What Happened in 2020? The New Paradigm for Asset-Based Lenders in a Chapter 11 Case and What Should (Can) They Do About It?

To say a lot happened in 2020 doesn’t begin to capture what the year brought. In the economy, this included a significant increase in Chapter 11 filings for larger businesses from filings in 2019, particularly in retail. And for asset-based lenders it included a significant shift in their role in the larger bankruptcies. Asset-based lenders faced real challenges how to best protect their position and enhance the likelihood of a successful outcome. Confronted with a landscape that requires a new map to navigate, we look at what happened, how it happened and, most importantly, what should (or can) the asset-based lender do about it?

2020 brought to the fore a dramatic transformation of the role of the asset-based lender in the financing of a debtor in Chapter 11. Once upon a time, not in a galaxy so far, far away, the asset-based lender rigorously negotiated the terms of the DIP financing it would provide to the debtor upon the commencement of the Chapter 11 case, with the asset-based lender having a pervasive influence over the pace and direction of the case, and a necessarily cooperative debtor company. Of course, it was never quite that simple. But the contrast of that classic paradigm with the reality confronted by the asset-based lender in 2020 provides the backdrop for the magnitude of the shift in the role of the asset-based lender in the bankruptcies of 2020. And while that classic paradigm or some version of it may still be the case in many parts of the markets that use asset-based lending, in the larger, syndicated credits, “not so much,” and certainly, at least “not as much.”

What Happened?

The call comes in. The borrower tells the lender it is filing Chapter 11. The lender calls its lawyers. Where once lender’s lawyers would race to draft the financing order for the debtor’s counsel to submit to the Bankruptcy Court at the outset of the case, now it is not unusual for the lender’s lawyers to be presented with a draft of a cash collateral order prepared by debtor’s counsel, or even worse, a proposed financing order to be used to approve some other lender’s Chapter 11 financing with just a select few provisions addressing how the debtor is going to use the asset-based lender’s cash collateral. The mantra of the asset-based lender has always been to provide the DIP financing so as to be able to approve the budget, set the milestones, get the reporting and access to information and have the Bankruptcy Court approve the ability to exercise remedies in case of a default, not to mention the “roll up” and the benefits of cross collateralization and cash dominion—all benefits that came from being the key financing source in the Chapter 11. But as we look back over the major cases of 2020, like JC Penney, Neiman Marcus, Brooks Brothers, Stage Stores and others, that no longer seems to be the prevailing scenario.

Now, the asset-based lender may be relegated to the role of a bystander while the debtor and the other parties establish the way the case will proceed. To avoid this result, it is critical or the asset-based lender to use all of the tools at its disposal to proactively establish its position in order to receive critical rights as part of the use of its cash collateral.

How Did This Happen?

All the New Players

As asset-based lending has become a capital markets product, it has become one layer of debt in the deeper capital structures of its larger borrowers. At the same time, the nature and character of the debt providers filling out the capital structure have changed or, if not changed in terms of the name of the institution, have developed new strategies. Multiple new players are now engaged with the capabilities and the will to participate in the Chapter 11 case in ways that reduce the leverage of the asset-based lender. Ironically, while the deep capital structures of many asset-based borrowers benefit the asset-based lender by decreasing its risk of loss and offering a greater number of alternatives for a safe exit, it has also increased the likelihood that the role of the asset-based lender will be diminished.

As it turns out, while having the other layers of debt may help reduce the risk of the asset-based lender, introducing other parties into the capital mix, with borrowers now having separate term loans and multiple tranches of notes, secured and unsecured, has meant that the critical role of the asset-based lender that was once a forgone conclusion--may just be gone.

And these other capital providers are not just family members or company officers. These are deep-pocketed private debt funds often affiliated with a private equity firm, with a clear willingness to use their resources in flexible ways to offer additional liquidity to the bankrupt borrower to protect their initial investment or at least to put themselves in a position of controlling the process that will determine the return on their investment. And the most common basis for this debt has become a “split collateral” structure so that the term lenders or noteholders have first liens on fixed assets, while the asset-based lender has a first lien on current assets, which provides further leverage for the term lenders or noteholders.

The term loan lenders or noteholders are often the “fulcrum creditors” in the capital structure, so that the extent of these lenders’ recovery will depend entirely on the success or failure of the debtor’s restructuring process. As such, they have become the force to be reckoned with as a company heads to Chapter 11. Guided by their advisors, and sometimes with equity positions that give them direct insight to a company’s status, they will put together their financing proposal for the Chapter 11 early on and be fully engaged.

