By Kenneth Ayotte (UC Berkeley School of Law) and Aurelio Gurrea-Martinez (Singapore Management University)
Synopsis
The ability of viable but financially distressed firms to obtain new financing to keep operating and pursuing value-creating projects is one of the most critical aspects for a successful reorganisation. Unfortunately, when a company becomes insolvent, lenders are rationally skeptical to extend credit. To address this problem, the United States Bankruptcy Code adopted a system, known as debtor-in-possession (‘DIP’) financing, that seeks to encourage lenders to extend credit to financially distressed firms.[1] This is done by providing DIP lenders with different forms of priority that may include a new lien, a junior lien, a senior lien, an administrative expense priority, or an administrative expense priority to be paid ahead of other administrative expenses.[2] Thus, the United States has created a system that can make bankruptcy proceedings serve as liquidity providers for viable but financially distressed firms.[3]
As a result of the successful experience of the United States, many countries around the world have adopted (or considered the adoption of) some forms of DIP financing provisions. By analysing the features and evolution of debtor-in-possession financing in the United States, this article seeks to highlight certain risks and challenges associated with a system of DIP financing. It concludes by suggesting various policy recommendations for countries considering the adoption or amendment of DIP financing provisions
1. The evolution of DIP financing in the United States
The DIP financing provisions existing in the United States have not changed since the U.S. Bankruptcy Code was enacted in 1978. Yet, the practice of DIP financing has changed significantly. This has been due, at least in part, to changes in the capital structures of the firms filing for bankruptcy in the past decades.[4] In the 1980s and 1990s, many companies filing for bankruptcy used to have unsecured debt mainly comprising junk bonds.[5] In the late 1990s and early 2000s, the most common type of companies filing for bankruptcy were usually those fully funded by secured debt and with no unencumbered assets.[6] More recently, however, the capital structure of large companies filing for bankruptcy is generally very fragmented and it typically includes leveraged loans and collateralised loan obligations.[7] Moreover, these companies are often driven by a private equity sponsor.[8]
These divergences in capital structures have led to different DIP financing practices as well as different outcomes and challenges in bankruptcy. In the 1980s and 1990s, debtors were able to obtain DIP financing using their unencumbered assets. Thus, the primary concern in bankruptcy was the existence of lengthy reorganisation procedures led by managers and therefore, the conflicts potentially arising between the shareholders/ managers and creditors.[9] In the late 1990s and early 2000s, secured debt-heavy capital structures became the norm.[10] This led to conflicts between secured creditors and unsecured creditors and bankruptcy procedures dominated by secured creditors.[11] In the types of bankruptcy proceedings observed in the current environment, a primary concern is that the existence of certain out-of-court transactions – often referred to as ‘creditor-on-creditor violence’ – as well as the increasing power gained by DIP lenders leads to inefficient outcomes and distortion of priorities in bankruptcy.[12] As a result, 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.[13]
2. International divergences in the treatment and approval of DIP financing
Most jurisdictions have some form of DIP financing provisions.[14] The primary divergences existing in the design of DIP financing across jurisdictions rely on two aspects: (i) the different forms of priority that can be provided to DIP lenders; and (ii) the actors in charge of approving the new financing.[15]
In terms of the priority provided to DIP lenders, most jurisdictions allow DIP lenders to get a new lien or an administrative expense priority.[16] In some jurisdictions, they can also get a junior lien and an administrative expense priority to be paid ahead of other administrative expenses.[17] Finally, there are certain jurisdictions, such as Singapore and the United States, where lenders can also obtain a senior lien.[18]
Depending on the actor in charge of approving the new financing, countries have adopted models that may be classified into four primary categories: (i) court-led models; (ii) debtor-led models; (iii) creditor-led models; and (iv) trustee-led models.[19] In some cases, countries have adopted a combination of models. For instance, in the United States, any new financing for debts and expenses outside the ordinary course of business requires court approval. For debts and expenses in the ordinary course of business where the debtor’s counterparty obtains an administrative expense priority, however, court approval is not needed.[20] Therefore, this type of new financing – and the priority attached to it – only needs to be approved by the debtor. Therefore, even within the same insolvency regime, the actor in charge of approving the new financing may change depending on the type of debts or expenses incurred by the debtor as well as the priority potentially obtained by the DIP lender.
