The need for speed and common sense: rewriting s. 365(c) (2) to recognize the practice of prepetition agreements for s. 364 debtor-in-possession financing.

• Author: Pew, Derek N.

The era of the leveraged buyout (LBO) has passed, replaced by the age of the Chapter 11 filing.(1) In the 1980s, American companies engaged in a profligate exchange of debt for equity, spurred by the accessibility of capital for the acquisition and defense of corporate assets.(2) Eventually, however, huge debt servicing burdens, coupled with recent marketwide downturns and a concurrent dearth of refinancing capital,(3) proved too much for these companies to bear. Facing decreasing revenues, reduction of cash flow, and, consequently, frequent defaults on debt obligations,(4) these companies have been turning, in increasing numbers, to Chapter 11 protection from their creditors. The combination of the flood of general business Chapter 11 filings(5) and LBO failures has resulted in a dramatic alteration of the landscape of modern bankruptcy in the United States. Significantly, this increase in filings tests the ability of the Bankruptcy Code to respond to the financial and legal needs of these companies and their creditors.

Neither the general economic environment at the time of the principal redrafting of the Bankruptcy Code in 1978, nor that at the time of the 1984 amendments, bears much resemblance to the current bankruptcy environment.(6) Indeed, the current swell of corporate assets under Chapter 11 protection must have been unforeseeable to Code drafters for whom there was no hint of such an overwhelming future financial collapse.(7) And although much of the Code has demonstrated flexibility, and, to a certain extent, has been reformed by amendment where it has fallen short, the rapid changes in legal and financial approaches to the current Chapter 11 problem have demonstrated shortcomings, particularly in the area of large corporate and LBO failures.(8)

Most prominent among these shortcomings has been the confusion in the Code regarding the means available for accelerating the bankruptcy process. Speed in bankruptcy is important in several ways that are accentuated by the recent increase in business failures. For courts overburdened by bankruptcy filings,(9) speedier recoveries and quicker processes mean alleviation of crowded dockets. For certain debtors,(10) a speedy emergence from bankruptcy means swifter restructuring of debt and faster return to competition in the market, as well as a reduction in legal fees.(11) Finally, for creditors, speed means, all other things being equal, lower legal costs and quicker collection on loans that are in default.(12)

The desire for speed has focused lawyers' attention on developing new methods for handling clients' bankruptcy needs. At the forefront of these methods has been the use of prepackaged bankruptcies(13) and hybrids of them.(14) Concurrently, the desire for speed has changed the financial sector's lending habits by focusing banks' attention on the lending opportunities created by the increasing use of these accelerated bankruptcy processes.

In particular, there has been an increased emphasis by money-center banks on postpetition lending to large failing corporations.(15) Section 364 of the Code(16) sanctions certain loans that help debtors operate postpetition(17) by providing needed working capital. These loans help stimulate emergence from bankruptcy by allowing more normal business operation in the period before confirmation of a plan for reorganization.(18) To attract creditors who would otherwise be subject to substantial risk because of the lack of assets available for security,(19) these postpetition loans are frequently superpriority loans, in which courts offer priority over all existing creditors to the new lender. For new creditors, the loans offer comparatively short maturities and high up-front fees.(20) Consequently, many money-center banks that had excelled in leveraged buyout financing have shifted their emphasis to debtor-in-possession (DIP) financing.(21)

Although DIP financing plays a clear role in the Code as a postpetition vehicle, it is unclear what role it has prepetition. In practice, debtors may need to negotiate comprehensively for or agree to DIP financing prepetition.(22) Although, generally, prepetition executory contracts are assumable by the DIP to the extent that they bring value to the estate,(23) the Code does not allow such assumption of financial accommodation contracts.(24) Section 365(c)(2) of the Bankruptcy Code expressly prohibits the assumption or assignment of prepetition contracts made "to make a loan, or extend other debt financing or financial accommodations, to or for the benefit of the debtor, or to issue a security of the debtor ...."(25)

