Restructuring

This installment of the Weil Bankruptcy Blog’s series on the ABI Commission Report is the second of two posts that address the Commission’s recommendations relating to postpetition financing.  This post covers the Commission’s recommendations with respect to certain controversial terms in postpetition financing agreements and the timing of approval for certain other financing terms (Sections IV.B.2 and IV.C.1 of the report), while the previous post covered the Commission’s recommendations with respect to adequate protection (Section IV.B of the report). 
Postpetition Financing – Controversial Terms
When it came to postpetition financing, the Commission sought to preserve a “robust, competitive” market for postpetition financing while curtailing certain financing terms that the Commission believed to “overreach or negatively impact the rights of other stakeholders beyond the terms necessary to obtain postpetition credit in a particular case.”  To that end, the Commission made a number of recommendations with respect to specific terms that may be controversial but are commonly found in sophisticated postpetition financing agreements.
First, the Commission recommended a prohibition on provisions that “roll-up” (or pay down) prepetition debt, unless the postpetition financing (i) is provided by new lenders that do not hold the prepetition debt affected by the provision, or (ii) repays the prepetition debt in cash, extends substantial new credit to the debtor, and provides “more financing on better terms” than alternative financing proposals.  In either scenario, the bankruptcy court must also find that the proposed postpetition financing is in the best interests of the estate.  Through this recommendation, the Commission sought to curb the practice of providing postpetition financing on terms that significantly improve the position of a prepetition secured creditor in exchange for nominal new credit.
Second, the Commission recommended a prohibition on forward cross-collateralization (i.e., securing prepetition debt with postpetition assets), except in the context of adequate protection, and even then, only to the extent that such cross-collateralization covers a decrease in the value of collateral as of the petition date.  Although the Commission conceded that cross-collateralization “may serve valid interests that would benefit the estate,” it determined that the practice also resulted in “overreaching” and the “impermissible improvement of a prepetition lender’s position,” which it sought to curtail with its recommendation.
Third, the Commission recommended a prohibition on granting postpetition lenders a lien on, or any interest in, the chapter 5 avoidance actions held by the estate or the proceeds of such actions.  The Commission’s recommendation was based on its review of the “original policies” for granting avoidance powers to the estate, including fair distribution, and its observation that avoidance actions and their proceeds are often “among the few unencumbered assets of a debtor’s estate and therefore may be the only resource available to repay unsecured claims.”
Finally, the Commission recommended that provisions in prepetition intercreditor or subordination agreements that prohibit a junior secured creditor from extending postpetition financing to the debtor should be unenforceable, provided that (i) the postpetition financing provided by the junior secured creditor cannot prime the perfected security interests of the senior secured creditor, and (ii) if the bankruptcy court approves the junior secured creditor’s postpetition financing, then the senior secured creditor should have the option to match the terms offered by the junior secured creditor and to provide the financing in lieu of the junior secured creditor.  Additionally, contractual provisions that would allow the senior secured creditor to recover damages for breach of contract relating to those provisions against the junior secured creditor under non-bankruptcy law for would also be unenforceable.  The Commission reasoned that this recommendation would facilitate the robust, competitive market for postpetition financing it sought to ensure for the benefit of all stakeholders because “[a]mong other things, this waiver often removes an interest and viable source of financing from the debtor’s pool of potential postpetition lenders, which may affect both the availability and terms of any postpetition financing for the debtor in possession.”
Postpetition Financing – Timing for Approval
The Commission also considered a longer list of specific financing terms that it found to be generally acceptable, but inappropriate either in the first 60 days after a debtor files for chapter 11 or in an order authorizing postpetition financing on an interim basis.
Specifically, the Commission recommended that bankruptcy courts should not approve postpetition financing that includes “milestones, benchmarks, or other provisions that require the trustee to perform certain tasks or satisfy certain conditions” within the first 60 days of a chapter 11 case.  The Commission elaborated on that phrase, explaining that it covers “tasks or conditions that relate in a material or significant way to the debtor’s operations during the chapter 11 case or to the resolution of the case,” and includes “deadlines by which the debtor must conduct an auction, close a sale, or file a disclosure statement and a chapter 11 plan.”  The Commission, however, expressly excluded from that phrase “payment of scheduled loan amounts, customary loan covenants, reporting requirements, ministerial tasks, or the debtor’s compliance with a budget, provided that the budget does not impose disguised milestones or benchmarks.”
In addition, the Commission recommended that bankruptcy courts should not approve “permissible extraordinary financing provisions” in an interim order.  The Commission defined the phrase “permissible extraordinary financing provisions” to include:

(i) milestones, benchmarks, or other provisions that require the trustee to perform certain tasks or satisfy certain conditions [as defined above]; (ii) representations regarding the validity or extent of the creditor’s liens on the debtor’s property or property of the estate; or (iii) if some or all of the proposed postpetition lenders hold prepetition debt that would be affected by the postpetition facility, a provision that refinances prepetition debt with proceeds of the postpetition facility that is otherwise permissible under the principles relating to postpetition financing terms [as described above].”

