Debtor-in-Possession Financing. Sris Chatterjee * Upinder S. Dhillon ** Gabriel G. Ramírez *** Forthcoming Journal of Banking and Finance, 2005

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1 Debtor-in-Possession Financing Sris Chatterjee * Upinder S. Dhillon ** Gabriel G. Ramírez *** Forthcoming Journal of Banking and Finance, 2005 * Corresponding Author Graduate Business School, Fordham University, New York, NY 10023, (212) , Fax (212) , chatterjee@mary.fordham.edu ** School of Management, Binghamton University, Binghamton, NY 13902, (607) , Fax (607) , dhillon@binghamton.edu *** Department of Economics and Finance, Michael J. Coles College of Business, Kennesaw State University, Kennesaw GA 30144, (770) , Fax (770) , gabriel@coles2.kennesaw.edu This is a substantially revised version of an earlier paper which was presented at the 1997 Financial Management Association and 1998 Western Finance Association meetings. We thank David Dubofsky, Mitch Drucker, Michael Fruscione, Jean Helwege, Venkat Subramaniam, James Seward, the editor, associate editor, and a anonymous referee for their helpful comments. We acknowledge that CIT and Chemical Bank provided some of the data for this study. Gerard Coscolluela, Cameron Cross, E.G. Kim, Yoshi Kimura, Kartik Raman, and Adel Shaikh provided valuable research assistance with data collection at various stages. The authors are responsible for any remaining errors. Electronic copy available at:

2 1 ABSTRACT Several recent papers have documented the benefits of Debtor-in-possession (DIP) financing in the restructuring of firms in Chapter 11. However, the view on benefits is not unanimous and some legal scholars have raised doubts about DIP financing s effects on debt-holders and the possibility of expropriative wealth transfers. In this paper we address this issue by analyzing both stock and bond price data for a comprehensive sample of DIP loans and find significant positive abnormal stock and bond returns at the announcement of DIP loans. Also, we do not find evidence of wealth transfers from junior to senior debt-holders. Further, we examine the DIP loan process in detail and we document important institutional features of DIP loans such as maturity, covenants, fees and interest charges. We find evidence of intense monitoring using covenants. We also find higher fees and charges associated with DIP loans. We argue that overall the results are consistent with the information processing role of financial intermediaries. JEL Classification Code : G21, G33 Keyword: Bankruptcy, Chapter 11, Bank Loan, DIP financing, DIP, Wealth Effects, Monitoring Costs. Electronic copy available at:

3 2 1. Introduction In this paper we provide additional evidence on Debtor-in-Possession (DIP) financing of distressed firms. We focus on two aspects of DIP loans:(1) DIP financing announcement effect on security prices, and (2) structure and characteristics of DIP loans. We analyze both stock and bond returns, and we do so for the largest DIP sample. Previous researchers have not examined bond price data, which allow us to examine whether DIP financing leads to wealth transfers as often suggested in the debate on the appropriateness of DIP loans. Financially distressed firms that restructure under Chapter 11 typically need financing for the continuation of business. Financing under Chapter 11 protection is called debtor-in-possession (DIP) financing. DIP financing is a unique form of secured financing available to firms filing for Chapter 11 under the U.S. Bankruptcy Code. The finance and legal literature provides arguments against secured financing such as DIP loans because these loans provide incentives for managers to undertake risky, possibly negative NPV projects, which is the overinvestment problem discussed in Gertner and Scharfstein (1991) and Triantis (1993). 1 However, John (1993) points out that DIP financing is valuable for firms in financial distress. Recent papers address the issue of whether DIP loans enhance the efficiency of reorganization in Chapter 11 focusing on explaining the benefits (role) of DIP financing. John and Vasudevan (1996) and Dhillon, Noe and Ramírez (1995) develop theoretical models in which DIP financing provides benefits either in the form of certification or signaling - the DIP loan is a positive signal of the firm s future prospects. Fayez and Meyer (2001), using a small sample of firms, find a correlation between the DIP announcement s positive stock price reaction and subsequent successful reorganization. Carapeto (2003) finds higher probability of successfully reorganization for DIP firms and positive effects 1 For an overview of the secured credit debate see White (1994). More specifically, Jensen and Meckling (1976) analyze the risk-shifting incentives associated with financial distress and Kanda and Levmore (1994) discuss the risk shifting resulting from secured borrowing in general.

4 3 of DIP loans on recovery rates at reorganization conditional on loans structure. A recent paper by Dahiya, John, Puri, and Ramírez (2003) finds that (1) DIP-financed firms have a shorter reorganization period (they are quicker to restructure under Chapter 11) and (2) contrary to perception, there is little evidence of systematic overinvestment in DIP-financed firms. Also, Triantis (1993) and to some extent Datta and Iskandar-Data (1995), and Chen, Weston, and Altman (1995) address the value added by new senior financing in reducing the underinvestment problem. In short, there is broad agreement that DIP financing is beneficial in the reorganization process. However, none of these studies look at assessing the benefits of DIP financing in terms of the market reaction of the firm s securities at the time of such loans are announced. In this paper we address to what extent are the benefits of DIP financing shared by both stockholders and bondholders of the distressed firms and if not, then whether the stockholder gains are at the expense of bondholder losses?. We also investigate how DIP loans are structured and how the DIP lender is compensated for the services rendered. We document a rapid growth of DIP financing during the latter part of the 1990s. The recent Chapter 11 filings of large publicly traded firms such as LTV Corp. (Dec 2000), AMF Bowling (July 2001), Bethlehem Steel Corp. (October 2001), WorldCom (July 2002) and United Airlines (December 2002) and the availability of DIP financing in these cases provide an example of the vital role of DIP financing in bankruptcy restructuring. We find positive stock and bond price reaction to the announcement of DIP financing. We also find evidence, based on a subsample with data available, that there is no wealth transfer from junior to senior bondholders. We contribute to the literature by showing that both stockholders and bondholders gain from the benefits of DIP financing as recognized by the market at the time of the announcement of such loans and that there is no wealth transfer resulting from the super-priority status given to these loans. Our analysis also shows that DIP loans are typically short-term revolving lines of credit that restrict the use of proceeds to working capital and that DIP loans incorporate a significant

