As if bankruptcy wasn’t tough enough, it now seems that the days when management teams and senior lenders could sit down and civilly hammer out reorganizations are over. Companies’ existing credit structures and the general lack of credit are driving the terms of debtor-in-possession (DIP) financings.  DIPs are allowing some lenders to move up in capital structure at the expense of others. Bankruptcies involving companies taken over in leveraged buyouts by private equity (PE) funds during the boom, like Lyondell and Aleris, are proving to be particularly acrimonious. Meanwhile, the appearance of distressed investors, like those at Chesapeake, can greatly complicate the already complicated bankruptcy process. Overall, today’s DIPs and the claimant leapfrog games they spawn are transforming the bankruptcy process into a more adversarial and litigious forum and altering the distressed investment landscape.

Companies are so over-leveraged that there’s not enough to go around once they enter bankruptcy.  While not unusual in the bankruptcy process, it has become both more complicated and, overall, worse, as the complicating role of private equity funds, distressed investment funds, and certain European rules around assets play out.  Of note: PE firms have a huge – and potentially conflict fraught – incentive to salvage underwater equity positions by providing DIP financing and leapfrogging the lenders and creditors.  With or without these funds, all of this leaves lenders to an inter-creditor struggle, to-and-fro, between clever structuring by some, and objections by the left-out others. 

As background, when a company files for bankruptcy, it often needs additional funding to continue operations and to maximize the value of the estate. Lenders that provide DIP financing during this process are able to secure a superpriority lien that “primes” the liens of existing lenders. In today’s credit constrained market, debtors often have only a sliver of equity (if any at all) left on their balance sheet.  Consequently, they are attempting to entice existing lenders (new lenders are practically unheard of) to pony-up more cash by allowing them to “roll up” part of their prepetition debt.  A rollup basically transforms dollars lent pre-petition and secured by a senior lien into part of the funds lent under the DIP and secured by the priming lien.

Over-leverage during the credit boom left many companies with so much debt that even secured lenders are facing equitization, and DIP lenders worry about the same risk. “Fulcrum investing” had been the common practice – where distressed investors buy unsecured debt (bonds and notes) right before a soon-to-be debtor goes bankrupt.  Assuming that senior lenders got paid out (and retired) from the proceeds of asset sales or exit financing, this left the fulcrum-owner to trade the fulcrum debt for full equity ownership of the whole business post-bankruptcy. In our new world, fulcrum investing has refocused on investments in DIPs because of over-leverage.

The zero-sum game in over-leveraged companies becomes clear from the case of Lyondell. Lyondell, a Houston-based chemicals company, received a one-year mega-DIP of $8.5 Billion, $3.25 Billion of which is new money.  The company was bought in 2007 by European PE powerhouse Access, which attempted to be included in the DIP but withdrew because of complaints.  Controversially (and there is always some of controversy in a DIP): the loan was approved by the court over three powerful objections. The first of these was that of ABN AMRO, a major pre-petition lender, that was concerned that participation in the roll-up would contractually require lenders to forfeit rights to European collateral; the second was that of the Unsecured Creditors Committee which alleged that a one-year DIP for a globe-spanning company was negotiated in bad faith and built to default; the third was that of the trustee for the largest unsecured creditor’s claim, stating that it was contractually guaranteed parity with prepetition lenders.  With little equity on its books to begin with, expect the bankruptcy proceeding to become even move acrimonious as the one-year deadline approaches.

As if over-leverage weren’t bad enough, further complication is added by private equity owners, who often serve dual roles. This is made clear in the case of aluminum recycling conglomerate Aleris.  TPG, the company’s sole equity holder after a 2006 buyout, considered providing DIP financing, in order to recover on its investment. However, it “decided” against it, after loud complaints from affected interested parties. The $1.075 billion DIP was eventually provided by other pre-petition lenders, though not all of them, leading to some of the following struggle. Together with TPGs continuing role (and plans for more), this proceeding has become particularly complicated.

Lender Goldman Sachs (through its J. Aron & Co. commodities unit), transferred a third of a pre-petition secured claim to TPG and retained the rest.  The two filed a motion in with the Delaware Bankruptcy Court on March 4, 2008 alleging Deutsche's actions in arranging the DIP unfairly subordinated the duo’s claims, failed to obtain the contractually required consent, and failed on the legal standard of providing “adequate protection” for prepetition lenders. Deutsche objects to all of the above, and further asserts that J. Aron was estopped from its claim. The reason? It had, separately, already agreed to roll up 5% of its debt in an agreement offered to all secured lenders, but unrelated to the DIP. This separate rollup had been put in place to counter claims to European assets. Aleris has delayed its hearing on the DIP approval until March 16, the results are still unreported, so that its Official Unsecured Creditors' Committee may have time complete its review of the DIP. TPG remains in the fight – it has reportedly told its investors to prepare for capital calls (forking over committed funds) so that the fund can buy the DIP term loan as it begins to trade in the secondary market.
 
Opportunistic funds can add another element of acrimony, even if they weren’t private equity owners previously.  Consider recent events at Chesapeake, a bankrupt packaging company.  Chesapeake’s Chapter 11 petition cites all the usual causes as to its bankruptcy, but front and center, again, is debt.  Prepetition lender Wachovia committed to a $37.1 million DIP. The debtor immediately negotiated a $485 million, minus outstanding secured indebtedness and other expenses, “stalking-horse” bid from distressed investors, who acquired a control position in Chesapeake's bonds, Oaktree Capital and Irving Place Capital. The Unsecured Creditors Committee, feeling a little melancholy because the plan will wipe them out, filed an objection to the bid procedures and DIP.  The Committee is concerned that Wachovia and the bidders might have somehow “talked” Chesapeake into a sale that is to their sole-benefit and to the detriment of the rest of rest of the interested parties. The Committee is requesting time to review certain documents related to transaction.

Every DIP is a bespoke contract because every capital structure (not to mention more prosaic business, industry, and economic issues) is different. Executives, lawyers, and accounts need to be aware of the terms shaping the market, because DIP terms are molding the bankruptcy process and spawning litigation, as claimants leapfrog one and other in the claims structure, expose themselves to a variety of conflicts of interest, and negotiate with distressed investors. PE firms, hedge funds, and collateralized loan obligation (CLO) are all hungering for the quick capital gains that rollups provided and the high-rates of returns attached to DIPs. Will the addition of these short-term investors, the enhanced bargaining power of priming liens, turn the established, and still rather contentious, bankruptcy process into an acrimonious nightmare? In any event, DIP terms will continue to be extremely creditor-favorable as long the credit crisis continues. Distressed and restructuring firms need legal knowledgeable bankruptcy counsel now more than ever.

Published: March 17, 2008