Pandemic Hope for Chapter 11 Financing

abstract. The pandemic revealed that the increasing complexity of debtors’ capital structure could supply much-needed competition in the Chapter 11 financing market, as other inside lenders increasingly challenge a debtor’s favored inside lenders. After discussing the benefits of this surprising development, the Essay identifies several impediments and offers strategies for removing them.

After Neiman Marcus, the luxury department store, filed for Chapter 11 in May 2020, two different groups of lenders vied to provide bankruptcy financing. Neiman’s managers had arranged a $675 million lending package with a group of its first lien lenders prior to bankruptcy and requested approval for that group to provide the financing at the outset of the case.1 Another investor group, which included Mudrick Capital Management and Third Point, quickly countered with a $700 million loan proposal.2 The competing investors offered a lower interest rate and a different strategy for resolving Neiman’s financial distress.3

Neiman’s choice of lenders for its operations in bankruptcy was quite remarkable in two respects. First, Neiman had ready access to financing, as reflected in its receiving two different financing offers. The economy was shut down due to COVID-19, and there had been ominous signs in the financing market. Only a few weeks earlier, Sanchez Energy, a company already in bankruptcy at the outset of the pandemic, announced that it was unable to repay its bankruptcy loan.4 Some commentators were warning that a crisis in the lending market might be imminent.5 But Neiman had little trouble obtaining a sizeable new loan. Its financial advisor “acknowledged that the proposed [financing] is ‘certainly unusual’ in the sense that the debtors are obtaining financing despite the company largely not operating at the moment given the store closures amid the Covid-19 pandemic.”6

Why was so much financing available to Neiman? In part because equity funds and other potential investors had an estimated $2.5 trillion of available funding (i.e., “dry power”) at the outset of the crisis, due to a perceived dearth of attractive investment opportunities.7 The unexpected buoyancy of the stock market also contributed. The large amount of federal money available under the CARES Act and other stimulus funding may have played a role, too, although that money could not be used for bankruptcy loans.8

The other remarkable feature of Neiman’s access to financing was that two different bidders offered to provide the “debtor-in-possession” financing.9 In most cases, a debtor has a single source of funding, usually from its principal prebankruptcy
lenders.10 The willingness of multiple lenders to provide DIP financing for Neiman may have stemmed in part from the confluence of the developments just described: large amounts of investable funds, a buoyant stock market, and the federal stimulus money.

But another, underappreciated factor also came into play: a striking shift in the capital structure of many corporate debtors. Capital structure is increasingly disaggregated.11 Companies often borrow not just from one group of lenders—as with a syndicated loan in which a variety of lenders have stakes—but from multiple groups of diverse lenders, often under arrangements that give one group a first lien on the debtor’s assets and the other a second lien.12 RadioShack, in an early illustration of this trend, had two major groups of secured lenders, with an agreement between the two groups and separate agreements within each group.13

In this Essay, I argue that this trend could help solve a serious, longstanding problem in the market for DIP financing. In the past, the senior lenders of most corporate debtors were banks or a single syndicate of banks and other lenders.14 Because of the information asymmetry between the debtor’s principal lenders (who have more and better information about the debtor) and outside lenders (who have less and worse information), outside lenders are discouraged from competing to finance corporate debtors. The effects of the information asymmetry are magnified by a “debt overhang” problem: because some of the benefits of any new financing will accrue to the existing lenders, new lenders are unlikely to offer financing unless they are given priority over the existing lenders.15 The vast majority—75% or 80%—of DIP loans come from the debtor’s existing lenders, and these lenders consistently earn supracompetitive profits, which suggests that the obstacles to alternative financing are severe.16

Due to the fragmentation of firms’ capital structures, many corporate debtors now have at least two groups of lenders, and sometimes more. Neiman Marcus, for example, had five different substantial groups of secured lenders.17 Although the new capital structure complexity has potential downsides,18 it also has a significant upside: it can provide a solution, or at least the beginning of a solution, to the lack of competition for DIP financing. Rather than outside lenders, a different source of alternative financing—other inside lenders, who do not face the same information asymmetries as outsiders—may challenge the favored insider lenders. Neiman’s ready access to financing and choice between multiple potential lenders could become a much more common experience among corporations filing for Chapter 11. Even the possibility that an alternative bid may emerge could force a debtor’s lenders to offer a more competitive rate for bankruptcy financing.