3. Adoption of DIP Financing Provisions: Lessons from the United States
3.1. The risks and costs of DIP financing (and how they can change over time)
An important takeaway from the experience of the United States is that while DIP financing plays an essential role in the successful reorganisation of many companies, it may also create costs that a bankruptcy procedure should control as much as possible. A bankruptcy filing will stay creditor collection activity; this prevents a ‘tragedy of the commons’ whereby creditors will race to the courthouse and put the firm’s going-concern value at risk. The stay buys time for the debtor, but it can also enable transactions that harm the creditors. The most basic risk created by a system of DIP financing is the risk of agency costs: that the new financing benefits the firm’s managers, shareholders, professionals, and other decision makers at the expense of the creditor body.[21] That, in return, can lead to an ex ante increase in the cost of credit. If so, a system of DIP financing may exacerbate the problems of financial exclusion and lack of firms’ access to finance existing in many countries – particularly, emerging economies.[22]
The agency costs of DIP financing may change over time or they can differ among firms, depending on the capital structure of the firms initiating a bankruptcy procedure. As was mentioned in the context of the United States, a major concern in the 1980s and 1990s was the risk that managers were in a position to opportunistically delay a reorganisation procedure by borrowing new financing on an unsecured basis. In today’s bankruptcy procedures in the United States, however, the primary risk of opportunistic behaviour is not between managers and unsecured creditors but between certain creditors (particularly pre-existing secured creditors becoming DIP lenders) who, sometimes in conjunction with the debtor and its management, may want to opportunistically favour themselves at the expense of the rest of the creditors. DIP financing provisions can steer a case in the way management prefers. The creditor body might have valuable causes of action against management for pre-bankruptcy misbehaviour, for example, and the DIP loan might try to end the case quickly to settle this litigation on the cheap. The rise of private equity-owned debtors in large Chapter 11 cases has exacerbated the intensity of these kinds of agency problems.
3.2. The importance of the ‘gatekeeper’ in charge of the approval of DIP financing
Another takeaway from the experience of the United States is that the gatekeeper in charge of approving the new financing plays a key role in the desirability of the system of DIP financing.[23] In the United States, this gatekeeper is a bankruptcy judge who generally has vast knowledge and experience in commercial and financial matters. Unfortunately, many countries embracing a similar court-led model of DIP financing do not have specialised bankruptcy courts. Even if they do, the judicial system may face certain weaknesses that undermine the credibility of the judiciary or the desirability of the court to make these types of complex decisions.[24] Therefore, countries considering the adoption of DIP financing provisions should carefully examine the independence, capabilities, credibility, resources and incentives of the actors in charge of approving the new financing. In the absence of competent, reliable and well-equipped courts, the agency costs of DIP financing described above are more difficult to control.
One way to address the agency cost problem is by giving creditors more power to approve the new financing.[25] This greater role may vary from the veto rights that creditors enjoy in countries like the Dominican Republic,[26] to the direct approval of new financing observed in countries like India and, in certain cases, in Chile.[27] Given that pre-existing creditors can end up worse off if the new financing destroys or diverts value, the company’s pre-existing creditors should play at least some role in the approval of new financing.
But stronger creditor blocking rights may create problems of holdout and costly delay. These problems are typically called ‘anticommons’ problems. The bankrupt firm’s need for liquidity may be immediate, and the firm’s survival may be at risk if new financing is not approved. In light of the need for speed, a rule requiring a vote and unanimous creditor consent, for example, would probably be a bad idea. Policymakers should be aware of the trade-offs between agency and anticommons problems when they consider the best way to give creditors a strong voice in the DIP financing decision.
Here are three specific challenges to consider in a system that seeks a strong degree of creditor consent to DIP financing. The first involves timing. Creditor consent to DIP financing can take time to acquire. Thus, in countries with competent and efficient courts, judges might have the power to approve a temporary financing package until consent can be acquired. For instance, in the United States, an official committee of unsecured creditors is always appointed. The committee typically consists of the seven largest unsecured creditors in the case. Though the committee has no veto power over DIP financing, their views are important to the judge. But these committees take time to form, and the debtor often needs some financing approved on the first day of the case. As a result, courts typically approve some financing on an interim basis for several weeks, and postpone final approval of a longer-term financing package until the committee can weigh in.
