ASPATORE SPECIAL REPORT Recent Trends in Debtor-in-Possession Financing Leading Lawyers Analyze Bankruptcy Financing 2016 Thomson Reuters/Aspatore All rights reserved. Printed in the United States of America. No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, except as permitted under Sections 107 or 108 of the U.S. Copyright Act, without prior written permission of the publisher. This book is printed on acid free paper. Material in this book is for educational purposes only. This book is sold with the understanding that neither any of the authors nor the publisher is engaged in rendering legal, accounting, investment, or any other professional service. Neither the publisher nor the authors assume any liability for any errors or omissions or for how this book or its contents are used or interpreted or for any consequences resulting directly or indirectly from the use of this book. For legal advice or any other, please consult your personal lawyer or the appropriate professional. The views expressed by the individuals in this book (or the individuals on the cover) do not necessarily reflect the views shared by the companies they are employed by (or the companies mentioned in this book). The employment status and affiliations of authors with the companies referenced are subject to change. For customer service inquiries, please e-mail [email protected]. If you are interested in purchasing the book this chapter was originally included in, please visit www.legalsolutions.thomsonreuters.com DIP and Exit Financing Trends and Strategies in a Changing Marketplace Paul H. Zumbro Partner Cravath, Swaine & Moore LLP 3 By Paul H. Zumbro Introduction In Chapter 11, inaction can be fatal—to achieve a successful reorganization, a company heading toward bankruptcy must act and must act quickly to avoid a liquidation or otherwise value-destroying outcome. Although many pressing issues may vie for the attention of the management of a company in distress, one of the most important tasks of any potential debtor is obtaining necessary bankruptcy financing. Such financing, known as debtor- in-possession or “DIP” financing, facilitates the reorganization of a “debtor-in-possession” (i.e., the company after it has filed a bankruptcy petition) by providing it fresh capital to fund its business during the pendency of the bankruptcy case. Obtaining DIP financing is also an important signal to the market, as vendors and customers will want assurances with respect to the reliability of the debtor’s ongoing payment capacity and the ability of the debtor to remain in business during the reorganization process. Showing that sophisticated lenders have examined the debtor’s finances and believe in the debtor’s ability to repay its post- petition obligations (and are thus willing to provide DIP financing) goes a long way to quell these worries, enabling the debtor to continue operating as a going concern while it pursues a reorganization. The policy of favoring corporate reorganization over liquidation animates Chapter 11. DIP financing is an integral step toward achieving that policy goal in any given case, and keeping current on the legal and other trends relating to this important segment of the financing market is crucial for any counsel practicing in this area. Recent Trends and the Regulatory Environment Affecting Debtor-in- Possession and Exit Financing The broader economic environment always has a major impact on DIP and exit financing trends. Currently, we are seeing a lot of DIP financings in the oil, gas and other energy sectors as a result of a pronounced and sustained decline in commodity prices, particularly oil and gas prices. There is a growing need for DIP financing in that area—but obtaining that financing can be challenging because asset valuations are declining or fluctuating rapidly. Such rapid changes in valuations lead to uncertainty about where the value line breaks—i.e., about which creditor group holds the “fulcrum 4 DIP and Exit Financing Trends and Strategies in a Changing Marketplace security” and will be entitled to the new equity of a reorganized company. For example, I worked on a recent oil and gas case where it appeared that the second lien bondholders would have the fulcrum security in the reorganization at the outset but, as a result of the dramatic decline in oil and gas prices, the second lien was wiped out, the first lien suffered significant losses and even the DIP loan was impaired by the time the case concluded. This type of uncertainty regarding valuations makes potential DIP lenders understandably more cautious about extending DIP financing than they would be in a more stable market environment. Uncertainty is not unique to the current environment, but the pronounced and sustained decline in commodity prices over the past 12-plus months has been rather stark and has had a wide-ranging impact not only on oil and gas companies but throughout the economy and financing markets. Although the