As the discussion above reflects, the descriptive and normative claims in this Essay draw on a rich literature about bankruptcy financing.19 This Essay is the first to point out that the solution—or at the least, a partial solution—to these concerns may lie in plain sight: in the fragmentation of debtors’ capital structures.

Unfortunately, three features of current bankruptcy practice may prevent this optimistic scenario from emerging. First, courts have been reluctant to grant nonconsensual “priming” liens—that is, liens that take priority even over the liens of existing lenders—which are needed to solve debt overhang problems.20 Second, the intercreditor agreements that first and second lienholders enter into sometimes prohibit second lienholders from providing bankruptcy financing absent consent by the first liens, thus stymieing a potential alternative source of funding.21 Finally, the debtor and key creditors often enter into a restructuring support agreement (RSA),22 which may preclude any of the signatories from offering alternative financing. As a result, the RSA may preempt competition to provide financing.

It is important not to overstate the impediments. Even if courts continue on their current track, the number of competing DIP financing offers seems likely to increase. Although courts have been reluctant to award nonconsensual priming liens, the lucrative fees in this market are likely to entice other lenders in the capital stack of debtors with fragmented capital structures to challenge favored bids, putting pressure on courts to take these bids more seriously. By more carefully scrutinizing contractual provisions that interfere with competitive offers, or by amending bankruptcy law to encourage more competition, courts and lawmakers could spur even more competition.

This Essay proceeds in three Parts. Part I describes the surprising abundance of funding during the COVID-19 pandemic. In Part II, the focus turns to the striking shift in the capital structure of many corporations that later file for bankruptcy, and the potential for this shift to increase the competitiveness of the bankruptcy-financing market. Finally, Part III analyzes potential impediments to a more competitive market for bankruptcy financing and proposes potential correctives for each. Much of Part III is devoted to judicial scrutiny of the obstacles to a competitive lending market, but it also considers the possibility of amending bankruptcy law to address courts’ reluctance to grant priming liens and loan provisions that stymie potential competing loans.

I. an abundance of bankruptcy financing

When the COVID-19 crisis worsened in early 2020, causing the American economy to shut down, it seemed to augur a surge in Chapter 11 filings and a potential liquidity crisis as corporate debtors struggled to obtain bankruptcy financing.23 During the Great Recession of 2008-2009, this is more or less what happened. In fall 2008, at the height of the crisis, access to bankruptcy financing evaporated for a few months, and corporate bankruptcies more than doubled.24

The COVID-19 pandemic had the potential to be even worse than the Great Recession, given the breadth of the economic shutdown. At first, the shutdown seemed to destabilize the DIP financing market. Sanchez Energy, which had filed for bankruptcy before the crisis, announced it would be unable to pay its bankruptcy
loan.25 The prospect of a default, an uncommon occurrence with DIP financing,26 and uncertainty as to how long the economic shutdown would last pointed to the possibility of major turmoil in the financing market.

Yet turmoil never materialized. Since the pandemic began, large corporate debtors have had ready access to financing. The most remarkable example was Hertz, which considered financing its bankruptcy by selling stock after a surge of speculative trading significantly increased the stock price.27 Were it not for the disapproval of the Securities and Exchange Commission, Hertz might not have needed a loan at all.28 In the Neiman Marcus bankruptcy, two different groups of lenders competed to provide financing.29 Overall, debtors obtained roughly $20.762 billion of DIP financing in 2020 amid the pandemic—over $5 billion more than debtors obtained in 2019.30

Why so much financing? One explanation is the estimated $2.5 trillion of “dry power” that distressed debt funds had at the outset of the pandemic.31 With attractive investment opportunities scarce, funds had accumulated capital. Potential lenders were unusually well-positioned to make bankruptcy loans due to this quirk of the lending environment.