A second issue is deciding on which creditor groups will have a say over the financing. Different creditors may have more or less skin in the game, and therefore different incentives to make value-maximising decisions. Namely, the precise level of skin in the game may differ among different classes of creditors as well as the type of priority granted to the DIP lender. For instance, if unsecured creditors are out-of-the-money, they may have incentives to gamble (or linger) for resurrection. Therefore, even if obtaining the DIP loan is not desirable because the firm is not viable and should be shut down as quickly as possible, they may want to approve the DIP loan with the purpose of keeping the firm alive. After all, if the company is immediately liquidated, out-of-the-money creditors would not get anything. However, if the company stays alive and its financial situation magically improves, the creditors can get something. Therefore, the possibility of receiving something is better than the certainty of getting nothing. Similarly, over-secured creditors may have incentives to reject the approval of new financing even if the DIP loan contributes to the creation or preservation of value. For them, shutting down the company and getting paid as fast as possible will probably be preferred.
The type of priority provided to the DIP lender and the position of the creditors in the ranking of claims will also affect the incentives of creditors in charge of approving a DIP loan. For example, if the new lender obtains an administrative expense priority and, as it happens in many jurisdictions, administrative expenses are exclusively paid with the debtor’s unencumbered assets, pre-existing secured creditors will not bear any costs associated with that decision. Therefore, that can reduce their incentives to make an optimal decision in the approval of new financing. As a result, there should be an alignment of incentives between those making the decision and those experiencing the costs and benefits of the decision. For that reason, perhaps the classes of creditors that should be entitled to approve the new financing should be only those whose claims are pari-passu or junior to the proposed financing.[28]
A third issue is the degree of creditor consensus required within a class of claims. If some creditor class is entitled to vote on the DIP financing, what should the voting threshold be? A unanimity rule would be impractical due to the possibility of holdouts. Suppose, instead, that a majority of a class, or some appointed committee of those creditors, is sufficient to approve. This might give the debtor the incentive to offer an expensive DIP loan opportunity to only those creditors. The J.C. Penney bankruptcy involved a DIP loan with terms that amounted to an interest rate over 500%, offered exclusively to the majority coalition who had the power to consent to a priming DIP loan.[29] As a result, the minority creditors were severely diluted and priorities were severely undermined. Any rule that allows a subset of a creditor class to approve a DIP loan will be vulnerable to these kinds of exclusive opportunities, and courts may be needed to police them. A requirement that DIP loan opportunities must be available to all creditors in a class, or a requirement that a majority of non-participants in the DIP loan approve the terms, would help alleviate this problem.
The anticommons problems we describe above are likely to be less severe for smaller firms who have simpler and less dispersed creditor structures. While less frequent – at least so far – in jurisdictions outside the United States, these types of problems would need to be anticipated and addressed by jurisdictions adopting a creditor-led model of DIP financing.
4. Conclusion
The adoption of DIP financing provisions sounds like a very tempting policy choice for regulators and policymakers interested in improving the attractiveness of a country’s insolvency and restructuring ecosystem. However, the experience of the United States shows that, while DIP financing has played an essential role in the success of Chapter 11 as a vehicle for the reorganisation of viable but financially distressed firms, it can also create agency problems that need to be kept in check by courts, creditors, or trustees. We suggest that greater creditor involvement should be warranted in countries with less competent and efficient courts and trustees. But greater creditor involvement may bring about anticommons problems of holdout and delay. We have suggested a few potential problems and solutions that can balance these anticommons and agency problems.
* This article was originally published in International Corporate Rescue Journal.
[1] US Bankruptcy Code, section 364.
[2] Ibid.
[3] Kenneth Ayotte and David Skeel, ‘Bankruptcy Law as a Liquidity Provider’ (2013) 80(4) University of Chicago Law Review 1557.
[4] Kenneth Ayotte and Edward Morrison, ‘Creditor Control and Conflict in Chapter 11’ (2009) 1(2) Journal of Legal Analysis 511. See also Vincent Buccola, ‘Sponsor Control: A New Paradigm for Corporate Reorganization’ (2022) 90(1) University of Chicago Law Review 1, 7–16.
[5] Ibid.
[6] Ibid.
[7] Kenneth Ayotte and Jared Ellias, ‘Bankruptcy Process for Sale’ (2021) 39(1) Yale Journal on Regulation 1.
[8] Vincent Buccola, ‘Sponsor Control: A New Paradigm for Corporate Reorganization’ (2022) 90(1) University of Chicago Law Review 1. See also Daniel Kamensky, ‘The Rise of the Sponsor-in-Possession and Implications for Sponsor (Mis)Behavior’ (2024) 171 University of Pennsylvania Law Review 19.
