Standardizing and Unbundling the Sub Rosa DIP Loan
Kenneth Ayotte
Alex Zhicheng Huang
In many recent chapter 11 cases, debtor-in-possession ("DIP") loans determine reorganization plan payoffs at the outset of the case. Recent DIP loans are tied to plan terms including rights offerings, which give the DIP lender exclusive rights to purchase discounted equity in the reorganized company, and backstop fees, which pay the rights holder for committing to purchase them. Terms like these raise fears that DIP loan approval is being used to short circuit the chapter 11 reorganization plan process—in bankruptcy parlance, that the DIP loan is a sub rosa plan. How should bankruptcy law manage this sub rosa DIP loan problem?
We argue that the problem is a common one affecting many types of pre-plan transactions that provide the estate with an asset (cash) but also fix the priority and/or payoff of liabilities. We argue that bankruptcy law uses a common set of tools to deal with these crossover transactions that simultaneously involve asset-side and liability-side effects. Where crossover is inherent to the transaction, the Bankruptcy Code standardizes the liability-side effect to protect the interests of the other creditors. Where crossover is strategic, courts police transactions by unbundling liability-side effects that are unnecessarily bundled into transactions involving the asset side.
We conduct a case study of the J. C. Penney bankruptcy to understand how a non-standard, bundled DIP loan transaction can be used strategically to distort priorities. In that case, a DIP loan tied to a restructuring support agreement allowed a majority group to prime a minority group, roll up undersecured debt,
[Page 524]
and control the allocation of payoffs in the case. We find that a standardized, unbundled DIP loan would have required an interest rate of at least 545% to give the majority group the same payoff it received in the case. We argue that courts should revive and strengthen standardization and unbundling norms. This would better defend priorities by encouraging competition and increasing transparency of DIP loan terms.
Introduction..........................................................................................525
I. Related Literature...................................................................531
II. The J.C. Penney Bankruptcy......................................................532
A. The DIP-RSA Bundle .............................................................. 533
B. The Sale/Credit Bid................................................................. 536
C. Measuring Value Diversion: An Interest Rate Approach ......... 538
III. Asset-Liability Separation and Crossover Transactions ... 540 A. Crossover Transactions .......................................................... 542
1. Standardization Strategies ................................................ 544
a. Executory Contracts ................................................... 544
b. Administrative Expenses ............................................. 544
c. DIP Loans .................................................................. 546
2. Unbundling Strategies....................................................... 546
a. 363 Sales with Crossover Implications........................ 546
b. 9019 Settlements......................................................... 547
c. DIP Loans .................................................................. 548
IV. The Missing Standardization Solution...................................551
A. In re LATAM Airlines ............................................................ 552
B. In re TPC Group ..................................................................... 553
C. In re SAS................................................................................ 553
V. The Case For Defending Priority: A Reassessment................554
Conclusion.............................................................................................557
[Page 525]
Imagine the following alternative to chapter 11. The debtor arrives in court at the first day hearing and announces which of the existing creditors they recommend to receive the "golden ticket." The golden ticket gives the recipient full ownership of the company's assets, free from the claims and interests of any other creditors. The judge verifies that the ticket holder is a creditor, but otherwise defers to the debtor's judgment as to how the winner is chosen; the amounts and priorities of the prepetition claims need not play any role in determining the winner.
Today's chapter 11 is not "golden ticket bankruptcy" yet, but it is quickly approaching it. Through DIP loans tied to reorganization plan outcomes, early stage hearings about DIP loans bear increasing resemblance to golden ticket hearings, allowing the debtor and its chosen DIP lender coalition to determine both the fate of the bankrupt firm and the lenders' own payoffs in the reorganization plan. sometimes, this is done directly through terms in the loan agreement itself. Another common device is tying the DIP loan to a restructuring support agreement ("RSA").1 The RSA conveys control rights to a subset of the creditors during the case and outlines payoffs to creditors in the eventual plan. Plan payment rights tied to DIP loans often include exclusive rights to purchase equity at a substantial discount to the plan values (rights offerings) and fees for making this commitment (backstop fees).2 Deviation from the RSA is an event of default under the DIP loan, so that pursuit of any other path risks immediate liquidation.
It is easy to understand why chapter 11 is moving in the direction of the golden ticket. Golden ticket bankruptcy would be ideal for achieving bankruptcy's asset-side goal: maximizing the value of the bankruptcy estate. Being an undivided owner of the company, the golden ticket holder would keep the firm alive whenever it is more valuable that way. Intercreditor disputes would vanish, along with the uncertainty and cost they create. Debtors and DIP lenders make exactly these arguments in seeking approval of the modern DIP loan. The RSA guarantees consensus among its signatories, they argue, reassuring key stakeholders that the company has a clearer and faster path to
[Page 526]
emergence. This eliminates cost and uncertainty that might put the company's very survival at risk.
of course, the main cost of this approach is the respect for priorities, bankruptcy's main liability-side goal. Though the absolute priority rule is considered the sine qua non of bankruptcy, the benefits of defending priority are much harder to see. They are mostly realized before the bankruptcy occurs, and through less apparent channels, such as greater access to credit and lower costs of capital for healthy firms.3 By the time the company approaches the bankruptcy judge for approval of the DIP loan, priority challenges appear to be no more than a tug-of-war between sophisticated investor groups. If proponents pit the company's survival against these indirect benefits, it is easy to see why approved DIP loans look more and more like reorganization plans.
If defending priorities is to remain a serious goal of chapter 11, however, courts must develop strategies to confront the sub rosa DIP loan problem. Luckily, the underlying problem is not a new one. It is merely a polar case of the common problems that pertain to the pre-plan transactions we call crossover transactions. Crossover transactions are ones that simultaneously implicate an asset-side decision (the use or exchange of an estate asset) and a liability-side decision (determining a creditor's priority and/or payoff). DIP loans are inherently crossover transactions under this definition: They provide a new asset for the estate (cash), but they also require giving the DIP lender a new obligation whose value and priority will affect the creditor body as a whole.
Crossover transactions are challenging because procedures tailored to asset-side and liability-side goals are inherently in tension.4 Preserving asset value during a bankruptcy case requires time-sensitive decisions and deference to management. Bankruptcy asset value can dissipate quickly if a key asset is lost. Chapter 11's debtor-in-possession model is founded on the belief that the debtor's management is best placed to make these crucial, time-sensitive business decisions.5 Hence, the law defers substantially to management's judgment.
[Page 527]
Liability-side procedures intended to defend priorities, on the other hand, require multilateral negotiation and time. Because plans may distribute complex securities based on uncertain and disputed asset values, plan valuation disputes can require more time to resolve. And because management has no special expertise or incentive to defend priorities, management's prerogative yields to the creditors, who have explicit voting rights regarding liability-side decisions.6
There are no silver bullet solutions to the crossover transaction problem. But we suggest that courts revive two strategies that would help restore balance between asset value preservation and respect for priorities. Both of these strategies are already part of bankruptcy law's norms. And they can be applied with varying degrees of strength depending on the facts at hand, making them more implementable than an all-or-nothing approach.
The first strategy is standardization. Some transactions are inherently crossover transactions. If the debtor wants to finance new postpetition assets, for example, it must create a new obligation on the liability side to compensate the asset provider. In these cases, the Bankruptcy Code (the "Code") typically provides a standardized way to govern them. The general approach is to defer to management's judgment regarding the asset side of the...
