Hello, I'm Stephanie Gleason, Senior Reporter for The Deal, and you're listening to Fresh Start. Today's topic is creditor on creditor violence, which is a colloquial term that's been used to describe very aggressive transactions. involving alliances between groups of lenders. It's one of the more complicated but also fascinating things happening in the world of distress right now. Here to talk us through the topic is Berkeley Law professor Kenneth Ayat.
His areas of research include bankruptcy, corporate finance, and law and economics. His paper, Bankruptcy or Bailouts, with former Fresh Start guest David Skeel, was chosen as a top 10 article in corporate and securities law. by the corporate practice commentator. His latest paper with Alex Wong is called Standardizing and Unbundling the SubRosa Dip Loan, which examines the ways these transactions are influencing loans in Chapter 11.
We'll discuss it further today. Thanks so much for being here today, Ken. Thanks, Stephanie. I'm looking forward to the conversation. Thanks for inviting me. Of course. I'm going to set the stage a little here about creditor-on-creditor violence. The original deal that started it all was in 2016, and J.Crew needed to raise funds. They didn't file for bankruptcy, but they needed money.
And they did a deal that many trace back to the original creditor on creditor violence deal. So maybe you could explain to us what we're talking about when we use that term. Yeah, thanks. And it's interesting, just like there's a lot of war in court and out of court about these deals, there's also a war of words about what to call them. And for the people who are on the losing end of these transactions, they'll call them creditor-on-creditor violence transactions.
proponents of them, they tend to call them liability management transactions. And the transactions kind of tend to fall into two buckets. One of them is called the drop-down and the other one is called the up-tier. And let me just talk a little bit about each one. So we can kind of set out those buckets. So J.Crew, as you mentioned, is the most famous example of what we call the dropdown. The dropdown transaction is company needs to...
refinance. And in the language of distress, people will say, the company needs some runway. They have some impending maturities. They need some more time to turn the business around. And the dropdown technique is taking collateral that we thought was subject to some group of lenders and moving that collateral into what's called an unrestricted subsidiary.
By moving the collateral into an unrestricted subsidiary, you can make it available to refinance other debt or otherwise provide some liquidity that allows the company to keep running. It gives it some runway, as I said. So J.Crew is the most famous. drop-down transaction. The other type of transaction is called an up-tier. The up-tier doesn't involve any new subsidiaries or any movement of assets, but what it involves is amending.
the loan documents to allow some group of lenders to take a senior position over others through an exchange. So they're exchanging their debt that was first lien debt into some kind of super senior layer of debt. And in that process, usually the company is getting new loans. So the company's getting new money, they're getting new liquidity, they're getting runway. And in the process, in both the dropdowns and the up tiers...
Some creditors will benefit and some creditors will be on the losing end. And, you know, I think getting back to the language again, why do we call them, you know, creditor on creditor violence transactions? All restructurings have winners and losers. But I think what sets these kinds of deals apart is two things. One is these are secured creditors that are being harmed by the transaction.
In the word secured, you have the word secure, right? So these are lenders who thought they had some kind of first lien position and collateral that they were secure. And then they come to find that either their collateral has been stripped away from them or they found themselves subordinated to a layer of debt that their contract said wasn't supposed to happen. So it's upsetting the expectations of the parties and the deals.
I think that's part of why it's called violence. And then the other part of it, which makes these deals endlessly fascinating to me as an academic is usually.
These transactions involve someone combing through the documents to find a loophole that will enable the transaction. And this was certainly true in J.Crew. In order to move this... collateral into an unrestricted subsidiary, they used a particular provision called a carve-out that was really meant to allow for overseas subsidiaries to invest, but they used it to move collateral. And then in the most famous up-tiering transaction, the Serta transaction, same thing. There was a provision.
called an open market purchase provision that was used to enable the up-tiering. So the upsetting of expectations is part of why these things come to be known as creditor-uncreditor violence. Yeah. Let's break down a couple of the things you just discussed. I'm a words person. I love the word, you know, like all the terms they've come up with with these things. But actually, I think for my mind, like the dropdown and the uptier really helped me sort of understand the way these transactions work.
even though it sounds a little opaque. So J.Crew is the dropdown. Right. And I think in J.Crew specifically, I believe it was made well that they spun off, right? Or like Neiman Marcus did it too. They spun off one of their brands. So they say drop down, but it's almost like to the side. And then they raise new debt against it on a very basic level, right?
