AMERICAN BANKRUPTCY INSTITUTE

Value Maximization Through the DIP Budget: A Creditor’s Perspective

Committee: Financial Advisors and Investment Banking

Jorge Gonzalez

Province, LLC; Miami

Sanjuro Kietlinski

Province, LLC; Miami

Joseph Pack

PACK LAW; Miami

Jessey Krehl

PACK LAW; Miami

Unsecured creditors are often out-of-the-money or positioned to receive a pittance of a distribution by the terms initially proposed by chapter 11 debtors and the secured lenders who consent to the proposal. This is particularly true if an unpaid portion of secured debt looms as a deficiency claim, threatening to further dilute general unsecured creditor (GUC) recoveries. Advisors of creditors – or an unsecured creditors’ committee (UCC) on behalf of its constituency –   must be creative and assertive, acting as a consensus-builder to extract value for GUCs. This means understanding how to find or develop leverage through law and policy to apply pressure on stakeholders to obtain a more meaningful GUC recovery.

Each bankruptcy case generally requires a multi-faceted approach to maximize value and minimize the claims pool. For example, in cases predicated on selling the organization’s main asset(s), developing an independent valuation analysis, supplementing the sale process with potential bidders, and advocating for a more adequate timeline are typical efforts to increase the numerator of the recovery equation. In addition, the latter point (extending the milestones of a truncated sale process) may also permit the UCC to conduct a more fulsome investigation into potential causes of action, which could also lead to a creditor’s elevation in the capital stack by subordinating higher-priority claims.

Reducing the denominator of the recovery equation (i.e., the universe of allowed pari passu GUC claims), however, is an effective means to address recoveries, but it is often

overlooked. For example, when dealing with a hurried filing, the DIP budget (the allowance for debtor spend during the pendency of the case) may contemplate generous payment allowances when considering the debtor’s  rights under bankruptcy law. Creditors should be well equipped to assess the proposed budget and know which questions to ask. For example, how much does the DIP budget provide for lease liability? Are full cures budgeted? Is “stub rent” contemplated in the forecast? How are rejection damages calculated? How much is available for§ 503(b)(9) claims? Are critical vendor, tax, PACNPASA, and other administrative or priority claims contemplated? These questions, some of which are discussed in more detail below, should be considered – particularly when analyzing the DIP budget – to maximize creditor recoveries.

Lease Claim Considerations

The assumption of leases, as amended, can materially improve recoveries for holders of GUCs. Existing lease terms can sometimes be restructured to yield mutually beneficial economic outcomes. In today’s commercial real estate market, landlords are more apt to negotiate cure, term and overall lease structure, rather than risk being left without a tenant and potentially triggering co-tenancy clauses.

Likewise, lease rejection requires careful consideration. UCC advisors should conduct an independent “4-wall profitability analysis” to ensure that management has appropriately analyzed lease rejection at the store level. Lease-rejection damages, even as capped under

• 502(b)(6) of the Bankruptcy Code, could result in large unsecured claims. Further complicating the matter, different jurisdictions apply§ 502(b)(6) differently. Some courts limit the cap only to those damages resulting directly from termination of the lease (but not collateral claims),[1] while other courts have imposed the cap on all damages related to the lease contract (including rent, taxes, costs, attorney fees and other financial covenants).

[21 These nuanced statutory considerations impact the cost-benefit analysis of lease

assumption versus rejection and must, therefore, be accurately reflected in both the GUC pool and the proposed DIP budget.

The DIP budget must also contemplate the payment of stub rent. As with the varied treatment of lease-rejection damages, the priority and payment of stub rent is also dependent on jurisdiction, and in many cases, stub rent may represent the only viable source of recovery for a landlord. The UCC must, therefore, advocate for its inclusion in the DIP budget and ensure timely payment (or, at a minimum, that it be set aside).

Beyond the world of real property leases, there are a litany of issues that stakeholders must be equipped to assess, and proper assessment  thereof  may be the  difference between a recovery or none at all. These issues include§ 503(b)(9) claims, critical vendor status, and the priority scheme under the Bankruptcy Code more generally.