In a prepetition agreement for DIP lending, however, both the creditor and the debtor are clearly aware of the impending bankruptcy. Indeed, the bankruptcy filing is a necessary precondition to the execution of the DIP financing agreement. It is illogical, therefore, to require renegotiation of the financing agreement after the filing. Moreover, this renegotiation requirement undermines the effort to speed the bankruptcy process through prepetition planning. The novelty of these prepetition agreements, however, means that challenges to the provisions of section 365(c)(2) have only recently come before the courts. The struggle between a literal reading of the Code, which clearly prohibits assumption of these agreements, and a reinterpretation based on the realities of the marketplace is apparent. Courts faced with prepetition financial accommodation agreements made by the parties in anticipation of bankruptcy have drawn conflicting conclusions.(26)

In the most recent case on point, In re TS Industries, Inc.,(27) the court found that prepetition workout agreements extending financial accommodations postpetition to a bankrupt are "not the type of agreement[s] that [were] contemplated as being barred from assumption under section 365(c)(2)."(28) This decision came down just four days after the Ninth Circuit had determined that "[s]ection 365(c)(2) unambiguously prohibits the assumption of financial accommodation contracts, regardless of the consent of the non-debtor party."(29) Although the TS Industries holding may well be the desirable result in light of the current bankruptcy environment--a point that is argued in this Comment--the logic of the court is tenuous in the face of the plain language of the statute prohibiting the assumption of financial accommodation clauses.

This ambiguity provides impetus for amending or redrafting section 365(c)(2). Uncertainty as to whether or not the Code will be read literally creates risk-shifting problems for the creditor and debtor. Instead of one interpretation which clearly leaves the risk with one party, allowing that party to contract accordingly, the uncertainty of how the Code will be read pressures both the parties into entering contracts in which each must assume that the risk burden will fall on her. The uncertainty thereby creates systemic loss, because both parties must expend resources to protect against a single risk.

The risk to the debtor is particularly grave(30) because of the irreversible change of circumstance that filing for bankruptcy brings to the debtor's business. A debtor relying on its ability to assume the prepetition contract for DIP financing--either because it assumes that the statute will be interpreted to allow assumption (TS Industries), or because it believes that even if the statute is read to disallow assumption (literal reading), the market will force the creditor to make good on its promise to finance(31)--may find itself filing for bankruptcy only to find that its creditor is unwilling to extend financing, hiding behind the "nonassumability" language of the statute. While such a change of heart by a creditor may be unlikely in the current market,(32) as DIP financing becomes more prevalent and more competitive,(33) it is logical that money-center banks will take more risks to win financing agreements, particularly if DIP financing proves to be highly lucrative. This added risk-taking would presumably be in the form of pricing (either lower fees and rates or different structures of rates, such as fixed rates) and covenants (less restrictive or less inclusive), both of which are valuable to the debtor, and both of which expose the creditors to added lending risks.

Accordingly, as time goes by, competitive pressures should make lending for DIP financing more dangerous, increasing the probability of a creditor choosing to opt out of its prepetition agreement in the event of unfavorable market changes. Paradoxically, as time goes by, and the number of successful DIP financings increases, debtors are likely to grow more confident in their ability to rely on prepetition DIP financing agreements, regardless of the language or interpretation of the statute. The potential catastrophe is obvious: a large debtor will file for bankruptcy only to find that the financing it was relying on to assist in its emergence from bankruptcy is no longer available. Such a change in plans endangers the successful reemergence of the company from bankruptcy, consequently jeopardizing the well-being of that company's employees, suppliers and customers, and the communities it serves.(34) Clearly, the Code should be changed to reflect the reliance that debtors place on the assumability of prepetition agreements for DIP financing, and to reduce the costs associated with unclear risk allocation due to conflicting interpretations of the Code.

This Comment first explores the Bankruptcy Code provisions regulating DIP financing and compares the transactions contemplated by statute with the practical operation of the current DIP financing market. Next, the Comment offers a generalized case study of a distressed company and its interaction with lawyers and lenders to demonstrate the forces that have brought DIP financing agreements into prepetition. The Comment then turns to section 365, which contains the general...