Yeah, the Neiman Marcus transaction was one of their brands. My Teresa, I think. My Teresa, that's right. So a European brand that they moved into unrestricted subsidiary kind of form. The J.Crew transaction was actually J.Crew's trademarks that they moved into the unrestricted subsidiary. But usually it involves in these dropdowns some kind of intangible asset.
That's hard to value. And the fact that it's hard to value is part of what enables the move because these documents, and again, this is part of what interests me so much, you would think a secured credit... contract might be pretty simple. It's like, here's your collateral, here's your interest rate, here's when you got the loan has to be repaid. But these are very complex documents. These are tens of thousands of words and hundreds of pages.
And the documents have these very specific limits as to what the company can and can't do. And so part of the, in moving intellectual property value, there are usually terms that prevent... movement of a particular amount of value. Well, if you're moving intangibles, it's kind of hard to know exactly what they're worth. And that can be to the advantage of the borrower in trying to make these moves. Right. And then the up-tiering is...
Like literally, you've moved the debt up in the priority. So it sort of has skipped above the old senior debt, right? Yeah, exactly. And again, the documents will have provisions saying. This is first lien debt, and you can't layer any liens on top of our liens without permission. The tough part is that there are also provisions that allow the documents to be amended.
And some of those provisions just require majority rule to amend the document. And so if the borrower can get a majority group to be the kind of winners in this up tiering, they can agree to make an amendment. That would allow for the layering of senior debt that the document previously didn't permit. Because you've got the majority to amend the document, you can layer on senior debt.
And the most clever part of these transactions is often, how do we get around provisions that are what are called sacred rights? So some things you can amend by majority rule. But other things, you require everyone, all the creditors to be on board to make an amendment. And in the CERTA up-tiering transaction...
There is a protection called pro rata protection. It basically says money that's paid out from the borrower to the lenders has to go to the lenders equally. So how do we get around that? And in Serta, there was... kind of an escape hatch that they use this device called open market repurchases. So if you can say that the majority lenders
weren't being paid in a non-pro rata way, their loans were purchased in an open market repurchase. That's what allowed them to get this new debt that's layered on top. All of this. And again, the reason we go back to the phrase violence, I think there's usually some kind of loophole that's being pulled on to make the transaction work out. Right. Yeah. Like one of the terms I've heard.
That's not creditor on creditor violence is like non pro rata deals where, like you said, they're skipping over this idea that all the creditors have to get paid out the same amount. And one of the things that... always stands out to me when you're reading. The minority group creditors almost always have sued to try to block these deals and you read the complaints.
They talk about not being included in meetings and things like that, where then the company unveils this deal. And it's amazing to me. So basically, a portion of the creditors or the lenders will... band together and leave out a certain group. And that's sort of, I think, where this idea of violence comes in, that they've been left out of a deal that a majority group is going to get paid out really well and a small group is going to be sort of left out.
Yeah, that's right, Stephan. I mean, I think the part of what makes this all controversial is, you know, if you want to do a restructuring and you offer the terms of the restructured debt to everyone. Usually, that is something that's okay because, look, all the creditors are getting the same deal. But when you pick out a majority group and offer the terms to only them, then clearly you get a deal that seems, after the fact, quite...
unfair. Of course, the proponents have arguments. I mean, their argument is, look, what's so bad about this? I mean, again, this is a distressed company that's getting runway from this. They're getting some more breathing space. It's keeping out of bankruptcy, which is costly for everybody and nobody wants. And look, this is the document you signed on to. This is the document you bought into. And so you're just getting the bargain that you struck.
Look, these are sophisticated parties that are trying to balance the interests of the debtor to have flexibility and the interests of the creditors to have protection. And indeed, some of these terms just can be amended by majority rule, and that's what they're doing. So this isn't just J.Crew and then Serta Simmons that have done these deals. There have been a whole group of... Those are probably the first in each category, but there have been tons of copycat deals first. And it feels like...
More recently, there have been sort of like taking the deals even further, making them maybe more aggressive. Is that right? Yeah. You know, I think this has been a real, I think, sea change in norm. And I think J.Crew was a turning point, I think, in these deals that the goal now, I think, in any restructuring liability management transaction is to read the documents carefully and try to do the most you can do. And I think each...
phase becomes the baseline for the next restructuring. So something happens like J.Crew that becomes the new normal, and then the next deal tries to take it a step further. space, the Encora restructuring is one that took the sort of up-tiering step further.