decline in commodity prices began more than a year ago, we had not fully felt those declines prior to 2016, as many oil and gas companies had hedging arrangements in place that locked in higher commodity prices (and related cash flows) and allowed them to mask liquidity issues for a good part of 2015. As those hedges have rolled off, the actual impact of the decline in commodity prices is now being felt much more acutely. In terms of the regulatory environment, the leveraged lending guidance that was issued by the Federal Reserve and other bank regulators, which has had a significant impact on leveraged financing in general, has also affected the DIP financing area in ways the regulators may not have intended. The guidance states that it is not intended to “discourage” DIP financing,1 but given how broadly the guidance is written, it unfortunately may do so in practice. For instance, the guidance contains some provisions relating to so- called “fallen angels” (i.e., companies that previously were investment grade but whose financial condition has deteriorated significantly), which states that unless a lender can clearly show how the extension of new credit or funds to such a company mitigates risk, the new loan will receive an adverse 1 With respect to DIP financing, the guidance states the following: “Nothing in the preceding [underwriting standards section] should be considered to discourage providing financing to borrowers engaged in workout negotiations, or as part of a pre-packaged financing under the bankruptcy code.” BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM, FEDERAL DEPOSIT INSURANCE AGENCY & OFFICE OF THE COMPTROLLER OF THE CURRENCY, INTERAGENCY GUIDANCE ON LEVERAGED LENDING (2013). 5 By Paul H. Zumbro risk rating. This is a challenging concept to apply in the context of DIP financing. While it is true that the main reason banks provide DIP financing is to protect their existing credit exposure and to thereby maximize their recovery in a situation where the borrower’s business has not performed well, this involves complex analysis in the context of often quickly changing circumstances that make it exceedingly difficult to “clearly” demonstrate risk mitigation. Imposing an additional layer of regulatory oversight with respect to credit exposures that banks are unquestionably economically motivated to protect does not make a lot of sense—and it is not the circumstance that the leveraged lending guidance was intended to address. However, because government regulators have been so vocal in their efforts to ensure that banks comply with the leveraged lending guidance, banks are quite sensitive to compliance issues and thus tend to err on the side of caution. For example, I recently worked on a DIP financing matter where my client did not have any economic exposure with respect to the credit; it was the agent under the pre-petition facility, but the secured lenders were really controlling the situation and driving the process because they had all the economic exposure. The secured lenders asked my client to be the agent under the DIP facility that the lenders were providing, because they sought continuity in terms of the agent’s role, and because as pre-petition agents we could help coordinate the process. Even though the agent had no existing economic exposure and it was not incurring any new exposure, acting as agent under the DIP facility was viewed as an “origination” for the purposes of leveraged lending guidance compliance. Accordingly, the agent had to go through a very extensive credit approval process that put pressure on its ability to execute in a timely manner—and timeliness is quite important in a bankruptcy scenario. The agent was ultimately able to obtain the credit approval it needed, but the overhang of the leveraged lending guidance on the process added considerable stress to an already stressful situation, with no regulatory benefit. The interplay between the leveraged lending guidance and DIP financing is an issue that requires further scrutiny and discussion between regulators and practitioners to provide additional clarity to debtors and lenders or agents contemplating participating in DIP financing, ideally (although probably unlikely) by the regulators replacing the statement of “non-discouragement” of DIP financing with a clear exemption for DIP financing. 6 DIP and Exit Financing Trends and Strategies in a Changing Marketplace Emerging Challenges for Clients Seeking Debtor-in-Possession or Exit Financing Unlike the situation in years past, when the agent would have meaningful economic exposure under a borrower’s main credit facility and would typically work with a relatively small group of commercial bank lenders in a workout or other distress situation, there has been a significant increase in the number of institutional lenders (hedge funds, CLOs, etc.) in the leveraged lending space, resulting in both a greater number of lenders and a different type of lender.