In addition to this private investment, the federal government pumped an enormous amount of federal money into the economy during the pandemic, both through legislative interventions such as the $2.1 trillion CARES Act, which directed funding to joint efforts of the Federal Reserve and Treasury, and through independent Federal Reserve programs.32 Because these programs generally could not be used for bankruptcy loans,33 federal money did not directly enhance access to DIP financing. Still, it appears to have increased liquidity for corporate debtors in indirect ways. For instance, the abundance of federal funds may have diminished funding opportunities for private lenders outside of bankruptcy, encouraging them to provide bankruptcy loans.

Like federal funding, the strength of the stock market throughout the pandemic may have also indirectly affected access to DIP financing. Many troubled corporate debtors appear to have been able to avoid bankruptcy altogether without borrowing money due to the ease of raising capital by selling stock.34 AMC Theatres is a vivid illustration. Though it was an obvious candidate for Chapter 11 early in the pandemic, it proceeded to raise $1.2 billion through equity issuances in a single quarter.35 In addition to indirectly boosting the DIP financing market by diminishing lending opportunities outside of bankruptcy, stock-market strength directly contributed to the robust market for the new stock of corporate debtors when they exited bankruptcy.36

Finally, another less obvious factor enhanced access to DIP financing: the increased complexity of corporate debtors’ capital structure due to first- and second-lien arrangements and other new financing structures, as discussed earlier and in more detail in the next Part. Compared to the $2.5 trillion in available funding and the massive amounts of federal aid, this capital-structure shift is less dramatic and was perhaps less important during the pandemic.37 But as I argue in Part II below, the new capital structure has major implications for the future of Chapter 11.

II. the new capital structure: multiple inside lenders

When the Bankruptcy Code was enacted in 1978, the bankruptcy-financing provision was one of its key innovations.38 The provision sharply expanded debtors’ ability to obtain financing by empowering bankruptcy judges to provide sweeping protections for lenders who agree to finance debtors’ operations in bankruptcy—including a “priming lien” that has priority even over existing secured creditors.39

If DIP financing functioned like the competitive markets taught in Economics 101, early entrants into the market would have made supracompetitive profits, which would have declined as the market matured. But this did not prove to be the case. Recent evidence suggests that DIP lenders continue to make extraordinary profits. One study, for example, found that lenders charge several percentage points higher than a competitive interest rate.40 Another concluded that DIP loans are priced similarly to junk debt, despite being far less risky.41

The key to understanding the stickiness of DIP lenders’ supracompetitive profits lies in another feature of the market: 75% or more of DIP loans are made by the debtor’s current lender.42 The dominance of insider lenders stems from two factors that discourage competition. The first is information asymmetries. Because a debtor’s existing lender has better information about the debtor, it is difficult for a new lender to compete.43 Second, the inside lender often has a lien on all the debtor’s assets; one study found that 75% of bankruptcy debtors obtain senior secured financing before bankruptcy and the loans are secured by all of the debtor’s assets 97% of the time.44 Unless the court grants a priming lien, a new lender’s loan may subsidize the existing lender at the expense of the new lender, since the existing lender has the first claim on any value created. This effect—debt overhang—may further discourage new entrants.45

If the debtor has a single lender or syndicate of lenders, the obstacles to obtaining financing from any lender other than the current lender may be insurmountable. If the debtor’s existing lender has offered to provide new financing, a new entrant will be competing with a lender that has better information and an existing relationship with the debtor, and it may suspect that the debtor will be reluctant to take a chance on a new lender. Even if the existing lender declines to supply additional funding, a new entrant may still be reluctant to offer financing, given the adverse signal sent by the current lender’s refusal to make another loan.

