Recent Developments in DIP Financing for International and Domestic Debtors

In summary

This chapter discusses the ability of foreign-domiciled debtors who pursue Chapter 11 bankruptcies in the United States to obtain debtor-in-possession (DIP) financing and focuses on recent trends with respect to certain features of DIP financing, including equity conversions and roll-ups of prepetition debt.

Discussion points

• Background of DIP financing in Chapter 11 cases
• Discussion of the types of DIP lenders
• Considerations with respect to the recognition of the DIP order in foreign jurisdictions
• Trends in DIP loans including roll-ups and equity conversions

Referenced in this article

• Chapter 11 of the US Bankruptcy Code
• In re Avianca Holdings SA, 20-11133 (MG) (Bankr. SDNY 2020)
• In re Grupo Aeromexico, SAB de CV, No. 20-11563 (SCC) (Bankr. SDNY 2020)
• In re LATAM Airlines Group SA, No. 20-11254 (JLG) (Bankr. SDNY 2020)

Chapter 11 has gained a strong foothold as a pathway for foreign-domiciled companies to reorganise, whether or not such companies have substantial operations in the United States. A key component in such reorganisations is the access Chapter 11 debtors have to a broader base of funding sources to obtain financing through their bankruptcy case to achieve a successful reorganisation and exit. Known as debtor-in-possession^[1] (DIP) financing, potential debtors either obtain financing from their existing secured lenders or through other third-party lenders through well-established market processes in the United States. This chapter provides an overview of DIP financing with a focus on international Chapter 11 debtors and discusses recent developments in DIP financing, including roll-ups of a debtor’s prepetition debt into DIP financing and conversions of DIP financing into equity upon a debtor’s emergence from Chapter 11.

DIP financing in Chapter 11 cases

DIP financing is routinely utilised in Chapter 11 cases, where the debtor seeking relief seeks to preserve its going concern operations and to emerge from bankruptcy or sell its business as a going concern. The US Bankruptcy Code (the Code) contains several provisions designed to encourage lenders to provide DIP financing in Chapter 11 cases. Due to protections provided under the Code, domestic and foreign debtors are often able to access liquidity that they would not be able to obtain outside of a US bankruptcy proceeding.^[2] Under the Code, post-petition lenders are provided automatic administrative expense priority for DIP loans and related obligations, and are routinely granted super-priority administrative claim status, wherein debt must be repaid prior to nearly all administrative obligations incurred during the case. In addition, upon notice and a hearing, the bankruptcy court may authorise a debtor to enter into a DIP facility that is secured by a first priority lien on the unencumbered assets of its estate and by a second priority lien on collateral subject to prepetition liens.^[3] To obtain authorisation to grant such liens, the debtor must show that it is unable to obtain post-petition financing on unsecured terms, which is often relatively easy for a debtor to establish.

If the debtor is still unable to obtain financing on such terms, the Code provides that a debtor can be authorised to grant liens on its assets that are senior or equal to existing liens, provided that such priming is consensual or that the prepetition secured lender is otherwise adequately protected.^[4] When DIP financing is provided by prepetition secured lenders, this priming is consensual. However, when new lenders (ie, ‘offensive’ DIP lenders, as discussed below) are seeking priming liens in prepetition collateral, the debtor must show that it is unable to obtain such credit otherwise and that either the existing secured lenders have sufficient equity value in their collateral or that they will be ‘adequately protected’ against any possible diminution in the value of their security interests.^[5] Adequate protection is designed to ensure the existing lender will not be worse off if the DIP loan is approved and such protection can take on many forms, including periodic cash payments to the secured lender, payments of post-petition interest or granting of additional liens to the creditor on previously unencumbered assets or replacement liens on collateral that do not continue to attach to property post-petition.

Once a debtor has lined up a lender to provide DIP financing, the debtor is required to obtain bankruptcy court approval for the proposed DIP financing.^[6] Although typically a debtor will seek such approval at the outset of the Chapter 11 case as part of its ‘first day’ motions, if the debtor’s liquidity needs are not as immediate, it may wait for some period of time after filing its bankruptcy petition to obtain such approval.^[7] Creditors and other parties of interest have a right to object to the terms of a proposed DIP financing and the bankruptcy court will ultimately decide whether to approve the financing after a review of the relevant pleadings and objections (if any) and after conducting an evidentiary hearing if required.^[8]

Types of DIP lenders

DIP financing can either be provided by a debtor’s existing lenders or by new third-party lenders. Prepetition secured lenders that provide DIP financing are termed ‘defensive’ DIP lenders because they are willing to make a DIP loan, in part, to mitigate the likelihood of a decline in the value of their collateral. The credit extended under the DIP facility will likely be subject to higher interest rates and fees than the prepetition credit and the loan documents will contain tighter covenants and more detailed reporting than is required under the pre­petition facility, as well as bankruptcy case milestones and events of default. Additionally, in their capacity as DIP lenders, such prepetition lenders will be able to exert more influence over the debtor and can help ensure that they will play a central role in the debtor’s restructuring negotiations. As discussed further below, in cases where existing lenders provide the DIP loan, it is not unusual for such facilities to contain a ‘roll-up’ of such lenders’ outstanding prepetition debt.

