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Chapter 11 Reform: Proposed ‘Adequate Protection’ Recommendation Hurts Retailers

Date: Apr 06, 2015 @ 07:00 AM
Filed Under: Bankruptcy

The analysis becomes even more troubling in the context of other financing offered to retailers. For example, retailers often supplement their asset-based loans with secured cash-flow loans for additional liquidity. Lenders who provide both asset-based loans and secured cash flow loans typically take blanket security interests in all assets of the borrower.  The total leverage (asset-based loans plus cash-flow loans) is generally limited by a metric that proxies for the “going concern value” of the company (e.g. multiple of EBITDA). Absent negotiated cure rights, an Event of Default is triggered when leverage exceeds “going concern value.” This structure makes sense from an underwriting perspective, as the lender’s exit in a downside scenario involves selling the company as a whole. However, this logic must be reevaluated in a world where adequate protection is calculated at “foreclosure value.”

Market Reaction

If the adequate protection recommendation is implemented, it is not difficult to predict the lending market’s reaction. Secured lenders would underwrite loans that provide less incremental liquidity, as advances would be tied to “foreclosure value” of collateral. In the asset-based lending context, even if initial advances are tied to other metrics (e.g. NOLV), lenders would still take protective measures in the event of a downside scenario. These measures include implementing additional borrowing base reserves or reducing advance rates on inventory. Cash flow loans would also provide less incremental liquidity, with total leverage likely tied to metrics other than proxies for “going concern value.” In addition to liquidity constraints, new loans would have higher pricing and more restrictive structure, especially in the beginning stages of this new regime. Restrictive structures may include unfettered discretion (instead of commercially reasonable discretion) to alter advance rates or borrowing base reserves.  Lenders may also impose higher availability blocks or other means of suppressing liquidity. 

Importantly, while the Commission’s recommendations are certainly not lender friendly, it is not lenders who will suffer the most under this framework. Lenders will find ways to operate in most environments, taking protective measures as to liquidity, pricing, and structure. However, retailers in distress or turnaround mode will not enjoy the same fate. The liquidity runway needed to turn around a retail business will be cut short. As a result, retailers will face more bankruptcies, restructurings, and liquidations – and these events will arise sooner than under the existing bankruptcy framework. Borrowers operating on the razor’s edge, who previously could have executed a turnaround plan, will incur the increased costs (and other unpleasantness) associated with these events.  Admittedly, the adequate protection proposal would make it easier for new lenders to provide DIP financing. However, this new DIP financing – coupled with an existing loan tied to “foreclosure value” – would not create more liquidity than under the existing framework. Lenders are only willing to advance against collateral up to an asset’s projected recoverable value. Having multiple lenders involved in financing a debtor does not change this rule. If anything, bankruptcy cases would become longer and more expensive as a result – priming DIP financings are not for the faint of heart.

The Commission’s recommendations were intended to benefit debtors but ignored the fact that markets are dynamic. Industry participants react to changes in law, and this is especially true in a banking or lending environment. If the adequate protection recommendation is implemented, secured lenders’ focus on capital preservation will remain unchanged – but borrowers, especially retailers, will ultimately bear the brunt of the proposal’s unintended consequences.

Daniel P. Wilansky
Vice President, Chief Compliance Officer | Salus Capital Partners
Daniel P. Wilansky is the Chief Compliance Office at Salus Capital, responsible for providing legal, regulatory, and compliance guidance. In this role, Dan manages Salus' compliance with the Investment Advisors Act of 1940, other laws and regulations, and internal polices and procedures. Prior to joining Salus, Wilansky was an attorney at Ballard Spahr LLP, where his practice involved representing investment banks in the underwriting of tax-exempt bond offerings and lenders in a variety of commercial and real estate finance transactions. Before beginning a transactional practice, Wilansky completed a judicial clerkship at the Appeals Court in Boston. He holds a B.Mus. in Piano Performance from the University of Michigan and a J.D. and an M.B.A. in Finance (with honors) from Boston University. Wilansky is admitted to practice law in Massachusetts and Maryland.
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