been employed by companies coming out of formal restructuring .... biggest concern in the Province of Quebec, where ther
DIP FINANCING STRATEGIES FOR DISTRESSED COMPANIES Carole Hunter, Jonathan Levin and Edmond F.B. Lamek When companies face troubled times financially, they inevitably find themselves in a situation where their existing lenders and other creditors are looking for a material recovery on their claims as soon as possible, and yet the company itself is in need of additional borrowings in order to implement a strategy to maximize returns to existing creditors. These incongruous realities make the negotiation of financing during a restructuring a delicate, and often times hotly contested debate among stakeholders who may have differing agendas, or differing views of the ultimate viability of the company’s business. Below, we look principally at a number of business dynamics of “debtor in possession” financing in a formal courtsupervised restructuring environment, as well as some of the exit financing strategies that have been employed by companies coming out of formal restructuring proceedings in Canada. I.
DEBTOR-IN-POSSESSION FINANCING
When a corporation is faced with the prospect of commencing restructuring proceedings under the Companies’ Creditors Arrangement Act1 (the “CCAA”), one of the issues that will invariably arise is the manner in which the company’s ongoing operations will be funded during the restructuring period. Over the past several years, many debtors have utilized what is known as “debtor-in-possession” (“DIP”) financing, a concept (and phraseology) adapted from financing which is legislated in Chapter 11 of the United States Bankruptcy Code2. DIP financing refers to financing provided to an insolvent debtor while it attempts to reorganize in accordance with applicable insolvency legislation, which, in the majority of cases in Canada, is the CCAA. This type of financing will ordinarily be sought at the time of the debtor’s initial application for protection from its creditors under the CCAA. The DIP financing will be authorized and secured by a court order made in the CCAA proceedings, which will also grant a charge on the property and assets of the debtor in favour of the DIP lender (hereinafter “DIP Charge”). In Canada, the development of DIP financing in the context of restructuring proceedings has been the product of much negotiation and ingenuity among the financial stakeholders in the major Canadian restructurings, and a certain degree of judicial interpretation and arm-twisting. In most cases, the provision and structure of the DIP financing is unchallenged by the time it is brought before the court for approval, since the DIP financing is generally the subject of intense negotiations between the principal stakeholders of the debtor company prior to the commencement of proceedings under the CCAA. Because the Courts do not tend to take an interventionist role in DIP financing issues unless a dispute arises, the debtor
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R.S.C. 1985, c. C-36, as amended. Bankruptcy Code, 11 U.S.C.
and the DIP lender are afforded considerable latitude in negotiating the terms and structure of the financing. Canadian courts will generally only become involved in issues relating to DIP financing where the terms of the financing are controversial (e.g. most commonly, where the DIP lender is given a super-priority security position over the objections of existing creditors with security over the debtor’s assets being charged). (a)
Choosing the DIP Lender
When faced with a cash-flow crisis and an inevitable insolvency filing, a debtor company can, at least in theory, look to two principal sources of DIP financing: its existing senior lender or lenders, or external lenders with no current stake in the company’s business. As discussed later in this chapter, the financing can, however, be provided by the debtor’s other existing stakeholders.3 On the surface, an existing lender with a financial stake in the outcome of the company’s restructuring would appear to be the most convenient source of DIP financing, since the debtor has an ongoing relationship with the existing lender and because the existing lender should have an understanding of the company’s business prospects, asset values and cash flow requirements. While the specialized third party DIP lenders have garnered a reputation for moving quickly in arranging loans, their inability to conduct extensive due diligence can often lead to a lower level of funds being available to the company, and materially higher fees being charged. There are a variety of factors that will affect a debtor’s choice of (and ability to choose) the party that will become the DIP lender. The company’s existing relationship with its senior lender will invariably dictate the role that lender will take in the restructuring proceedings, be it DIP lender or not. Since most financial institutions (or syndicates of them) do not, on a regular basis, make DIP loans, or advance credit in situations where a borrower is already in default, existing lenders will have to be satisfied that there is a substantial business case for them to advance additional credit by way of DIP loan. The lender will first look at its existing collateral coverage and compare the likely outcome in a liquidation scenario (i.e. an immediate orderly shut down as opposed to a restructuring). If the lender’s position is clearly in a shortfall position in a liquidation scenario, then the lender will next have to consider whether or not it would be “throwing good money after bad” by advancing additional funds to the company. This is the time when the lender must take a long hard look at the ways in which the company got itself into this position, and whether those factors can be remedied by restructuring in a timely and cost effective manner, and by the existing company management team. Conversely, if the existing lender finds itself in a comfortable over-secured position, its decision to advance DIP financing is made easier, since any degradation of collateral as a result of an unsuccessful attempt at a restructuring will not economically impact the lender’s existing position.