If the DIP financing is provided by third parties that do not have a prepetition relationship with the debtor, the lenders are termed ‘offensive’ or ‘new money’ lenders. New money DIP lenders are often attracted by the generous economics of DIP facilities and, in some cases, are interested in extending post-petition credit because they view DIP financing as a means to pursue a loan-to-own strategy (either through credit bidding their DIP claims or through a debt-to-equity conversion, as discussed below).^[9] These lenders are generally willing to finance DIP facilities where there exists sufficient unencumbered collateral to support the DIP obligations, where prepetition lenders are over secured or where the prepetition lenders otherwise consent to having the debtor grant the DIP lender a priming lien.

Recognition of the DIP order in foreign jurisdictions

Upon the commencement of a Chapter 11 case, the debtor is protected by the Code’s statutory ‘automatic stay’, which goes into effect immediately upon a bankruptcy filing and has purported worldwide applicability.^[10] The stay operates to enjoin substantially all creditor enforcement actions during the pendency of the Chapter 11 case against the debtor and property of the debtor’s estate – both within the United States and within foreign jurisdictions. Despite the purported worldwide applicability of the automatic stay, in the absence of a parallel local recognition proceeding supporting the Chapter 11, a debtor will need to assess whether the stay will be honoured by non-US parties that may hold debtor assets or hold claims against the debtor and whether non-US courts will recognise and enforce the stay against such parties if required.

The decision on whether to seek recognition of the DIP order in a parallel local proceeding is motivated by a concern as to whether the US bankruptcy stay will be honoured by non-US parties that may hold debtor assets or hold claims against the debtor and whether non-US courts will recognise and enforce the stay against such parties. A debtor’s decision to seek local recognition of the DIP order involves an analysis of the particular situation including the jurisdictions involved, the composition and nature of the debtor’s creditors (including, most importantly, their jurisdictional and commercial nexus to the United States) and the location of the debtor’s assets. In certain jurisdictions and situations, the debtor may decide (or be required) to obtain formal recognition of the DIP order in a local proceeding to ensure that the DIP obligations and claims and liens on collateral are properly authorised under local law and will be enforced in the local jurisdiction. For example, the DIP facility in the LATAM Airlines Chapter 11 case included a closing condition that the debtors obtain local recognition of the DIP order by the Colombian Superintendence of Companies, authorising the incurrence of the debt and the pledge of collateral.^[11]

In other jurisdictions and situations, local approval of the DIP may not be feasible or it may entail additional risks that the lenders or the debtors do not want to take on. In these situations, the debtors may seek to obtain local law pledges of collateral and perfect such pledges through the requisite local law processes.^[12] The debtors and DIP lenders also may take some comfort in the power of the automatic stay – even in situations where a foreign Chapter 11 debtor does not commence a parallel local recognition proceeding, to the extent that the debtor’s major creditors are international financial institutions or have substantial business or other interests in the United States, such creditors may nonetheless be disincentivised from violating the stay in the United States given the potential that they may have repeat interactions with United States bankruptcy courts.

Roll-ups

In the context of defensive DIP loans (provided by a debtor’s existing lenders), DIP lenders may seek to have their prepetition secured debt repaid with the proceeds of the new post-petition financing or otherwise ‘converted’ into DIP obligations. In this scenario, a certain amount of newly borrowed funds from the proposed DIP facility will be deemed to repay either all or part of the prepetition loans or such loans will be deemed converted into post-petition loans. This transformation is termed a ‘roll-up’ because the existing prepetition lender gets to roll-up its prepetition claims and liens into post-petition administrative claims and liens via the DIP facility. Roll-up features can be structured a number of different ways – some are effectuated by a single draw on the DIP facility and some provide for a ‘creeping’ roll-up over time on a dollar-for-dollar, or similar, basis. While the roll-up does not provide a debtor with additional liquidity, the debtor’s existing prepetition lenders, who may already have liens on substantially all of the assets of the debtor, can be encouraged to provide new money in exchange for the ability to transform the rolled-up portion of their prepetition debt into debt that will benefit from super-priority claims and liens, better economics and tighter controls.^[13] Indeed, in negotiations with prepetition secured lenders, it is often used as enticement to encourage all lenders to participate in post-petition financing, with debtors’ and the lead lenders offering the roll-up feature only to those lenders that agree to extend new money. For these same reasons, roll-ups of prepetition obligations can be subject to challenge by unsecured creditors and often careful attention is paid by the bankruptcy court to the percentage of new money provided in the roll-up and whether the roll-up benefits any prepetition lenders that are not providing DIP financing (measured most often by the ratio of new money to roll-up debt).

