A sophisticated business has emerged to provide liquidity by way of distressed loans, debtor-in-possession financing and existing financing.
Distress financing flourished as a niche that offered greater returns, larger fees and often a high degree of protection by way of a court-ordered first priority charge. With little real perceived risk and premium returns, many lenders entered the market; and with few big insolvencies, distressed debtors were
flush with choice.
This liquidity clearly benefited the restructuring process. Fresh capital plays a critical role in insolvency:
• it gives the debtor the necessary liquidity to explore and maximise its opportunities during the insolvency process - such as a going concern sale or a restructuring of its operations or balance sheet;
• strong lender support also signals to suppliers and customers that the debtor's business is stable and has the necessary financial support to continue despite its filing. It provides comfort to the market, which can restore the debtor's trading terms, and thereby increase liquidity and drive financing costs down; and
• liquidity is often needed to facilitate a plan to restructure and recapitalise the debtor's balance sheet on emergence. New capital is a useful means to compromise existing indebtedness and restart the debtor's enterprise on a strong footing.
Debtor-in-possession (DIP) financing, the terminology borrowed from the US, was ubiquitous and became the norm with facilities in excess of US$1 billion arranged quickly and easily. However, all of that came to a sudden halt in early 2008. The US$1 billion DIP facility to Quebecor World Inc in January 2008 was likely the last of the old-style DIP loans (Quebecor World filed for protection in Canada and the US).
As the world faces a severe economic downturn, credit has become scarce and insolvency financing has dried up. Indeed, given its somewhat exotic (risky) nature, insolvency financing has perhaps suffered disproportionately. Thus, at the moment when insolvencies are starting to increase exponentially and DIP financing is most needed, credit for distressed companies has largely disappeared.
This absence of liquidity is already being felt. What was once a robust DIP lending market has shrunk to a handful of participants. Distress lenders are largely sitting on the sidelines or have left the game altogether. The consequences of this credit crisis for corporate insolvency are stark, as explored here.
MORE PRE-EMPTIVE FILINGS
When it becomes clear to distressed companies that they will be unable to access capital during a restructuring, they will be forced to file early. A prudent distressed company will file for protection while it still retains sufficient capital to preserve its business operations and fund its insolvency process.
Preservation of capital has become paramount to the insolvency process, recognising that additional capital is unlikely to be available. The result is pre-emptive filings. Companies cannot afford to exhaust every opportunity and then file secure in the knowledge that they will be financed. Since preservation of capital is critical, we can expect filings to be precipitated by cash events, such as a scheduled payment of interest or principal of debt.
For example, on 14 January 2008, Nortel Networks filed for protection in Canada, the US and England, the day before its interest payment of US$107 million was due to be paid. The company had cash on hand of US$2.4 billion, but chose to file for protection. As the affidavit filed by Nortel in support of its Canadian application for court protection noted:
"With no current access to the capital markets and the prospects of the capital markets opening up in the near term being very dim, substantial interest carrying costs (including the 15 January interest payment) on over US$4 billion on unsecured public debt, and significant pension plan liabilities that are expected to increase in a very substantial and material manner principally due to the adverse conditions in the financial markets globally, it has become imperative for the Nortel Companies to protect their current cash positions by seeking relief in both Canada and the United States."
The company needed to ensure that it had the capital to see it through the process. In the absence of a third-party lender, that meant filing well before an actual liquidity shortage.
In a different credit environment, companies like Nortel Networks may have had the luxury to delay a filing while exploring other solutions.
In the absence of funding, many distressed companies will be forced into immediate liquidation once they file. Debtors that do not exercise sufficient foresight will find themselves hitting a hard wall: payrolls cannot be met, taxes cannot be remitted, and pension contributions cannot be made. Given prospective director liability, operations may have to cease suddenly and immediately. One such example is Zoom Airlines, a Canadian discount transatlantic carrier, which was forced to file for creditor protection in Canada and Britain when its creditors refused to give Zoom any more time. Thousands of travellers were stranded at several airports when all flights were abruptly cancelled and bankruptcy proceedings commenced. Zoom attempted until the day it grounded its fleet to secure a financial lifeline that would keep its aircraft flying.