And it did it in two ways. One, and again, the loophole aspect of this is really fascinating. So in Quora... a minority group actually got together and formed to try to block the up-tiering that they were expecting and yet found that it happened to them anyway and the you know the clever aspect from the majority side was the majority in Incora, because we were talking about secured bonds and not loans, the bonds, some of the material terms can be changed with more than two thirds.
The minority group had more than two-thirds of the debt, but what the majority group did was they basically got the borrower to issue them enough new debt to be able to cross over the two-thirds threshold. and then executed their up-tiering. So using additional debt to get over that threshold was one of the interesting and aggressive parts of Angora. And then the other part of that was, usually for the borrower and the shareholders of the borrower,
All they're getting from it is, again, like kind of more runway. So they're getting maybe some new money, more time basically to turn the business around. And that helps their equity value that way. In Incora, the sponsors got a little bit more than that even. They had some unsecured debt that they used the tiering to elevate their own priority over the minority lenders. So that was kind of...
a more direct benefit that they took through this restructuring. And so, you know, the minority group, they're not like just going to take it. Pretty much most of them, there is litigation and lawsuits. Yep. And where does that stand? I mean, are these deals still permitted? Or there haven't been any rulings, have there, to say that lenders and creditors can't do this?
Yeah, well, so there have been some signs recently that courts are showing a willingness to push back. And so in CERTA this year, A judge said that some of the important claims survived a motion to dismiss. So that's not a final ruling. But I think what market participants are paying a lot of attention to is...
Two things. The minority lenders will say, well, look, this is a breach of the contract. This was, in the case of Serta, you say this is an open market purchase, but what you did was a private exchange. It wasn't any... open market purchase in the sense of what the document says. So there's a breach of contract claim, which kind of gets into the weeds of what the document says. But I think even more, maybe bigger than that.
is a claim of an implied duty of good faith and fair dealing, which is in every contract. The judge in Serta said that that survived a motion to dismiss. And that could be a big deal because... Again, in these complicated documents, if you're smart enough and you look hard enough, you can always find something, some kind of loophole.
The four corners of the document in general is not going to be enough to protect minorities against these transactions. It becomes kind of a game of whack-a-mole. There is evidence out there suggesting that Documents do improve over time. Adjustments get made to try to correct J.Crew. So after J.Crew, there was J.Crew blockers started showing up in documents and there were certain blockers too. But this game of Whack-A-Mole...
You can shut down the last transaction, maybe not the next one. But it's a different step if courts are willing to say, look. Apart from the specific language of the contract, you took some steps to not honor the spirit of the contract. And so when courts are willing to consider this kind of good faith and fair dealing, that gives the minority a bit more than just the four corners of the document.
Right, right. And so you have been sort of looking at the way these deals, which are all happening outside of bankruptcy. These are companies that are distressed that, as you said, need runway. And although several of them have eventually gone on to file for bankruptcy, these are deals that are happening outside of Chapter 11. But your new paper sort of looks at the one case in particular that did a deal that seems to be modeled after...
after SIRTA in some ways. JCPenney, can you explain how that worked? Yeah, you know, this is something I've been doing a little bit with my work lately is taking a particular... company, a particular story and doing a deeper dive on it to understand exactly what's going on in these complex transactions. And JCPenney...
Gave me mixed feelings when I went to study it. And by the way, this is a paper that a working draft will be coming out soon with my co-author, Alex Wong. It's called Standardizing and Unbundling the Subrosa Diplome. Talk more about that kind of technical title in a second. But as a kid, JCPenney was an institution. I mean, I remember you always got to go back to school. You want to buy some clothes to get ready for back to school. You go to JCPenney and in studying bankrupt companies.
A lot of times this happens. Companies that were institutions when you're growing up are now only a fraction of their former selves. And JCPenney, the difficult retail environment, and of course, when COVID hit. In 2020, it was an absolute apocalypse for retailers. And so here you've got a company wants to be open and selling pants, but the pandemic shut it all down. And now they've got to decide what to do.
