Leveraged lenders are rallying to defend some of the advantages they hold when corporate issuers hit Chapter 11.
An effort to modernize the corporate bankruptcy process is in full swing, and banks and other secured creditors fear they could lose their hard-fought right to credit bid, face restrictions on debtor-in-possession financing and suffer other setbacks.
Critics say changes in the capital markets have given secured creditors the upper hand in bankruptcies, making it harder for companies to use the process to gain a fresh start. But leveraged lenders' interest in preserving their collateral must be balanced equitably with the interests of other bankruptcy parties, a Loan Syndication and Trading Association official says.
"Even if one were to concede that bankruptcy is more difficult than it used to be, you have to look at the Bankruptcy Code in the much larger context of leveraged lending in general," Elliot Ganz, the general counsel for the LSTA, said in an interview. "It's a secured market, and lenders rely on a clear rule of law that protects their collateral."
Part of the reason for the overhaul effort is to catch the law up with changes in the financial markets.
The Bankruptcy Code was enacted in 1978 before banks syndicated commercial loans to institutional investors and when secondary trading of claims was virtually nonexistent. That meant a company in bankruptcy generally negotiated a workout with just its direct lenders and vendors.
Borrowers have changed, too. The biggest employers are now services companies whose most valuable assets are contracts or some kind of intellectual property, rather than manufacturers with hard assets.
Today's borrowers also tend to be more indebted. By the time they file for Chapter 11, they typically have used all of their assets to secure debt, making it difficult to get additional financing to keep the business running while they negotiate with existing creditors.
Reforms enacted in 2005 focused more on consumer bankruptcy.
The American Bankruptcy Institute, a trade group made up of thousands of lawyers and financial professionals who rescue distressed companies, has established a commission to explore an overhaul of the code. Its goal is to better balance the interests of reorganizing business debtors and creditors who want to preserve the value of their collateral.
The commission, which held its fourth hearing on Nov. 15, is mulling changes to many parts of the bankruptcy process, some of which might not threaten secured creditors. It has yet to make any recommendations to Congress, and any overhaul of the Bankruptcy Code is expected to take years to implement.
Nevertheless, LSTA officials are concerned.
"We agree that there's more secured debt, but I don't know that it's what leads to more difficulty" in the bankruptcy process," Ganz says. "We also don't agree that that claims trading does either. In fact, claims trading has had a beneficial effect, providing liquidity and making the reorganization process more efficient."
The LSTA has formed its own working group to monitor the ABI's efforts. Its first meeting is scheduled for Dec. 5.
One of the rights secured creditors seek to protect allows them to use their debt as currency when a borrower puts assets on the block.
This right was affirmed in a closely watched decision issued by the Supreme Court in May. But the opinion focused on the language in the Bankruptcy Code that governs bankruptcy sales and creditor payment plans. Justices declined to consider the merits of credit bidding, saying this was "a matter for the consideration of Congress, not the courts."
Some experts are calling for credit bidding to be restricted or eliminated because, they say, it gives lenders an advantage over other bidders. Charles Tabb, the Mildred Van Voorhis Jones Chair in Law at the University of Illinois, has argued that a secured creditor should be permitted to credit bid only if it demonstrates that the inability to do so would disadvantage it.
Danielle Spinelli, a partner at Wilmer Cutler Pickering Hale and Dorr LLP, cited Tabb's argument as a reason for concern in her own testimony at the commission's Nov. 3 hearing.
"Taking away the right to credit bid on the ground that secured creditors have too much power would do nothing more than reduce the estate's recoveries and make it easier to transfer businesses in Chapter 11 to buyers preferred by existing management, rather than buyers who value them most highly and will put them to their highest and best use," Spinelli said in her written testimony.
Debtor-in-possession financing is another area where bankruptcy professionals and secured lenders may not see eye to eye.
Kathryn Colman, an attorney in private practice with Hughes Hubbard & Reed, urged the commission at its Nov. 3 hearing to consider statutory limitations on what a DIP lender may require of borrowers. She represents distressed companies and their private-equity sponsors and reiterated their concerns about strong-arm tactics by some lenders.
"Lenders providing post-petition financing no longer do so in order to make good returns with assured repayment, or protect their pre-petition positions by getting collateral for previously unsecured loans," Colman said in her written testimony. "Instead, they often do so in order to take control of the debtor, through covenants, deadlines, and default provisions. And these are no mere financial tests to ensure the safety of the lender's repayment."
She cited the following examples of some frequent tactics: DIP financing matures, and no further funds may be lent, unless the debtor holds a sale of its assets under Section 363 of the Bankruptcy Code within 60 days after the date of the funding; a requirement that any pleadings filed in the case must be preapproved by the DIP lender; and provisions prohibiting a debtor from filing a reorganization plan without preapproval by the DIP lender.
Such restrictions are necessary because lenders have to be "pretty darn comfortable" before providing DIP financing, Ganz says.
He acknowledges that "sometimes lenders might overreach, and what happens now is judges push back. But to suggest that legislatively you can't have certain control provisions only means companies won't be able to get DIP financing."