Debtor-in-possession Research Articles

Interim Finance in Creditor-Oriented Bankruptcy Codes: A Study in the Context of Insolvency & Bankruptcy Code, India

This study examines interim financing with specific reference to the Insolvency and Bankruptcy Code, 2016 (IBC) in India. Interim financing is recognized as relevant to the successful outcome of the bankruptcy process. Internationally, bankruptcy regimes are considered robust if they contain enabling provisions allowing interim financing. IBC, hailed as creditor-friendly legislation, authorizes the insolvency professional (IP) to raise interim finance during bankruptcy. However, despite enabling legislation, the segment remains challenging. This study, through a qualitative methodology, examines the issues of mobilizing interim finance under the IBC. First, through a theoretical lens, this article discusses the importance of recognizing the distinct dimensions of interim financing under creditor-oriented regimes, like IBC, relative to the more established debtor-in-possession (DIP) financing model in the US (a debtor-friendly bankruptcy regime). This article argues that interim financing under creditor-oriented bankruptcy regimes faces certain inherent limitations (like lower lender motivation due to a lack of relationship banking or control/governance opportunities) relative to DIP financing, which primarily stems from who controls the firm during bankruptcy (IP or the corporate debtor). Through an interview method, this article then examines some specific issues in raising interim finance under the IBC. This research finds a lack of repayment visibility (quantum & timelines), narrow perception of interim finance and subtle differences between the objectives of the IP and lenders (resolution vs. recovery) are some practical impediments. From a normative perspective, this article suggests that improvements in IBC efficiency would improve takeout visibility to lenders. Greater stakeholder engagement will help alleviate conflicts and broaden the perspectives on the ultimate objectives of interim finance. Additionally, this article suggests learnings from the DIP model include a more early (ex-ante) consideration of interim finance (including potential sources). This article also calls for regulatory clarification on the inclusion of funding from the CoC in the technical definition of interim finance.

An invisible man, a double agent, and a five‐tool player: Three issues for the Chief Restructuring Officer in Korean corporate reorganization procedures

AbstractThe Chief Restructuring Officer (CRO) system in Korea was introduced in 2011 after the Debtor Reorganization Act adopted the Debtor‐in‐Possession (DIP) system in 2006. However, the introduction of the CRO system in Korea, which was based on the American system, was problematic due to the lack of legal grounds, the vagueness of its legal status, and the complexity of its roles. This article explores the emerging issues related to the status and roles of a CRO in the Korean corporate‐reorganization procedure. Three major issues are analyzed: lack of legal ground and its codification (“Invisible Man”), the dual legal status of being a debtor's adviser and creditors' protector (“Double Agent”), and the expansion of the CRO's roles (“Five‐Tool Players”). This research also sketches the legal landscape of corporate reorganization practice in Korea. It provides some possible suggestions to foster the chances for debtor rehabilitation through improved operation of the CRO system.

Rent Extraction by Super-Priority Lenders

We present strong evidence of supra-competitive pricing of debtor-in-possession (DIP) loans to large firms in Chapter 11 bankruptcy. Over-collateralized and with super-priority, strong covenants, rollups, and debtor-funded monitoring costs, these loans are almost risk-free. Nonetheless, loan spreads average 600 basis points, which is 60% higher than leveraged-loan (junk') spreads charged the same firms within three years before bankruptcy filing. While prepetition lenders have a strong bargaining position when supplying DIP loans, spreads are no lower when DIP loans are supplied by new lenders. Junior claimants often contest DIP-loan terms in court - to little avail.