You've got 60,000 employees, you've got stores that are shuttered, and you've got creditors that were over what to do with the company. And JCPenney, the transaction, as you said, Stephanie, what happened... Inside of bankruptcy was very much like the Serta deal that happened outside of bankruptcy, but it happened through the device of the bankruptcy loan, which is called a dip loan, debtor in possession loan. So they did an up-tiering.
using the dip loan as the device to do it. But when you do things inside of bankruptcy as borrower and the majority group, you have a lot more power and the lenders have a lot more power than they would outside of bankruptcy. So in these sort of type deals, yeah, the majority got priority position over the minority group and they did what's called a...
a rolling up. They took some of their debt that was originally sharing equally with the minority and put it at a higher position than the minority. That's a rolling up. Well, JCPenney did a rolling up too, but- Not only did they do that, but they used big trend in corporate reorganization is the majority group not only rolled up their first lien debt into this debtor and possession loan that had this super senior position.
but they also took control over the case. And this is a big deal in the world of bankruptcy that really at the beginning of cases, the debtor and possession loan all but determines the outcome of the case. Not only are you making a loan and getting a certain priority position, but you're saying as part of the loan, this is how we want the case to play out. So JC Penney, you're getting this new money. Here's the new money you get.
But in a couple months, you have to present to us a business plan, and we can either approve that business plan or not approve that business plan. If we don't like it, we can proceed to an immediate sale that could close the business down. If we like it... You can keep going and have a shot at survival. But these loans that are tied to what are called restructuring support agreements or RSAs give the dip lender a lot of control over how the case plays out.
and how the lenders are paid back. So a dip loan isn't just an ordinary loan anymore. It's really a loan plus control over the case. plus kind of a predetermination of who gets paid in the reorganization plan and how much. Right. So in your paper, you talk about taking this to its furthest extent, golden ticket bankruptcy. Can you explain how you think that you could get from where you are in J.Crew to jump to this golden ticket bankruptcy?
I guess comes from the Willy Wonka and the chocolate factory. So this is just a thought experiment from me, which is, you know, suppose that we had a world where the debtor comes into bankruptcy court and says, look, judge, here's the deal. Here's the creditor or creditor group that we've chosen to receive the golden ticket. And when you get the golden ticket, you get everything. So basically, you're awarded.
The company, 100% of the company, you control the assets, you can do with them what you want, you get 100% of the payout. And bankruptcy doesn't work that way. It is just a thought experiment. But we're arguing that that's kind of the direction that bankruptcy law is going. And is that a good thing or a bad thing? The good side to it, and this is what...
parties argue in court when they're trying to get these transactions through is, look, decisions need to be made quickly. And again, if you think about JCPenney, again, with all their stores being closed, they're bleeding tons of cash. And decisions need to be made quickly. Vendors, we need shipping of new products from vendors. If they're ever going to sell anything, they're ever going to be able to open up again. Decisions need to be made quickly and parties who could leave.
you know, ship their stuff somewhere else. They need certainty. Golden Ticket would provide that certainty. Just give the entire company to one party. No one's going to fight anymore because all the litigation's gone. No squabbling over value. You get it all. And that clears things up. Now we can exit bankruptcy really quickly, really cheap, and have a path that reassures all of our counterparties that we're going to survive. And so it sounds like crazy at first, but you can see what...
the benefit of it is. And thinking about it from a judge's point of view, all this kind of intercreditor warfare just seems like a costly distraction. Because again, you've got a whole business at stake here with 60,000 people who rely on JCPenney being alive. And here you've got a war of hedge funds about who gets what.
What's really at stake here? It's survival of the business. And let's get rid of these hurdles and allow the company to move forward. So you can kind of understand why these increasingly aggressive kind of plan determining loans. get approved by courts. And the phrase sub Rosa, the sub Rosa dip loan, is the idea that the loan kind of behind the scenes determines the reorganization plan. The way bankruptcy was set up to work is...
At the beginning of the case, you get a loan. The loan allows you to operate in bankruptcy. And at the end of the case, you confirm a plan of reorganization that decides who gets what. And increasingly, those two things are blending together that the dip loan. looks a lot like a plan of reorganization right at the start. And so in bankruptcy language, we would call that kind of a sub-Rosa diploma. Right, where the outcome has been determined.
