Publication
Introduction
Randy Klein and Prisca Kim have authored "ABI Bankruptcy Reform: Will It Destroy Cash Flow Lending?," published in the April 2015 edition of The Bankruptcy Strategist.
The article discusses the Final Report of the American Bankruptcy Institute Commission to Study the Reform of Chapter 11 and its potential impact on cash flow lending.
The article is published below in full with the permission of The Bankruptcy Strategist, an ALM Publication.
ABI Bankruptcy Reform: Will It Destroy Cash Flow Lending?
Randall Klein and Prisca Kim
The Bankruptcy Strategist
When Congress enacted the 1978 Bankruptcy Code, two competing groups of lawyers and academics squared off: those who favored restructuring opportunities for debtors by restricting the scope of secured lender rights and remedies; and those who favored the expansion and protection of commercial lending laws. (See Kronman, "The Treatment of Security Interests in After-Acquired Property Under the Proposed Bankruptcy Act," 124 U. Pa. L. Rev. 110-111 (1975)). Under state law, a broad security interest could give a secured creditor a lien on all future, after acquired collateral. But the tension focused on whether to allow a secured creditor to improve its position with new property acquired after the bankruptcy case. The result was the broad mandate of Section 552 of the Bankruptcy Code: A prepetition lender with a lien on an asset enjoys a post-petition lien on the proceeds of that asset.
This rule fit well with the asset-based lending practices in 1978. For example, a prepetition lender’s lien on a book publisher’s inventory prepetition would continue post-petition with respect to accounts generated from the sale of such inventory and the eventual cash payment when received by the debtor. If that cash was then used to purchase all of the raw materials for the production of new books, the lender’s lien would attach to those new books and all of the resulting accounts and cash. However, if that cash was used to purchase only half of the raw materials and the other half was purchased with post-petition trade credit, the proceeds of the finished goods would be allocated based on the “equities” of the case. Thus, because asset-based lending was the predominant form of secured lending in 1978, the Bankruptcy Code requirement for an equitable sharing of proceeds between secured and unsecured components was relatively uncontroversial.
But after 1978, borrowers began to obtain a fundamentally different type of secured loan based upon the aggregate value of the assets as a going concern — cash flow lending. Companies would be bought and sold as going concerns for purchase prices tied to multiples of EBITDA. Lenders would provide financing based on a fraction of the purchase price secured by liens on substantially all of the purchased assets. Some lenders would offer cheaper financing in exchange for first lien priority and other lenders, sometimes in multiple tranches, would charge incrementally higher interest for second or third lien priority to account for the additional risk that the collateral would be insufficient to satisfy their loans after paying the lenders with higher priority. All of these lenders assumed, of course, that the blanket lien on substantially all of the assets would be protected during bankruptcy, such that the proceeds from the sale of a company as a going concern would first be applied to reduce the secured debt in the order of priority and any residual proceeds would be applied towards the unsecured claims (e.g., trade creditor claims).
Cash Flow Lending
The option of obtaining cash flow loans prepetition and keeping the business intact in bankruptcy depends upon a few critical features of current Chapter 11 law and practice: liens on post-petition net cash flows (which form the basis for the ultimate purchase price as a going concern) are respected as proceeds of prepetition liens on the enterprise, and lenders are entitled to the adequate protection of the going concern value of their collateral when the debtor continues as a viable operating entity. (See Casey and Klein, "The Pre-Petition Right to Post-Petition Income Streams and the Misinterpretation of § 522," ABI Journal (Dec/Jan 2010)).
Hundreds of billions of dollars of financing are predicated on these assumptions (See Allison Taylor and Alicia Sansone, "The Handbook of Loan Syndication & Trading," at 9 (2007) (“Had bankruptcy judges used their considerable discretion to rule against [enterprise value as a] form of collateral, the value of seniority and security in many loan agreements would have been greatly diminished, and the advantages of this asset class would have been diluted.”). Outside bankruptcy, this type of financing seems to be extraordinarily beneficial as it promotes commerce, growth, funding of acquisitions, and the free flow of credit to allow for payment of employees, trade creditors and other liabilities.
The 1978 Bankruptcy Code, however, was structured around assumptions about asset-based lending, not cash-flow lending. There are no defined terms that expressly recognize cash flow lending, enterprise value loans, going concern valuations and the like. At the same time, the consequence of extensive secured lending has manifested itself in taking away the flexibility and dexterity of debtors who would prefer to use Chapter 11 to fix operational issues and fend off the collection efforts by secured creditors. But when the entire balance sheet is engulfed in secured debt, the debtors find themselves without the flexibility in bankruptcy they would have enjoyed had they not borrowed as much secured debt. On the other hand, secured lenders are concerned that continuing operating losses coupled with the accrual of professional fees would result in increasing diminution of the net realizable value of their collateral — the business as a going concern. As a result, the debtors are often forced to maximize going concern value through expedited 363 sales. (See generally Klein and Juhle, "Majority Rules: Non-Cash Bids and the Reorganization Sale," Amer. Bankr. L.J. 210 (2010)).
The American Bankruptcy Institute Commission
In response, the American Bankruptcy Institute (ABI) formed a working group of some of the best and brightest minds in the restructuring community to produce a report reviewing the current issues with the Bankruptcy Code and providing recommendations. (The ABI Commission to Study the Reform of Chapter 11, 2012-2014 Final Report and Recommendations).
