DIP financing has become one of the most closely watched aspects of today’s Chapter 11 cases. In this conversation, ABF Journal Editor-in-Chief Rita Garwood sits down with Seth Lieberman, Partner at Pryor Cashman, to discuss how DIP financing has evolved, why negotiations have become more complex, and the legal developments influencing restructuring today. From inclusiveness in DIP participation to adequate protection disputes, non-pro rata roll-ups, equity conversions, and the cases practitioners should be watching, Lieberman offers insight into the issues shaping today’s bankruptcy landscape.
Rita Garwood: You have been DIP agent counsel in some very active cases this year. From where you’re sitting, what has changed the most about how DIP financing is negotiated compared to how it was a few years ago?
Seth Lieberman: That’s a great question. We have been, and we continue to be, blessed to represent agents in some of the largest, most complex, relevant Chapter 11 cases that are out there, including Inotiv, Trinseo, and we just got out of OPI.
To answer your question, which I think is going to be a theme in our discussion over the next several minutes: we’re going to be talking about inclusiveness.
I think inclusiveness is one of the great changes about DIP financing and how it’s negotiated over the last several years. Let me explain what I mean, because that’s a broad term.
This starts with the idea that there are fewer Chapter 11s than there were several years ago, so the sample size is smaller. But importantly, conventional wisdom suggests that one of the chief reasons underpinning fewer Chapter 11s is the increase in costs.
If we can agree with that premise, then heightened inclusiveness in the context of DIP participation makes sense. It not only makes DIP financing more certain, but it obviously decreases the chance that DIP financing will be messy. There’s less chance there will be competing DIP facilities, a priming DIP fight, or a valuation fight.
All of these things are costly. All of these things can be value destructive. All of these things can be very difficult for a bankruptcy estate.
If the restructuring community over the last several years has grown wary of Chapter 11 and sees it as a last resort, then when Chapter 11 is actually implemented, an inclusive DIP in order to minimize fees and lessen the chance of potential value destruction is most welcome.
I’ve personally observed that inclusiveness among willing participants in a DIP facility has been the greatest change in DIP financing over the last several years.
Garwood: For listeners who are not in bankruptcy court every day, why has DIP financing become such a consistent flashpoint in large Chapter 11 cases rather than the procedural step that it used to be?
Lieberman: Here’s the hard truth, Rita. Debtors need liquidity to operate in Chapter 11. That’s not controversial. While there are willing lenders out there, financing comes with strings attached. I’m not just handing out money left and right.
What do those strings look like? There’s nothing nefarious about this. Lenders should say, “I’m going to lend on certain terms.” It’s their money. If they’re willing to lend, their willingness to do so is subject to certain terms, and that shouldn’t be offensive or surprising.
After all, these lenders are rational economic actors.
However, DIP lending and the terms of DIP lending have grown to be far more complex, onerous, and comprehensive than simply rates and returns.
They now include roll-ups, which I’m sure we’ll talk about. They inevitably include timelines. Those timelines, or milestones, get baked into DIP term sheets, DIP credit agreements, and DIP orders.
So why does any of this matter?
The reason it matters is that lenders will often condition their lending on, let’s say, a Section 363 sale being consummated within 30 days. Or maybe a disclosure statement being approved within 60 days of the petition date. Or perhaps the company emerging from Chapter 11 within 90 days.
Let’s also assume, for purposes of this conversation, that these DIP lenders are really the only game in town.
Against that backdrop, should the company or the judge try to extract those milestones from the loan documents?
The answer is largely no, and those milestones will not be extracted from the DIP documents.
Now the conversation becomes as much about control of the Chapter 11 case as it is about financing.
Lenders have lent conditionally, not unconditionally, upon certain events transpiring by certain dates.
If those events don’t occur by the dates contemplated in the DIP documents, those documents—subject to what they actually provide—likely allow the lenders to exercise certain remedies: expedited conversion, calling a default, or foreclosing on collateral.
Some argue that the loan has become the case.
I’m not sure I agree with that, but I would say that all the bells and whistles built into DIP documents—milestones, roll-ups, lender veto rights when it comes to exit debt—give DIP lenders a great deal of control.
Some would probably say outsized control in a Chapter 11 case.
To be clear, I’m not indicating that’s a bad thing. I don’t think that’s necessarily the wrong result. It’s the lender’s money, and the debtors need it.
But as a result, these DIP loans come with what many people view as an uncomfortable level of case control.
That’s why this has become such an important issue.
Garwood: That makes sense.
In DIP hearings today, adequate protection disputes are coming up a lot. What is driving that?
Lieberman: Can we talk a little bit about what adequate protection is? I don’t want to assume everyone knows.
The Bankruptcy Code contains a provision that enables a debtor to obtain DIP financing. That financing can be secured by a lien that is senior or equal to an existing lien, so long as the existing lienholders receive adequate protection.