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A discussion of the financing that can be provided by other stakeholders is set out in further detail in the section on “Financing from Key Suppliers and Customers”. Depending on the circumstances and the financial or other interests of the parties, the DIP financing could also be provided by other creditors of the debtor.
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An existing lender will be motivated to provide the DIP financing principally to maintain the maximum level of control over its security position and the direction of the restructuring process, and avoid being “primed”4 by a third party lender. Because an existing lender is able to exercise a significant degree of control over the conduct of the company’s refinancing through the imposition of conditions, covenants and court orders which require consultation with the DIP lender on various matters in the restructuring, the existing lender will likely be more comfortable about providing the financing. The existing lender may also be concerned that a third party lender will have a different perspective on the restructuring of the debtor that may not result in the existing lenders’ position being maximized or protected throughout the restructuring process. From the debtor’s perspective, the existing lender as the DIP lender has its advantages, particularly where the parties have a good working relationship, and the causes of the company’s financial difficulties are identifiable and solvable. The existing lender knows and understands the debtor’s business and may be able to offer valuable insights into the restructuring, and will have the incentive to do so, given its larger stake in the outcome. The existing lender may also be less aggressive in establishing the fee structure for the DIP financing. However, equally commonplace are situations in which the existing lender has lost confidence in the debtor’s business model, long term viability, or management, with the result that regardless of the financial position of the lender’s existing position, the existing lender will propose onerous terms of the financing which result in the lender retaining almost complete control of the restructuring process. This is unlikely to be conducive to a restructuring and may greatly increase the likelihood that the restructuring is a failure. In these cases, the debtor will invariably be better off locating a new source of financing, even over the objections of the existing lender. A third party DIP lender also has its advantages and disadvantages. Obviously, DIP lenders are motivated to provide DIP financing because of the significant monetary returns that are available by way of distressed debt level interest rates and a myriad of fees, and the very limited financial risk that is associated with court ordered priming security. A new lender has the principal advantage to the company of being solely profit-based, and having no preconceived notions or biases in respect of the direction of the restructuring of the debtor’s business, and may therefore provide the debtor with significantly more flexibility in the restructuring as long as the DIP lender achieves its expected profit levels in the anticipated time horizon. (b)
Issues Affecting the Structure of the DIP Financing
There are many issues that affect the structure of the DIP financing. The amount and timing of availability of the DIP financing to the debtor is generally the most important issue to deal with by the Courts in approving a DIP borrowing at the outset of a CCAA proceeding. At this time, very few creditors will have received notice of the commencement of the CCAA 4
“Priming” is a term used to describe the subordination of the existing lender’s security position to a superpriority security charge established in favour of the third party DIP lender.
