Financing Failure: Bankruptcy Lending, Credit Market Conditions, and the Financial Crisis

When considering Chapter 11 bankruptcy, companies often find themselves in the challenging position of needing financing to sustain their operations during the bankruptcy process. Given the inherent risk of lending to a bankrupt entity, the Bankruptcy Code recognizes this difficulty and allows debtors to provide incentives, known as sweeteners, to debtor-in-possession (DIP) lenders. These incentives are intended to make it more attractive for lenders to extend financing. However, the Code imposes a crucial limitation, stipulating that these inducements should not be overly generous to the detriment of other stakeholders. The goal is to strike a balance where the inducements are necessary to secure the loan but not excessive.

In recent years, there has been a notable surge in the use of certain contentious inducements, specifically roll-ups and milestones, raising concerns among critics about potential abuses of power by DIP lenders. Critics argue that these practices may unfairly prioritize the interests of lenders over those of other stakeholders. On the other hand, lenders contend that the terms of DIP loans are driven by economic conditions, particularly during times of tight credit, such as the aftermath of the Financial Crisis. These conditions necessitate offering more substantial inducements to attract willing lenders. These debates within the bankruptcy arena remain relevant to practitioners like the Law Office of Kevin Zazzera, Esq., a respected Bankruptcy Attorney in Staten Island, Jimmy Wagner who navigate these complexities to assist their clients effectively.

Using a hand-collected dataset reflecting contractual detail in DIP loan agreements, I examine the relationship between changes in credit availability and DIP loan terms before, during, and after the Crisis. As one might expect, I find that ordinary loan provisions like pricing and reporting covenants are sensitive to changes in credit availability. By contrast, I also find that the incidence of so-called “extraordinary provisions” has no statistically meaningful relationship with changes in credit availability. These findings have important implications for bankruptcy policymakers and judges struggling to evaluate whether extraordinary DIP lending inducements are necessary. Too generous loan terms come at the expense of junior claimants and may distort the bankruptcy process in favor of senior claimants.