Section 363 Sales and DIP Financing

With respect to sales of substantially all of the assets of the debtor in a section 363 sale, the Commission did recommend, among other provisions, that such sales not occur within the first sixty days of the chapter 11 case unless the proponent of a quicker sale can establish, by clear and convincing evidence, that the assets of the debtor will suffer a substantial diminution in value if the sale is delayed for the requisite sixty days. The existing secured parties’ unwillingness to fund the sale process will not constitute cause to shorten this mandatory waiting period. Similarly, “milestone” and similar provisions in DIP financing agreements and orders that would necessitate a sale prior to the expiration of the sixty-day period would be prohibited absent a similar showing. (Such extraordinary provisions would, however, be allowed in final financing orders entered after the 60-day period). This short moratorium will allow all stakeholders to review and weigh in on the proposed sale process, generate competitive bids, if any, and otherwise structure a process that maximizes value. Quick, emergency sales are to be the exception, not the norm.

Given the clear out for true emergencies, and the adequate protection requirements and attendant safeguards, secured party recoveries would not be diminished by these protections. Indeed, experience suggests that recoveries will increase for all stakeholders, including secured parties. While there may be some delay in realization of recoveries, this modest delay is a small price to pay for better, fairer results.

Redemption Option Value

The Commission’s ROV proposal, admittedly a work-in-progress, simply provides a mechanism, in the case of a sale of substantially all of the assets of the debtor or emergence pursuant to a plan of reorganization, whereby junior creditors can realize a return from any post-emergence increase in the value of the enterprise as long as the increase would be sufficient to cover the senior secured creditor’s allowed claim in full. In other words, when ROV is used, the “juniors” can obtain value only if the senior class (usually the fulcrum class) would be paid in full from the reorganization value of the assets and/or enterprise. If the concept is adopted, most practitioners anticipate that—where value of the option is likely—the secured party will be incentivized to buy out the option at emergence. Indeed, a market for ROV may also emerge.

ROV is the natural “other side of the coin” to the anti-Pine Gate provisions of the current Bankruptcy Code. Sections 363(k)(credit bidding) and 1111(b)(the option to elect to be treated as fully secured and capture appreciation), and related provisions, were designed to protect secured lenders from being crammed down when the collateral—for market or other reasons—was at its lowest value, with the debtor’s equity owners or other stakeholders later capturing the appreciation value when the market returned or conditions abated. ROV, in a post-claims trading, loan-to-own environment, similarly protects junior interests against the likelihood that a senior, fulcrum class (often a secured party) will acquire all of the debtor’s assets or value at a low point in the market or at an otherwise low valuation, with junior classes receiving nothing, only to have the valuation increase post-emergence.

Again, since the “option” only has and receives value when the senior class is or will be paid in full, ROV cannot by definition decrease secured lender recoveries. If such a lender decides to buy out the option, that lender presumably realizes the likelihood of such full payment.

The Report was three years in the making. We ask all interested parties, but in particular the lending community, to study the Report carefully and with an open mind. We are confident that a fair reading of the Report as a whole, with all of its balances and counterbalances, will support the view that it is far more lender-friendly than the early press has implied. The Commission’s hope was that the Report would generate discussion and consideration, as it has to date. We continue to welcome your input and suggestions as to how any of the recommendations may be improved.

Note: The views expressed in this article are those of the authors and are intended to spark a meaningful dialogue about chapter 11 reform. They are not attributable to the American Bankruptcy Institute or the ABI Commission to Study the Reform of Chapter 11.