The Commission found that, although the foregoing terms may be appropriate in certain situations, such terms had a “potentially significant impact … on chapter 11 outcomes,” which necessitated clear and effective notice that could not be provided during the frenetic beginning of a chapter 11 case.  In reaching its conclusions, the Commission interpreted data concerning cases subject to milestones and benchmarks to suggest that such provisions were usually a self-fulfilling prophecy (e.g., financing agreements with sale-oriented milestones were significantly less likely to result in a reorganization), which can put those provisions at odds with the reorganizational objective espoused by the Commission.
Postpetition Financing – Observations
As in the adequate protection context, the Commission again sought to strike a balance in its recommendations on the terms of postpetition financing.  On the one hand, the Commission clearly intended to place limits on financing terms that reduce a debtor’s restructuring options or negatively impact the rights of other stakeholders.  On the other hand, the Commission understood that such terms are often an incentive for lenders to extend necessary postpetition credit; although the Commission openly acknowledged a split within its membership on whether lenders needed these incentives to extend postpetition financing or would continue to lend without them.
Notably, the Commission stopped short of recommending that secured creditors’ collateral be used to pay for the costs of administration or to guarantee some form of recovery for junior creditors (i.e., “pay to play”)—an idea that was  is anathema to the secured lending community.  In a response (here) to criticism from the secured lending community, Messrs. Robert Keach and Albert Togut, the co-chairs of the Commission, took care to stress that the exclusion of a pay to play recommendation from the report reflects the Commission’s balanced approach.  They explain that pay to play was rejected despite being “discussed at length at the Commission’s field hearings” because its “potential negative impact … outweighed the possible benefits achieved.”  Messrs. Keach and Togut also defended a “short moratorium” on provisions like milestones and benchmarks, arguing that, because of “the clear out for true emergencies, and the adequate protection requirements and attendant safeguards, secured party recoveries would not be diminished by these protections,” and “[w]hile there may be some delay in realization of recoveries, this modest delay is a small price to pay for better, fairer results.”
Nevertheless, the Commission’s recommendations with respect to postpetition financing terms would, on their face, limit the protections available to postpetition lenders.  Moreover, these recommendations could also have a negative impact on prepetition secured creditors because their cash collateral may be accessed more easily on day one of the case (as explained previously) even as they are forced to wait 60 days or longer for customary, “permissible” protections.  It is reasonable to expect that the loss of these protections would increase the cost of borrowing to account for the increased risk taken by secured lenders.  It is also possible that the increased risk will drive out certain lenders (for example, prepetition secured lenders subject to regulation), reducing available capital and leaving only those lenders willing to take on greater risk in pursuit of outsized returns.  Neither of these outcomes would further the debtor’s reorganizational objectives.  Nor would they further the Commission’s stated goal of preserving a “robust, competitive” market for postpetition financing.  Thus, we can infer that the Commission was guided by the belief that it would be economically rational for prepetition and postpetition lenders to extend credit, even without certain of the protections they currently enjoy.
Conclusion
As the saying goes, “it takes money to make money.”  It also takes money to reorganize.  For a company in the throes of financial distress, postpetition financing can provide the liquidity necessary to fund continued operation and restructuring expenses.  It is not surprising, then, that certain data gathered for the Commission suggest that “the majority of debtors that enter into postpetition financing agreements do not liquidate, but rather reorganize.”
This premise appears to have motivated the Commission as it crafted recommendations intended to facilitate a debtor’s rehabilitation either by increasing the ease with which a debtor may access postpetition financing (e.g., lowering the hurdle of adequate protection by adopting a foreclosure value standard) or by limiting the financing terms that inhibit or conflict with a debtor’s reorganizational objectives (e.g., prohibiting “milestones, benchmarks, or other provisions that require the trustee to perform certain tasks or satisfy certain conditions” within the first 60 days of the chapter 11 case).  It seems clear that the Commission’s recommendations, if adopted in their entirety, would significantly impact the reasonable expectations of borrowers and lenders alike.  We leave it to our readers, however, to debate whether the recommendations amount to much-need recalibration of leverage between a debtor and its lenders, unnecessary interference in the well-developed market for postpetition financing, or something else entirely.