The Past, Present and Future of Debtor-in-Possession Financing

Chapter 11's distinctive post-petition financing rules trace their ancestry back to the origins of large scale corporate reorganization in America in the nineteenth century. In this sense, post-petition financing has always been with us. But in the past decade, the role of the financers has changed. After a century in the shadows, post-petition lenders have stepped onto center stage. The DIP loan agreement has become the single most important governance lever in many large Chapter 11 cases. Why have these formerly bashful financers suddenly started hogging the spotlight? I argue in this article that the generous terms offered to DIP financers have encouraged lenders to make loans to cash-starved debtors, and that these lenders have used their leverage to fill a governance vacuum that was created by the enactment of the 1978 Code. Prior to the New Deal, J.P. Morgan and a handful of other Wall Street banks dominated the governance process when large companies were reorganized. The New Deal reformers kicked the Wall Street banks out in 1938, and required that a trustee be appointed to run the debtor's business in large reorganization cases. When the 1978 Code eliminated the mandatory trustee requirement, it left a governance void in Chapter 11. After creditors were burned in a number of post-1978 cases, bank lenders began using their post-petition financing agreements to rein in debtors' managers, and to influence the course of the reorganization process. After recounting this history in Part I of the Article, I describe the current DIP financing arrangements in Part II. There are two general kinds of DIP loans. In most cases, the DIP financing takes the form of a standard loan. By structuring the loan as a revolving credit agreement, and imposing strict conditions on each new round of financing, the lender is assured that it will have significant leverage over the debtor's managers' decision-making throughout the Chapter 11 case. I call these arrangements loan-oriented DIP financing. I refer to the second type of DIP financing arrangement as loan-and-control financing. In these cases, the DIP loan is used to transfer control to the DIP lender itself, either through a sale to the DIP lender or as the intended outcome of the Chapter 11 reorganization. Although DIP lenders have improved Chapter 11 governance in the past decade, there are significant grounds for concern as well. I explore these concerns in Part III. With loan-oriented DIP financing, the principal concerns are that the lender may have too great an incentive to force the debtor to liquidate assets, due to the lender's priority status; and that the lender will use the post-petition loan to improve the status of loans it extended prior to bankruptcy. The principal danger with loan-and-control transactions is that the lender will use the DIP financing agreement to divert value from general creditors or stymy other, competing bids for control of the troubled company. I offer a variety of proposals for counteracting these problems. Courts should refuse to permit provisions that protect a pre-petition loan, for instance; better yet, the pre-petition and post-petition loans should be separated, and the pre-petition portion paid last. With loan-and-control transactions, I argue that provisions that could chill alternative bids should be subject to at least as much scrutiny as anti-takeover devices receive outside of bankruptcy. I also argue that claims trading is often a superior mechanism for transferring control, and should be encouraged by reducing some of the frictions that interfere with the market. Part IV concludes the Article by very briefly describing some of the implications of the analysis for other jurisdictions.