Restructuring

As liquidity returns to the market, will roll-ups roll-out?
The statutory framework for obtaining debtor in possession (or postpetition financing) is straightforward, with section 364 of the Bankruptcy Code providing a staged approach for a debtor to obtain approval for the financing it needs to continue operating during its chapter 11 case.  While bankruptcy courts routinely approve debtor in possession (or “DIP”) financing, financing proposed by existing prepetition lenders often draws heightened scrutiny on both the proposed financial terms (such as interest rates and fees) and non-monetary terms, like the security package. 
 A debtor that cannot obtain unsecured financing to fund its operations during its chapter 11 case may attempt to obtain credit with administrative priority over certain competing administrative expenses, secured by a first priority lien on the unencumbered assets of its estate, and by a second priority lien on its remaining encumbered assets.  During our recent credit winter, debtors have been forced to look even further to obtain credit, relying on section 364(d) to obtain authority for DIP lenders to provide credit ranking above or equal to all other secured debt.  Such credit is permitted by the Bankruptcy Code where no other credit is available, but the debtor must provide “adequate protection” to the existing secured lenders (see section 364(d)(1)). 
With less credit available to distressed borrowers during an uncertain economic climate, debtors frequently have turned to their existing lenders to obtain the financing necessary to continue their operations.  These lenders, who may already have liens secured on substantially all of the assets of the borrower, have looked to further protect their position and any additional capital (or existing cash collateral) advanced, by only granting the distressed borrower the funding it desperately needs on the condition that the entire prepetition facility is effectively bought out by the new DIP facility. 
This dynamic has led to the evolution of the “roll-up”: prepetition lenders, providing postpetition financing, have offered, and obtained, a postpetition facility that effectively pays off (or “rolls-up”) the prepetition secured debt.  This process can take place in a single stage, or as additional money is borrowed (the debtor, as postpetition funding is obtained, applies an equivalent amount of collateral sale proceeds first to the repayment of the prepetition facility until the outstanding obligations are fully “rolled” into the postpetition facility) by the debtor.  A roll-up effectively transforms the existing lenders’ prepetition claims into a postpetition, administrative expense.
Bankruptcy courts generally shy away from approving debtor in possession financing that improves the position of certain prepetition creditors at the expense of other creditors for obvious reasons.  One of the biggest drawbacks to a roll-up, and the reason bankruptcy courts are skeptical of DIP loans containing roll-ups, is that a debtor cannot “cram down” its prepetition lender under section 1129(b) of the Bankruptcy Code once the roll-up has been completed, giving its secured lender, as a practical matter, a very powerful position with respect to the debtors’ restructuring. In a cramdown scenario, a debtor could, for instance, alter material financing terms of the prepetition claim over a lender’s objection. If the debtor is planning to retain the existing lender to provide exit-financing, this may be not be an issue – however if a lender is not willing, or is unable, to provide exit financing, a debtor pursuing a roll-up requires an exit strategy that involves the payment of the entire facility, in cash, on the date of its emergence from chapter 11 protection. 
Where credit markets are so tight that a debtor has no other reasonable prospect of financing, or where a lender is oversecured and the roll-up would simply be beneficial to the estate, roll-ups may be a reasonable option in a debtors’ quest for financing.  It is in this context that bankruptcy courts have approved roll-ups with increasing frequency, though with little commentary to give distressed borrowers, lenders or their advisors guidance on when roll-ups are, and are not, acceptable.  Recent roll-ups include: In re Uno Restaurant Holdings Corporation, et. al., Ch. 11 Case No. 10-10209 (MG) (Bankr. S.D.N.Y. Jan. 20, 2010); In re Foamex International Inc., et al., Ch. 11 Case No. 09-10560 (KJC) (Bankr. D. Del. Feb. 18, 2009); In re Aleris International, Inc., et al., Ch. 11 Case No. 09-10478 (BLS) (Bankr. D. Del. Feb. 12, 2009); In re Tronox Incorporated, et al., Ch. 11 Case No. 09-10156 (ALG) (Bankr. S.D.N.Y. Jan. 12, 2009); and In re Lyondell Chemical Company, et al., Ch. 11 Case No. 09-10023 (REG) (Bankr. S.D.N.Y. Jan. 6, 2009). 
In Lyondell, the debtor sought approval from Judge Robert Gerber in the Southern District of New York for a DIP financing package of $8.25 billion to support the operations of this major international oil refiner and petrochemical producer, with an estimated annual interest burden on its debt of $1.3 billion. 
Following a contested final hearing that lasted three days, the bankruptcy court approved a DIP financing package that included a partial roll-up of prepetition secured term loans, structured to avoid a potential refinancing crisis on emergence by allowing the rolled-up prepetition debt to be repaid under a plan of reorganization with a five-year secured note. 
As with other decisions where roll-ups have been approved, Judge Gerber’s bench decision did not include a detailed analysis of the roll-up.  In disposing of a collateral objection from Bank of New York related to its inability to participate, along with various public noteholders, in the roll-up loan, Judge Gerber did find that that the roll-up was an element of the consideration being offered to those willing to offer new money that the debtors badly needed.  Judge Gerber further accepted uncontroverted evidence presented by the debtors that the DIP financing package would not be available absent the roll-up. 
In reviewing the standard for approval of a facility of this character, as set forth in the oft-cited decision in Farmland Industries, 294 BR 855 (Bankr. W. D. Mo. 2003), Judge Gerber noted that the debtors would be forced to liquidate in the absence of financing.  In determining that the proposed financing, including the roll-up, was an exercise of sound and reasonable business judgment on the part of the debtors, Judge Gerber found that the debtors and their professionals negotiated the best terms they could, and despite criticizing the pricing terms as “disappointing” by reason of then-present market conditions, ultimately determined them to be reasonable under the circumstances.  The court’s comments make clear that its outcome was determined by the extraordinary circumstances of the time: 

Folks, I should say that every decision we bankruptcy judges issue in this district, including dictated decisions after trial, tends to develop a life of its own and to become the precedent for the next case. I assume, or at least hope that economic conditions in this country, including freeze-ups of the lending markets and the very limited present availability of credit will ultimately improve. What I’m of a mind to recognize and respect now in the way of economic reality will be trumped by the facts on the ground with respect to economic conditions at the time of the next financing I’m asked to approve. And people should be wary of using this case as a precedent in the next one that comes down the road, especially if that’s the case after the liquidity markets have loosened up. 

Despite the lack of guidance available in cases in which roll-up DIPs have been approved, the following factors weigh in favor of roll-ups being approved:
–         Alternative financing not being able to be reasonably be sourced on better terms, or at all;
–         The proposed facility being in the best interests of the debtor, its estate and its creditors, as opposed to
          merely allowing its existing lender to strengthen its collateral position;
–         The prepetition lender advancing significant funds postpetition in excess of the prepetition facility
          balance;
–         The prepetition lender being oversecured; and
–         The extent to which prepetition and postpetition collateral is intermingled, or can be segregated (which 
          goes into whether the roll-up can be unwound).
As credit markets improve, and capital returns to the DIP financing market, it appears likely that the trend towards permitting roll-ups may well continue, though as Judge Gerber notes in Lyondell, bankruptcy courts will no doubt push debtors to present convincing evidence that no other form of financing is available without the roll-up.  As multiple sources of DIP financing emerge as a result of improvements in our economic environment, roll-ups may take a back seat as lenders compete by providing more attractive financing packages for debtors, so as to benefit from the attractive yields on DIP financings.