Leverage and Lenders of Last Resort

John J. Rapisardi is co-chairman of the Financial Restructuring Department at Cadwalader, Wickersham and Taft LLP in New York. Peter M. Friedman is special counsel in the firm's Washington, D.C., office. Cadwalader served as lead outside counsel to the Presidential Task Force on the Auto Industry with respect to the restructuring of Chrysler LLC and General Motors Corporation and their related finance companies. The authors gratefully acknowledge special counsel Douglas S. Mintz, resident in Washington, and associate Audrey Aden, resident in New York, for their assistence in the preparation of the article.

Historically, lenders have considered debtor-in-possession (DIP) financing an attractive and typically lucrative investment because DIP lenders generally are first in line for repayment when the company emerges from bankruptcy or liquidates. Prior to the current global recession, companies filing for Chapter 11 bankruptcy protection were able to secure financing with relative ease. In recent years, a competitive market for DIP lending had developed among investment banks, private equity firms, hedge funds and traditional lenders such as GE Capital.

The Deep Freeze

The current financial crisis has made obtaining any credit difficult for even the most credit-worthy borrowers. In the wake of the recent upheaval in the financial sector, credit markets froze and remained in a deep freeze for much of 2009. Although credit markets recently have shown signs of thawing, credit remains tight.

DIP financing, the lifeblood of cash-challenged Chapter 11 debtors, has proven no exception to the general freeze in the broader credit markets. As a result, DIP financing has become difficult to obtain and lenders have imposed significantly more stringent credit terms. Recent consolidation on Wall Street and a flurry of private equity firm and hedge fund liquidations has done little to spur competition in the DIP lending market. Further compounding the problem, many companies entering bankruptcy today are suffering the hangover from binging on easy credit, and thus, have few unencumbered assets to use as collateral for DIP financing.

The lack of competition and reduced liquidity of distressed companies has created an environment in which DIP lenders ' true lenders of last resort ' enjoy leverage over Chapter 11 debtors for whom DIP financing can mean the difference between a successful reorganization, on the one hand, and a fire-sale liquidation, on the other. As made evident by several recent bankruptcy cases (e.g., Lyondell, Chrysler, GM and VeraSun), DIP lenders have used their leverage as the provider of necessary capital to influence key terms of recent bankruptcy cases. Among the typical provisions lenders have received in recent months: loan maturities under a year; large roll-ups of prepetition debt; interest and expenses in the high double digits; and restrictive and case milestones.

The substantial leverage DIP lenders currently enjoy has not gone unnoticed. In a recent group of opinions in the bankruptcy cases mentioned above, Judge Arthur J. Gonzalez and Judge Robert E. Gerber, bankruptcy judges for the Southern District of New York, have acknowledged the increased leverage of DIP lenders in the current market and permitted certain actions by those lenders.

Cases in Point

Lyondell

In early January 2009, LyondellBasell Industries, one of the world's largest oil refiners and producers of polymers and petrochemicals, filed for Chapter 11 protection in the Southern District of New York for its U.S. subsidiaries and one of its European holding companies. Along with typical requests for first-day relief from the court, Lyondell requested approval of an $8.25 billion DIP financing package ' nearly double the size of any DIP financing previously approved by a court. Shortly thereafter, the court granted Lyondell interim relief, which provided Lyondell with access to $2 billion of the proposed DIP financing. After a three-day hearing on final approval of the DIP financing, the court granted final approval of Lyondell's DIP financing on March 1, 2009, making it the largest DIP financing in history at that time.

Fourteen of Lyondell's existing lenders participated in the DIP financing. Lyondell's DIP financing is comprised of two components: a $6.5 billion term loan, of which $3.25 billion is new money and $3.25 billion is “rolled-up” prepetition debt, and a $1.54 billion asset backed lending facility. That Lyondell secured DIP financing at the beginning of 2009, when credit markets were all but frozen, is evident from the aggressive terms imposed by its DIP lenders.