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proceedings or been afforded the opportunity to review and respond to any application materials they may have received. It is as a result of the desire to balance a debtor’s need to obtain critical financing with the need to protect the rights of other creditors, that the court will generally prefer to limit the initial borrowing under the DIP facility during the first 30 days of the CCAA proceedings5. In order to ensure that the debtor has sufficient funding during this period, care must be taken to ensure that the cashflow projections accurately reflect the debtor’s needs as well as any unforeseen difficulties which may arise. The existence of other secured debt and the nature and value of the debtor’s security will also affect the terms and conditions of the DIP financing. In cases where there are unencumbered assets or assets exceeding the value of the secured debt, the terms on which the DIP financing is provided may be less restrictive and the fees associated with the financing may also be less. If, however, there are assets of diminishing or uncertain value, the debtor may find that the terms of the DIP financing are more cumbersome and the interest rates and fees imposed by the DIP lender are akin to rates charged on high risk loans. The nature and value of the assets will also affect the security position which the DIP lender will require in order to provide the financing.6 The court orders that approve the provision of DIP financing and establish the DIP Charge generally provide that the DIP Charge does not need to be registered in accordance with provincial personal property security legislation (“PPSA”) in order for it to be effective against other creditors or a trustee in bankruptcy. The DIP lender may, however, decide to register a financing statement to protect its security position in any event. The decision to complete a PPSA registration will depend on, among other things, whether the DIP lender is an existing lender, whether the DIP lender is likely provide the exit financing, and the jurisdiction where the proceedings have been commenced. The jurisdiction and registration issue is of biggest concern in the Province of Quebec, where there is some uncertainty as to whether an unregistered court ordered DIP Charge can effectively grant the DIP lender a security interest in the debtor’s collateral, despite the Court order. The DIP lender will always require provisions in the DIP term sheet that provide them with information about the ongoing operations and financial position of the debtor. This information allows the DIP lender to assess the progress of the debtor towards a restructuring and the continued viability of the lender’s exit strategy. For this reason, the DIP lender requires real time information about any changes in the management of the debtor, the sale of assets or the closure of any operations, and will often request that the initial CCAA order specify that the DIP lender be consulted (or in cases of an existing lender acting as DIP lender, grant its prior 5
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See for example, Re Ivaco Inc. (September 16, 2003), Farley J. (Ontario S.C.J.) and Royal Oak Mines Inc., Re (1999), 6 C.B.R. (4th) 314, 1999 Carswell Ont 625 (Ont. Gen. Div. [Commercial List]). A discussion of the financing that can be provided by other stakeholders is set out in further detail in the section on “Negotiating the Security Position of the DIP Charge”.
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approval) before any such actions are taken by the debtor. The DIP lender may also place restrictions on such things as inter-company transactions and payments to the directors and officers of the debtor to ensure that the security position of the DIP lender is not unnecessarily eroded, and to ensure that the financing is not used in a manner that is not beneficial to the restructuring. (c)
Negotiating the Security Position of the DIP Charge
The initial order that is obtained by the debtor in respect of its restructuring under the CCAA will establish a number of charges against the debtor’s property, assets and undertaking, including an administrative charge, a directors’ and officers’ charge and a DIP Charge. The security position of the DIP lender is often the subject of intense negotiation and debate, particularly where the DIP lender is a third party lender and wants as high a ranking of a “super-priority” charge over the debtor’s assets as it can possibly get. It is rare that the DIP lender’s security will rank in absolute first priority over a debtor’s assets. Generally, the “administrative charge” which secures the unpaid balance of any fees and expenses (and other liabilities should there be any) of the monitor and any professionals retained by the debtor, will be the highest ranking court ordered charge established in an initial CCAA Order. The most common “battle” generally arises in respect of the relative ranking of the DIP Charge and the charge that is generally established to protect the directors and officers of the debtor from incurring any additional liability in their furtherance of the CCAA restructuring (the “D&O Charge”). Even the most well-meaning of directors will want to maximize the protection that can be achieved under a D&O Charge as they head into a CCAA restructuring. As such, there will be great pressure to have the D&O charge: (a) rank ahead of the DIP Charge; (b) encompass in its terms as expansive a time period (i.e. pre-filing as well as post filing) and as broad a scope as possible; (c) maximize its dollar amount; and (d) make it available to the directors without regard to existing policies of directors’ and officers’ insurance. The points of contention between a DIP lender and a company’s directors are obvious. Not uncommonly in recent CCAA filings, the DIP charge is split – either by subject matter (i.e. post filing liabilities) or by quantum – such that a portion of the D&O Charge would rank in priority to the DIP Charge, and the balance would rank in a subordinate position, but still be ahead of existing secured creditors. The priority of the DIP charge is not the only matter that has been the subject of significant negotiation and debate in recent CCAA restructurings. Another issue for DIP lenders and other secured creditors of the debtor is the desire for cross-collateralization of the DIP loan in circumstances where the filing is being made by a group of related entities, each of which has a different financial circumstance. The creditors of a particularly healthy and (relatively) assetrich entity may complain that their company’s assets should not be used as collateral for a DIP loan to the corporate group as a whole, since that will unfairly degrade their positions as creditors to the benefit of creditors of other affiliated entities.