By the structure of the loan. By the structure of the loan. And the idea is by tying the loan to this RSA or some other plan determining contract. the debtor, can they make some other choice? Can they take the case in some other direction? Well, not really, because they would risk losing access to their financing in bankruptcy if you make an event of default.
under the loan, pursuing some other alternative plan. Cash is king and the ability to control the purse strings gives the lender a lot of power. For the borrower to try to divert from that and pursue some alternative is unrealistic once you've locked the dip loan into the future plan outcome. And so... For example, there was a challenge to the loan in JCPenney, correct? Yeah. And the minority lenders are going to say...
look, first of all, you're not allowed to prime us. The documents don't permit that. And they also offered a rival loan. They said, look, you've got this loan that is extremely expensive. high interest rate, lots of fees, gives you control over the case and whether the company survives. We're going to propose an alternative loan that has better terms. And so in bankruptcy, that's one of the things the minority kind of has to do is...
propose an alternative that they say is better for the borrower. And again, they did kind of propose a rival loan that had better economic terms to it. But here's kind of where the weeds of bankruptcy law get. involved is the minority loan, which just like the majority loan was a priming loan, it was supposed to kind of come ahead of all the existing lien holders. The minority group, because they were in the minority,
didn't have consent to the priming. And so they would have had to have a priming fight. And that priming fight, the borrower argued, the company argued, would have been too costly, too expensive. In these situations, time is of the essence. And so the majority uses that to their advantage. They'll say, look, again, to have a priming fight, yeah, this minority groups loan their economics are better, but to have a priming fight.
is going to take too long. It's going to be too contentious and allege a parade of horribles that the company will blow up if we even go down that path. So yeah, we've got a loan whose economics are not quite as good, but because we're in the majority... We don't need to have this fight over the priming. And so it's just a clearer and faster path. And so the minority lost in that attempt to defend themselves through a competitive offer. And I think that's one of the real...
problems of chapter 11 is that in a majority situation like this, you're kind of a monopolist. If you can squash competition in that way... you can dictate the terms and ultimately dictate the terms of the whole reorganization. And chapter 11 wasn't really set up to deal with that problem. It's something that judges are having to wrestle with on a kind of case-by-case basis about how to balance these concerns.
Right. And so in JCPenney, the majority wins out. And what was the outcome? How were they rewarded? Yes. So the company survived, and the ultimate outcome was an opco-propco transaction. So their main landlord, Simon Brookfield, they took control of the operating company. So they're basically running JCPenney.
And the majority lenders became owners of a property company. They own the real estate and they're leasing it to the operating company. So that was the... outcome is jc penny survived and they survived in this kind of you know opco propco structure and so from the outsider's view that's kind of what happened from the point of view of who got what It was a huge win for the majority group. Alex and I did a little back of the envelope calculation because what this loan had was a bundle of features.
Your cell phone bill, you get a bill from Verizon and they tell you, oh, you're going to have a cell phone for $60 a month. And then you look at the bill and it's $120 and there's service charge and this fee and the FCC connection fee. you know, all these add-ons and this dip loan had a lot of add-ons to it that allowed the majority group to get a really big recovery. So what we did was we said, well, suppose this wasn't the...
complicated bundle that it was. Suppose it was just a plain vanilla loan that the majority group just made a dip loan, and the way that they got paid was just through the interest rate, like an ordinary loan would be paid. Well, in order to give the majority the same amount of money they got on a plain vanilla loan, the interest rate would have had to be...
over 500%. So it would have taken an interest rate of over 500% to give the majority kind of what they got out of JCPenney. Why did they get so much? It was a combination of fees, as I said. They took a 10% fee right off the bat. So 10% of the money that was bundled into the loan was actually taken straight away by the lenders as a fee. Also, this roll-up, they were able to take debt that would have been paid 40 cents on the dollar or less.
and move it into a super senior form, which is going to get 100 cents on the dollar. So they did that. But also through the way the company was reorganized. The super senior loan wound up getting more than 100 cents on the dollar. So something between different estimates out there. But on the loan, the super senior loan, they wound up getting between 130 and 160 cents on the dollar.
through the way they structured the transaction. So again, chapter 11 is kind of set up to do a final reckoning of the company through this plan of reorganization. But what they did was they did it through a sale. where they bid their debt, called a credit bid, to take control of the company. And what that enabled was for the majority group to kind of get the company without having to recognize what the company was worth.
And so if you can leave that opaque, you can get maybe more than 100 cents on the dollar in recovery without the minority group being able to do much to stop it. And so that's a long winded explanation for what happened. But the company survived. But it was a big win for the majority at the expense of the minority. Yeah, absolutely. And, you know, you think about a judge in this case reviewing these things and.