[9] Kenneth Ayotte and Jared Ellias, ‘Bankruptcy Process for Sale’ (2021) 39(1) Yale Journal on Regulation 1.
[10] Kenneth Ayotte and Edward Morrison, ‘Creditor Control and Conflict in Chapter 11’ (2009) 1(2) Journal of Legal Analysis 511.
[11] Ibid.
[12] Kenneth Ayotte and Jared Ellias, ‘Bankruptcy Process for Sale’ (2021) 39(1) Yale Journal on Regulation 1; Vincent Buccola ‘Sponsor Control: A New Paradigm for Corporate Reorganization’ (2022) 90(1) University of Chicago Law Review 1; Kenneth Ayotte and Alex Huang, ‘Standardizing and Unbundling the Sub Rosa DIP Loan’ (2023) 39(3) Emory Bankruptcy Developments Journal 523.
[13] 5 Kenneth Ayotte and Jared Ellias, ‘Bankruptcy Process for Sale’ (2021) 39(1) Yale Journal on Regulation 1.
[14] Aurelio Gurrea-Martinez, ‘Debtor-in-Possession Financing in Reorganisation Procedures: Regulatory Models and Proposals for Reform’ (2023) 24(3) European Business Organization Law Review 555, 558–571.
[15] Ibid.
[16] Ibid.
[17] Ibid.
[18] In the United States, see the US Bankruptcy Code, section 364(d). In Singapore, see the Insolvency, Restructuring and Dissolution Act 2018 (2020 Rev Ed), section 64(1)(d).
[19] Aurelio Gurrea-Martinez, ‘Debtor-in-Possession Financing in Reorganisation Procedures: Regulatory Models and Proposals for Reform’ (2023) 24(3) European Business Organization Law Review 555, 560–561.
[20] US Bankruptcy Code, section 364(a).
[21] George Triantis, ‘A Theory of the Regulation of Debtor-in-Possession Financing’ (1993) 46(4) Vanderbilt Law Review 901.
[22] Aurelio Gurrea-Martinez, Reinventing Insolvency Law in Emerging Economies (Cambridge University Press, 2024), 230-233.
[23] George Triantis, ‘A Theory of the Regulation of Debtor-in-Possession Financing’ (1993) 46(4) Vanderbilt Law Review 901.
[24] Kenneth Ayotte and Jared Ellias, ‘Bankruptcy Process for Sale’ (2021) 39(1) Yale Journal on Regulation 1; Aurelio Gurrea-Martinez, ‘Debtor-in-Possession Financing in Reorganisation Procedures: Regulatory Models and Proposals for Reform’ (2023) 24(3) European Business Organization Law Review 555, 573.
[25] Aurelio Gurrea-Martinez, ‘Debtor-in-Possession Financing in Reorganisation Procedures: Regulatory Models and Proposals for Reform’ (2023) 24(3) European Business Organization Law Review 555. Emphasising that the ability of judges/trustees to add value may depend on their expertise, see Kenneth Ayotte and Hayong Yun, ‘Matching Bankruptcy Laws to Legal Environments’ (2009) 25(1) Journal of Law, Economics, and Organization 2.
[26] Law 141–15 on Restructuring and Liquidation of Companies of 2015, Art 87. See Aurelio Gurrea-Martinez, ‘Debtor-in-Possession Financing in Reorganisation Procedures: Regulatory Models and Proposals for Reform’ (2023) 24(3) European Business Organization Law Review 555, 566–567.
[27] In India, the new financing needs to be approved by the committee of creditors. See the Insolvency and Bankruptcy Code 2016, s 25I. In Chile, new loans exceeding 20% of the debtor’s liabilities need to be approved by the creditors. See the Insolvency Act 2014 (Law 20,720), Art 74.
[28] Suggesting that the class of creditors involved in the decision to approve or reject the new financing should depend on the type of priority provided to the DIP lender, see Aurelio Gurrea-Martinez, ‘Debtor-in-Possession Financing in Reorganisation Procedures: Regulatory Models and Proposals for Reform’ (2023) 24(3) European Business Organization Law Review 555, 577–578.
[29] Kenneth Ayotte and Alex Huang, ‘Standardizing and Unbundling the Sub Rosa DIP Loan’ (2023) 39(3) Emory Bankruptcy Developments Journal 523.