The Effect of Debtor in Possession of the Insolvency Law on Management Performance of Corporate Restructuring

The Effect of Debtor in Possession of the Insolvency Law on Management Performance of Corporate Restructuring

Lock‐In Effects in Relationship Lending: Evidence from DIP Loans

AbstractDo prior lending relationships result in pass‐through savings (lower interest rates) for borrowers, or do they lock in higher costs for borrowers? Theoretical models suggest that when borrowers experience greater information asymmetry, higher switching costs, and limited access to capital markets, they become locked into higher costs from their existing lenders. Firms in Chapter 11 seeking debtor‐in‐possession (DIP) financing often fit this profile. We investigate the presence of lock‐in effects using a sample of 348 DIP loans. We account for endogeneity using the instrument variable (IV) approach and the Heckman selection model and find consistent evidence that prior lending relationship is associated with higher interest costs and the effect is more severe for stronger existing relationships. Our study provides direct evidence that prior lending relationships do create a lock‐in effect under certain circumstances, such as DIP financing.

Prearranged Reorganization Plans in Serbia: Form Over Substance

Similar to other countries, Serbia has established an expedited corporate restructuring framework introducing pre-arranged reorganization plans in the Law on Bankruptcy. New procedure has been widely used since the law came into effect, but with mostly dismal results. The reason for the widespread use lies in the fact that this procedure incorporates all key components of a hybrid procedure—debtor in possession, a moratorium and the possibility to impose the plan on dissenting creditors within the class. As a rule, pre-arranged reorganization plans are not feasible. Debtors’ owners in Serbia are unwilling to give up their equity and despite being unfeasible, creditors tend to support these plans as they are not willing to accept debt write-offs and/or debt-to equity swaps. This article examines the deficiencies of the procedure and suggests further reforms.

Do Economic Conditions Drive DIP Lending? Evidence from the Financial Crisis

A firm that seeks refuge in Chapter 11 typically requires financing for its continuing operations in bankruptcy. Because such financing is often hard to find, the Bankruptcy Code authorizes debtors to offer sweeteners to debtor-in-possession (DIP) lenders. These inducements can be highly effective in attracting financing. But because these sweeteners are thought to come at the expense of other stakeholders, the Code requires a showing that no less generous a package would have been sufficient to obtain the loan. Anecdotal evidence suggests that the use of certain controversial inducements skyrocketed during the Financial Crisis, leading critics to question whether DIP lenders were abusing their power. Defenders of DIP lenders, however, have responded that the contract terms in DIP loans simply reflect economic conditions: When credit is tight, as it was in recent years because of the Financial Crisis, of course more sweeteners are needed to induce lending.In this Article, we examine the relationship between economic conditions and the terms of DIP loans. Using a hand-collected dataset reflecting contractual detail in DIP loans, we study changes in DIP loan terms during the Crisis. As one might expect, we find that ordinary loan provisions like pricing and reporting covenants are sensitive to economic conditions. But we also find that so-called "extraordinary provisions," often justified as necessary to induce DIP lending, have no statistically meaningful relationship with economic conditions. Our findings have important implications for bankruptcy judges struggling to evaluate whether the sweeteners extracted by DIP lenders are really necessary to induce lending.

Debtor-in-possession financing, loan-to-loan, and loan-to-own

This paper provides new evidence on the roles and strategies adopted by different types of debtor-in-possession (DIP) lenders: “loan-to-loan” (LTL) lenders—prepetition secured bank lenders providing DIP financing, and “loan-to-own” (LTO) lenders—activist investors (i.e., hedge funds or private equity funds) providing DIP financing. We find that LTL is more likely in Chapter 11 firms with better operating performance, when prepetition bank lenders' stakes are at risk, or when they have prior lending relationships with the distressed borrower. In contrast, LTO is more likely in small firms or when prepetition bank lenders' loans are over-collateralized. Finally, we show that much of the governance improvement at the emergence is attributed to LTO lenders. We conclude that creditors of different institutional types adopt distinct strategies to enforce their control rights under Chapter 11 reorganization and to have contrasting effects on the governance outcomes of emerged firms.