Understanding the stakes, judges are very motivated to try to keep a company alive. That's one of their main priorities. And so that pushes against their ability to really... say no to these loans, right? Absolutely. And I don't envy the judge's position in all this. I mean, it's easy for an academic to just go out and start attacking judges, but I really don't envy their position in this because...
The parties are coming to the table and saying, look, this is a time sensitive deal that we've got here. And it's the only deal on the table. And it's this or potential liquidation. And in the case of this. sale of JCPenney for the credit bid, which again helped the majority get a big win, their argument was, we can't do a reorganization plan in the traditional way. There's no time for that. The holiday season's coming up.
Simon and Brookfield are here. They're willing to participate in this deal and they want the deal done now. They want to take control over JCPenney because they want to make sure the inventory is there on the shelves for the holiday season that's coming up. And for a judge to look at that argument and be able to push back and say, no, you're bluffing. This isn't time sensitive at all. You could do things in the normal way and give the minority lenders their...
the protection they're entitled to, it's hard. And so there's potentially a lot of risk. And if that threat is really carried out, a broad range of stakeholders, again, like employees. suppliers and so forth lose from this. And that's kind of a risk to take. But at the same time, I think we argue it's a risk worth taking because a lot of times what appears to the judge to just be a squabble between hedge funds.
has broader implications. It's troubling when bankruptcy is a device that can be used to... upend priorities in the way that happened in JCPenney. And if that continues to be the norm, if golden ticket, if we're moving in the direction of the golden ticket bankruptcy system, there's some real potential costs of that. And it does make sense, I think, to have a system that tries to defend the priority structure of debt.
You can imagine all kinds of things that could come from this, but what about the bankruptcy that doesn't really need to happen at all? What if a majority could do an up-tiering and they need to use bankruptcy law to do it? And now you've got a company that doesn't really belong in bankruptcy at all using the bankruptcy code just to achieve this restructuring of priorities. And once things go into bankruptcy, what happens to the fate of the company is really...
up in the air. And that was alleged in JCPenney. I mean, some parties did say, you know, they're saying they need this dip loan. But I see a couple hundred million dollars of cash on their balance sheet here. Do they really need this loan or is this just a device for creditor-uncreditor violence? And there was also some allegations that...
The lenders, the majority group, didn't even want JCPenney to reorganize. An unnecessary bankruptcy starts happening to do these credit-on-creditor violence transactions you worry about. what might happen more broadly for the system and all the stakeholders in the game. Right. So you think a world in which these deals are just rubber stamped in bankruptcy.
could ultimately lead to more problems for the companies involved. Yeah. And besides that, again, the unnecessary bankruptcy, which is something you worry about. Going back to what we were talking about before with the lender-on-lender violence stuff. Within the word secured debt is the word secure. And the whole benefit of secured debt, and maybe even the benefit of our bankruptcy system generally, is some people can lend and go away.
and not be sophisticated and not be intimately involved with the borrower. And if the collateral value is there, you're supposed to get paid. And I think that's a real benefit to our system, that it allows companies to really make a commitment. to lenders that if the collateral is there, you'll get repaid, even if you're not an activist hedge fund, and even if you're not in a majority group, and even if you didn't insist on an airtight document.
You contracted for collateral, and you're going to get repaid. And I think you worry about companies' cost of capital going up if the only way you can get paid in bankruptcy is to be a member of a sophisticated coalition. That's a very different system than the one we have. And I think it's an important role of bankruptcy law to try to defend the priorities that the parties contract for. Right. So these kind of deals.
down the road could make it more difficult for companies looking to take out loans in the first place. You see a lot of the victims in these transactions are CLOs. So these are vehicles that are set up to purchase pools of secured debt. issued by companies. And a lot of the holders of CLOs are insurance companies and pension funds and so forth. I think it's worthwhile to have vehicles that allow...
lenders who are distant from the borrower to be willing to provide capital to borrowers. And you start shutting down those avenues because, again, only the sophisticates get the money and then the less involved actors don't. you're potentially increasing costs of capital that could have unknown negative effects. And JCPenney is obviously a very dramatic... example of this, but have there been other companies that have taken similar approaches in Chapter 11 since then?