With current corporate debtors, however, the traditional pattern of a single lender or syndicate of lenders often does not apply. A debtor’s financing is much more likely to be fragmented.46 A key development has been the increased use of first- and second-lien arrangements in which a group of lenders holds a first lien on the debtor’s assets and another group holds a second-priority lien.47 The first and second lienholders often enter into an “intercreditor” agreement that specifies their rights vis-à-vis one another. Less common but somewhat similar are “unintranche” arrangements, which have a similar priority arrangement but are framed as single loan rather than separate first lien and second loans.48 Some corporate debtors have even more groups of senior lenders. Neiman Marcus had five separate collateralized loans ranging from $561.7 million to $2,253.1 million at the time of bankruptcy, including both second- and third-lien loans.49 Each group may itself be comprised of a variety of lenders, ranging from distressed debt funds to traditional commercial banks.

This fragmentation of corporate debtors’ borrowing can have problematic effects. Intercreditor agreements among the parties,50 or the lien structure itself,51 can interfere with an efficient restructuring process. But the fragmentation also has an important and underappreciated potential upside: it ensures that the debtor has multiple inside lenders, rather than just one. This creates the possibility of lending competition from within the debtor’s capital structure. The shift in debtors’ capital structure suggests that improved competition and a more efficient lending market actually may come not by encouraging outside lenders to provide DIP financing, as one might assume; it may come from other inside lenders instead.

The Nieman Marcus bankruptcy illustrates the potential pattern. When Nieman filed for bankruptcy, it had arranged for $600 million of new financing from a group of existing lenders, including Pacific Investment Management Co., Davidson Kempner Capital Management LP, and TPG’s Sixth Street Partners.52 An investor group that comprised investment firm Mudrick Capital Management LP and Third Point LLC countered with an offer to lend $700 million at a lower interest rate and significantly lower fees than the favored lenders’ loan.53

Mudrick Capital was not a random outside lender that saw Neiman Marcus as an attractive lending opportunity. To the contrary, Mudrick Capital already had a stake in Neiman Marcus, holding $144 million of its first-lien loans.54 Mudrick was thus an inside lender. Prior to Neiman’s bankruptcy, Mudrick had pressed its managers to pursue a sale or merger with Saks Fifth Avenue.55 Mudrick’s proposed loan reflected its vision for Neiman’s future. A key condition of the competing proposal was that Neiman Marcus would be required to first seek a sale of its assets, before attempting to reorganize its finances and operations. If no credible bidder emerged, Neiman Marcus could try to achieve a traditional reorganization.56

Neiman and its preferred lenders fended off the Mudrick threat by appealing to courts’ traditional reluctance to protect a new lender with a priming lien.57 Neiman argued that it would not be possible to provide adequate protection of the preferred lenders’ liens, which the DIP financing provision requires as a prerequisite for approving a priming lien. According to Neiman’s principal bankruptcy lawyer, a “non-consensual priming fight is not a fight that we could win.”58 Neiman’s and its lawyer’s not-so-subtle point was that, because Neiman and the favored lenders had no intention of agreeing to a priming lien giving Mudrick priority over their liens, the Mudrick bid could not be approved unless the court conducted a valuation hearing to determine whether Neiman’s assets were sufficient to ensure payment of the favored lenders despite their subordination to a new priming lien; any effort to demonstrate “adequate protection” would fail, they claimed. This seems to have been sufficient to dissuade the court from seriously considering the Mudrick alternative. Although the court described the preferred lenders’ loan as “expensive money” and mused that “[w]e all wish that Neiman Marcus could get a [Paycheck Protection Program] loan and that it would be free,” it rejected Mudrick’s challenge and approved the preferred loan.59

As the Neiman battle reflects, genuine competition in the DIP lending market will depend on courts’ willingness to grant nonconsensual priming liens in appropriate cases. Given that corporate debtors invariably have few unencumbered assets, alternative lenders face debt overhang issues and priming liens will often be essential.60 One reason for optimism that bankruptcy courts will indeed show more willingness to grant priming liens if an increasing number of alternative-financing offers emerge from within debtors’ capital stack is that the presence of a concrete alternative offer reduces the risk of a disastrous outcome if the court denies the favored lenders’ proposal. When debtors and their preferred lenders ask the court to approve a DIP financing proposal at the outset of the case, they often claim that the debtor is desperate for cash and will collapse if a proposed loan is not approved; in the absence of an alternative source of funds, bankruptcy judges are understandably reluctant to call their bluff.61 The threat is much less credible if an alternative lender has offered to provide funding.

