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Debtor-in-Possession Financing

Sris Chatterjee* Upinder S. Dhillon** Gabriel G. Ramrez***

Forthcoming Journal of Banking and Finance, 2005

Corresponding Author Graduate Business School, Fordham University, New York, NY 10023, (212) 636-6120, Fax (212) 765-5573, e-mail: chatterjee@mary.fordham.edu School of Management, Binghamton University, Binghamton, NY 13902, (607) 777-4381, Fax (607) 777-4422, e-mail: dhillon@binghamton.edu

**

Department of Economics and Finance, Michael J. Coles College of Business, Kennesaw State University, Kennesaw GA 30144, (770) 423-6181, Fax (770) 499-3099, e-mail: 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: http://ssrn.com/abstract=672321

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 financings 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: http://ssrn.com/abstract=672321

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 Ramrez (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 firms future prospects. Fayez and Meyer (2001), using a small sample of firms, find a correlation between the DIP announcements positive stock price reaction and subsequent successful reorganization. Carapeto (2003) finds higher probability of successfully reorganization for DIP firms and positive effects

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.

of DIP loans on recovery rates at reorganization conditional on loans structure. A recent paper by Dahiya, John, Puri, and Ramrez (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 firms 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

number of affirmative and negative covenants, which is consistent with the notion that DIP lenders actively monitor the firms activities2. The rest of the paper is organized as follows: Section 2 outlines the institutional and legal provisions of DIP financing. Section 3 describes the sample selection and data collection procedures. Section 4 presents an analysis of stock and bond price reactions to DIP announcements. Section 5 describes characteristics of DIP loans and fees for DIP loans. Section 6 concludes the paper.

2. Institutional details of the DIP financing process The DIP financing process is initiated once a firm files a petition for Chapter 11 protection either through the traditional method or a prepackaged bankruptcy. This filing activates the "automatic stay" provision in which the pre-petition lenders' contractual and legal rights (e.g., foreclosure, liquidation of collateral, and collection of interest or principal payments) are not enforceable unless permitted by the court or resolution of bankruptcy proceedings. DIP lenders usually ensure that the automatic stay remains in effect as long as the DIP loan is outstanding. Also, the reorganization plan requires that on the date the plan becomes effective, administrative claims and superpriority claims be paid in full (cash). Thus, DIP loans are paid in full (cash) under confirmation of a reorganization plan. In the normal course of business, lenders will not provide financing in Chapter 11 because their claims represent quasi-equity and because financial distress creates severe asymmetric information problems, making it more difficult to value the firm (Wruck (1990), and Gilson, Hotchkiss and Ruback (2000)). However, lending to a firm in Chapter 11 is made possible by a complex set of recontracting provisions in Section 364 of the Bankruptcy Reform
2

Discussions with managers at CIT, a leading DIP lender during the 1990s,suggest that extensive cash flow

analysis is performed before a loan is approved. Detailed worksheets and DIP loan documents obtained from one lender reveal careful scrutiny and extensive level of monitoring required for these loans.

Act of 1978. The main provision is "superpriority" which allows a DIP loan to have payment priority over unsecured pre-petition debt and administrative expenses. It is also common to find superpriority accompanied by a lien on unencumbered assets or even sharing a lien on assets which are already pledged to pre-petition secured debt. If this lien is of equal or senior rank to existing liens held by pre-petition lenders, the process is referred to as "priming." In some other cases, the pre-petition debt is collateralized with post-petition assets in a process called "crosscollateralization." In summary, Section 364 permits significant recontracting to facilitate lending to firms in bankruptcy.

3. Sample description 3.1 Sample selection and data collection procedure We first identified publicly traded firms filing for Chapter 11 during the period of January 1988 to December 1997 using The Default Yearbook and Almanac, Bankruptcy database from Securities Data Corporation (SDC), Bankruptcy DataSource and business news databases from Lexis-Nexis. This process yielded a sample of 740 firms filing for Chapter 11 during the period. We then conducted a two-step search of all sources available to us to identify firms that received DIP financing. First, we electronically searched the UMI News Abstracts, Dow Jones News Retrieval, and all Lexis-Nexis databases: Wires, abstracts, newsletters, all major newspapers, journals and magazines, business news, industry news, and six company news sites. The second step involved hand collection of data from Moodys manuals, SEC filings, Disclosure, 10-K reports, company annual reports, and reorganization plans, summaries, and court documents when available. We meticulously read through all documents available searching for DIP financing. We were not able to verify whether 52 firms received DIP financing and thus did not consider them for the final sample. We also eliminated 84 firms in the financial services, asbestos related chapter 11 filings, and regulated firms that filed for Chapter 11. This

search resulted in a sample of 185 publicly traded firms that received DIP financing3. The remaining 424 firms that filed for Chapter 11 are classified as non-DIP firms.