The Virtual Clerk's Office: A Proposed Model Judgment Lien Act for the Computer Age

This article addresses one aspect of the law regarding the satisfaction of judgments: when a creditor is determined to have a lien on property of the debtor. The unnecessary cumbersomeness of the present system, which limits the ability of creditors to promptly obtain a legally cognizable interest in specific property, hampers creditors in preventing the debtor's use, sale, or hypothecation of property that could be used to satisfy their debts. This is particularly true of intangible property and property where federal law or the law of sister states controls transfers. Not only do judgment creditors face the risk that the debtor will voluntarily dissipate or transfer assets, but also the risk that they will be defeated by subsequent parties who deal with the debtor, become creditors, and are able to find assets. Possibly the most pernicious of those subsequent creditors are the federal and state taxing authorities. The tax lien, once filed, locks in all personal and real property of the debtor. Bankruptcy also presents a serious difficulty for the judgment creditor. If the debtor files for bankruptcy before the creditor can locate personal property of the debtor, the creditor (despite having obtained a judgment) has no greater priority than all of the unsecured creditors of the debtor. If the judgment creditor locates personal property and obtains a lien on that property shortly before the date that the debtor files a Bankruptcy petition, the creditor's lien can be avoided as a preference. Even where a debtor files a Chapter 11 petition and maintains control of the business as a debtor in possession, the debtor can still use the preference section to avoid the creditor's lien.This article proposes that the computer systems currently being introduced to automate court systems around the country serve as the vehicle for the implementation of major reforms in the substantive and procedural law regarding judicial liens. The most significant change would involve the creation of statewide judgment liens on virtually all of the property of the debtor. This article will explore how the proposed system might deal with various types of property and particular third parties, and how to solve some of the transitional problems involved in adopting such a system. The changes proposed are incorporated in a Model Judgment Lien Act (MJLA) which is set forth in the Appendix of this article. It is hoped that the MJLA makes clear precisely how the rules discussed in the article would operate.

Restructuring the European Business Enterprise: the European Commission’s Recommendation on a New Approach to Business Failure and Insolvency

Two events are currently changing the landscape for business restructurings in the European Union: the ‘Restructuring Recommendation’ (RR) of the European Commission, issued in 2014, and the 2015 recast of the European Insolvency Regulation (EIR). In this paper, we critically review the RR and put it into the context of the reform of the EIR. We find that the recast EIR and the RR do not dovetail perfectly—a restructuring proceeding as proposed by the RR would not necessarily be within the scope of the recast EIR; we also suggest that, in any case, the EIR is not optimally designed to facilitate restructurings, given its treatment of secured creditors. Regarding the regulatory approach pursued in the RR, the Commission rightly pushes towards harmonisation with respect to Member States’ restructuring regimes—regulatory competition is not a sensible regulatory alternative in this area. However, we criticise both the methodology and scope of the harmonisation proposal of the RR: sketchy minimum harmonisation of restructuring rules leaves huge potential for residual diversity in Member States’ restructuring laws, and the Commission’s narrow focus on restructuring proceedings ignores several aspects of the complicated interaction between the Member States’ formal insolvency laws and the restructuring mechanism proposed. Further, we disagree with the substantive recommendations for Member States’ restructuring laws suggested by the RR: they wrongly require financial difficulties or a likelihood of insolvency as an entry test for the recommended restructuring proceeding, and the process appears susceptible to abuse by sophisticated financial investors—it does not provide for the mandatory appointment of a supervisor and allows significant curtailments of creditor rights without sufficient safeguards in place. Instead, we propose an efficient debtor-in-possession (DIP) regime as an alternative that could be initiated regardless of a firm’s solvency, provided that it is economically viable and that the filing is not abusive.

Restructuring the European Business Enterprise: The EU Commission Recommendation on a New Approach to Business Failure and Insolvency