The Commission solicited and received input from trade groups, practitioners, and academics. On the issue of cash flow lending, the Commercial Finance Association (CFA) requested express protection for cash flow lending and adequate protection of going concern value. One of the CFA’s specific recommendations was that the ABI Commission clarify Section 552 so as to confirm that post-petition income streams are encumbered as proceeds of the prepetition lien on substantially all of the debtor’s assets: equipment, inventory, receivables, intellectual property, and general intangibles like trademarks and customer lists and goodwill.
What the Report Recommends
Instead, the ABI Report recommends the exact opposite. The Report endorses the notion that the fuzzy, undefined “equities of the case” language in 552 (historically used as an equitable tool described above) should be given an even more expansive and elusive interpretation that would arrogate enterprise value away from encumbered assets. (ABI Report at pp. 231-233). It recommends the transfer of enterprise value away from the assets based upon the post-petition services of employees and estate professionals.
Professor Michele Harner, who “maintained exclusive control over the substance of the final Report” (ABI Report at p. 3), has separately attacked the legal underpinnings for cash flow lending and has gone so far as to suggest that perhaps cash flow lenders have failed to appreciate the legal risk posed by these outlier theories. Harner, "The Value of Soft Variables in Corporate Reorganizations" (U. Ill. L. Rev. 2015 forthcoming) (suggesting that lenders “likely have not priced into their credit packages” her theory that an “all asset” lien should not result in a lien on the value of a company as a going concern).
Moreover, the ABI Report recommends lowering the required evidence to make a showing of the value provided by the debtor — the debtor would merely need to show some contribution to value, whether through time, effort, money, property, other resources or cost-savings. (ABI Report at p. 234).
No one would seriously contend that a prepetition debtor could obtain financing to buy a business one day, sell it the next and be permitted to not pay back its lender because it wanted to allocate sale proceeds to employees or other third-party creditors. Yet, that is exactly the post-bankruptcy result that the ABI Report invites. Increasing the risk to secured lenders will result in loans with higher interest rates and will dramatically restrict the amount of available credit. Ultimately, the ABI Report’s recommendations would penalize all potential borrowers for the benefit of the very small minority of those borrowers that will end up commencing a bankruptcy case.
Analysis
Even if 552 were to be clarified to recognize cash-flow lending (much in the same way Section 928 was amended to protect the expectations of the municipal bond industry that relies upon a prepetition lien on postpetition revenue streams), the ABI Report recommends a drastic and pernicious alteration of creditors’ rights: adequate protection should be based upon the value the secured creditor would have received upon foreclosure under state law, meaning the net value that a secured creditor would have received in a hypothetical, commercially reasonable foreclosure sale. (ABI Report at 67).
To those of us in the lending industry, it was no surprise that the ABI Commission did not accept the CFA’s invitation to do away with the rule in Timbers (United Saving Assn. of Tex. v. Timbers of Inwood Forest Assoc., Ltd., 484 U.S. 365 (1988)) and to require interest payments as part of adequate protection. But it was a shock to see the ABI Commission recommend decimating the concept of adequate protection for cash flow lenders and protecting their interest only to the extent of foreclosure value. This recommendation has no regard for the fact that cash flow loans are predicated on a sale of the business as a going concern or the practical difficulty in attempting to choose a value based on a hypothetical sale.
“[I]t is a mistake to think that the value of the [the senior lender’s nonbankruptcy right] is the modest amount realized in a foreclosure. … Going-concern liquidation sales outside of bankruptcy are possible … Especially when only institutional debt is to be restructured, creditors outside of bankruptcy can effect going concern sales of entire firms quite easily.” Baird, "The Rights of Secured Creditors after ResCap" (U. Ill. L. Rev. 2015 forthcoming). A lower threshold for adequate protection means that the debtors can easily obtain third-party priming financing or the use of cash collateral. Unless the going concern sale value includes an amount sufficient to repay that third party financing or diminution from the use of cash collateral, an earlier going concern sale could have protected a higher value for the secured creditor and would have respected its prepetition expectations.
The recent recommendations about limiting liens on post-petition enterprise value also has led to speculation that lenders will likely demand a work-around to account for the shift in expectations. For example, all operating assets could be required to be held in a special purpose vehicle the only creditor of which would be the senior secured lender (or senior and junior lenders subject to contractual intercreditor and subordination agreements). Trade creditors and employee claims would be at the parent company level, whose claims could only be satisfied if the sale proceeds of the subsidiary exceeded the value of the secured and institutional debt claims. Under the current Bankruptcy Code, the reason this would work is that Section 1129(a) (10) requires the debtor to have at least one assenting class in order to confirm a cramdown plan over the objection of the secured lenders. As an SPV, and as is typical in single asset real estate structures, cram-down would not be an option. However, the ABI Commission had a final parry: Among the over 200 recommendations (with no mention of enterprise value lending) is the elimination of Section 1129(a)(10). (ABI Report at pp. 257-58).
Depriving secured lenders of their reasonable commercial expectations by lowering the standard for adequate protection to foreclosure value and inviting future attacks on enterprise value lending and the scope of blanket liens is simply not good policy and should not be the purpose of a federal bankruptcy law.
