By Robert M. Hirsh and Phillip Khezri
Debtor-in-possession lending is far from simple, but it can provide many benefits for financing providers who can successfully navigate the process. Robert M. Hirsh and Phillip Khezri of Lowenstein Sandler walk through some of the basics of DIP lending to serve as a starting point.
Debtor-in-possession lending comes with many benefits if a lender is guided by experienced counsel who can help navigate the many pitfalls that may arise during the negotiating of terms and the drafting of the documents, including a credit agreement and DIP orders. However, without experienced counsel, a DIP lender can face unique risks, especially if a DIP lender does not get the benefit of its bargain because either the DIP terms were poorly negotiated, the bankruptcy case does not proceed as planned, the collateral is not worth as much as the lender expected, or the DIP credit agreement is poorly drafted.
To help avoid these risks, this article will discuss the various stages of DIP lending, including negotiating a term sheet and drafting a credit agreement and order. The discussion will focus on best practices and pitfalls during each stage, including negotiating the collateral base, fees, interest rate and other unique provisions of a deal, as well as drafting provisions in a credit agreement and bankruptcy order to protect the lender and ensure it has sufficient control of the disposition of the bankruptcy case, including milestones, carve-outs, foreclosure rights and credit bidding rights.
Negotiating a Term Sheet
Once the right opportunity is found, the DIP lender’s counsel will engage with the debtor’s1 counsel to obtain more information relating to the proposed loan terms, including the length of the loan, whether the loan is of a single or multi-draw variety, the interest rate, the borrowing and guaranteeing entities, the collateral base and the preexisting liens on such collateral. This information is typically provided after the proposed lender signs a non-disclosure agreement. Using this information, the proposed lender will draft a term sheet for presentation to the debtor’s professionals, who will likely be competing with other lenders (including preexisting secured lenders). In many situations, the existing lender will lend to the debtor to maintain control of its collateral and ensure its secured loans are not primed by an outside lender. Only when an existing lender refuses to loan, or such proposed terms are onerous and “not market,” will a debtor typically seek financing from third-parties.
After reviewing all potential term sheets, the debtor’s professionals will start shopping terms among the potential DIP lenders to obtain each lender’s best offer. Experienced counsel will know which “asks” are legitimate and which may be overreaches and will also be able to advise a potential lender of the materialness of each request, allowing the lender to concede on non-material points (which may be material for the debtor’s needs) while standing firm on other requests.
A term sheet contains many of the following salient terms:
- The borrowing and guaranteeing entities
- The lender entity
- The size of the loan facility
- The applicable interest rate and default interest rate
- Any applicable fees (commitment fee, exit fee, etc.)
- The maturity date of the loan
- Limitations on the use of the proceeds
- Collateral being issued as security
- Priority of liens, including any preexisting liens
- Carve-outs for funding the wind-down if an event of default occurs
- Other standard loan terms
The DIP term sheet will be a living document that will be subject to constant change as the parties engage in a give-and-take process until the DIP documents are executed and approved by the bankruptcy court. This process is intensified due to the time constraints of the case, with initial approval of a term sheet to the finalizing of a credit agreement sometimes taking only several days. This truncated timeline can be a shock to many first-time DIP lenders, making it even more important to have counsel who has experience with the process and is comfortable working under extreme time constraints.
Drafting DIP Documents
Once selected as the DIP lender, the lender’s counsel typically drafts the necessary documentation associated with the loan, namely a credit agreement and DIP order. Poor or inexperienced drafting is one of the biggest risks associated with DIP lending. Inexperienced counsel may not be able to properly draft language that encompasses their client’s expectations, thereby increasing the client’s risk or worsening the business terms from the parties’ agreement in the term sheet. Moreover, inexperienced counsel may not even know what pitfalls they must protect against if they have not previously acted as counsel for a DIP lender.
Some of the most important drafting terms, the reason for their importance and some best practices are as follows:
- Good Faith Finding: A good faith finding, pursuant to Section 364(e) of the Bankruptcy Code, protects a lender from any modification, amendment, or vacatur of the DIP order by protecting the validity of the debt owed by the debtor and maintaining the priority of such debt. While some parties may object to vacatur of the DIP order being included, the DIP lender must ensure that Section 364(e) protections apply in the event the DIP order is vacated for any reason.
- Language Requiring Debtor to Draw: Being a DIP lender comes with many benefits, including interest and fees. However, if the debtor fails to draw on the DIP facility, the lender may only be entitled to some of those fees and, likely, reduced interest (if the DIP agreement provides for any interest on undrawn amounts). By requiring the debtor to draw within a set time after entry of the DIP order, the lender will ensure it receives the full benefits of making the funds available to the debtor.
- No Obligation to Monitor: This provision is included to ensure the lender has no duty to monitor the use of the DIP proceeds or the collateral securing the DIP facility. This language is essential to ensure that no third party can claim the lender is a fiduciary and should deter any such parties from making a claim for any lender liability causes of action.
- Milestones: A DIP lender has the right to establish case milestones, in negotiation with the debtor, to ensure the case progresses responsibly and that the DIP lender is repaid within the time frame set forth in the DIP credit agreement. Milestones will include deadlines relating to a sale process, the refinancing of the DIP loan and/or the confirmation of the bankruptcy plan. DIP lenders should keep milestones as tight as possible in order to leave the door open for negotiations to extend them. Shorter milestones allow the DIP lender to have more control over the case and more leverage in negotiations.
- Credit Bidding: Most Chapter 11 cases today are used to effectuate a bankruptcy sale process. A DIP lender must ensure it has the right to credit bid on collateral at any auction in order to ensure such collateral is not sold for less than market value. A DIP lender should include language in the DIP order providing for the right to credit bid not only its principal but all fees and interest. If the DIP lender is lending with the goal of acting as stalking horse, it should attempt to include language allowing it to obtain stalking horse protections, such as a breakup fee and expense reimbursement.
- Carve-Out of Professional Fees: Carve-out provisions in a DIP order require the lender to fund certain professional fees to allow professionals to oversee the wind-down of a bankruptcy case in the event of a DIP default. A DIP lender should include language in the DIP order providing that such fees will not require the DIP lender to lend in excess of the DIP facility amount and that the DIP lender has no direct obligations to pay professionals. Including this language will eliminate any recourse professionals may seek against the lender if the debtor fails to segregate carve-out funds for a wind-down from the DIP proceeds.
Lenders that seek to benefit from being involved in the bankruptcy process by providing DIP facilities should carefully select counsel who understands how to negotiate the many issues and nuances of the process in order to avoid the pitfalls that may arise during a bankruptcy case. By retaining experienced DIP counsel, first-time DIP lenders will have a relatively stress-free experience in what can be a difficult and complex market. Without experienced counsel, the risks of bankruptcy lending may outweigh the substantial benefits and may cause many first-time lenders to reconsider providing this type of lending again.
- References to the “debtor” mean the pre-bankruptcy entity seeking funding in a forthcoming bankruptcy case.