Of course, inside lenders are not all similarly situated. A distressed-debt investor that has recently acquired a portion of a senior or junior loan will have less of an information advantage than a single bank that has been a firm’s longtime lender and provides all of the debtor’s banking services. This difference in status may be reflected in the terms of the loans the new insiders offer. A newly arrived distressed-debt investor may be more likely to seek to impose strict limitations on the debtor’s options in bankruptcy, for instance, to minimize the risk of the loan.62 The new lender may also be more willing to provide exit financing—that is, new financing for the debtor as it emerges from bankruptcy—given that it will have the benefit of all the information produced by the bankruptcy case when it offers to make an exit loan (assuming the exit financing offer is made during or at the end of the case, rather than at the outset).

To be sure, increased competitiveness in the DIP financing market would bring costs as well as benefits. If a debtor’s relational bank or other senior lenders anticipate competition from other lenders if the debtor files for bankruptcy, this may affect their behavior prior to bankruptcy. For instance, they may be quicker to insist that the debtor put a chief restructuring officer in place to protect their interests. Lenders might also impose a higher interest rate to offset the loss of potential DIP financing profits. Although the prospect of bankruptcy lending competition is probably not salient enough to affect loans to financially healthy debtors, it might impact struggling debtors.

Despite these potential costs, genuine competition in the DIP financing market would almost certainly improve the efficiency of the bankruptcy process. In addition to the burden of paying supracompetitive interest rates, the risk that favored lenders and a debtor’s managers will make deals that benefit one or both at the expense of the company and its other constituencies is quite high when the company falls into financial distress.63 A competitive financing market would help to address both concerns. A momentous unintended consequence of the increased complexity of corporate debtors’ capital structure is that it makes financing market competition much more likely.

III. impediments to competitive financing

The story this Essay has told thus far is an optimistic one. Bankruptcy financing was far more abundant during the pandemic than expected. Moreover, the shift in debtors’ capital structure suggests that DIP financing will be more competitive after the pandemic than it was before, at least among firms with fragmented capital structures.

The most obvious impediment to a more competitive lending market is courts’ reluctance to grant nonconsensual priming liens. Unlike the consensual priming liens a debtor’s existing lenders often give to themselves—with a new DIP loan priming their prebankruptcy loan—a nonconsensual loan requires a bankruptcy judge to determine at a valuation hearing that the earlier loan will be adequately protected. A thawing of this reluctance is essential to the emergence of a competitive lending market, given the debt-overhang issues that discourage new lenders from making loans without an assurance of priority. As discussed in the last Part, there are grounds for cautious optimism that this thawing could in fact occur.64

But two additional impediments could interfere with the emergence of a more competitive DIP financing market. First, intercreditor agreements sometimes contain provisions that explicitly preclude potential lenders from making bankruptcy loans. Second, the restructuring support agreements that have become a key feature of many Chapter 11 cases may indirectly achieve the same preclusive effect, by committing potential lenders to a reorganization strategy that incorporates the preferred lenders’ DIP loan. In this Part, I discuss these impediments and propose solutions for each.

A. Explicit Restrictions on Financing

When a corporate debtor borrows under a first- and second-lien financing arrangement, the first and second lienholders often use an intercreditor agreement to allocate their rights vis-à-vis one another. One standard term gives first lienholders the exclusive right to enforce the parties’ rights in their collateral.65 More aggressive restrictions may preclude the second liens from objecting to a reorganization plan supported by the first liens or may prohibit the second liens from providing DIP financing absent consent from the first lienholders.66

The last of these provisions—the loan prohibition—is of concern here. It is not difficult to see why first lienholders might wish to have such a provision. Much as the second lienholders could undercut the first liens by objecting to a reorganization plan favored by the first liens, or by supporting a plan opposed by the first liens,67 providing financing also could interfere with the first lienholders’ objectives. A loan from the second liens could prolong the case at a time when the first lienholders want to force a sale or other quick resolution.