Regarding§ 503(b)(9) claims, by way of example, advisors must analyze governing contracts regarding the receipt of any goods in the 20-day lookback period. Whether governed by the Uniform Commercial Code or the CISG, shifts in risk of loss are seldom discussed or analyzed by UCC advisors but should indeed be examined. What precisely qualifies as “receipt” in the relevant jurisdiction to give rise to a priority§ 503(b)(9) claim is an independent analysis that must be conducted in respect of the goods in question and industry standards. A DIP budget that does not pay administrative claims on a timely basis (e.g., one that ignores legally required payments of§ 503(b)(9) claims) improperly places the burden of administrative solvency on unsecured creditors.

A recent phenomenon that UCCs have encountered is also the “reverse-engineered” DIP budget: a cash-flow forecast developed with the pretense of disclosing facial solvency, which upon closer examination reveals an administratively insolvent estate. To elucidate this stratagem, UCCs may investigate the DIP budget’s underpinnings by analyzing the underlying assumptions, and potentially even depose debtor representatives in respect of these suppositions.

DIP Legalities that Impact Recoveries

Among other leverage points that can generate recoveries are also those related to the provisions of the DIP credit agreement. For instance, does the DIP financing require valuable releases? Does it propose waivers of the debtor’s rights to the marshaling of assets, the “equities of the case” exception under§ 552(b), or the surcharge of collateral under§ 506(c)? If so, are these provisions appropriate? Does the DIP loan propose a roll-up of pre-petition debt, high effective interest rates and fees, and/or improperly placed super-priority liens?

Challenging releases and/or waivers with scope limitations and threatened litigation ensuing therefrom can provide important and meaningful value to stakeholders.

Policy Considerations: Taxes and PPP Loans 

Advisors must also remain current on changes in economic policy and regulations, as, on occasion, they may have a profound impact on a UCC’s ability to drive recoveries or, conversely, the debtor’s ability to discharge claims. This is especially true in the climate of the ongoing pandemic, where weighing government assistance and tax consequences has become increasingly important. Does the DIP budget account for policy benefits, such as net operating losses (NOLs) and/or Paycheck Protection Program (PPP) loan discharges?

On March 27, 2020, the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) was passed by the U.S. government, providing a $2 trillion economic stimulus package. Under

• 172 of the CARES Act, companies are permitted to carry back NOLs from 2018, 2019 and 2020 tax years to the previous five tax years and deduct up to 100% – an increase from 80%. For example, if a company generated NOLs in 2018, it may offset taxable income from 2013 through 2017, potentially resulting in a tax refund. Companies may evaluate using this legislation to amend 2018, 2019 and 2020 tax returns to include all losses, such as those on asset sales, inventory write-downs, or transfer-pricing adjustments, to  name a few.  In addition, certain bankruptcy accrual (noncash) damages, such as lease rejections, may potentially qualify, which could significantly increase tax refunds, depending on the case specifics. Further, UCCs must diligence PPP loan protection and investigate whether the grant of a PPP loan is forthcoming. PPP loan forgiveness is not a foregone conclusion simply because a formal insolvency proceeding was commenced.

The Price to Play

In short, a paramount condition for a UCC and its professionals must be that the debtor prove that it has sufficient funding to confirm its chapter 11 plan of reorganization and/or bankruptcy sale, and to conduct a post-sale wind-down (if applicable). A DIP lender must understand that chapter 11 is not a free process for its sole benefit. The DIP lender must be prepared to pay all administrative claims and finance a realistic sale process (if applicable) that paves the way to confirmation of a sale and/or plan. If it wishes to enjoy the protections under chapter 11 and its proposed DIP agreement, there must be a cost.

A debtor must also understand that to enjoy the financing required to file for bankruptcy protection, it too must protect the value of the estate for the benefit of all creditors. These issues must be addressed early in the proceeding if not by the debtor, then by the UCC and its professionals. To the contrary, the DIP lender may have fewer incentives to provide additional funding over the pendency of the case, or the debtor may simply not be able to confirm and effectuate the proposed plan or sale – obviating the very purpose of chapter 11.

[11 See, e.g., Kupfer v. Salma (In re Kupfer), 852 F.3d 853 (9th Cir. 2016).

[21 Cf. In re Mr. Gatti’s, 162 B.R. 1004 (Bankr. W.D. Tex. 1994).

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