Yeah, the development that's happening in this space, again, is like the dip loan is looking more and more like a reorganization plan. And one of the developments that's been happening in cases like LATAM, a Chilean-based Latin American airline. SAS Group, the Scandinavian airline, is you're starting to see dip loans that are supposed to be payable with equity. So a loan is supposed to be debt.
supposed to be repayable with debt, but you're seeing loans that are supposed to be repayable through rights offerings. This is the idea that the holder has the right to be repaid with stock. in the reorganization plan that they can purchase at a discount. And again, just like the controversy in all these lender-on-lender violence transactions, you have the ability to get certain treatment that's available to only a certain group and not to others.
So the right to purchase stock in the reorganized company at a discount is a very valuable right. And it's being offered to only majority groups in these deals with the minorities being cut out. And the challenge with all that is you're asking a judge, again, in a time sensitive kind of context, loan needs to be approved for the company to survive. They need the money.
And yet you're giving away rights that you have no idea what they're worth. I mean, the ability to purchase discounted stock in a reorganization plan that maybe, you know, months, maybe even years ahead is something that's very hard to value. And expecting a judge to be able to put a value on that to know what's being given away is unrealistic. And one of the things we argue in the paper is, you know, loans are, and the bankruptcy code makes dip loans standardized. It says...
Look, you can get repaid. You're making a new loan to the company. You're entitled to be repaid. But the way you get repaid is with debt, with a principal and an interest rate. And that serves a kind of transparency function. It makes it possible to know. what the borrower is giving away when they sign on to this dip loan. And so these developments of paying loans with equity really undermine that. And again, kind of blur these lines between what's a loan and what's a reorganization plan.
Right, right. You beat me to it. My next question. So out of court. Of course, it's about the documents and like, can you protect against this and the documents? The way you were talking about it before sort of reminded me of like COVID and the vaccines, like trying to stay in front of the variants with the vaccines. Like, can they keep the contracts far?
to be able to predict what loopholes they might find next. But it's a good analogy. It's a little like fighting the last war kind of. Right. That's what you worry about in these situations when you leave it only to the letter of the documents. But it seems to me in bankruptcy, it might be easier to protect against these kind of deals. And I'm wondering if you have any thoughts on how courts might be able to do that. Well, as I said, I think that courts...
I think would benefit from drawing a line as to, number one, how a dip loan can be repaid. It's meant to be debt. Can't repay a dip loan with equity. That shouldn't be admissible dip loan compensation. Another thing we argue in the paper is that there's a benefit to unbundling transactions. A loan is supposed to be a loan. When you start tying a loan, bundling it to these RSAs that…
ultimately determine the outcome of cases, you're doing too much upfront. And again, it's in the interests of the lenders to do this, to say, you know, to take advantage of the time emergency context of the dip loan. to try to bundle in a lot of things. But some things should be left for the reorganization plan when you have time to really determine whether priorities are being respected.
or not. And so we put these two words out there, standardizing and unbundling with the idea that these are tools that judges have applied throughout the history of bankruptcy law and should keep an eye on to make sure that we keep bankruptcy working the way it was intended to work. It is supposed to be a tool that gives the company liquidity, allows it some time and breathing space to make decisions, but doesn't at the same time lock down the outcome at the very start.
It almost seems like you're encouraging judges to call the bluff a little bit and let's see if there's a more standard diplone that we can make work in this context. Is that fair, you think? I think that's right. Yeah, I think judges do ultimately have to kind of call the bluff. Look, in emergency situations where there's not a lot of lenders available, interest rates are going to be high, potentially. That's maybe part of the story.
It's a necessary part of the game. But I think to say that the loan has to take this form, that it has to predetermine the reorganization plan, it has to be payable with rights offerings. I don't think they really made the case that this has to be. That if not for approving these kind of non-standard terms, there's no loan and the parade of horribles happens and the company liquidates. I think...
Most people you talk to in this field would say that these things are probably bluffs and that if judges said, look, it's a standardized product, it's got to be a loan, it's got to have an interest rate, it doesn't get to predetermine the reorganization. And that's the court in this LATAM. case did say that. The court did label the dip loan with plan determining effects a sub-Rosa dip loan, so you've got to go back to make this a loan. But I think that's something that judges will...
have to do to prevent this bankruptcy from being the golden ticket. Well, Ken, thank you so much for being here. I really appreciate you coming on to talk about these important issues with us. Oh, thanks, Stephanie. No, I enjoyed the conversation. And thanks for giving me a chance to talk about my research a little bit. Absolutely. I'm Stephanie Gleason, and you've been listening to Fresh Start.