If the second lienholders are trying to prolong the case and divert value from the first lienholders, a loan prohibition might be justifiable. But the risk that a DIP loan will be used to divert value does not seem great. Offering to make a DIP loan would be a cumbersome way to divert value, given that it requires a substantial new investment from the second lienholders. To be sure, the investment would be compensated, but it is a substantial upfront expenditure nonetheless. Moreover, it seems more likely that a loan prohibition will be used to divert value from other creditors to the first lienholders than it is that a loan from the second lienholders will divert value from the first liens. Of particular importance for present purposes, the uncertain benefits of the loan prohibition come at the cost of cutting off one of the most promising potential sources—perhaps the most promising source—of alternative funding.

Loan prohibitions can be analogized to two other provisions that limit a debtor’s options in Chapter 11: prebankruptcy stay waivers and ipso facto clauses. Stay waivers are usually negotiated by a debtor and its lender as part of an out-of-court workout of a loan; in return for the lender’s forbearance, the debtor agrees not to oppose a motion to lift the stay if the debtor subsequently files for bankruptcy.68 An ipso facto clause makes the debtor’s insolvency or bankruptcy an event of default under a contract.69 Courts are skeptical of stay waivers, but sometimes enforce them if other creditors have notice of their provisions.70 Ipso facto clauses are invalidated by several provisions of the Bankruptcy Code.71

Although the consequences of a loan prohibition are less severe than with a stay waiver, loan prohibitions actually are more problematic. The context where courts have tended to uphold prebankruptcy stay waivers is small businesses whose lender has a security interest in all of the debtor’s assets.72 A large majority of small businesses are not viable when they file for Chapter 11 and end up liquidating, with most or all of the value of the business going to the principal lender if there is one and little recovery for other creditors.73 Waiving the stay so that the lender is able to foreclose on the debtor’s assets therefore is not likely to impose externalities on other creditors, and courts generally do not enforce waivers if other creditors will be harmed.74

Loan prohibitions are more similar to ipso facto clauses in this regard than to the stay waivers that courts generally enforce. An ipso facto clause may deprive the debtor of a contractual relationship or of the financing it needs to efficiently resolve its financial distress. Loan prohibitions in intercreditor agreements impede financing in similar fashion. Each undermines the purpose of Chapter 11, which is to provide a collective forum that enables the parties to preserve the going-concern value of a business if the business is viable when the debtor files for bankruptcy.75 A stay waiver that does not affect the interests of creditors other than the debtor’s principal lenders does not raise the same concerns.

The same point can be made another way: liquidity is essential to the reorganization process;76 contractual provisions that interfere with a debtor’s ability to obtain new financing are thus inherently suspect. Given the conflict between loan prohibitions and the purpose of Chapter 11, a statutory prohibition is justified. Indeed, I have argued elsewhere that a provision in current law that precludes debtors from invoking prebankruptcy commitments by a lender to extend credit should be repealed.77 Making both of these adjustments would have a salutary effect on access to financing in bankruptcy.

Even in the absence of legislative reform, bankruptcy judges could address the problem by refusing to enforce loan prohibitions in most or all cases. Courts should override the provisions unless there is clear evidence the loan would be used to divert value from the first lienholders or other lenders that invoke the prohibition.78

B. The Chilling Effect of Restructuring Support Agreements

The second impediment to a competitive DIP financing market is more subtle and difficult to police. In many current bankruptcies, the parties enter into RSAs with key creditors before filing for bankruptcy.79 The RSA commits its signatories to support a reorganization plan consistent with the terms outlined in the RSA.80 RSAs provide a variety of important benefits, such as enhancing coordination among the debtor and its creditors by committing the signatories to requiring that anyone who buys a claim from them also honor the RSA. Absent an RSA, a deal that had been carefully negotiated might fall apart if enough of the signatories sold their claims to other investors.81

Although often beneficial, RSAs sometimes have problematic features. They may be unjustifiably coercive, for instance, or give excessive fees to favored parties.82 Another feature of many RSAs is of particular concern here. Like the loan prohibitions discussed in the last section, an RSA may preclude potential lenders from offering bankruptcy financing. At first glance, one might doubt that a potential lender would sign an RSA if the lender would lose the opportunity to make a profitable loan as a result. But RSAs often give signing fees to their signatories;83 the prospect of receiving a signing fee may therefore persuade the lender to forgo offering alternative financing.