Priced at a 13% rate of interest plus an additional 7% in fees, the Lyondell DIP undoubtedly reflects the higher cost of capital in the prevailing market. Objectors to the Lyondell DIP challenged heavily the short maturity (less than a year) and the aggressive milestones. Specifically, the case milestones mandate that Lyondell deliver a draft plan of reorganization to its lenders within eight months of the petition date, file the plan a month later and obtain confirmation less than a year after the petition date.

Certain of Lyondell's creditors vigorously opposed the DIP financing, arguing that it imposed unworkable deadlines and that it was priced too expensively. While Judge Gerber expressed serious concerns about certain features of the DIP financing, he ultimately approved it, finding that the “debtors absolutely need the requested financing” and that “the terms that are now available for DIP financings in the current economic environment aren't as desirable as they were when I ruled on similar motions earlier in my tenure on the bench.” See Transcript of Lyondell Hearing, Feb. 27, 2009 at 734:5-735:2.

In evaluating the propriety of the proposed DIP financing, Judge Gerber applied the standard set forth in the Farmland decision from the Bankruptcy Court for the Western District of Missouri, and in many respects, Judge Gerber adopted the view of the Farmland court: “[l]et there be no doubt ' the DIP Lenders drove a hard bargain ' . However, hard bargains are often the lot of Chapter 11 debtors. Chapter 11 post-petition financing is 'fraught with dangers for creditors,' and debtors may have to enter into hard bargains to acquire (or continue to receive) the funds needed for reorganization ' . It is not impermissible for a bank to use its superior bargaining power to obtain creditor-favorable terms in a financing agreement.” In re Farmland, 294 B.R. 855, 885-86 (Bankr. W.D. Mo. 2003).

Specifically, in evaluating the unsecured creditors committee's claim that the DIP financing was priced too high, Judge Gerber acknowledged that the terms were “hardly ideal,” but, citing to present market conditions, conceded that “as disappointing as the pricing terms are ' the provisions are reasonable here and now.” In addition, Judge Gerber identified with the unsecured creditors committee's concerns with respect to the duration of the DIP financing and the aggressive case milestones, calling these terms “the most serious issues with respect to ' the facility.” However, Judge Gerber found that the Debtors agreed to the maturity date and the milestones “as a matter of necessity and as a matter of ' appropriate business judgment.” In particular, the arguments of the DIP lenders that the shorter duration was justified by the lack of “long-term visibility” into Lyondell persuaded Judge Gerber to permit the loan terms. Judge Gerber found the maturity date “sufficiently reasonable ' not to risk the loss of the facility by disapproving it.” Finally, while Judge Gerber recognized that the case milestones left “little room for error,” he found that Lyondell's evidence and representations established that the milestones could be achieved and thus were permissible. See Transcript of Lyondell Hearing, Feb. 27, 2009 at 739:20-744:21.

Chrysler and General Motors

In the recent landmark bankruptcy cases of Chrysler and General Motors, which filed for Chapter 11 protection in the Southern District of New York on April 30, 2009 and June 1, 2009, respectively, the bankruptcy court addressed squarely the leverage exercised by the DIP lender in those cases ' the United States government. In Chrysler, the United States Treasury, a prepetition lender, and Export Development Canada agreed to provide Chrysler with $4.96 billion in DIP financing. Although the U.S. and Canadian governments agreed to price the DIP facility at a better-than-market rate, the governments, as lenders, set a short duration for the facility ' a maximum of six months ' and the loan agreement set milestones for action Chrysler needed to take to effect an asset sale pursuant to section 363 of the Bankruptcy Code. For example, in the event that Chrysler failed to obtain entry of a bidding procedures order by May 15, 2009 or failed to obtain final approval of the asset sale by June 15, 2009, an event of default would occur under the DIP financing.

