Debtor in Possession Financing Trends in the United States – Equity-Based Terms and Fees

Debtor-in-possession (DIP) financing is a specialised form of lending available to debtors in US Chapter 11 proceedings. Given the unique nature of these loans and their importance to a debtor’s restructuring, they are subject to stringent statutory requirements under the Bankruptcy Code and bankruptcy court approval. Although DIP loans share many features with regular-way debt instruments, debtors and their lenders often negotiate bespoke terms that reflect the unique risks and circumstances involved in extending credit to a Chapter 11 debtor.

For example, in certain situations, parties negotiate DIP terms that seek to use reorganised equity – that is, equity of the reorganised company – to compensate or incentivise the DIP lenders to provide the loan. Lenders may seek or demand equity-based compensation in situations where they want to capture potential equity upside in the reorganised debtor or effectuate a “loan to own” strategy. From the debtor’s perspective, equity-based terms often reduce the amount of cash required to fund the debtor’s restructuring and emergence from bankruptcy.

Despite these potential benefits, courts and objecting parties often scrutinise such terms and raise concerns that they provide outsized or “off-market” returns to DIP lenders or constitute inappropriate end-runs around safeguards imposed under the Bankruptcy Code. Recent cases involving these terms have attracted significant market attention and underscore the disparate outcomes that can result when debtors seek approval of such provisions.

This article provides an overview of common structures equity-based terms can take, including illustrative examples and situations where objections or issues were raised by the court or other parties in interest.

One common structure is DIP loans that are convertible into reorganised equity in lieu of cash repayment. The conversion feature can be automatic or discretionary (at the debtor’s or the lender’s option) and may convert at a rate equal to the reorganised equity’s estimated value as set forth in the debtor’s Chapter 11 plan (“plan value”), at a discount to plan value, or at a fixed valuation. 

For example, in Grupo Aeroméxico, SAB. de CV’s bankruptcy cases, the court approved a DIP that included an USD800 million tranche of loans convertible at each DIP lender’s option into equity at plan value or any lower valuation offered to a third party. Neither the court nor any party in interest objected to the inclusion of the conversion feature during the DIP approval process, likely due to the fact that the conversion was structured at plan value or at a discount set through the plan confirmation process, and was therefore subject to the procedural safeguards provided under the Bankruptcy Code. 

In Avianca Holdings SA’s bankruptcy cases, the court approved a USD722 million tranche of DIP loans convertible at the debtors’ option into at least 72% of the fully-diluted reorganised equity at an 8% discount to plan value. Although the Avianca DIP included a fixed discount to plan value, the debtors’ subsequent exercise of the conversion feature was subject to stakeholder objection and court approval during the confirmation process.  Pushing the fixed-discount concept further, LATAM Airlines Group SA sought approval of a DIP that included a USD1.15 billion tranche of loans convertible at the debtors’ option into reorganised equity at a 20% discount to plan value.  Multiple creditors objected to the proposed DIP, including on the basis that the proposed equity conversion feature amounted to a sub rosa plan that improperly circumvented the Bankruptcy Code’s confirmation requirements. The bankruptcy court agreed with the objectors and denied the DIP, reasoning that the conversion feature fixed important terms of any future plan of reorganisation without any market test, oversight, or the requirement for subsequent court approval.

Finally, SAS AB recently obtained approval of a DIP in its Chapter 11 cases that granted its DIP lender the option to convert its loans into equity at a rate tied to a fixed total enterprise value of USD3.2 billion. Additionally, the DIP lender was granted a “tag right” that allowed it to subscribe for up to 30% of the reorganised equity on the same terms made available to any third party. Although the court expressed concerns about the propriety of distributing reorganised equity outside of the plan confirmation process, especially in light of the LATAM decision, it ultimately approved SAS’s DIP on the basis that: 

In addition to conversion features and related rights, DIP lenders sometimes also seek fees payable in reorganised equity. To date, equity-based fees appear to draw less scrutiny from bankruptcy courts than convertible DIP loans. That said, courts and parties in interest may question the reasonableness of such fees, and will analyse whether such fees provide outsized or off-market returns to DIP lenders. 

Most recently in Lumileds Holding BV’s Chapter 11 cases, the debtors sought approval of a DIP that reserved 57.7% of the reorganised equity to satisfy certain DIP and exit facility fees. The bankruptcy court initially questioned the participation fee of 36.7% of the reorganised equity as off-market, especially because the DIP also provided for a backstop fee, but was persuaded to approve the fee after hearing testimony that such fees should be viewed in light of the DIP-to-exit structure and that the amount was comparable to fees in similar facilities.

It is likely that equity-based DIP terms will continue to proliferate as stakeholders seek creative ways to use such provisions to achieve their objectives while overcoming objections or concerns from the court or stakeholders. As Judge Wiles noted with some concern when he approved the DIP in SAS, “I worry that when we open the door to the inclusion of equity options in DIP financing agreements we almost guarantee that we will have these issues in future cases.”