Two events are currently changing the landscape for business restructurings in the European Union: the “Restructuring Recommendation” (RR) of the European Commission, issued in 2014, and the 2015 recast of the European Insolvency Regulation (EIR). In this paper, we critically review the RR and put it into the context of the reform of the EIR. We find that the recast EIR and the RR do not dovetail perfectly – a restructuring proceeding as proposed by the RR would not necessarily be within the scope of the recast EIR; we also suggest that in any case the EIR is not optimally designed to facilitate restructurings, given its treatment of secured creditors. Regarding the regulatory approach pursued in the RR, the Commission rightly pushes towards harmonisation with respect to Member States’ restructuring regimes – regulatory competition is not a sensible regulatory alternative in this area. However, we criticise both the methodology and scope of the harmonisation proposal of the RR: sketchy minimum harmonisation of restructuring rules leaves huge potential for residual diversity in Member States’ restructuring laws, and the Commission’s narrow focus on restructuring proceedings ignores several aspects of the complicated interaction between the Member States’ formal insolvency laws and the restructuring mechanism proposed. Further, we disagree with the substantive recommendations for Member States’ restructuring laws suggested by the RR: the proposed restructuring rules wrongly require financial difficulties or a likelihood of insolvency as an entry test for the recommended restructuring proceeding, and the process might be abused by sophisticated financial investors as a tool to enrich themselves at the expense of outside creditors and/or the debtor firm – it does not foresee the mandatory appointment of a supervisor, and it allows significant curtailments of creditor rights without sufficient safeguards in place. Instead, we propose an efficient debtor-in-possession (DIP) regime as an alternative that could be initiated regardless of a firm’s solvency provided that it is economically viable and that the filing is not abusive.

A Theoretical Framework for Evaluating Debtor-in-Possession Financing

The US bankruptcy code provides enhanced priority and security features to debtor-in-possession (DIP) loans which can be obtained from a lender with whom the borrower may have no past lending relationship. The enhanced priority of DIP financing, and the choice of a DIP lender, significantly impact the investment decisions made by the firm. We show DIP loans from an existing lender leads to a higher level of investment. We also show that a higher priority of DIP financing also leads to higher investment by the firm. A bankruptcy judge should take these incentives into account when approving the DIP loan.

The Changing Nature of Chapter 11

The U.S. Chapter 11 bankruptcy system has long been viewed as debtor friendly, with frequency of absolute priority deviations (APD) in favor of equity holders commonplace, as high as 75%, before 1990. In the 1991-2005 period, we find a secular decline in the frequency of APD to 22%, with the frequency as low as 9% for the period 2000-2005. We identify the increasing importance of debtor-in-possession (DIP) financing and key employee retention plans (KERP) in bankruptcy as the key drivers of this secular decline. We also find management turnover in Chapter 11 has increased by 65% since 1990 and that APD are more likely when management has substantial share holdings in the firm. The time spent in bankruptcy has also declined from about 23 months before 1990 to 16 months after 2000. Collectively, these results are consistent with the thesis that Chapter 11 has increasingly become creditor friendly over the years. We discuss the implications of our results for models that assume that equity has a valuable dilatory option in the bankruptcy process.

Creditor Governance Through Loan-to-Loan and Loan-to-Own

This paper provides new evidence on the roles and strategies adopted by different types of debtor-in-possession (DIP) lenders: “loan-to-loan” (LTL) lenders — prepetition secured bank lenders providing DIP financing, and “loan-to-own” (LTO) lenders — activist investors (i.e., hedge funds or private equity funds) providing DIP financing. We find that LTL is more likely in Chapter 11 firms with better operating performance, when prepetition bank lenders’ stakes are at risk, or when they have prior lending relationships with the distressed borrower. In contrast, LTO is more likely in small firms or when prepetition bank lenders’ loans are over-collateralized. Finally, we show that much of the governance improvement at the emergence is attributed to LTO lenders. We conclude that creditors of different institutional types adopt distinct strategies to enforce their control rights under Chapter 11 reorganization and to have contrasting effects on the governance outcomes of emerged firms.

The Value of Social Networks During Periods of Distress

We examine the impact of social networks during (i) a financial crisis, (ii) industry downturns, and (iii) periods when firms are in financial distress. We find that socially well-connected firms exhibit better performance during the financial crisis of 2007-2009. The positive relation is strongest for firms that are financially constrained, or operate in competitive industries. Well-connected firms have better access to debt financing during the crisis, and this is especially true among financially constrained firms. During industry downturns, firms with more social connections also perform better. When individual firms become severely financially distressed, personal connections to lenders reduce the probability of bankruptcy filing and increase the probability of obtaining Debtor-in-Possession (DIP) financing if they nevertheless have to file. In addition, firms obtaining DIP financing from connected lenders are more likely to emerge from Chapter 11. Overall, our results suggest that social networks benefit firms in times of distress.

