When a company enters Chapter 11 bankruptcy protection and wants debtor-in-possession (DIP) financing from a bank or permission to spend proceeds of accounts receivable that have been pledged (that is, use cash collateral), it needs the bankruptcy court’s approval. A key part of the debtor’s request is a budget, which typically covers 13 weeks.
The debtor will try to show that it can pay claims that arise after the case commences that have administrative status. However, some pre-bankruptcy claims have administrative status, too — including vendor claims for goods received by the debtor within the 20 days before bankruptcy. This is a relatively new provision, aimed at discouraging the debtor from “loading up” — that is, taking in a lot of goods right before bankruptcy.
In budget negotiations, a lender tries to restrict funds to uses that benefit the lender’s collateral and that are necessary to debtor operations. The debtor seeks enough to operate its business and, hopefully, reorganize. But the lender has significant leverage in negotiations.
A protracted fight can impair the debtor’s ability to stabilize. Some debtor “asks” will be denied by the lender. These may include money for more inventory, money for critical vendors (which the debtor says it must pay at the risk of further damage), professional fees, capital expenditures, and payment of 503(b)(9) claims. In negotiations, concessions are granted to the lender in exchange for DIP financing without a battle — which can be costly in terms of professional fees, diversion of management’s attention, and business stability.
On the table for the lender: the non-default interest rate, default interest rate, commitment fees, unused line fees, monitoring fees, early termination fees, maturity date, letter of credit fees, and whether unencumbered debtor assets will become subject to lender liens and security interests.
In a “roll-up,” the debtor establishes a new loan facility upon bankruptcy and newly borrowed funds pay off the pre-petition loan. Eventually, the pre-petition loan is repaid, leaving only a post-petition loan outstanding. The lender benefits because it obtains a security interest in debtor assets not previously encumbered.
The questions here are: how much is the additional collateral worth; and how does that value compares with the additional dollars being lent?
A roll-up can be a disguise to improve the lender’s position at the expense of unsecured creditors. It also may be too expensive, when the value of new collateral is compared with the amount of new money borrowed. That justifies analyzing whether the debtor is better off seeking to use cash collateral (spend the dollars that it receives each day from proceeds of receivables) and letting the bankruptcy judge determine lender protections.
Lenders usually seek a security interest in avoidance actions, also known as “preferences” — claims the debtor has against its own vendors to recover payments (outside the ordinary course) made during the 90 days preceding the bankruptcy. Lenders that finance debtors will receive proceeds of claims against the debtor’s unsecured creditors, although many courts don’t permit this. When asked to extend post-petition trade credit, a vendor may condition credit on a waiver of preference claims, if any.
For a fee (an unused line fee), companies are given the option to borrow money (within certain conditions) even if the borrowing doesn’t happen. A lender may provide $10 million in credit conditioned upon the borrower having sufficient working capital (A/R and inventory) to justify advances under agreed upon-advance rates.
It’s not uncommon for bankruptcy budgets to be “oversized” — that is, the stated amount of the loan facility exceeds what the debtor is projected to (or able) to borrow.
But there’s more to think about than the interest rate. How much will be borrowed, and what is the aggregate of interest plus all of the “extras”? When fees are added to interest and where the loan will be outstanding for a limited time, dollars paid to the lender during the life of the loan, divided by the amount of dollars borrowed from the lender, can dwarf the stated interest rate.
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, some or all administrative claims might not be paid.
In order for a vendor to receive critical vendor status, it usually must agree to provide the debtor with post-petition trade credit equal to the amount of its claim treated as a critical vendor. The benefit here is that the creditor’s pre-petition claim is converted to an administrative claim. But for a vendor pre-petition claim with 503(b)(9) status, the vendor is simply swapping one administrative claim for another. The vendor should ensure that pre-petition claims being treated as critical would not otherwise have administrative status.
A 13-week budget is prepared on a cash basis rather than on an accrual basis. Thus, it is difficult to determine profitability. However, where the budget reflects the weekly borrowing base, there is some insight into whether the debtor’s business continues to erode.
Smart creditor committees will demand information on sales (versus receipts), margins, backlog, and year-over-year results of operations, and they will seek to determine what the debtor’s performance would be if the additional, direct costs attributable to the bankruptcy were excluded. Normalized operations don’t have the baggage of bankruptcy — professional fees, court costs, filing fees, extra bank fees, etc. Normalized operations also may be a snapshot of the debtor as if it were not burdened by assets or businesses held for sale.
The U.S. Trustee oversees administration of bankruptcy cases and requires that debtors file monthly operating reports, usually on a cash-flow basis. But they shouldn’t be heavily relied upon for an accurate picture of the debtor’s post-petition operations, and they don’t provide much insight into the risk level in providing post-petition credit.
DIP budgets tend to be constructed conservatively regarding things like the amount of post-petition credit expected and revenues. A debtor wants to tell its lender and the creditor committee that it beat its budget. But that is not very insightful, as it can simply be the result of timing or very conservative assumptions.
Finally, Chapter 11 financing is subject to default triggers, such as exceeding permissible line item variances in the budget, exceeding the permissible variance in the overall budget, and 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 to commence a liquidation, etc. The amount of post-petition credit and when that credit should be reeled in should be re-evaluated when key milestones approach.
Kenneth A. Rosen leads the bankruptcy, financial reorganization, and creditors’ rights department at Lowenstein Sandler LLP.