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Existing DIP lenders may in some circumstances use a DIP loan and/or a DIP Charge to improve their existing security position, either by making it a condition of the DIP loan that the DIP Charge also secure the creditor’s existing position, or that the debtor continue to pay down the creditor’s existing facility by way of DIP loan advances during the course of the restructuring. These conditions allow a lender to improve its position by: (i) gaining courtordered security over any assets of the debtor company which it did not previously have security over; (ii) negating any problems (such as flawed PPSA registrations or flawed security documentation) with existing security by means of the DIP Charge; or (iii) paying down the existing (problematic) position with a well secured DIP loan (which also has the benefit of keeping the existing loan as a performing loan on the books of the lender). In the CCAA proceeding in Air Canada, the DIP term sheet required that the DIP Charge ordered by the court secured not only the financing to be provided by the DIP lender, but also the obligations owing to an affiliate of the DIP lender in respect of various aircraft leases.7 What is more interesting is that while Air Canada negotiated such significant DIP financing and supported the collateralization of the affiliated aircraft lease position as a necessary condition of the financing being imposed by the DIP lender, Air Canada barely drew upon its DIP facility during the course of its restructuring. (d)
Using DIP Financing as Marketing Tool during the Restructuring
In the time period preceding a filing under the CCAA, the debtor’s cashflow is often restricted by the availability formulas under its existing credit facilities. At the same time, suppliers begin to impose cash-on-delivery or cash-in-advance terms, or worse, require pay downs of existing debt levels before any further goods will be supplied. At the commencement of CCAA proceedings, to the extent that they have not already done so, suppliers will often seek to impose cash-on-delivery terms upon the debtor which will have the effect of causing an immediate drain on the company’s already strained cash position. The provision of DIP financing not only provides the debtor with cash availability critical for its operations during the restructuring period, it also has the ancillary benefit of bolstering customer and supplier confidence about the likelihood that they will get paid should they advance credit to the debtor company for goods and services delivered during the restructuring. This comfort may allow the debtor the latitude to negotiate with customers of suppliers to ease off on the restrictive payment policies instituted prior to the CCAA filing, and provide the debtor with greater cash flow to fund its ongoing operations. The customers will also have more confidence in the debtor’s ability to remain in business, at least in the short term, and continue to purchase products and services in the hopes of the debtor surviving and remaining a customer (and source of future profits) of the supplier after a successful restructuring.
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See the April 1, 2003 commitment letter from General Electric Canada Inc. in Air Canada, Re (2003), 2003 Carswell Ont 1220 (Ont. S.C.J. [Commercial List]).
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II.
FINANCING FROM OTHER STAKEHOLDERS
As an alternative to, or a condition of, a lender providing DIP financing, a debtor may also obtain certain credit facilities and other financial accommodations from its key suppliers and/or its key customers which will improve the debtor’s cash flow position during its restructuring. Financing received from suppliers and customers is generally not in the form of a line of credit or other formal credit arrangement, but results instead from a change in the manner in which the parties conduct business with one another. The debtor will often seek longer payment terms from suppliers during a restructuring. The increased time in which the debtor has to make payments for goods and services required for its operations allows the debtor to have more cash flow available with which to fund other aspects of its business and restructuring. This may also have the effect of decreasing the debtor’s reliance on other, more expensive forms of financing. Where a debtor has multiple sources of supply of a particular input, and has the financial support of a DIP loan, the debtor can often use the offer of increased levels of future business as an incentive to its suppliers to provide credit terms during a restructuring. The debtor can also attempt to improve its cash flow by obtaining financing from its customers, which is often accomplished by the debtor and the customer entering into an accommodation agreement, which has become the norm in the automotive industry. This type of agreement obligates the debtor to continue to produce the customers’ products (and, if so funded by the customer, to build additional inventory banks for the customer in case the restructuring is not successful), and also obligates the customers to accelerate the payment of their pre-filing accounts receivable without set-off, and to continue to purchase products from the debtor on a cash-on-delivery or cash-in-advance basis for a fixed period of time. An accommodation agreement can also provide that the customer will purchase the raw materials required by the debtor to produce the customers’ products. This has the benefit of allowing the debtor to avoid funding the up-front costs of production while still obtaining payment for the finished product (less the cost of the raw materials) in a timely manner. Given the need for continued and continuous just-in-time delivery in the automotive sector, lenders to automotive manufacturers are keenly aware of the leverage that they hold over the customers of a debtor company by the threat of a shut down of manufacturing activities. This can provide the debtor with a considerable boost to its cash flow during a restructuring. In many cases, if the lender is sufficiently secured, and the component manufactured by the debtor company is essential enough, the lender can transfer much of the risk associated with the debtor’s restructuring over to the customer by merely threatening to liquidate the debtor. Recently, in the case of Greening Donald Co. Lid., the principal financial investors sought to petition the debtor company into bankruptcy, recognizing that its single
