Q: The shift from brick and mortar stores is accelerating, leading to more retail businesses seeking Chapter 11 protection. How do you view this trend?
A: While retail bankruptcies continue to offer challenges for the bankruptcy courts, I view the recent Payless Shoe Source emergence from Chapter 11 as a strong signal that brick and mortar retail shopping is not a thing of the past. Payless emerged with a cleaned-up balance sheet and only half of its $1 billion debt. While Payless closed about 1,700 mall-based stores, traditional brick and mortar locations continue to play a significant role in the reorganization through capital investment in new international (Latin America and Asia) stores. Clearly, Amazon does not regard brick and mortar retail shopping as a thing of the past, given its interest in Whole Foods. I do think that our court will continue to see growth in retail filings, in particular the casual dining segment of the restaurant industry. Fewer shoppers at the malls translates to less money spent dining out.
Q: Since the Great Recession, many have claimed that those in the finance industry have learned a lesson. From your perspective, what have you seen over the past five years to illustrate substantial change, and what has remained the same?
A: From what I have seen and read, DIP lending has been on the rise as lenders appear to be re-entering the market. Indeed, there is even competition among lenders to provide DIP loans and exit financing. It seems that this uptick is enabling more Chapter 11 debtors to emerge from bankruptcy without a total liquidation of assets. Notwithstanding, Chapter 11 continues to be utilized primarily as a tool for asset sales, rather than restructuring. Some of this is attributable to the Supreme Court’s decision in LaSalle, which impaired equity’s ability to retain a stake in the reorganized company. As a result, debtors are more likely to walk away — leaving assets to the lender — or to negotiate a lender-supported asset sale structure. Successful drawn-out battles with lenders in Chapter 11 are the exception. Now, Chapter 11 cases have to overcome numerous hurdles, such as a revised Article 9 of the UCC which makes it easier for lenders to perfect properly their liens and avoid attack in bankruptcy. Additionally, Chapter 11 debtors face such restrictive measures as stock pledges and “bad boy” guarantees, which serve to limit the utility of bankruptcy. Finally, during the last five years, we have seen nontraditional lenders firmly in control and changing the dynamics of insolvency negotiations. Equity and hedge funds hold substantial debt, with long-term goals differing dramatically from traditional institutional lenders.
Q: Do you see a continuing trend of DIP financing being most prevalent in situations where a 363 sale is required?
A: There is no doubt that as a consequence of the over-leveraged capital structures found in borrowers entering the Great Recession, together with penal anti-debtor legislative changes in the 2005 bankruptcy code amendments, the lending community has been reluctant to accommodate the need for DIP lending in Chapter 11. If loans were made, they were conditioned on a debtor reaching certain Section 363 benchmarks. As noted, however, I am hearing about and seeing evidence of greater interest and competition for DIP loans. There is a slight change in the lending landscape, where there has been a relaxation of the compressed sales process and shortened timeframes found in DIP loan commitments. I view this softening as a direct result of observed failures in the Section 363 process to produce either a viable stalking horse bidder or acceptable recoveries. Extended marketing efforts are beginning to replace rushed liquidation scenarios to produce greater value for the debtor’s assets. Unsecured creditor committees are taking a greater role in the sale process and limiting their objections to DIP financing terms.
Q: During Chapter 11 proceedings, Toys ‘R’ Us requested $16 million to provide bonuses to its executive team to keep them from leaving during the critical holiday season. What is your opinion of this unusual request?
A: I cannot comment on a pending matter (including cases being handled by colleagues), so I must limit my views to how I address similar issues coming before me. Now, an executive “pay day” of $16 million certainly makes for eye-catching headlines. However, given the size and complexity of the Toys ‘R’ Us bankruptcy proceeding, I am neither shocked nor awed by the request. Incentive-based bonus plans for debtor company executives can offer palpable returns for creditors and help expedite bankruptcy proceedings. Indeed, a few years back, a significant study was undertaken by two finance professors, which confirmed that retention and incentive bonuses for managers during restructuring efforts were linked to greater creditor dividends and faster paced proceedings. Complex cases often demand retaining existing managers who have valuable industry-specific knowledge and maintain critical vendor/customer relationships. I have no issue with tying compensation to productivity levels and performance goals, even if they appear overly generous to the naked eye.
Q: How has the Dodd-Frank legislation affected the world of secured lending and changed the outcomes on a daily basis? How do you view the Dodd-Frank regulated world where the risk associated with lending to less-than-investment-grade borrowers is highly controlled by the government?
