The primary catalyst for most Chapter 11 bankruptcy filings is an impending lack of cash. Debtor-in-possession financing, which keeps a business running, is often the most critical and contentious issue presented to a court at the start of a bankruptcy case.
In exchange for the risk of providing liquidity to a bankrupt company, DIP lenders receive, among other things, priority over existing debt and other claims. The courts frequently approve this type of financing.
In what is a more common trend, DIP lenders seek the opportunity to participate in post-reorganization debtors’ equity at the start of the deal through the granting of equity. Recent decisions offer guidance on the types of equity-linked DIP financing that bankruptcy courts are likely to approve.
How it works
Cash-strapped debtors are encouraged to accept equity-linked DIP financing, as this may reduce the cash payment elements of financing. From the lender’s perspective, this provides an opportunity to participate in debtors’ potentially lucrative capital after the reorganization.
However, post-reorganization equity provided to DIP lenders may reduce recovery for creditors by taking equity that might otherwise be available to those creditors or investors paying cash for equity.
Equity-linked DIP financing is not new.
For example, in 2009 equity-linked DIP financings were approved in the bankruptcy cases of General Growth Partners and ION Media Networksand more recently in 2020 in Avianca and AeroMexico. And on November 2, Phoenix Servicesthe U.S. Bankruptcy Court for the District of Delaware has approved uncontested equity-linked DIP financing.
However, not all equity-linked DIP financing is created equal. One that provides a simple conversion of the DIP facility provides flexibility and value to debtors when formulating a reorganization plan. As seen in recent examples, equity-linked DIP financing with options to convert at a discount to the plan’s equity value can limit obligors’ flexibility in proposing a plan.
For example, the United States Bankruptcy Court for the Southern District of New York in LATAM declined to approve DIP financing with an equity conversion at a discount to plan value. However, the same court of SAS in September 2022, approved a similar share conversion despite the “apprehensions.”
Judge James L. Garrity, in refusing to approve the LATAM agreement, highlighted specific concerns regarding the DIP’s stock conversion feature. He said the discount was untested in the market, debtors could make the choice without judicial review, and the election dictated the key terms of any plan through such an allowance.
DIP financing was later revised to remove the stock conversion feature and approved.
In perhaps the most aggressive equity-linked DIP financing offered, DIP lenders in SAS researched both conversion and tag options for post-reorganization equity.
The call/conversion option was for approximately $700 million of outstanding DIP loans at a strike price of the total business value after the reorganization (the underlying stock value) of 3 .2 billion. If the total value exceeded $3.2 billion, DIP lenders would be entitled to convert their DIP loans at a discount.
The tag option allowed DIP lenders to purchase up to 30% of the post-reorganization shares issued under a plan at the same valuation as other investors. Notably, the conversion and beacon options were terminable at the debtor’s option, but required the payment of substantial termination fees.
The court was clearly troubled by the prospect of allocating a specified percentage of post-reorganization equity outside of the plan process.
Judge Michael Wiles, echoing Garrity in LATAMsaid “decisions regarding the issuance of shares in reorganized debtors should be reserved for the plan process and noted that he had ‘categorically denied’ such terms in previous cases”.
Wiles expressed concern not only about the conversion and tag options, but also what his decision might mean for future cases and opening a Pandora’s box. He said that “if we have learned anything during the administration of the Bankruptcy Code, it is that if we open a door through a crack in one case, the door opens more and more in the following cases”.
Despite his apprehensions, he approved DIP funding with conversion and tag options. He noted the similarities with the DIP funding rejected in LATAM¸ and said he would have many questions about legal and economic principles if any party raised an objection.
These cases and decisions provide guidance for equity-linked DIP financings. We can say with some degree of confidence that a DIP financing with conversion into shares at the valuation of the plan will be favorably received by the courts.
However, the more aggressive equity-linked DIP financings, such as those that include a rebate to plan value, may be decided depending on the circumstances of the case and whether the parties with an economic interest in the case contest the DIP funding. At least one court seems to invite such an objection.
This article does not necessarily reflect the views of Bloomberg Industry Group, Inc., publisher of Bloomberg Law and Bloomberg Tax, or its owners.
andrew minear is a partner in the Restructuring and Insolvency department of Fried Frank.
Adam L. Shiff is a restructuring and insolvency partner residing at Fried Frank. His practice focuses on all aspects of restructuring, bankruptcy, insolvency and related litigation.