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

Abstract

When contemplating Chapter 11, firms often need to seek financing for their continuing operations in bankruptcy. Because such financing would otherwise be hard to find, the Bankruptcy Code authorizes debtors to offer sweeteners to debtor-in-possession (DIP) lenders. These inducements can be effective in attracting financing, but because they are thought to come at the expense of other stakeholders, the Code permits these inducements only if no less generous a package would have been sufficient to obtain the loan.

Anecdotal evidence suggests that the use of certain controversial inducements — I focus on roll-ups and milestones — skyrocketed in recent years, leading critics to question whether DIP lenders were abusing their power. Lenders, however, respond that DIP loan terms simply reflect economic conditions: When credit is tight, as it was in recent years because of the Financial Crisis, more sweeteners are needed to induce lending.

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.

Keywords: bankruptcy, debtor-in-possession financing, reorganization, Financial Crisis, extraordinary provisions, roll-up, milestone

JEL Classification: G33, G32, G20