A: By necessity, I must shy away from any political debate; notwithstanding, it is undeniable that Dodd-Frank has and continues to have a negative impact on the capital available for commercial projects, resulting in a substantially tightened lending market for small and medium businesses. Needless to say, the overly restrictive lending requirements in place under Dodd-Frank also hinder reorganization efforts for these businesses. Empirical evidence, such as a recent George Mason University report, confirms that since Dodd-Frank’s enactment and related regulations, compliance costs have increased by more than 35% for community banks, hindering the ability to deploy capital. Small and medium businesses can no longer rely upon community banks to provide needed funding in and outside of Chapter 11. Yet, it even may be too premature to gauge the ill effects of this legislation since only now can we start to discern the true impact of the new risk-retention requirements under Dodd-Frank (lenders must now retain 50% of loan values on their books), which only took effect on December 24, 2016. Simply put, loans are now less profitable and less attractive to banks, forcing borrowers into more costly and risky nonbank lending scenarios.
Q: How do you view the recent trend of inter-creditor agreements among lenders in a bankruptcy proceeding? It’s not uncommon that a commercial bank will team-up with a non-regulated lender to structure a deal that makes sense and is sensitive to Dodd-Frank regulation.
A: As your readers know all too well, inter-creditor agreements (ICA) and agreements among lenders (AALs) play substantial roles in bankruptcy proceedings, and bankruptcy courts have treated these agreements in varying ways. Issues have arisen regarding the jurisdiction of the courts, enforcement of the agreements and the continuing ability to invoke certain bankruptcy code rights. Judge Brendan Shannon’s recent decision in RadioShack is noteworthy in understanding the treatment of these types of agreements. Judge Shannon ruled that an AAL affected the treatment and rights of the secured lender and thus fell within the bankruptcy court’s jurisdiction to enforce. Many may view this as surprising, given that unlike an ICA, an AAL is an agreement among lenders under a single credit facility and does not require the debtor’s participation or consent. One could easily argue that the AAL should be beyond the bankruptcy court’s jurisdiction. However, we see bankruptcy courts enforcing these agreements nonetheless.
Q: In general, asset-based lenders are protected in the event of a default. However, during a restructuring this isn’t always the case. Are there cases where the secured lender is not protected, even with documentation, and in what context?
A: Secured lender recovery can be placed at risk when documentation is poorly drafted by inexperienced counsel or other professionals. Several years back, I published an opinion which denied a secured creditor’s bid for super-priority status under Section 507(b) of the Bankruptcy Code. The lender asserted entitlement based on the alleged failure of replacement liens to protect against the diminution of the collateral. As your readers are aware, Section 507(b) is intended to compensate the secured claimant for the difference between the adequate protection provided and the actual decrease in collateral value. While the lender’s documents did require replacement liens on post petition receipts, nothing in the agreed cash collateral order stated that the replacement liens were granted as adequate protection. Indeed, the term “adequate protection” never appeared once in the cash collateral order. Nor had the court ever ruled on the value of the underlying collateral, making it impossible to find that there had been a drop in value. Properly drafted stipulations and language in the cash collateral order would have remedied the problem and allowed the lender to recover.
Q: The American Bankruptcy Institute documented a drop in the number of Chapter 11 business bankruptcy petitions (See related story on page 26). The ABI recently reported “high cost of filing remains an obstacle for businesses to consider financial relief of bankruptcy.” What is your view?
A: I have the benefit of reading that for the month of November commercial Chapter 11 filings have increased 12% over the prior year’s total. I think this will be a continuing trend, notwithstanding expenses involved. The “high costs” associated with bankruptcy filings are overstated and often subject to incomplete analysis. Chapter 11 continues to offer undeniable benefits unavailable as part of out-of-court workouts or state court insolvency proceedings. For instance, the bankruptcy code caps lease rejection claims and provides relief from early lease termination charges. Likewise, the ability to offer DIP lenders priming liens and super-priority claims, as well as the availability of free and clear sales under Section 363, continue to make bankruptcy courts attractive venues for restructuring efforts. While there can be no denying that complex Chapter 11 cases lend themselves to mounting professional fees (which again makes great fodder for newspaper headlines), what’s often overlooked is the comparable high costs of professionals in out-of-court workouts. Outside of bankruptcy, professional fees can mount in workouts as well; however, these fees are not tracked like bankruptcy fee awards.