When charting a course through bankruptcy, retailers must prioritize maintaining sufficient liquidity to fund operations and the expenses associated with the case. To accomplish this, retailers typically use a lender’s cash collateral and obtain debtor-in-possession (DIP) financing. Both are critically important tools that allow the retailer to purchase new inventory to restock store shelves, pay employees, and signal to vendors and other stakeholders that the retailer has the financial resources to fund a turnaround and exit from bankruptcy as a viable enterprise.
This article summarizes DIP financing basics and trends, including the structure, pricing, maturities, milestones, and other key provisions of the DIP financings in recent retail bankruptcy cases, including Toys R Us, Claire’s, Payless, Bon-Ton, Gymboree, and others.
Section 364 of the U.S. Bankruptcy Code governs DIP financing and is designed to facilitate debtor financing, while balancing the interests of lenders, unsecured creditors, and other parties. Section 364 provides a list of options, depending upon the debtor’s financing needs and the incentives necessary to entice lenders, including:
Bankruptcy courts customarily permit DIP lenders to obtain the greatest possible protection by using Section 364(d) to obtain a priming lien (and, for good measure, also use Section 364(c)(1)–(3) to obtain a superpriority administrative expense claim, lien on unencumbered assets, and a junior lien on encumbered assets).
Prepetition lenders, rather than new third-party lenders, are a frequent source of DIP financing to retail debtors. They do so, in part, to protect their position against possible priming liens—a practice known as “defensive” DIP financing. Almost universally, retail debtors seek an asset-based revolving loan (ABL) DIP facility, which permits them to borrow against accounts receivable, inventory, and other assets, to maintain continuity with most retailers’ prepetition credit facility structure.
Retail debtors may seek additional liquidity through a “first-in, last-out” (FILO) tranche in these ABL facilities, which provides enhanced liquidity through an additional loan based on the incremental asset value above the ABL lending limits. The FILO lenders advance their loan proceeds first, before the ABL lenders, but are paid after the ABL loans. Bon-Ton’s recent DIP facility included a $600 million ABL facility with a borrowing base comprised of inventory, credit card receivables, and real estate, among other assets, and a $125 million FILO facility based on a portion of the value of the ABL assets exceeding the borrowing base limits.
Recently, many retailers have paired a revolving ABL DIP facility with a term loan DIP facility. Pursuant to a split-lien structure, the ABL lenders have a first-priority lien on the borrowing base assets, including accounts receivable and inventory, and the term lenders have a first-priority lien on other assets, including real estate and intellectual property. Each lender group also typically has a second-priority lien on the other creditors’ pool of collateral.
Term loans are more expensive because of higher interest rates. The debtor must pay interest on the entire funded term loan, as compared to paying interest on the funded portion of the revolving loan, which could be significantly less than the commitment amount.
One recent trend is retail debtors employing multidraw term loans, which are drawn in increments upon achievement of certain milestones and carry reduced interest costs over time as a result of lower funded indebtedness. For instance, Payless obtained an $80 million DIP term loan, which included an initial $30 million draw upon entry of the final DIP order and $50 million to be drawn for the period following the disclosure statement order through the effective date of the plan of reorganization.
Due to a number of factors, retailers face increased costs and unique challenges to completing a successful reorganization. These include the time period to assume or reject leases under Section 365(d) of the Bankruptcy Code and the grant of administrative priority classification with respect to all goods received by the debtor within 20 days of the petition date under Section 503(b)(9). They are forced to make decisions about the direction of their bankruptcy cases before filing and conserve as much cash as possible or risk liquidation.
Within this framework, many recent retail debtors have commenced bankruptcy proceedings to implement a planned, and often prenegotiated, balance sheet restructuring and quickly exit from bankruptcy. The compressed timelines force debtors to be more aware of the immediate need for exit financing and, in some cases, obtain committed exit financing before filing. For example, Remington Outdoor Company filed for bankruptcy on April 3, 2018, with an ABL DIP facility, which will convert to exit financing.
A retailer’s short ride through Chapter 11 has also caused companies to reconsider the need for traditional DIP financing entirely. Southeastern Grocers commenced a prepackaged bankruptcy proceeding on March 27, 2018, without traditional DIP financing. Instead, the company intends to fund its balance sheet restructuring through a combination of cash collateral and extended credit terms from its largest supplier, which will provide approximately $100 million in additional liquidity and a bridge to the company’s $1.125 billion committed exit financing that is in place as of the petition date. This approach relieves the debtor of interest, fees, and other costs associated with a traditional DIP credit facility. Figure 1 summarizes recent DIP credit facility structures.