A debtor has to demonstrate several things, including that those lienholders will receive adequate protection against any diminution in the value of their collateral.
At its most basic level, adequate protection means protecting a secured creditor against a decline in the value of its collateral position during the bankruptcy case.
Depending on its form, adequate protection can extend beyond that purpose.
It can grant creditors control rights through budget compliance covenants, operational covenants, restrictions on the use of cash, and similar provisions.
While the Bankruptcy Code doesn’t define what adequate protection is or identify acceptable forms of adequate protection, the case law has taught us that it can take many forms.
I’ll list a few:
- Cash payments
- Information rights
- Payment of default interest
- Ensuring that an equity cushion exists
- Payment of professional fees and expenses
- Replacement liens
- The indubitable equivalent
There are all sorts of possibilities.
So now that we understand what adequate protection is, what’s driving these disputes?
Lienholders often argue that the value of their collateral will diminish during the Chapter 11 case, and that the decline will be significant enough that anything short of granting multiple forms of adequate protection would be insufficient to protect their interests.
They should argue that. They’re lienholders.
Unsurprisingly, debtors often take a different view.
Debtors say, “Don’t worry about your collateral. There’s no reason to believe its value is at risk of diminishing during the bankruptcy case.”
If there is risk, they’ll argue it’s remote enough that a single form of adequate protection is more than sufficient to protect the creditor’s interests.
That’s the tension.
These disputes are commonplace. They’re almost an everyday occurrence.
That said, I think it’s important to note that fighting these disputes through a full evidentiary hearing is rare.
They’re often negotiated and ultimately resolved out of court to avoid what is otherwise a significant evidentiary burden and the costs associated with full-scale adequate protection litigation in a Chapter 11 case.
Garwood: Are you seeing courts converge on more predictable standards for what counts as adequate protection, or is this still very judge by judge?
Lieberman: I gave six or seven examples of what can constitute adequate protection, and they all can be used as forms of adequate protection. With that said, I’ll give you one exception.
When we start talking about adequate protection or trying to pinpoint predictable adequate protection standards, that’s really hard to do. Why? Because facts matter first and foremost.
Facts drive a bankruptcy judge’s determination as to whether the adequate protection being offered is, in fact, adequate. Because of that, it’s difficult to generalize that there are consistent standards across jurisdictions, judges, or circuits.
I want to footnote that with one exception.
I mentioned the idea of an equity cushion as a form of adequate protection.
An equity cushion is the difference between an asset’s market value and the secured debt against it. It’s basically the buffer that protects the lender.
If a building is worth one million dollars and there is eight hundred thousand dollars of secured debt against it, there is a two-hundred-thousand-dollar equity cushion.
Jurisprudence seems to have crystallized among most judges and circuits regarding what could or should be considered a sufficient equity cushion.
I think bankruptcy judges generally recognize that a cushion of around twenty percent is the threshold where a senior creditor’s lien is considered adequately protected.
With that exception, I would still say that adequate protection remains very much a case-by-case determination.
Garwood: Since Serta Simmons, it feels like everyone has been talking about non-pro rata roll-ups. They’ve been getting a lot of attention.
Can you explain, in plain terms, what a roll-up is doing and why treating lenders unequally within the same class has become so contentious?
Lieberman: Sure. A roll-up is a feature of a DIP facility. It effectively converts prepetition funded debt into post-petition funded debt.
If I lent one hundred dollars on a secured basis before the petition date, a roll-up effectively treats that loan as though I made it after the bankruptcy filing.
That prepetition debt is merged into the DIP facility, and it gives that debt something special that it otherwise wouldn’t receive as prepetition debt.
Specifically, it gives the debt super-priority status and the protections that accompany DIP financing—protections it would not otherwise be entitled to receive.
A non-pro rata roll-up occurs when only a select group of prepetition lenders are allowed to roll up their debt into senior liens or super-priority DIP claims.
You’re excluding similarly situated lenders.
For the lenders who are allowed to participate, the structure improves their position relative to the lenders who are not participating.
Non-pro rata roll-ups effectively shift value in favor of participating lenders and increase their leverage in the debtor’s restructuring.
Not surprisingly, non-pro rata roll-ups often give rise to what has become the flavor of the day—lender-on-lender violence.
Lenders excluded from the DIP or excluded from the roll-up often argue that the non-pro rata treatment violates the underlying credit agreement because those agreements typically contain pro rata sharing provisions.
That issue has become central in many recent decisions.
Some lenders receive better terms or exclusive participation rights, while others are left out or subordinated.
I’m not prepared to say that this is always case dispositive, but it can be very important when determining who ultimately exerts the greatest amount of control as a DIP lender.
Garwood: Equitizing DIP facilities effectively allows DIP lenders to convert into ownership of the reorganized company.
