Do Economic Conditions Drive DIP Lending?: Evidence from the Financial Crisis
41 Pages Posted: 24 Aug 2016 Last revised: 21 Sep 2017
Date Written: September 20, 2017
When contemplating Chapter 11, the first step for many firms is 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 highly effective in attracting financing. But because these sweeteners are thought to come at the expense of other stakeholders, the Code permits these inducements only if the judge determines that 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. DIP 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.
In this Article, I examine the relationship between economic conditions and DIP loan terms. Using a hand-collected dataset reflecting contractual detail in DIP loans, I study changes in DIP terms during the Crisis. As one might expect, I find that ordinary loan provisions like pricing and reporting covenants are sensitive to economic conditions. By contrast, I also find that so-called “extraordinary provisions,” often justified as necessary to induce DIP lending, have no statistically meaningful relationship with economic conditions. These findings have important implications for bankruptcy policymakers and judges struggling to evaluate whether the sweeteners extracted by DIP lenders are really necessary to induce lending.
Keywords: bankruptcy, debtor-in-possession financing, liquidation, restructuring
JEL Classification: G33, G32, G20
Suggested Citation: Suggested Citation