3.2 Sample characteristics Table 1 presents a description of the sample. Panel A shows the distribution of the sample by year of Chapter 11 filing. About 30.4% of firms filing for Chapter 11 obtain DIP financing representing total loans of $10.798 billion. The number of firms obtaining DIP financing increased significantly during the 1990s from upper twenty percents in the early 1990s to mid forty percents in the late 1990s. The proportion of loan to total assets (a relative measure of loan size) also increased over this time period. Thus, DIP financing is becoming an increasingly important tool for financing of firms filing for bankruptcy. Two recent recordbreaking filings by Worldcom and United Airlines, using DIP financing, are examples reflecting the importance of this trend. ----------------------Table 1 about here ----------------------Panel B presents the distribution of firms filing for Chapter 11 by industry as defined by the two-digit SIC code. The proportion of firms obtaining DIP financing varies across industries. The proportion of DIP firms in the industrial and consumer manufacturing sectors is 25.3% and 29.8% respectively, 31.8% for air transportation and 21.2% for other industries. This proportion increases to 49% for the retail sector. There are also differences in the relative size of DIP loans across industry sectors. Consumer manufacturing and air transportation firms borrow 20% to 30% of their total assets, while retail firms borrow 48% of their total assets followed by consumer manufacturing borrowing 38% of their asset base. The need for DIP loans is primarily driven by

We thank Dahiya, John, Puri, and Ramrez (2003) for making their sample available to us for double

checking and comparison purposes.

working capital requirements of firms during the reorganization process, thus industries with larger working capital needs require greater DIP borrowing. Retail firms are able to obtain larger loans since they normally have larger, lien-free, inventories and accounts receivables which are used as a borrowing base for DIP loans4.

4. Security price reaction to DIP financing announcements In this section we investigate the security price reaction to the announcements of DIP financing. Given the potential benefits of DIP documented in prior literature, we would expect a positive stock price reaction after the announcements of DIP loans. Standard event study methodology similar to Patell (1976) and Dodd (1980) is used to estimate stock excess returns. See Brown and Warner (1985) for a description and application of the methodology. The estimation period for the market model is from 200 days to 60 days prior to the announcement. The CRSP value weighted market index is used and standardized cumulative abnormal returns (SCAR) are used. Since these are financially distressed firms a majority of the returns are expected to be generated by infrequent trading data. We use the Scholes-Williams (1977) procedure to adjust for the non-synchronous trading problem. Firms with simultaneous Chapter 11 and DIP announcements are excluded from the analysis. We select the standard three-day window, [day -1 to +1], as the announcement period for this study. The results are presented in Panel A of Table 2. --------------------------Table 2 about here --------------------------The three-day [-1,0,+1] announcement period standardized cumulative abnormal return (SCAR) is 3.40% with a z-statistic of 3.73, which is significant at the 1% level. Many event studies report the two-day SCAR over for day 0 and day +1. For this sample, the SCAR [0,+1] is

From interviews with VP of DIP department at CIT

5.11% with a Z-statistic of 5.89 (not reported in the table. We also examine the sign of these two SCARs (not shown in Table 2) and find that about 63% of the stock returns are positive and statistically significant (using a sign test) at the 10 percent level. Thus, outliers do not appear to be driving the statistical significance of the results. More importantly, we examine the SCARs for day 1 and day 0 and find that SCAR [-1,0] is not significant which suggests that there is no leakage of information prior to the DIP announcement 5. We also conduct a battery of checks for robustness. Results using market adjusted excess returns, and traditional market model excess returns are very similar to the results presented here. Returns using different estimation periods for the model and for computing variance as well as the use of equally-weighted index remain practically unchanged. Conclusions based on median cumulative excess returns are also identical to those based on standardized average cumulative abnormal returns. Results are not presented in the paper but are available from the authors. The results are not sensitive to the choice of methodology, index, excess return measurement, or estimation period. Thus, we conclude that the positive stock price reaction to DIP loan announcements reflects the benefits of DIP financing. These benefits can come from a better probability of a successful reorganization and/or earlier bankruptcy resolution for DIP firms [Dahiya, John, Ramrez, and Puri (2003)], more monitoring and/or certification by DIP lenders [Dhillon, Noe, and Ramrez (1995)], and/or the higher probability of a successful reorganization as suggested by Carapeto (2003). The impact of DIP loans on pre-existing debtholders (specially junior creditors) remains an open issue. If DIP financing leads to overinvestment in negative NPV projects or if it leads to expropriation of wealth from bondholders, then we should see a negative bond price reaction. On the other hand, if DIP financing leads to investment in positive NPV projects or if it creates other
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The SCAR [-1,0] is 0.94% with a Z-statistic of 1.72. We also examined the stock standardized cumulative abnormal returns over a [-60, -2] window (not reported in the table) and as expected, they are significantly negative reflecting the fact that most DIP firms file for Chapter 11 bankruptcy within the month prior to DIP financing.