It may not even be the existing noteholders or term lenders that appear at the time of the filing of the Chapter 11 prepared to offer additional financing to the Chapter 11 debtor. Much as asset-based lenders discovered years ago that “DIP financing” could be a “product”, there are private debt funds looking for opportunities to obtain the significant returns available in the context of a Chapter 11 financing by providing the liquidity that will enable the debtor to ride through the Chapter 11 process to a sale or plan of reorganization. The new lender that arrives on the scene closer to the filing may also have the added benefit of a clearer picture on how the Chapter 11 is going to play out, so as to better understand its risk. And the risk may be managed with conservative financing structures imposed by the new lender that may have a good headline for the amount of funding it is prepared to provide, but with hooks and traps that make the reality less dramatic. It has always been the case in Chapter 11 that the party providing the extra liquidity is in the best position to get the control, as well as all available protections and benefits, including significant fees and pricing. As a result of providing those funds, the new lender will generally prevail over any attempts to offer a competitive financing or reduce the scope of its rights.

The Role of the Debtor’s Professionals

Debtor’s advisors and counsel have always played a critical role in the Chapter 11 process for a company as only makes sense, given that most management teams will not have had the same level of experience in finding their way through the unique elements of the process, and certainly will not have the knowledge as to judges and courts and prior cases that provide the foundation for going forward into the world of Chapter 11.

The larger companies that are now commonly using asset-based lending with more widely held ownership don’t have management with the same direct level of economic investment as a smaller, family-owned business might, for example. And the fact that the nature of directors’ duties in the “zone of insolvency” are so deeply enmeshed in statutes and case law only contributes further to the deference to counsel and advisors. What does this mean for the asset-based lender? All of the pre-Chapter 11 efforts to cultivate a working relationship with the key players in management, to develop a common understanding of how the ABL functions in the context of a particular business, is lost—leaving the asset-based lender adrift with little or no point of contact at the borrower to assert any influence or develop shared expectations for the Chapter 11 process.

Meanwhile, while not always manifest, the implicit character of the legal process as adversarial casts a shadow over how the conversations in the weeks up to filing are conducted.

The Asset-Based Lender’s Predicament

In looking at the financing needed for a Chapter 11, if returns are so good and the risk so manageable, why doesn’t the asset-based lender take the extra step and provide the liquidity itself, especially when, often relative to the total dollars involved, the actual amounts of the additional liquidity required may not be that significant?

The Borrowing Base

First, to state the obvious, the asset-based lender is tethered to its borrowing base structure, at least in the first instance. In some cases, given the competitive market, the lender may have originally gone out with particularly aggressive advance rates or less than optimal collateral as part of the borrowing base. In that context, the asset-based lender will not be keen to “stretch” further in connection with the Chapter 11.

Alternatively, as is often the case as a company heads into trouble, the asset-based lender will conscientiously “scrub” the borrowing base with a careful examination of each category of receivables and inventory and the debtor’s liabilities, looking to eliminate some of the riskier elements of the borrowing base either by the use of eligibility criteria or reserves. As a result, the asset-based lender will go into the Chapter 11 in a relatively good collateral position and an inclination not to take on more risk by loosening the reserves and eligibility criteria to create more liquidity and thereby reversing the rigorous efforts just undertaken with respect to the borrowing base.

Is it enough?

Even if the asset-based lender is prepared to offer some additional liquidity--is it enough? This has two dimensions. First, is it enough in the view of the debtor and its advisors as will be needed to give the company the “runway” to get to and through the Chapter 11? Second, is it enough relative to how much the alternative sources of capital may be offering?

In the end, one of the consequences for the asset-based lender of adhering to the fundamentals is to put it at a distinct disadvantage in the battle for control.

The Lost Benefits of Cash Dominion

Another disadvantage for the asset-based lender is the current approach to “cash dominion” in larger transactions. In a traditional asset-based lending structure, the proceeds of the receivables and other collateral are paid into a bank account of the company used exclusively for receiving such proceeds, which are then transferred on a regular basis to the lender to pay down the revolving loans, with the company then borrowing as needed. In larger transactions, the transfer of the cash to the lender only is triggered if excess availability under the borrowing base formulas falls below an agreed-upon amount set out in the credit agreement. As the amounts of excess availability that trigger “cash dominion” have been lowered over time given the leverage of borrowers in the negotiations, it is less likely to occur even as the company is in some level of distress.

There is also the possibility that a company may draw down on its asset-based credit facility using up all of its excess availability and then immediately file for Chapter 11, before the lender is in a position as a practical matter to implement cash dominion, or the company may draw just up to the threshold for triggering cash dominion.