5 20 Table 1 Sample Description Dollar figures are in millions. This table presents descriptive statistics for our sample of 185 Chapter 11 firms obtaining DIP financing and 424 Chapter 11 firms that did not obtain DIP financing during the period Panel A: Distribution of firms by year Year Number of Filing for Chapter 11 Number of Non-DIP Number of DIP DIP Percent of DIP Amount of DIP loan in millions Mean loan to total assets $ % % , % , % , % % % , % , % , % Total % $10,798 Panel B: Industry distribution a Industry Number of Filing for Chapter 11 Number of Non- DIP Number of DIP DIP Percent of DIP Amount of DIP loan in millions Mean loan to total assets Industrial manufacturing $ % Consumer manufacturing % Air Transportation % Retail , % Others , % Total $10,798 a SIC codes are classified as manufacturing industrial ( , , ), manufacturing consumers ( , , ), air transportation ( ), retail ( ), and others (1700, , , , and ).

6 21 Table 2 Stock and bond excess returns around the announcement of DIP loans This table presents security price reaction to the announcement of DIP approval. A market model using Scholes-Williams (1977) procedure to adjust for non-synchronous trading is used to compute standardized cumulative abnormal stock returns (SCARs) 1. A methodology similar to Warga and Welch (1993) is used to compute monthly risk adjusted bond excess returns. The individual bond return is adjusted for risk using the Lehman Brothers high-yield bond index. To avoid data biases outlined by Warga and Welch (1993), the monthly bond prices do not include "matrix" prices and are from the Moody's Bond Record. All multiple bond issues are considered. For stocks, the announcement period is defined as days 1, 0, and +1 while for bonds the announcement month is month 0. Returns are reported for 62 stocks and 53 bonds with available data and are in percent. with simultaneous Chapter 11 and DIP announcements are excluded from the analysis. Panel A: Standardized Cumulative Abnormal Returns (SCAR) Trading Days Standardized Cumulative Z Statistic Excess Returns (SCAR) [-1,0,+1] We conduct a series of checks for robustness tests. We estimate excess returns using the traditional market model, and market adjusted returns. Additionally, we re-estimated the models using equally- and valueweighted index. We also used median excess returns. The results are very robust to the change of model, procedures, estimation periods, index choices, and measurement of excess returns. Panel B: Monthly bond excess returns Month Excess return z-statistic

7 22 Table 3 Structure of DIP loans This table presents the structure of DIP loans during the period Maturity, type of DIP facility, restrictions on use of proceeds, and collateral for the loan are provided. The data are from the SDC syndicated loans database. Data on borrowing base is available for only 21 firms from court documents, credit agreements, internal documents, and reorganization plans. Structure of DIP Loans Number of firms Maturity One year or less 38 (35%) Between 1 and 2 years 47 (43%) Over 2 years 24 (22%) 109 Type of DIP Facility Revolving line of credit for less than one year 24 (25%) Revolving line of credit for over a year 59 (60%) Loan (term, demand, bridge) 7 (7%) Others (limited line, stand by letter) 8 (8%) 98 Number of DIP facilities with revolving line of credit and/or term loan 25 (25%) Restrictions on use of proceeds Working capital 29 (63%) General corporate purposes 10 (22%) Allowed operating expenses 6 (13%) Real estate loan 1 (2%) 46 Borrowing base Inventory 8 (38%) Inventory and accounts receivable 11 (52%) Cash or other assets 2 (10%) 21

8 23 Table 4 Covenants in DIP loans a This table presents the distribution of covenants for 20 DIP loans with available data from court documents. For comparison, covenants of junk bonds and bank loans taken from table 3 (Panel B) of Gilson and Warner (1997) are also presented. Frequency in Percent Type of covenants DIP Loans Junk Bonds Bank loans Affirmative covenants Financial reporting and disclosure b Payment of insurance, obligations, and taxes, and compliance with other laws Negative covenants Operating activities Capital expenditures Disposition of assets Financing activities Specific financial ratios that trigger defaults Cash payouts Preservation of lender s collateral and/or seniority Changes in management, control, and ownership Parent-subsidiary transactions a Information obtained from 10 DIP court motions, 6 credit agreements, and 4 reorganization plans. Information on affirmative covenants is only available on the credit agreements or DIP court motions. b Includes annual, monthly, and weekly reports; consultants and bankers reports; business plans; court motions, applications, and financial information filed in Chapter 11; reports to committees, shareholders, creditors, and financial community; audits; projections; notice of default, changes in the environment, or material adverse changes; and Uniform Commercial Code search results. Other conditions include permission for professionals to examine and inspect books, verify material reported, and to conduct physical inventory.