Several of Chrysler's prepetition lenders opposed the proposed asset sale and challenged the U.S. and Canadian governments' involvement in the case and their perceived level of influence over Chrysler. Judge Gonzalez dismissed these attacks by pointing to the “economic reality” of the situation ' the U.S. and Canadian governments were “lenders of last resort” and no one else was willing to lend to Chrysler. Judge Gonzalez recognized that, in the current credit market, those lenders willing to extend financing have the “ability to dictate many of the key terms upon which any funding will occur,” and stated that such a “take it or leave it,” outcome-determinative negotiation style is merely “the harsh reality of the marketplace.” Further, Judge Gonzalez stated that Chrysler was free to reject the proposed DIP financing, and that by choosing the financing, rather than the alternative (e.g., liquidation), Chrysler had exercised its business judgment. Accordingly, Judge Gonzalez found that, while the U.S. and Canadian governments had provided the terms upon which they were willing to lend to Chrysler, the “usual marketplace dynamics play[ed] out” and the governments' exercise of leverage over Chrysler, as lenders of last resort, was not inappropriate and did not lead to the governments becoming “insiders” of Chrysler. See In re Chrysler LLC, 405 B.R. 84, 104-106, 108 (Bankr. S.D.N.Y. 2009).

Similarly, in General Motors, the United States Treasury, a prepetition lender, and Export Development Canada agreed to provide General Motors with $33.3 billion in DIP financing. Just as in Chrysler, the U.S. and Canadian governments priced the GM DIP facility at a better-than-market rate, but insisted upon a maximum of duration of six months and again set milestones for GM to effect an asset sale pursuant to section 363 of the Bankruptcy Code.

Although GM's creditors did not raise the same challenges that were raised in Chrysler with respect to the U.S. and Canadian governments' influence as DIP lenders, Judge Gerber acknowledged that the governments were lenders of last resort, noting that “the U.S. Treasury (with its Canadian EDC co-lender) is the only entity willing to extend DIP financing to GM.” Further, Judge Gerber matter-of-factly accepted that, as lenders of last resort, the U.S. and Canadian governments had placed certain conditions on the extension of credit, and found that these conditions were imposed to: “(i) preserve the value of the business; (ii) restore (or at least minimize further loss of) consumer confidence; (iii) mitigate increasing damage that GM itself, and the industry, would suffer if GM's major business operations were to remain in bankruptcy; and (iv) avoid the enormous costs of financing a lengthy Chapter 11 case.” See In re General Motors Corp., 407 B.R. 463, 480, 484 (Bankr. S.D.N.Y. 2009). Accordingly, Judge Gerber approved the $33.3 billion DIP financing to GM, making it the largest DIP facility approved to date.

Conclusion

As evidenced by the DIP financings obtained and approved in the past year, and as acknowledged by Judge Gerber and Judge Gonzalez, the DIP financing landscape has been dramatically altered by the current economic downturn. DIP lenders today enjoy leverage over troubled companies. However, the leverage currently enjoyed by DIP lenders is largely a function of the present state of the credit markets. Upon a further thawing of the credit markets, DIP lenders' leverage may wane and the market should lead to less onerous financing terms. This fact was recognized by Judge Gerber in Lyondell, when he cautioned that “people should be wary of using [Lyondell] as a precedent in the next one that comes down the road, especially if that's the case after the liquidity markets have loosened up.” See Transcript of Lyondell Hearing, Feb. 27, 2009 at 740:17-20.

John J. Rapisardi is co-chairman of the Financial Restructuring Department at Cadwalader, Wickersham and Taft LLP in New York. Peter M. Friedman is special counsel in the firm's Washington, D.C., office. Cadwalader served as lead outside counsel to the Presidential Task Force on the Auto Industry with respect to the restructuring of Chrysler LLC and General Motors Corporation and their related finance companies. The authors gratefully acknowledge special counsel Douglas S. Mintz, resident in Washington, and associate Audrey Aden, resident in New York, for their assistence in the preparation of the article.