As a result, the company may have cash available to it so that, upon the commencement of the Chapter 11 case, it is not as critical for the company to have financing in place to get funds to operate during those early days of the Chapter 11— with the obvious shift in negotiating leverage between debtor and lender.

What About the Intercreditor Agreement? Getting “Primed” Through Cash Collateral Use

Given the other debt in the capital structure of the borrower, there is usually an intercreditor agreement. And intercreditor agreements have become much more complex. The provisions dealing with bankruptcy now go on for pages—with specific provisions tailored to deal with the run of cases concerning intercreditor agreements that arose from the 2008 financial crisis—court decisions out of the bankruptcies of Energy Future Holdings (formerly known as TXU), Momentive, Boston Generating, Ion Media, La Paloma, Radio Shack and others.

These intercreditor agreement provisions now address how a Chapter 11 financing might be provided to the common debtor in some detail.

To start, most intercreditor agreements in a customary “split collateral” arrangement include the consent by term loan lenders or noteholders to the asset-based lender providing the Chapter 11 financing, subject to certain conditions. And vice-versa. In the intercreditor agreement, the term lenders or noteholders consent in advance to the asset-based lender providing the Chapter 11 financing, secured by its first lien on the accounts, inventory and related assets (the “ABL priority collateral”), and a second lien on the intellectual property, equity interests, equipment and real estate (the “term loan priority collateral”). Similarly, the asset-based lender consents to a Chapter 11 financing provided by the term lenders or noteholders based on their first lien on term loan priority collateral and second lien on ABL priority collateral. But, a consent in advance by each side is not a prohibition on the other group of lenders providing the Chapter 11 financing. Each side is free to offer its own Chapter 11 financing and the other simply can’t object—leaving the debtor as master of its own fate in selecting the financing and leading to the “dueling” offers of DIP financing from each side.

Most intercreditor agreements will include an “anti-priming” provision, which says that no lender will offer a Chapter 11 financing secured by liens with priority over the liens of the other lender. In the most common “split collateral” structure, this means the term lenders will not seek to “prime” the asset-based lender on the ABL priority collateral, clearly, an important protection in today’s environment. So, in theory this should force the term lenders or noteholders to provide more “fresh” capital, rather than look to the ABL priority collateral to “help” finance the company during the Chapter 11. But this is not actually the case.

In fact, as we often witnessed in 2020, the term lender’s DIP financing proposal assumes or even relies on the debtor’s use of the asset-based lender’s cash collateral (i.e., the post-petition proceeds of inventory and account receivable) to supplement the liquidity needs of the debtor. When the company gets the use of cash collateral, meaning the post-petition proceeds of the receivables and inventory that are the ABL priority collateral, through its cash collateral order, it has the benefits of this funding, leaving the asset-based lender with adequate protection in the form of either its “equity cushion” (that is the perceived value whether realistic or not of the accounts and inventory in excess of the actual asset-based loans outstanding) or replacement liens on the post-petition receivables and inventory. So, between the cash collateral and some supplemental financing from the term lender or noteholders or some third party private debt fund, the Chapter 11 debtor gets what it needs.

What Should the Asset-Based Lender Do?

In view of these developments, what should the asset-based lender be thinking about in approaching the Chapter 11?

Just to put it all in context, here’s a follow-up question: Is it really all bad that another party is prepared to put up additional funds to support the distressed borrower? Isn’t that a fundamental chapter in any workout playbook?

The issue here is not necessarily that the additional liquidity is provided—but how it is provided. What are the consequences to the asset-based lender of the liquidity coming in through a financing?

First, while it may not help immediately, in term of loan documentation, there is the “easily said but difficult to do” possibility of:

• setting higher excess availability thresholds for cash dominion triggers, and
• the use of anti-hoarding provisions.

Of course, in the continuing competitive market, notwithstanding the current economic environment, increasing excess availability thresholds would be great—but can it realistically be done without the risk of losing new deal opportunities?

2020 has seen the discovery by asset-based lenders of the utility of anti-cash hoarding provisions, which have now become part of the asset-based lender’s tools in a way that was never needed before because of the ability to use cash dominion. Anti-hoarding concepts have come into the asset-based lending market as a way of trying to compensate for the weakening of cash dominion triggers.

In looking at excess availability thresholds for triggering cash dominion and other rights, the ability to conduct appraisals in order to determine the actual levels of availability become important. The absence of the right to do so also adversely impacts the ability to get excess availability to the threshold to trigger cash dominion.