Lock-In Effects in Relationship Lending: Evidence from Dip Loans

Do prior lending relationships result in pass-through savings (lower interest rates) for borrowers, or do they lock in higher costs for borrowers? Theoretical models suggest that when borrowers experience greater information asymmetry, higher switching costs, and limited access to capital markets, they become locked into higher costs from their existing lenders. Firms in Chapter 11 seeking debtor-inpossession (DIP) financing often fit this profile. We investigate the presence of lock-in effects using a sample of DIP loans. We first account for selectivity bias by using the inverse mills ratio form a first stage. Then, in a second stage, we jointly estimate the relationship between loan price and non-price terms accounting for selectivity bias. We find that the existence and intensity of prior lending relationships are associated with higher interest costs, longer maturities, and smaller DIP loans. Taken together, our study provides direct evidence that prior lending relationships do create a lock-in effect under certain circumstances, such as DIP financing.

Free Falling with a Parachute that May Not Open: Debtor-in-Possession Financing in the Wake of the Great Recession

Debtor-in-possession (DIP) financing is one of the most important building blocks of a Chapter 11 bankruptcy case. The recent economic downturn, however, has frozen the DIP financing market. Absent the financing necessary to reorganize, many companies will be forced to liquidate. Who will fill the void in DIP financing as banks exit the market? This note seeks to explore alternative options - local banks, the government, and private equity or hedge funds - that may fill the vacuum left by the banks, and the risks and rewards associated with DIP financing. As these alternate institutions go forward, the landscape of DIP financing may forever change, with not only increasing risk of loan default and inflationary concerns, but also the opportunity to profit.

Information, Credit Risk, Lender Specialization and Loan Pricing: Evidence from the DIP Financing Market

We provide an empirical support for theories of lender specialization using the recently developed market for Debtor-in-Possession (DIP) financing. The legal environment in which DIP financing operates represents a natural laboratory for testing determinants of lending specialization (e.g. lender choice). We find that the choice of lender is not driven by credit risk, but by information considerations and that this lending specialization has loan pricing effects. In short, banks (non-bank lenders) lend to more (less) transparent firms and at lower (higher) loan spreads. Our results are consistent with the interpretation that banks provide important and useful services.

The Changing Nature of Chapter 11

The U.S. Chapter 11 bankruptcy system has long been viewed as equity friendly, with absolute priority deviations (APD) in favor of equity holders occurring as often as in 75% of the cases in the 1980s. By contrast, based on a more recent and much larger sample of bankruptcies from the period 1991-2005 we document an average frequency of APDs of only 22%. Moreover, we find a secular decline in the frequency of APDs over our sample period. The time spent in bankruptcy has also declined steadily, from 23 months in the 1980s to 16 months after 2000. We argue and find evidence that innovations in the bankruptcy process, such as reliance on debtor-in-possession (DIP) financing and adoptions of key employee retention plans (KERPs) help explain this secular decline. We also find that APD are more likely when management has substantial share holdings in the firm. Collectively, these results suggest that Chapter 11 has become more creditor friendly in recent years.

Debtor-in-possession financing and the resolution of uncertainty in Chapter 11 reorganizations

This paper investigates the use of debtor-in-possession (DIP) financing by firms reorganizing under Chapter 11. A model is developed in which there is asymmetric information between the creditors of a distressed firm and its management. In this context, it is demonstrated that reliance on DIP financing resolves informational asymmetries regarding the true economic value of distressed firms. The model's conclusions are empirically supported in the paper and by results of extant research. The signaling role of DIP financing is evidenced both by the positive stock price reaction to DIP announcements and the fact that firms employing DIP financing have more successful reorganizations.