What is the appeal for lenders in a situation like that, and what’s the objection from other stakeholders when it happens?
Lieberman: The law requires that, unless the DIP lenders elect otherwise, DIP facilities must be repaid in full in cash at the conclusion of a Chapter 11 case.
That helps explain why the roll-up concept is so significant.
If a prepetition loan is treated as post-petition debt through a roll-up, and post-petition debt must be repaid in cash, that treatment becomes extremely valuable.
More recently, DIP financings have included the option to convert outstanding DIP amounts into equity of the reorganized debtor.
Why is that beneficial?
It can benefit the debtor by reducing the amount of cash that must be paid when the company emerges from bankruptcy.
If the debtor has to repay the DIP in full upon emergence, that creates a significant liquidity burden.
Administrative insolvency is more relevant today than we’ve seen in Chapter 11 for a long time.
Having DIP lenders agree to equitize their DIP instead of requiring full cash repayment can help avoid administrative insolvency.
However, not everyone equitizes a DIP simply for the sake of doing so.
This feature can also be used to divert value to favored parties.
From a lender’s perspective, the ability to equitize a DIP provides an opportunity to participate in the post-emergence equity of the reorganized debtor and, in some situations, to acquire that equity at a discount to plan value.
They’re effectively getting it on the cheap.
That potential upside is what creates the controversy.
Creditors as a whole may object because they believe DIP lenders are receiving valuable equity at a discounted price.
That’s the tension.
There have been a range of outcomes in recent decisions.
While some courts have rejected DIP financings with equity conversion features as impermissible sub rosa plans, I think those cases are the exception rather than the rule.
The law appears to be moving toward allowing DIP lenders to elect to equitize their DIP in the context of large Chapter 11 cases.
Garwood: If you had to bet on where DIP financing litigation is headed over the next year, which of the issues we talked about today do you think produces the next big appellate decision?
Lieberman: Good question. I think Converge One, which was a district court decision that limited non-pro rata roll-ups, is very important.
What that decision will look like on appeal to the Fifth Circuit is equally important.
We know about Serta, and now we have the Fifth Circuit’s Serta decision. We know about Del Monte, which is also on appeal.
I think Converge One is where we should start.
You have a district court decision that does not bind the Houston bankruptcy courts, but it is certainly instructive to them.
Houston is unquestionably one of the most popular bankruptcy venues in the country.
So what does the Converge One district court decision mean to those bankruptcy judges?
They’re not bound by it, but do they feel compelled to follow it?
When will we get a decision from the Fifth Circuit?
Will it be reversed?
How will it be reconciled with Del Monte?
There are a lot of unanswered questions, and that’s really what I’m focused on—the implications of non-pro rata roll-ups in the context of a Fifth Circuit appeal in Converge One.
Garwood: Last question.
What is the one piece of advice you would give to counsel on either the debtor or creditor side when walking into a DIP financing negotiation in today’s environment?
Lieberman: I started our conversation talking about inclusiveness. That’s one of the biggest differences between where we were several years ago and where we are today.
The one piece of advice I’d give is this:
If you’re going to exclude lenders from your DIP negotiations, you do so at your own peril. This advice applies to debtors and to creditors who are already in the deal—the preferred or included creditors.
I’m not simply talking about the post-LME world, where certain debt holders had the opportunity to participate in the liability management exercise but chose not to and are then excluded from the DIP.
I’m not particularly concerned about that situation.
I know those cases exist. I’m involved in one right now.
The better argument there is that those excluded lenders chose not to participate in the LME. As a result, under the post-LME capital structure, they aren’t entitled to participate in the DIP because of their own decision.
I’m talking about a different situation.
Suppose there’s an LME, but certain lenders never had the opportunity to participate at all.
They’re left out entirely.
Then, in the post-LME world, only the lenders who participated in the LME are allowed into the DIP.
I think debtors and lenders who are in the deal need to be very careful in that circumstance.
That would be my advice.
Why?
Because while the law is still developing, it appears to be moving in a direction where, if a debtor or participating lender can walk into court and say, “That lender who’s objecting had the opportunity either to participate in the DIP or to participate in the prepetition LME, which would have given them the right to participate in the DIP,” then I don’t think that excluded lender has a particularly strong argument.
Those arguments are made all the time, but I don’t generally see them succeeding.
It’s different when the lender who has been excluded was excluded from the very beginning—both from the LME and from the DIP process.
That’s when the argument carries more weight.
So my advice to counsel on either the debtor or creditor side when entering DIP negotiations is this:
Assess who may object.
Assess what opportunity they had to participate in the first instance.
If they never had an opportunity, proceed at your own peril.
But if they had the opportunity and chose not to participate, I think you’re on much stronger footing.
Garwood: Good advice.
Seth, thank you so much for joining me today and talking through all of this. I appreciate you taking the time to be here.
Lieberman: Rita, thank you so much for having me.