Over the past decade, practitioners have been split on whether roll-ups are an temporary artifact of tight credit markets,^[14] such as during the Great Recession, or a more permanent part of the DIP financing tool kit.^[15] During the Great Recession, debtors found that lenders were often unwilling to extend new money financing absent a debtor’s willingness to roll part of their pre-petition debt into the DIP facility.^[16] Debtors were successful in getting bankruptcy courts to approve roll-ups by arguing that there was no other reasonable prospect of financing especially in cases where the debtor owned few assets to secure a new DIP loan. For instance, during the Great Recession, the DIP facility in the Lyondell Chemical Chapter 11 case included a roll-up where holders of Lyondell’s US$12.2 billion prepetition first lien indebtedness were given the opportunity to roll-up US$3.25 billion of their prepetition first lien facility claims into the DIP facility on a dollar-for-dollar basis, in exchange for providing new money to the DIP loan.^[17] However, in more recent years, the roll-up has become a fairly standard feature of defensive DIP financings for both domestic and foreign-domiciled Chapter 11 debtors, although creditors and courts do still scrutinise the terms and structure of the roll-up feature and it is typically not approved until the final DIP hearing.

One such recent case involving foreign domiciled debtors is the Avianca Chapter 11, which was filed in the Bankruptcy Court for the Southern District of New York on 10 May 2020.^[18] The Avianca DIP facility includes approximately US$1.2 billion in new liquidity, along with a roll-up of about US$722 million of prepetition debt^[19] and was approved without objection by the bankruptcy court on 5 October 2020. The roll-up includes US$220 million of prepetition notes (the Existing Notes Roll-Up) and US$386 million under a certain prepetition convertible secured loan facility provided to certain of the debtors by United Airlines, Inc, an affiliate of Kingsland Holdings Limited, an affiliate of Citadel Advisors LLC, and certain other lenders (the Stakeholder Facility Roll-Up).^[20] The debtors’ pleadings in support of the DIP facility argue that Avianca would not have been able to enter into the DIP facility without the proposed roll-up.^[21] The debtors noted that, given the covid-induced economic environment for airlines, ‘the pool of potential lenders has been limited’ and the debtors have been ‘compelled to entertain “hard bargains” to obtain the full amount of funding’.^[22] In particular, the debtors noted that, without the roll-up, certain existing secured noteholder lenders would not have released their liens or consented to priming liens on their collateral, which were key to the proposed DIP facility.^[23] The debtors also argued that the roll-up would not prejudice the debtors’ estates because the amounts to be rolled up under both the Existing Notes Roll-Up and the Stakeholder Facility Roll-Up were less than the value of collateral securing the respective debt.^[24]

Equity conversions

Traditionally, DIP facilities are required to be repaid in full and in cash at the end of a debtor’s Chapter 11 case, whether in connection with a plan of reorganisation, a 363 sale or a combination of the two. In certain situations – in particular, prepackaged or pre-arranged bankruptcies – DIP facilities can be structured to provide that the outstanding DIP obligations convert into secured exit financing upon emergence from bankruptcy. Although less common, some DIP facilities provide for conversion of outstanding DIP obligations into equity of the reorganised debtor on emergence, most commonly at the debtor’s election. These conversion features can be of great benefit to debtors that are seeking a quick exit from bankruptcy (such as in the case of a prepack) or that are looking to mitigate the risks associated with obtaining the liquidity necessary to repay the DIP obligations at the end of the case. In this covid-19 era, where the debtor’s projected revenues and its relative access to international debt or equity markets at the end of the case are extremely difficult to predict. Mitigating the risk of not being able to appropriately time the debtor’s exit from Chapter 11 has become extremely important to certain businesses.