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largest customer (representing over 90% of Greening’s business), purchased an essential component of air bags used in the vast majority of automobiles manufactured in North America. Ultimately, the customer had to take the novel step of applying to the Court for an order pushing Greening into CCAA proceedings and approving a DIP loan from the customer on a DIP Charge priority basis.8 It is noteworthy that the customer was not a creditor of Greening but in fact owed Greening approximately $2 million for goods supplied – sufficient monies to fund Greening through the initial stages of its CCAA proceedings. Had the customer simply accelerated payment of its receivable, the customer would have lost any leverage or control it had as DIP lender, and would also have lost its set-off rights in respect of the amounts owing to Greening. Ultimately, the other creditors of Greening negotiated for an accelerated payment schedule for the customer’s receivables in order to reduce the amounts required by Greening under the DIP loan. DIP loans can also be advanced by prospective purchasers of the business under CCAA protection. For example, in the CCAA proceedings of Hemosol Corp and Hemosol LP, the company’s existing lenders advanced a DIP loan during the marketing process for the Hemosol business. However, when the successful bidder began to encounter delays in negotiating a number of ancillary arrangements which were conditions of its offer, the principal lender refused to advance any additional amounts to fund the monthly cash burn of the business (and the professionals) while the bidder continued with negotiations, and also refused to be primed by any additional DIP financing. As such, rather than lose the bid and see the Hemosol assets go into liquidation, the bidder agreed to advance a second DIP loan, subordinate to both the existing DIP Loan and the principal lender’s existing position. One of the most creative non-traditional DIP lending strategies employed in recent years involved the acquisition of the Hamilton Specialty Bar (“HSB”) division of Slater Steel Inc. (“Slater”) in 2004. During the course of the Slater CCAA proceedings, Slater had unsuccessfully attempted to find a going-concern buyer for the HSB division. In part because of certain issues relating to the HSB collective agreement, not the least of which was the significant shortfall in the hourly workers’ pension plan, no parties were interested in buying HSB as a going concern. However, a party did come forward with an offer for the assets which provided that, following the acquisition of the assets by the purchaser, Slater would continue to operate the HSB business and employ the hourly employees for a period of time while the purchaser negotiated a revised collective agreement, with the HSB union and also a resolution of the pension issues with the union and the Financial Services Commission of Ontario (“FSCO”). During this negotiation period, the purchaser did two unique things: it completely funded the costs to Slater of operating the HSB business (including significant protections for employeerelated director liabilities for Slater directors), and second, the purchaser (a single purpose entity) itself went into CCAA protection immediately upon acquiring the assets from Slater, and itself 8
See the November 17, 2006 commitment letter from Autoliv Asp, Inc. in Greening Donald Co. Ltd. et al. (November 17, 2006), 06-CL-6738 Lederman J. (Ont. S.C.J.).
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obtained a DIP loan from a company related to it (the “New DIP Lender”). By putting such a structure in place, the purchaser was able to avoid becoming a successor employer by keeping the business operating under the Slater legal entity with the purchaser’s assets on loan, and because the purchaser itself was insolvent from the outset, the threat of an asset liquidation by the New DIP Lender remained throughout the purchaser’s negotiations with the Union and FSCO, if satisfactory arrangements could not be reached. Once acceptable pension and collective agreement amendments were agreed upon, the New DIP Lender effected what amounted to a judicial foreclosure of the HSB assets, and ultimately became the new HSB operating entity. As can be seen from the foregoing anecdotal examples, the uses, sources and strategies of DIP loans in CCAA restructurings can be as limitless as the imaginations of the insolvency professionals and financial stakeholders who structure them. By keeping this kind of flexibility in mind, a restructuring professional can achieve much more than simply “keeping the body alive” while the restructuring takes place around it. By managing, and in some cases completely skewing the business dynamics in a restructuring through an appropriate DIP loan structure, the chances of a successful outcome for all stakeholders can be greatly increased.
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