The favored insider financing in Neiman Marcus was linked to an RSA in precisely this way. As Neiman’s financial advisor put it in his declaration supporting the financing request, the DIP financing agreement, the RSA, and a related agreement were “integrated and intertwined.”84 Lenders who wished to participate in the $675 million DIP financing were required to sign the RSA,85 which dictated the path of the Chapter 11 case, committing the parties to a prompt recapitalization that would give control to the lender groups that provided the DIP financing. Signatories of the RSA would receive lucrative fees for agreeing to “backstop”—that is, to purchase any portion of a planned loan or issuance of stock that the debtor is unable to find investors for—the DIP financing and $75 million in additional financing when Neiman exited Chapter 11.86

The RSA and DIP financing arrangement created two major impediments to alternative insider-financing offers. First, the preferred lenders minimized the risk of competition by locking up the vast majority of Neiman’s current lenders. Of the three principal lender groups, 78% of the first, 99% of the second, and 70% of the third were signatories of the RSA and thus could not offer alternative financing.87 This significantly reduced the number of inside lenders that could plausibly bid against the preferred financing offer.

Second, and related, an inside lender that wished to make an alternative-financing offer would be forced to forgo the lucrative backstopping fees. The form of the fees implicitly precluded an inside lender from both signing the RSA and making an alternative-financing offer, since signatories to the RSA received their compensation in the form of fees for backstopping the preferred financing. If the RSA offered cash fees to signatories, by contrast, it would be logically possible both to participate in the RSA and to offer alternative financing. But this distinction ultimately makes little difference: either way, the RSA had multiple terms that would be violated if a signatory sought to provide alternative financing. RSA signatories were required to “support the Restructuring Transactions,”88 and were not permitted to “object to, delay, impede, or take any other action to interfere with acceptance, implementation, or consummation of the Restructuring Transactions,” or to “propose, file, support, or vote for any Alternative Restructuring Proposal.”89 Lenders that signed the RSA thus gave up the right to offer alternative financing.

Given these impediments to challenging the favored inside DIP financing proposal, it is quite surprising that a competing bid nevertheless emerged. Mudrick appears to have been excluded from the negotiations on the preferred financing.90 Neiman and the preferred lenders may have assumed that the large percentage of lenders included in the favored bid would discourage competitors.

In its response to the Mudrick offer, Neiman emphasized the fact that the Mudrick lenders held only a minority of the major existing debt—not enough to control a vote of the existing lenders whether to agree to a priming lien for Mudrick’s alternative financing—and that the proposal would therefore require a nonconsensual priming of the existing lenders. “[T]he Debtors received a competing proposal from a group of term loan lenders [i.e., the Mudrick group] that did not collectively hold greater than 50% of outstanding term loans, the requisite amount to achieve consent under the Term Loan Facility,” according to Neiman’s financial advisor.91 “As a result, the proposal would have required nonconsensual priming of existing term loan lenders with little to no remaining unencumbered collateral to offer to primed term loan lenders as adequate protection.”92

Neiman Marcus would have been a good opportunity for a court to grant a nonconsensual priming lien, or at the least to have given it more serious consideration. The willingness of the existing lenders to provide $675 million of new financing secured by their existing liens suggests that Neiman’s assets were valuable enough to support significant new lending. Perhaps the Mudrick proposal was too flawed, but it was significantly cheaper. The court could have devoted a hearing specifically to the question of whether Neiman’s assets were sufficient to assure adequate protection of the existing lenders in the context of a priming lien.

