By Colleen Honigsberg (Stanford Law School) and Frederick Tung (Boston University School of Law)
For many firms, obtaining debtor-in-possession (DIP) financing is crucial for a successful reorganization. Such financing can be hard to find, however, as lenders are understandably hesitant to lend to firms in severe financial distress. The Bankruptcy Code solves this potential dilemma by authorizing debtors to provide DIP lenders with various sweeteners to induce lending. But because these sweeteners are thought to come at the expense of other stakeholders, the Code permits these inducements only if the judge determines that no less generous a package would have been sufficient to obtain the loan.
Certain types of lending inducements, frequently described as “extraordinary provisions,” have become the subject of growing concern. Anecdotal evidence suggests the use of these provisions has skyrocketed in recent years, leading important bankruptcy courts and the American Bankruptcy Institute to question whether these provisions are really necessary for a robust DIP market—or whether DIP lenders are extracting excessively generous terms. Defenders of DIP lenders, however, have pointed to a plausible external explanation for the popularity of extraordinary provisions in recent years: The Financial Crisis. When credit is tight, lenders demand more inducements. Indeed, judges have explicitly cited credit conditions in approving controversial inducement packages.
In this article, we provide the first evidence on the relationship between credit availability and DIP loan terms. Using a hand-collected dataset reflecting contract terms from DIP loans issued between 2004 and 2012, we study the relationship between DIP loan terms and broader market conditions. As predicted, we find a statistically significant relationship between credit availability and ordinary loan provisions like pricing and reporting covenants. By contrast, we find no evidence that “extraordinary” provisions like roll-ups and case milestones are related to credit availability. We hope that our findings will inform judges and policymakers struggling to evaluate whether the sweeteners extracted by DIP lenders are really necessary to induce lending.
The full article is available here.