Equity conversions are potentially attractive from the perspective of cash-strapped debtors and also for lenders that may recognise the underlying value of a business despite current exogenous factors from the pandemic. When presented with a DIP facility containing an equity conversion feature, the bankruptcy court will often scrutinise which parties are provided the ability to participate in the DIP financing, the economic terms of the conversion and other conversion features (such as which entity controls the conversion election). As with roll-ups, some practitioners believe equity conversions are a feature of weak credit markets and should be less prevalent when credit markets are robust.^[25] However, as described further below, equity conversions have featured prominently in certain recent bankruptcies in the airline industry.

The covid-19 pandemic has significantly factored into debtors’ structuring of their DIP facilities, given the additional pressures brought to bear on liquidity, especially in certain hard-hit industries, such as the airline industry. The ability to convert DIP obligations into reorganised equity at the end of a case provides meaningful flexibility for debtors in situations where liquidity may not be readily available on emergence. The approved DIP facility in Avianca, which contains a senior Tranche A of US$1.296 billion and a junior tranche B of US$722.3 million, contains an equity conversion option where the borrower can elect to pay the entire US$722.3 million junior Tranche B DIP facility (together with any fees) with equity of the reorganised debtors on exit.^[26] The terms of the equity conversion include an equity floor of no less than 72 per cent of the aggregate common equity (on a fully diluted basis) and that the equity provided to the Tranche B lenders will be subject to a 8.5 per cent discount compared to the plan equity valuation of the reorganised debtors.^[27] In seeking approval of the facility, the debtors’ motion noted that ‘the debtors’ decision to exercise the equity conversion option will be subject to a robust marketing process . . . as well as the court’s further review and approval’ and such a decision to exercise the conversion right will be ‘subjected to the [Unsecured Creditors Committee’s] right to object, along with other parties in interest, in connection with confirmation of the debtors’ eventual Chapter 11 plan’.^[28]

Similarly, the Aeroméxico DIP facility, which was approved in a final order entered on 13 October 2020, contains an equity conversion feature – although the conversion in Aeroméxico is at the lenders’ option.^[29] The lenders have the ability to elect to receive common stock of the reorganised debtors as repayment for their loan subject to satisfactory tax, legal and regulatory review.^[30] In support of the equity conversion aspect of the DIP facility, the debtors argued that the inclusion of the equity conversion:

substantially increases the odds of a successful reorganization as a going concern, as it provides a potential pathway to emergence from Chapter 11 without having to raise substantial exit financing.^[31]

The debtors subsequently revised the equity conversion feature to remove drag-along rights that would have enabled the DIP lender to drag the minority investors along as part of the restructuring if it chose to convert its holdings into equity.^[32] Under the revised election procedures, minority DIP lenders may choose whether to take stock or cash out after the majority DIP lender makes its own election.^[33]

Although the DIP facility that was ultimately approved in the LATAM Airlines Chapter 11 cases did not provide for equity conversion, the initial proposed DIP facility contained such a feature.^[34] The initial DIP facility provided that one of the three tranches of post-petition debt could be converted into equity on emergence (originally the conversion feature was at the DIP lenders’ option, but as part of a subsequent amendment, the debtors obtained control of the election). The proposed equity conversion feature was limited to a specific tranche of the DIP facility that was provided by certain LATAM shareholders in exchange for, among other things, a waiver of their pre-emptive rights as shareholders under local Chilean law to participate in any issuance of reorganised equity of the debtors on exit.^[35] The unsecured creditor’s committee and ad hoc bondholder groups objected to the DIP on a number of grounds, including that the limited equity conversion feature subverted the reorganisation process and gave rise to improper sub rosa plan treatment with respect to those shareholder DIP lenders. The bankruptcy court ultimately found that, although the terms of the DIP financing were reasonable and proposed in good faith, it could not approve the DIP facility as proposed because the equity conversion, which was limited to those lenders that were shareholders of the company and was connected to a waiver of the exercise of such shareholders’ preemptive rights, was a sub rosa plan.^[36] Following further negotiations between the debtors, the DIP lenders and the Unsecured Creditors’ Committee, a revised DIP facility that did not include an equity conversion feature was approved by the bankruptcy court.^[37]

Conclusion

International debtors filing for Chapter 11 in the United States are able to take advantage of an established market for DIP financing. Chapter 11 debtors are increasingly successful in including features in DIP facilities such as roll-ups and equity conversions that were previously subject to greater levels of scrutiny and that some practitioners thought were limited to times of illiquid financial markets. The recent cases involving certain Latin American airlines including Avianca, Aeroméxico and LATAM suggests that these features may have gained a stronger foothold in the DIP financing tool kit.

Notes