Standardizing and Unbundling the Sub Rosa DIP Loan

In many recent Chapter 11 cases, debtor-in-possession (DIP) loans determine reorganization plan payoffs at the outset of the case. Recent DIP loans are tied to plan terms including rights offerings, which give the DIP lender exclusive rights to purchase discounted equity in the reorganized company, and backstop fees, which pay the rights holder for committing to purchase them. Terms like these raise fears that DIP loan approval is being used to short-circuit the Chapter 11 reorganization plan process—in bankruptcy parlance, that the DIP loan is a sub rosa plan. How should bankruptcy law manage this sub rosa DIP loan problem?

In our paper, we argue that the problem is a common one affecting many types of pre-plan transactions that provide the estate with an asset (cash) but also fix the priority and/or payoff of liabilities. We argue that bankruptcy law uses a common set of tools to deal with these crossover transactions that simultaneously involve asset-side and liabilities-side effects.

Some transactions are inherently crossover transactions, such as DIP loans. DIP loans are inherently crossover because, to finance new post-petition assets, the debtor must create a new obligation on the liability side to compensate the asset provider. Another type of crossover transaction is the strategic crossover transaction. In these cases, parties strategically bundle liability-side add-on effects, which could otherwise be postponed to the plan, into transactions involving the asset side.

Where crossover is inherent to the transaction, the Bankruptcy Code standardizes the liabilities side effect to protect the interests of the other creditors. Where crossover is strategic, courts police transactions by unbundling liability side effects that are unnecessarily bundled into transactions involving the asset side.

We conduct a case study of the J.C. Penney bankruptcy to understand how a non-standard, bundled DIP loan transaction can be used strategically to distort priorities. In that case, a DIP loan tied to a restructuring support agreement allowed a majority group to prime a minority group, roll up under secured debt, and control the allocation of payoffs. We find that a standardized, unbundled DIP loan would have required an interest rate of at least 545% to give the majority group the same payoff it received in the case.

We argue that courts should revive and strengthen standardization and unbundling norms. This would better defend priorities by encouraging competition and increasing transparency of DIP loan terms.

The authors’ paper can be found here.

Kenneth Ayotte is the Robert L. Bridges Professor of Law at the University of California, Berkeley - School of Law.

Alex Zhicheng Huang is the Lloyd M. Robbins JSD Fellow at the University of California, Berkeley - School of Law.