DIP Financing: a Review of Best Practices and Recent Developments - Or - the Skinny on Dips1

DIP Financing: A Review of Best Practices and Recent Developments - or - The Skinny on DIPs1 Presented at the 43rd Annual Seminar on Bankruptcy Law and Rules, Atlanta, Georgia March 30 –April 1, 2017 Manuscript: David L. Eades Glenn Huether Moore & Van Allen, PLLC Discussion Panel: Hon. Frank J. Santoro U.S. Bankruptcy Judge Eastern District of Virginia Corali Lopez-Castro Kozyak Tropin & Throckmorton David L. Eades Moore & Van Allen PLLC 1 Sorry. 1 Introduction. If you actually read this manuscript (and, hey, you got this far), you will notice very quickly that it does not qualify as a particularly scholarly treatment of debtor in possession financing issues. I’ve cited a few cases, but only when I think they touch on an interesting or unresolved issue. On the other hand, I’ve also tried not to insult your intelligence or experience with a manuscript that assumes you’ve never seen a DIP loan before. If I drafted this with anyone particular in mind, it was the lawyer who has been involved in several DIP lending situations and knows he/she will be again, but who also is capable at times of forgetting some basic points and of missing some recent developments. In other words, I drafted it for lawyers like me. I hope it helps.2 The Statutory Framework. In the previous millennium, when I was a young lawyer, one old partner at our firm had one constant mantra: Re-read the statute, and re-read the rules - every time. He was didactic, maybe even a little bit batty about it (he said it pretty much every day), but he was right. Knowing exactly what the Bankruptcy Code, the Bankruptcy Rules and the applicable local rules require in connection with any proposed DIP financing package is critical. Section 364. Bankruptcy Code Section 364 lays out the roadmap for approval of any DIP facility. I say roadmap, but a better metaphor is probably a ladder. The rungs of the ladder work like this: 2 One thing is for sure, I could not have drafted it without the help of my colleague, Glenn Huether. Thanks, Glenn! 2 Rung 1. Is the prospective DIP lender willing to provide unsecured financing with mere garden variety administrative priority? If yes, (1) wow! and (2) congratulations, you don’t need court approval for the facility. See § 364(a). If no,3 proceed to Rung 2: Rung 2. Is the best prospective DIP lender willing to provide unsecured financing with, and only with, priority over all other claims with 503(b)(1) or 507(b) priority?4 If yes, simply demonstrate this to the satisfaction of the court and, if the court also approves of all of the other terms of the financing package (potentially a big “if”, as we shall see), off you go. See §§ 364(b) and (c)(1). If no, keep climbing: Rung 3. Is the prospective DIP lender willing to provide financing with senior liens on unencumbered property and/or with liens junior to prepetition liens (with super-priority administrative status almost always thrown in). If yes, it’s the same “show and go” as above. See §§ 364(c)(2) and (3). This is the most common priority package in chapter 11 cases requiring DIP financing, at least when the DIP loan is coming from a lender who was not a prepetition lender. But it’s not the last rung of the ladder: 3 Each of the next three successive “rungs” require a showing that sufficient postpetition credit at the previous rung was not, under the debtor’s particular circumstances, practicably available. 4 Except, in most cases, as pertains to avoidance action proceeds. More on this later. 3 Rung 4. If the debtor can show that it is unable to find financing unless it grants liens that are senior or equal to existing prepetition liens, it may be able to procure court approval of such a loan package. This can be a very tall order, however. Section 346(d)(1)(B) requires that the debtor must show that the interests of the prepetition lender whose liens are impaired by the DIP financing are adequately protected. Priming facilities that achieve this goal usually do it in one three ways: Consent. In many instances, the prepetition lender will consent to the priming in exchange for a negotiated set of protections for its primed security interest. This can often occur in syndicated credits, where a subset of lenders in the prepetition secured credit facility provide the DIP financing. Many, if not most, syndicated credit agreements allow lenders holding a majority (or super- majority) of the loan commitments to direct the agent who holds liens for the benefit of all the lenders in the facility to voluntarily subordinate those liens to another lender or set of lenders. Equity Cushion. If the prepetition lienholder will not consent to subordination of its liens in favor of a DIP facility lender, the court may nonetheless allow a lien priming based on a