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

Breaking Bankruptcy Priority: How Rent-Seeking Upends the Creditors’ Bargain
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Editor’s Note:  Breaking Bankruptcy Priority: How Rent-Seeking Upends the Creditors’ Bargain, by Mark Roe and Fred Tung, was selected as one of the ten Best Corporate and Securities Articles of 2014. This “10-best” list reflects the choices of academic teachers in this area from more than 560 articles published last year. The article was the subject of a Bankruptcy Roundtable post on April 8, 2014 at its time of publication. It was the only bankruptcy-based article on the “10-best” list. That list can be found here.

By Mark Roe, Harvard Law School, and Frederick Tung, Boston University School of Law

Roe 124tungprofileIn “Breaking Bankruptcy Priority:  How Rent-Seeking Upends the Creditors’ Bargain,” recently published in the Virginia Law Review, we question the stability of bankruptcy’s priority structure. Bankruptcy scholarship has long conceptualized bankruptcy’s reallocation of value as a hypothetical bargain among creditors: creditors agree in advance that if the firm falters, value will be reallocated according to a fixed set of statutory and agreed-to contractual priorities.

In “Breaking Priority,” we propose an alternative view. No hypothetical bargain among creditors is ever fully fixed because creditors continually seek to alter the priority rules, pursuing categorical rule changes to jump ahead of competing creditors. These moves are often successful, so creditors must continually adjust to other creditors’ successful jumps. Because priority is always up for grabs, bankruptcy should be reconceptualized as an ongoing rent-seeking contest, fought in a three-ring arena of transactional innovation, doctrinal change, and legislative trumps.

We highlight a number of recent and historical priority jumps. We explain how priority jumping interacts with finance theory and how it should lead us to view bankruptcy as a dynamic process. Breaking priority, reestablishing it, and adapting to new priorities is part of the normal science of Chapter 11 reorganization, where bankruptcy lawyers and judges expend a large part of their time and energy. While a given jump’s end-state (when a new priority is firmly established) may sometimes be efficient, bankruptcy rent-seeking overall has significant pathologies and inefficiencies.

The paper is available here.

Breaking Bankruptcy Priority: How Rent-Seeking Upends the Creditors’ Bargain
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Post by Frederick Tung, Professor at Boston University School of Law

In “Breaking Bankruptcy Priority:  How Rent-Seeking Upends the Creditors’ Bargain,” recently published in the Virginia Law Review, Mark Roe and I question the stability of bankruptcy’s priority structure and suggest a new conceptualization of bankruptcy reorganization that challenges the long-standing creditors’ bargain view. Bankruptcy scholarship has long conceptualized bankruptcy’s reallocation of value as a hypothetical bargain among creditors: creditors agree in advance that if the firm falters, value will be reallocated according to a fixed set of statutory and agreed-to contractual priorities.

In “Breaking Priority,” we propose an alternative view. No hypothetical bargain is ever fully fixed because creditors continually attempt to alter the priority rules, pursuing categorical rule changes to jump ahead of competing creditors. These moves are often successful, so creditors must continually adjust to other creditors’ successful jumps. Because priority is always up for grabs, bankruptcy should be reconceptualized as an ongoing rent-seeking contest, fought in a three-ring arena of transactional innovation, doctrinal change, and legislative trumps.

We highlight a number of recent and historical priority jumps. We explain how priority jumping interacts with finance theory and how it should lead us to view bankruptcy as a dynamic process. Breaking priority, reestablishing it, and adapting to new priorities is part of the normal science of Chapter 11 reorganization, where bankruptcy lawyers and judges expend a large part of their time and energy. While a given jump’s end-state (when a new priority is firmly established) may sometimes be efficient, bankruptcy rent-seeking overall has significant pathologies and inefficiencies.

The paper is available here.