Forced liquidations mean that businesses will literally disappear. For example, Circuit City and Linens ‘n Things, once household names, look as if they may vanish. Even if there is a core business with good stores, credit is needed to finance a purchase, restart, or both. That credit is simply not available.
While many insolvency practitioners are anticipating a boon of work from this economic crisis, early signs are that many filings will be over very quickly. After the flurry leading to the initial attendance, there is an immediate liquidation with the proceeds going to the first place lenders. There are few real issues and no money over which to fight. Crumbs cannot feed a feeding frenzy.
MORE RELATIONSHIP LENDING
It is now clear that where once DIP lending was the domain of specialty lenders, the preponderance of insolvency financing (for the short term at least) will come from existing stakeholders. Financing is now being provided by those who have to provide financing. These lenders are providing liquidity because they already have a relationship and their recoveries are directly at risk.
In other words, we can see that the motivation for the distress financing that is taking place is not solely fees and rates. There are often more compelling reasons for making the credit available. Having said that, the price of lending has gone up significantly as supply has decreased and demand multiplied.
For example, in the case of Tribune Company, Barclays Bank provided the necessary financing by keeping its operating lines open. Similarly, in the case of Circuit City, while the lending syndicate agreed to extend its facility post-filing, there were no other prospective lenders. To obtain the DIP facility, the DIP lenders required a broader security and cross-collateralisation.
Existing lenders will continue the facility post-filing where it is necessary to preserve the assets and maximise recoveries. In other circumstances, financing is obtained from equity holders or the government (as in respect of the US auto industry).
LEND TO OWN
Similarly, some financing is being provided by lenders who see insolvency lending as an opportunity to buy the assets of the debtor at an opportunistic value: hence, the rise of "loan to own" lenders. These lenders are prepared to advance a DIP loan, not necessarily for the returns, but rather in anticipation that they will be able to bid their debt at some juncture in the proceeding and, absent a higher bid, take over the company. If the debtor company successfully restructures and repays the DIP loan, so be it. If the debtor company cannot, then the DIP lender takes the business for the price of the DIP loan.
In the absence of credit, companies will have to restructure their businesses more quickly and plan to emerge from insolvency protection while they still have the funds to do so. We can expect lenders to insist upon shorter timetables for sales processes, bar notices and the preparation of a plan. Complex restructurings require substantial capital for long periods - something simply unavailable now.
Indeed, one can anticipate a greater premium on resolving the issues of a distressed company outside of the formal bankruptcy process so that the delays and fees associated with a formal court restructuring are avoided. In Canada, two large forestry companies, Tembec and Ainsworth Lumber, recently reorganised outside of an insolvency filing. Many other such restructurings are concluded without mention in the financial press.
However, there is a counter-tension. With the expanse of credit markets in the past decade, many new players, including specialty lenders or private equity firms, are now key stakeholders. Debtor companies are highly leveraged with more debt on their balance sheet and more complicated lending arrangements, with various levels of debt and various asset classes supporting different security. This may lead in certain cases to enormous complexity and possibly acrimony as creditors struggle to preserve their recoveries. In addition, non-traditional lenders who have not diversified may find themselves in a position in which they cannot afford to take the loss that they are facing. This is a recipe for irresolvable stakeholder conflict.
In addition, debtor companies that were planning to emerge from insolvency protection will find it difficult to obtain the financing that they had anticipated or planned upon, or both. Thus, while shortening some restructurings, the current credit crisis will unnecessarily exacerbate and prolong others.
At the end of the day, until the credit markets, especially in the insolvency process, are normalised, we can expect sub-optimal outcomes from restructurings. Debtor companies will not have the resources to pursue the best available opportunities. In this prevailing climate, debtor companies need to act quickly and decisively and to remember that, above all, as the never-more-true cliché goes: cash is king.