The Neiman experience also suggests that courts should scrutinize RSAs that are linked to DIP financing especially closely if they are likely to discourage competing loans from within the capital stack.93 Because it locked up substantial majorities of the current lenders, the Neiman RSA was particularly suspect. In its objection, Mudrick stridently insisted that the backstop fees bore no relation to any value the backstoppers were providing, because there was little risk the backstop would be needed and the fee would be paid in steeply discounted stock.94 If this is correct, the court should have balked at the fees.95 Policing excessive fees would diminish the pressure for lenders to join a favored deal and increase the likelihood of competition from other inside lenders.

Another strategy for addressing the chilling effect of RSAs would be more intrusive, though it too would not require legislative change. Courts could forbid parties from using an RSA to prevent inside lenders from offering alternative financing, thus disentangling DIP financing from the RSA. This would be difficult to do if an RSA fee is directly linked to the DIP financing, as it was in Neiman. But if an RSA signatory wished to offer alternative financing, the court could require that the signatory be permitted to participate in the RSA (and fees linked to the RSA) if its financing offer did not prevail. In contexts where the RSA fee is not linked directly to DIP financing, a court could make clear that it would not enforce an RSA covenant that treats an alternative DIP financing offer as an event of default under the RSA.

I have focused primarily on judicial correctives, in part due to the greater ease of implementation. Courts can intervene immediately, whereas legislation is much more uncertain, especially given that the flaws in the bankruptcy-lending market may not seem sufficiently urgent to capture lawmakers’ attention. Attempting to remedy these frictions legislatively is also more likely to have unintended consequences than case-by-case intervention by courts.

Despite the advantages of judicial oversight, the chilling effect of RSAs on competitive lending also could be addressed legislatively. Indeed, the prohibition on provisions that prevent potential lenders from offering bankruptcy financing, as discussed earlier,96 could easily be made broad enough to invalidate RSAs to the extent that they prevent potential lenders from offering alternative financing.

***

Although the fragmented capital structure of many current debtors is grounds for optimism about the trajectory of the DIP financing market, especially if the impediments to competition in this market are addressed, it is important to acknowledge the limitations of the developments I have focused on. The increased competition among inside lenders that the Essay identifies and seeks to encourage will only occur with firms that have multiple lenders. Firms that fit the traditional paradigm of relying on a single bank lender for financing, as most smaller corporations still do, will not have the option of seeking funding from an alternative inside lender. These smaller firms already are much less likely to obtain DIP financing, and much less likely to reorganize, than large corporations.97 Under ordinary circumstances, these outcomes may not be problematic, since few small firms appear to be viable when they file for bankruptcy. But in the event of a crisis that causes even viable firms to default, additional intervention may be needed to assure that these viable firms have access to the funding they need in bankruptcy.98

Conclusion

From a bankruptcy perspective, the pandemic had an unexpected silver lining: it revealed that a potential solution to the DIP financing market’s serious deficiencies is right in front of us. Rather than looking for ways to entice outside lenders to provide more competition for DIP financing, inside lenders may more effectively serve this role. After all, they suffer far less from the information asymmetry that discourages outside lenders from competing with a favored inside lender.

Although competing bidders are already emerging, as in the Neiman Marcus case, they face significant obstacles, including courts’ reluctance to grant them nonconsensual priming liens and contractual provisions that forbid potential lenders from offering an alternative source of financing. In addition to identifying these concerns, this Essay has considered how courts and Congress could remove them. Bankruptcy courts need to be more open to priming liens—and as more competing bids emerge, there is some hope they will be—and they should invalidate RSA provisions that interfere with potential alternative-financing offers. Bankruptcy law should be amended to bar loan prohibitions. Increasing competition in the bankruptcy-financing market would reduce the cost of credit for bankruptcy debtors, and it would remove one of the most glaring current impediments to an efficient reorganization process.

S. Samuel Arsht Professor of Corporate Law, University of Pennsylvania Carey Law School. I am grateful to Matthew Bruckner, Robert Rasmussen, David Smith, Wei Wang, and the editors of the Yale Law Journal for helpful comments and conversation, and to Caroline Nowlin and Jinle Ye for excellent research assistance.