Second, the asset-based lender may want to really consider the benefits of having more significant influence on the Chapter 11 case by providing additional liquidity relative to the risks, as counterintuitive as it may be to offer more financing when confronted with a borrower in distress. It may be that, in some instances, getting in early with just the right amount of “stretch” will better position the asset-based lender strategically in the process. Of course, this assumes that the asset-based lender gets the opportunity to offer such “stretch” financing. As we have seen, that opportunity is not always forthcoming, particularly given the involvement of other players and the role of the borrower’s advisors.

Third, and perhaps most critically, the asset-based lender may want to be proactive in looking for potential partners to provide the additional liquidity, and approaching the debtor with a Chapter 11 financing package. The challenge here is that it may require some compromises on matters of control of the financing, on such significant rights as establishing and maintaining the borrowing base and managing its components during the Chapter 11. But, with the right partner, any such limitations may be worth it. Those limitations on the asset-based lender’s discretion required to address the concerns of the other lender may result in more control and better protections in the Chapter 11 than would otherwise be the case. The asset-based lender may need to carefully consider introducing a “first in last out” tranche, with its benefits and challenges.)

Finally, the asset-based lender can accept that it will be in a position of having its cash collateral used in the Chapter 11, but then think about the critical elements of the cash collateral order that it will require. For this purpose, let’s go back to some of the reasons that asset-based lenders have traditionally wanted to provide the Chapter 11 financing:

• require compliance with the budget,
• establish “milestones”,
• cross-collateralization through the “roll up” of pre-petition debt into post-petition debt,
• additional collateral, like leaseholds,
• ability to require consultants and advisors,
• super-priority administrative expense claim,
• the release of pre-petition claims against the lender,
• limit on time period for creditors’ committee and others to challenge the lender’s pre-petition liens,
• 506(c) waiver of any claim for a surcharge on the lender’s collateral,
• current payment of interest, fees and expenses,
• lift stay only on notice in the event of a default by debtor.

While cross-collateralization and roll ups are not permitted with the use of cash collateral, since the lender is not making new advances so as to create post-petition debt or receiving proceeds of receivables that may be applied to pay down the pre-petition debt in order to effect the “roll up”, to the extent that the asset-based lender can get the items above as part of its cash collateral order, it may mitigate the risks to the lender’s recovery.

The issue becomes identifying the incentive for the debtor to include the list above in the cash collateral order and figuring out the strategy that will make it happen. Here the focus will have to be on the “adequate protection” package that the ABL lender can negotiate, or even litigate, for in the Chapter 11. The Bankruptcy Code requires, that in exchange for the debtor using its cash collateral the secured lender must receive “adequate protection” to protect the creditor from the diminution in value of its collateral as used by the debtor.

Unfortunately, the Bankruptcy Code and the Bankruptcy Courts have been somewhat creative in finding what might constitute such “protection” and often it is not what the lender would find “adequate”—notwithstanding the debtor’s view and the Bankruptcy Court’s willingness too often to accept that view. The approach here for the lender will be very case specific-driven by the underlying facts--with the additional hurdle of the leverage that the debtor has at the outset of the Chapter 11 case by being able to make the initial presentation to the Bankruptcy Court and establish the narrative. The lender and its counsel will have to look carefully at every element of the case to develop the reasons the debtor should agree to grant the lender the rights the lender needs to best protect its position in the Chapter 11.

About the authors:

David W. Morse is member of Otterbourg P.C. and presently co-chair of the firm’s finance practice group. He represents banks, private debt funds, commercial finance companies and other institutional lenders in structuring and documenting loan transactions, as well as loan workouts and restructurings. He has worked on numerous financing transactions confronting a wide range of legal issues raised by Federal, State and international law.

Dan Fiorillo is member of Otterbourg P.C. and for over 20 years has specialized in the representation of banks, commercial finance and factoring companies, specialty lenders, hedge funds, real estate lenders, private equity groups, corporations, fiduciaries and other institutional clients in all aspects of restructuring transactions, workouts, bankruptcy and other insolvency proceedings, including debtor-in possession financing, cash collateral use arrangements, exit financing, distressed acquisitions of assets, assignments for the benefit of creditors, state and federal receivership proceedings, foreclosures and secured party sales. He has represented lender and borrower clients in various financing transactions, including asset-based revolving credit facilities, senior and junior secured term loans, mezzanine debt facilities, unitranche facilities, construction loans and cash flow loans. He has appeared before numerous federal and state courts across the country representing various clients.