showing that the value of the collateral securing the prepetition debt is large enough to fully secure both the DIP facility and the prepetition secured loan. Of course, if the court turns out to be wrong about this, the 4 primed lender usually has only the cold comfort of Section 507(b) to – hopefully – make it whole. For this reason, courts tend to err on the side of caution when asked to find that a prepetition lien is adequately protected by excess collateral value. In part because potential DIP lenders tend to not want to invest the necessary underwriting diligence in loans they may never be allowed to make, full-blown “priming fights” are not particularly common. Value Preservation. In rare instances, a court may allow a DIP facility to prime an under-secured prepetition lender upon a finding that the facility is likely to achieve a better recovery for the prepetition lender than the lender would realize in an immediate liquidation. The rationale in these instances is that the under- secured creditor whose lien is primed by a DIP loan is adequately protected because the DIP facility means the primed lender’s collateral remains part of a going concern and thereby maintains its fair market value. The problem here, of course, is that the DIP loan may only delay and impair an inevitable liquidation, leaving the prepetition lender with a worse collateral position than it had on the petition date, without so much as an apology note. Case Example. In Binder & Binder – The National Social Security Disability Advocates (NY), LLC, et al., the Bankruptcy Court for the Southern District of New York 5 approved a priming DIP facility provided by the debtors’ prepetition mezzanine lender. (See Case No. 14-23728, Bankr. S.D.N.Y. Mar. 20, 2015). Binder & Binder was a company that provided advocacy services to disability claimants across the country. In Binder & Binder, the debtors initially entered into a DIP facility offered by their senior secured lenders. This initial DIP facility contained, among other things, very tight covenants and a requirement to file a liquidating plan within six months of the petition date. It also included the requirement of a first- day rollup (more on these below), which various parties objected to and the court declined to approve. The debtors defaulted under the facility in less than a month. Against a backdrop of a likely immediate liquidation, the debtors sought alternative financing. Their prepetition mezzanine lender responded and offered an alternative DIP facility on much more favorable terms and conditions for the debtors. As security for the alternative DIP credit facility, the mezzanine lender was granted a priming first lien on all of the estates’ assets (other than chapter 5 causes of action). Part of the proceeds from the alternative DIP 6 facility was used to repay the senior lenders in full for all amounts extended under the initial DIP facility. The mezzanine lender’s priming alternative DIP facility was approved by the court. The court found that the senior secured lenders were adequately protected because the business would continue as a going concern via the priming DIP facility and that the senior secured lenders who were pushing for a liquidation would, if successful, likely have received a much smaller recovery on their claims. Practical 364 Considerations. Demonstration of Need. While Section 364 doesn’t say anything about having to prove an actual need for DIP financing (defaulting, presumably, to the debtor’s business judgment), as a practical matter demonstrating need is often critically important. For one thing, if you are seeking approval of the financing before the final hearing, Rule 4001(c)(2) requires a showing of need (more on this below). For another, the more dire the need for postpetition financing, the greater the ability able to push the envelope in terms of getting the more controversial provisions of a DIP financing package approved. Keep in mind that “need” can encompass more than just filling a potentially fatal cash flow “hole”. A suitably sized DIP facility can be critical to convincing vendors, customers and employees to continue to engage with the debtor. 7 Early Preparation. Within the bounds of expense and client willingness to consider “downside” options, it is important to negotiate and prepare DIP financing packages and concomitant filings well before the petition date. Leaving key issues such as DIP facility sizing, pricing and budgeting to be resolved on the eve of filing may imperil the entire reorganization, Section 363 sale or orderly liquidation. While the cases are clear that Section 364 does not require that the search for the best possible financing package be exhaustive, there must be some showing that better options weren’t practically available.

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