In addition to funding bankruptcy expenses and ordinary working capital, proceeds of DIP facilities are frequently used by retail debtors to refinance prepetition debt through a roll-up. In a roll-up, the DIP loan proceeds are applied to satisfy prepetition debt and thus convert it to post-petition debt. Prepetition lenders that provide DIP loans view roll-ups as a critical protection because, among other safeguards, the lender receives a superpriority administrative expense claim, which is cramdown-proof because all administrative expense claims must be paid in full in cash on the effective date of the plan pursuant to Section 1129(a)(9) of the Bankruptcy Code. Thus, the DIP lender cannot be forced to receive less than what it is owed.
Roll-ups are frequently subject to attack based on the arguments that they (i) upset the priority scheme of the Bankruptcy Code by potentially converting undersecured prepetition debt into priority post-petition debt that could be secured by new collateral, (ii) come with increased court protections, and (iii) provide the DIP lenders with additional leverage, all at the expense of other creditors.
Courts scrutinize roll-ups to determine whether the prepetition lenders are extending significant new money or are simply refinancing the prepetition debt and improving their lien and priority position. Courts also examine whether a robust marketing effort was undertaken before determining that a roll-up was a necessary component of obtaining DIP financing. Despite the potential objections associated with roll-ups, a variety of courts have approved their use in recent bankruptcy cases, including the Southern District of New York (BCBG), Eastern District of Virginia (Gymboree), Southern District of Indiana (hhgregg), Eastern District of Missouri (Payless), Western District of Pennsylvania (rue21), and Delaware (The Walking Company).
Almost all retail DIP facilities include “all assets” collateral packages, with limited exceptions. For prepetition lenders, providing the DIP facility offers an opportunity to shore up their collateral position by obtaining liens on previously unencumbered assets that may have been excluded from the initial deal, such as specified real estate. Additionally, although controversial, the DIP lender may obtain liens on avoidance actions and/or proceeds of avoidance actions.
Requesting liens on unencumbered assets and avoidance actions routinely draws objections from unsecured creditors because such collateral pools may be those creditors’ only source of recovery. In the Bon-Ton, Payless, and The Walking Company cases, the DIP lenders initially sought liens on proceeds of avoidance actions but ultimately did not obtain them in the final order. However, DIP lenders have obtained liens on proceeds of avoidance actions in other cases, including Toys R Us, hhgregg, Gymboree, and rue21.
Interest rates on recent retail DIP credit facilities have generally ranged from 250 to 450 basis points over LIBOR for revolvers and from 500 basis points over LIBOR to a fixed rate of up to 12 percent for new money term loans.
Closing fees associated with DIP facilities come in a variety of forms and are not always disclosed in DIP motions and orders. Typically, lenders charge a commitment fee and/or closing fee, which can range from 0.5 percent to 3 percent of the commitment amount. Additionally, DIP lenders may charge other fees, such as an arrangement fee or an exit fee. Figure 2 summarizes the interest rates and fees from recent retail cases.
As discussed earlier, retailers, as a matter of survival, often seek a quick exit from bankruptcy. Relatedly, DIP facilities routinely include short maturities and aggressive deadlines to accomplish milestones in a case. Retail DIP facility terms are as short as four months and are rarely longer than 12 months. Milestones may vary from case to case, but many are structured around the 120-day or, as extended pursuant to Section 365(d) of the Bankruptcy Code, 210-day period to assume or reject leases.
Working backward from this 210-day marker, many lenders require a 90-day cushion in the milestones if the collateral must be liquidated. Thus, a retail debtor must determine a path to exit shortly after filing and may simultaneously pursue a sale and plan of reorganization rather than experiment with various operational changes under bankruptcy protection. Figure 3 includes maturities and significant milestones for several recent retail cases.
Retail DIP facilities are rarely governed by extensive financial covenants. Instead, they rely on an excess availability covenant in some ABL DIP facilities and, more generally, on a variance covenant that requires the debtor to meet certain cash receipts and disbursements targets, subject to permitted variances, pursuant to a weekly budget approved by the DIP lenders. As shown in Figure 4, permitted variances of 10 percent to 20 percent are common.
While debtors are expected to stipulate to the validity, perfection, and priority of the prepetition lenders’ liens and claims in exchange for those lenders providing DIP financing, the unsecured creditors’ committee (UCC) retains the right to object to these matters. A UCC’s attack on the prepetition liens may be a source of recovery for unsecured creditors if those liens are invalid or have not been properly perfected. The parameters of this challenge period are set forth in the DIP financing order.
Further, DIP lenders are expected to allow, as an exception to the DIP lenders’ priming lien, a carve-out for professional fees for the debtors and UCC. The carve-out is typically capped following an event of default under the DIP credit agreement. Figure 5 summarizes the challenge periods and post-default carve-outs established in recent retail bankruptcy cases.
The retail DIP financing market remains robust and well established, yet every DIP facility is unique based on the particular retailer’s needs, the lender’s requirements, the UCC’s concerns, and the court’s opinions. Given the headwinds in the industry, retail will remain a prime source for DIP financing opportunities.