternative financing available to it. Similarly, the Code could require that the Debtor establish that the rolled up portion of prepetition debt is oversecured or that absent the “rollup” of pre-petition debt as a condition to consent to a priming lien, no consensual priming of such lender’s lien could occur. D. Liens on Avoidance Actions In addition, a Final Order could mandate that avoidance actions be the last asset available to satisfy the DIP loan. Such assets should be available to satisfy the DIP loan only if substantially all other assets otherwise available to repay the loan would not satisfy the lender in full. Conclusion There is no evidence that any particular DIP loan provisions regularly cause Debtors to liquidate or force them into unwanted section 363 sales. The provisions of DIP loans that some Commission members have labeled as oppressive provide DIP lenders with the structural protections they need to extend credit on the terms and conditions they do. Despite historical repayment in full of most DIP loans, potential lenders must negotiate and price DIP loans based on the particular circumstances of specific Debtors, and the lenders assume significant risks when they commit to DIP financing in advance of a filing. The lack of competition among DIP lenders is a result of most Debtors’ delay in addressing their financial distress before filing Chapter 11 or because the pre-petition debt is undersecured and no other lender, absent a successful priming litigation, would provide such financing. Competition would be increased if the Debtor were required to show at a hearing on DIP financing that it had commenced its search for financing early enough that multiple lenders had time to diligence the Debtor and propose terms for a loan. Similarly, mandating time between the “interim” and “final” DIP orders, and reimbursing reasonable fees, would permit additional third party lenders to diligence the Debtor once the Chapter 11 commenced. Concerns about roll ups and liens on avoidance actions— notwithstanding the lack of data demonstrating they lead to liquidations or section 363 sales— could be diminished by, among other things, requiring additional liquidity in a specific proportion to the rollup (or evidence that there is no alternative financing available without the roll-up) and reserving avoidance actions as the last asset available to pay DIP lenders. 10