The Evolution of Debtor-in-Possession Financing in the United States: Lessons from Professor Ayotte’s SGRI Lecture
In the past couple of weeks, we have had the immense honor to welcome Professor Kenneth Ayotte to Singapore as the Inaugural Singapore Global Restructuring Initiative (SGRI) Visiting Professor at the Singapore Management University Yong Pung How School of Law. While Professor Ayotte needs no introduction, he is the Robert L. Bridges Professor of Law at the University of California, Berkeley School of Law. He joined Berkeley Law in 2014. From 2007-2014, he was a Professor of Law at Northwestern University. From 2002-2007, he was an Assistant Professor in the Finance and Economics group at Columbia Business School. Professor Ayotte has served as a director of the American Law and Economics Association and an Associate Editor of the International Review of Law and Economics. He teaches corporate finance and bankruptcy law. His research uses financial and economic tools to better understand the bankruptcy system. His most recent articles have focused on valuation disputes in corporate reorganizations and the treatment and evolution of debtor-in-possession financing in the United States. He holds a BA from the University of Virginia and PhD in Economics from Princeton University.
One of the most important aspects for the successful reorganization of viable but financially distressed firms is the ability of these companies to obtain liquidity. Unfortunately, when a company becomes insolvent, lenders are skeptical to keep extending credit. For that reason, several jurisdictions around the world, including the United States and Singapore, have adopted certain provisions (“DIP financing provisions”) that encourage lenders to extend credit to financially distressed firms by providing them with different forms of priority. By doing so, bankruptcy law becomes a “liquidity provider” for viable but financially distressed firms, as it was emphasized in a fascinating paper that Professor Kenneth Ayotte and Professor David Skeel published in the University of Chicago Law Review.
During two exciting weeks, the Singapore insolvency community has had the honor to learn from Professor Ayotte’s pioneering work on DIP financing. In the SGRI lecture delivered by Professor Ayotte on 28 March 2023, he spoke about the evolution of DIP financing in the United States. A very important takeaway from his fascinating lecture was that, while the DIP financing provisions existing in the United States have not changed since the U.S. Bankruptcy Code was enacted in 1978, the capital structure of firms filing for bankruptcy has changed over time and this has led to different issues and DIP financing practices that have affected the fate of reorganization procedures.
Namely, Professor Ayotte explained how many large companies filing for Chapter 11 in the '80s and '90s used to have unsecured debt mainly comprising junk bonds. In the late 1990s and early 2000s, it was more common to observe companies without unencumbered assets and a capital structure mainly comprising secured debt. More recently, however, the capital structure of large companies filing for bankruptcy typically includes leveraged loans and collateralized loan obligations. As it was mentioned by Professor Ayotte during his lecture, these changes in capital structures have led to different DIP financing practices as well as different outcomes and challenges in bankruptcy. In the '80s and '90s, debtors were able to obtain DIP financing using their unencumbered assets. Therefore, the primary concern in bankruptcy was the existence of lengthy reorganization procedures led by managers and the conflicts potentially arising between shareholders/managers and creditors. In the late 1990s and early 2000s, changes in capital structures and market practices led to a different concern in bankruptcy: the existence of exacerbated conflicts between secured creditors and unsecured creditors as a result of the rise of going concern sales and bankruptcy procedures mainly dominated by secured creditors.
As we can learn from various studies published by Professor Ayotte, one of them in conjunction with Professor Jared Ellias (Harvard Law School) and a recent article co-authored with Alex Zhicheng Huang (Berkeley Law), a primary concern in large bankruptcy procedures nowadays is that the existence of certain out-of-court transactions, sometimes called creditor-on-creditor violence, as well as the increasing power gained by DIP lenders, may lead to inefficient outcomes and a distortion of priorities in bankruptcy. Therefore, this new reality in financing practices and capital structures can lead to conflicts between those currently leading the restructuring process –typically private equity sponsors and first-lien secured creditors providing DIP financing– and different groups of creditors.
Apart from his pioneering work on DIP financing, Professor Ayotte has also conducted other innovative empirical studies where he has explored aspects such as the valuation disputes typically arising in corporate reorganizations, the treatment of leases and executory contracts in bankruptcy, and the factors driving the choice of venue in bankruptcy. His research has also focused on other fascinating issues in corporate finance and corporate bankruptcy, including the increasing complexity of capital structures, the governance of companies in financial distress, the need to match bankruptcy laws to different legal environments, the value of a fresh start for insolvent entrepreneurs, and the bankruptcy-bailout dilemma in the context of financial institutions. During his two weeks in Singapore, Professor Ayotte kindly shared some of his pioneering studies with different stakeholders in the insolvency community in Singapore, and he also taught a fascinating course on the law and finance of corporate reorganizations in the United States.
On behalf of the Singapore Global Restructuring Initiative and the Singapore Management University Young Pung How School of Law, I would like to express my sincere gratitude to Professor Ayotte for joining us as the Inaugural SGRI Visiting Professor. It has been an honor to welcome him to Singapore and to have the opportunity to learn from one of the world’s leading experts on corporate bankruptcy. We very much look forward to seeing you in Singapore again soon, Ken! So far, have a safe flight back to California! :-)