The following is a contributed article from Kenneth Rosen, Esq., of Lowenstein Sandler LLC. Opinions expressed are author's own.
If you haven't thought about how to position your company for bankruptcy protection, now is the time. For many companies, the $2.1 trillion stimulus package, and other steps the federal government has taken, won’t be enough to keep business afloat as people stay home to limit the spread of the coronavirus.
The first rule for you, as CFO, is to understand negotiations typically favor the lender from which you seek post-petition financing, otherwise known as debtor-in-possession financing. For that reason, going into the bankruptcy process with visibility into the ways lenders will try to leverage their position can help you respond in the best way possible.
Companies in chapter 11 seeking debtor-in-possession (DIP) financing, or to spend the proceeds of accounts receivable that have been pledged to them (their cash collateral), must obtain bankruptcy court permission. You submit a motion to the court, along with your budget, and explain how you want to use the financing. The typical DIP financing term is 13 weeks.
In your DIP request, you're seeking to show you'll have funds to pay claims that arise after you enter chapter 11. These are known as administrative claims. However, some claims incurred before bankruptcy have administrative status, too. Section 503(b)(9) of the bankruptcy code states that claims of vendors for goods received within the 20 days before the bankruptcy also have administrative status. This is a relatively new provision intended to discourage you from "loading up" on a lot of goods on the eve of bankruptcy.
In the budget negotiations, the lender wants to restrict your spending to uses that benefit its collateral and which are the minimum necessary for your operations. You're seeking enough dollars to operate your business and, you hope, reorganize. The lender, though, has a great deal of leverage over you in the budget negotiation; it knows that a protracted fight over financing can impair your ability to stabilize your business.
That means some of your requests will be denied, possibly including money for more inventory purchases, professional fees, capital expenditures, payment of 503(b)(9) claims, or for your critical vendors. Those are the vendors you believe you must pay despite the commencement of bankruptcy or else risk being further damaged.
Part of the negotiations involves concessions you’re willing to make to the lender in exchange for getting DIP financing without a destabilizing and costly battle.
Negotiations, rollups and preferences
On the negotiating table for lenders are non-default interest rates, default interest rates, commitment fees, unused line fees, monitoring fees, early termination fees, maturity dates, letter of credit fees, and whether any debtor assets that previously were unencumbered will become subject to the lender’s liens and security interests.
A common practice, called a rollup, is when you establish a new loan facility upon bankruptcy and the funds borrowed are used to pay off your pre-petition loan. Eventually, the pre-petition loan is repaid and only the post-petition loan is outstanding.
This benefits lenders who obtain a security interest in your assets not previously encumbered. But how much is the additional collateral worth and how does that value compare with the additional dollars being lent by the lender?
A rollup can be a disguise to improve the lender’s position at the expense of your unsecured creditors. Look at it carefully, because it might be too expensive when the value of new collateral is compared to the amount of new money to be borrowed.
You should consider analyzing whether you're better off seeking to use cash collateral (the dollars you receive each day from proceeds of receivables) and letting the bankruptcy judge determine what protections the lender is entitled to.
Lenders usually seek a security interest in avoidance actions, also known as preferences. These preferences are claims you have against your own vendors to recover payments (outside the ordinary course) made during the 90 days preceding the date of bankruptcy.
In other words, a price for the lender financing your operations is that the lender will receive the proceeds of claims against your unsecured creditors. Many courts will not permit this. But the practice is not unheard of in certain circumstances. When being asked to extend post-petition trade credit, a vendor may condition credit on a waiver of preference claims, if any.
Unused line fees
Another key concept revolves around unused line fees, which are the fees paid for money that you’re permitted to borrow (with certain conditions) but don't actually borrow. A lender may provide a $10 million credit line, for example, but it’s conditioned on you having sufficient working capital (accounts receivable and inventory) to justify the advances under agreed-upon advance rates.
Additionally, be wary of oversized bankruptcy loans. This is when the stated loan-facility amount far exceeds the amount you’re projected (or able) to borrow. Having the extra can sound like a positive but you pay a fee for the excess.
It's also important to remember that when calculating the cost of money, you should not simply look at the rate of interest. The question is how much will be borrowed and what will be the aggregate of interest plus all of the extras. When fees are added to interest, and when the loan will be outstanding for a limited time, the total amount of dollars paid to the lender during the life of the loan divided by the amount of dollars actually borrowed from the lender can dwarf the stated interest rate.
There's also the matter of administrative claims. Lenders typically won't approve a line item in the 13-week budget for 503(b) (9) claims. As a result, if the chapter 11 case fails, there is risk of such administrative claims not being paid in whole or in part.
Track lenders’ progress
A 13- week budget is prepared on a cash basis rather than on an accrual basis. Thus, it is difficult to determine profitability. However, when the budget reflects the weekly borrowing base, there is some insight into whether your business is continuing to erode.
The prudent creditors committee in a chapter 11 case will demand information on sales (versus receipts), margins, backlog, year-over-year performance and will drill down to get to your "normalized" operations post-petition. Normalized operations are operations without all of the baggage of the bankruptcy – professional fees, court costs, filing fees, extra bank fees, and so on. They also may be a snapshot of your company as if it were not still burdened by assets or businesses held for sale.
The United States Trustee (part of the Department of Justice) oversees the administration of bankruptcy cases. One of its requirements is the filing of monthly operating reports. These reports usually are on a cash flow basis. They should not be heavily relied upon for an accurate picture of your post-petition operations. They don't provide much insight into the level of risk in providing post-petition credit.
DIP budgets tend to be constructed on a conservative basis with regard to things like the amount of post-petition credit expected and revenues. There’s typically a temptation on your part to tell the lender and the creditors committee that it beat its budget, but beating your budget is not all that significant; it can simply be the result of timing differences or very conservative assumptions.
Finally, financing in chapter 11 is subject to default triggers. These include exceeding permissible line item variances in the budget, exceeding the permissible variance in the overall budget, or missing milestones required as a condition to continued financing.
The milestones can include a deadline to obtain a contract of sale for the business, deadline for filing a plan of reorganization, deadline by which to commence a liquidation, and so on. Re-evalute the amount of post-petition credit, and when that credit should be reeled in, when approaching key milestones.
This might seem like a lot to understand. But amid our latest bout of economic turmoil, it makes sense to prepare to navigate the complexities of the bankruptcy process with an eye on what the lenders' goals are.