The last major revision to U.S. business reorganization laws occurred in 1978. In the nearly four decades since then, the markets and financial products, as well as the industry itself, have evolved. Accordingly, ABI established the Commission to Study the Reform of Chapter 11 to evaluate the U.S. business reorganization laws and propose reforms “that will better balance the goals of effectuating the effective reorganization of business debtors — with the attendant preservation and expansion of jobs — and the maximization and realization of asset values for all creditors and stakeholders.”[1]
On Dec. 8, 2014, the Commission published its Final Report[2] recommending revisions to the current Bankruptcy Code. The Report, which is approximately 400 pages long and the product of a nearly-three-year study undertaken by the Commission, recommends reform of numerous aspects of chapter 11 seeking to, among other things, reduce barriers to entry, facilitate certainty and more timely resolutions of disputes, enhance restructuring and sale options for debtors, and incorporate checks and balances on rights and remedies of the debtor and of creditors.
Some of the most striking recommendations relate to the determination of adequate protection and the modifications to debtor-in-possession (DIP) financing. This article provides a brief overview of the Report’s recommendations with respect to those sections.
Adequate Protection: Proposing a Uniform Determination Approach
To utilize its property encumbered by liens during the chapter 11 case, the Bankruptcy Code requires a debtor to provide the secured creditor with adequate protection of its interest in the property. Section 361 of the Bankruptcy Code describes three nonexclusive means by which adequate protection may be provided: periodic payments; additional or replacement liens; and other relief that will result in the realization of the “indubitable equivalent” of the secured creditor’s interest.
Historically, courts have used several valuation standards in assessing the sufficiency of adequate protection, including liquidation value, going-concern value and market value. The Commission, however, recommends that uniformity be established by requiring that adequate protection be determined using the “foreclosure value” of the collateral. Foreclosure value, which differs from liquidation value, is defined as “the net value that a secured creditor would realize upon a hypothetical, commercially reasonable foreclosure sale of the secured creditors’ collateral under applicable nonbankruptcy law.” According to the Report, the “foreclosure value” should be determined at the time of the request for adequate protection.
Notwithstanding the foregoing, the Commission suggests that a secured creditor may be entitled to receive adequate protection in excess of the foreclosure value if the secured party can demonstrate a sufficient equity cushion in the property (i.e., a sufficient differential between the foreclosure value and the § 363x sale value[3]). The Commission also recommends that the adequate protection order include a provision providing that in the event the debtor’s reorganization efforts fail, or if the court finds cause supporting relief from the automatic stay, the debtor must sell the secured creditor’s collateral under § 363 of the Bankruptcy Code unless the creditor elects otherwise. Finally, the value of the collateral for adequate protection purposes is not meant to be a determination of value for other purposes in a chapter 11 case, such as determining the amount of a secured creditors’ allowed claim, for which the reorganization value can be used.
Protections Relating to DIP Financing: Proposing Limits on Lenders
A typical DIP financing has many different components, all often designed to provide the DIP lender with sufficient adequate protection of its interests. One component of adequate protection in the marketplace today is the use of cross-collateralization. There is currently a split in the case law regarding the permissibility of cross-collateralization of a secured creditor’s prepetition debt with additional collateral postpetition. The Commission recommends that cross-collateralization remain an available method for providing adequate protection to pre-petition secured creditors solely where cross-collateralization will protect against the decrease in the value of the secured creditor’s interest in the debtor’s property. Thus, cross-collateralization should be permitted only to the extent of any postpetition diminution in value of the collateral.
Another form of adequate protection is the inclusion of “roll-up” provisions in DIP financing orders. Roll-up provisions permit the proceeds of the financing to be used to satisfy the lender’s prepetition claim. The Report suggests that DIP financings should be prohibited from containing such provisions unless the lender extends substantial new credit on terms better than any alternative party or the court finds that the roll-up is in the best interests of the estate.
In addition, DIP orders often grant postpetition lenders and/or prepetition secured parties liens on, and/or superiority claims in, chapter 5 avoidance actions or the proceeds of such actions. The Commission suggests that debtors should generally be prohibited from granting liens in chapter 5 avoidance actions or the proceeds thereof as a form of security or adequate protection to secured creditors. Only where the adequate protection awarded to the secured creditor is determined to be insufficient should a secured creditor be allowed to receive recoveries from avoidance actions through the creditor’s superpriority claim under § 507(b) of the Bankruptcy Code.
Moreover, DIP orders often contain waivers of certain rights afforded to debtors under the Bankruptcy Code. For example, § 506(c) provides debtors with the ability to recover from secured creditors’ collateral the necessary costs and expenses of disposing of that collateral. In addition, § 552(b) provides that the lien of a secured creditor extends to the proceeds, products, offspring and profits of a creditor’s collateral that are realized postpetition, “except to the extent that the court, after notice and a hearing and based on the equities of the case, orders otherwise.” The Report, however, finds that because current-day chapter 11 cases have fewer unencumbered assets and limited free cash flow, § 506(c) and § 552 waivers should be prohibited.
Finally, it is becoming increasingly common for DIP orders to include certain milestones (e.g., filing a plan or commencing a sale process) that if not satisfied result in an event of default. The Report proposes prohibiting financing orders from containing milestones or benchmarks requiring the debtor to take certain actions in a bankruptcy or from containing representations regarding the extent and validity of a secured party’s liens within 60 days of the filing of the petition date.
Conclusion
Ultimately, the recommendations contained in the Report are just that: recommendations. The Commission undertook a comprehensive study of all aspects of the Bankruptcy Code, and in so doing, highlighted areas where reform may be possible. The foregoing provisions are only a small portion of the proposed reforms. Whether these reforms are adopted is in the purview of Congress; however, many of the recommendations with respect to adequate protection and DIP financing are designed to better protect all parties in the bankruptcy process by providing uniformity and predictability while balancing the rights of parties to negotiate and reach their own deals.
[1] See Commission’s mission statement, Report at 3. The Commission is comprised of 18 commissioners and four ex officio members, who are among the most prominent chapter 11 professionals in the United States.
[2] A copy of the Commission’s Report can be obtained at https://abiworld.app.box.com/s/vvircv5xv83aavl4dp4h or by clicking here.
[3] The Commission suggests the creation of new § 363x to address sales of all, or substantially all, of the debtor’s assets outside of a plan. The new section will have a moratorium on a sale for the first 60 days, with a relief provision if there is significant value deterioration. Parties will need evidence satisfying the clear-and-convincing standard to overcome the 60-day moratorium.