beneficial effects shared by both stockholders and bondholders, then we should see a positive bond price reaction. Therefore, we examine bond price reaction for evidence on this issue. We determine monthly risk-adjusted bond excess returns using methodology similar to Warga and Welch (1993).6 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. If a firm has multiple bond issues, the bond excess return is the average of all traded bonds with available data. From panel B of Table 2, the month [0] bond return is 0.46% with a z-statistic of 3.36.7 We get essentially the same result by using median bond returns. For example, the median month [0] bond return (not reported in Table 2) is 0.11% and significant at the 5% level. The month [-1] bond return is negative and significant, reflecting the fact that all firms in our sample with bond data obtain DIP financing either during the prior month or during the month of the Chapter 11 filing and filings of Chapter 11 lead to negative stock and bond price reactions. The positive reaction for up to two months following the announcement is probably due to the confirmation of several pre-packaged bankruptcies during that period8. Bebchuk and Fried (1996), as well as Warren (1996), point out that pledging of assets to new secured lenders can lead to a transfer of wealth from existing creditors to new secured creditors, particularly when firms are in financial distress. Thus, we examine (results not reported) a small sample of firms with data on both senior and junior debtholders, and find that both types of debtholders have positive abnormal announcement period returns. This evidence is indicative of absence of wealth transfers from junior to senior creditors and that the beneficial effects of DIP financing are not restricted to senior debt only. We now turn to the institutional

We attempted to obtain daily bond prices from several sources including IDC but were unable to do so due to lack of data for bonds for Chapter 11 firms.

Since some Chapter 11 and DIP announcements are in the same month the results are biased downward. Thus the results reported here are conservative.

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details of DIP loans in an attempt to provide insights on monitoring activities of DIP lenders.

5. Characteristics of DIP Loans In this section, we investigate the structure, provisions, and covenants of DIP loans. These loan features are likely to capture the extent of the monitoring role of DIP financing. Covenants on DIP loans are of special interests in this area. When firms file for Chapter 11, the automatic stay provisions freeze debtholders rights to enforce their claims and render existing debt covenants practically unenforceable. Thus, DIP loan covenants effectively reinstate the monitoring provisions lost due to the automatic stay.

5.1 Structure of DIP loans This section analyzes the structure of DIP loans. Information on maturity, loan type, and use of proceeds is from the SDC syndicated loans database. For the borrowing base analysis, we use documents filed with the bankruptcy courts, reorganization plans, annual reports of individual firms, and internal loan approval documents for a DIP lender. Despite our efforts, we were not able to collect data for the entire sample. The results of this analysis are presented in Table 3. ----------------------Table 3 about here ---------------------The maturity of DIP loans rarely exceeds 2 years (only in 22% of the cases). The majority of the loans either mature in a year or less (35%) or between 1 and 2 years (43%). The median maturity for the loan is 1.5 years (mean of 1.59 years) suggesting that the funds are not intended for capital investment. DIP loans are usually made in the form of revolving line of credit (RLC) either for less than one year (25% of the loans) or over a year (60% of the loans) and in many cases (25% of the
8

For a detailed study of prepackage bankruotcies see Chatterjee, Dhillon, and Ramirez (1996).

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RLC facilities), the RLC is accompanied by a term loan and/or a letter of credit. In few cases (7% of the loans), the DIP facility took the form of a loan exclusively (either as a demand, bridge, or term loan) and in 8% of the cases, the DIP facility was in other forms of credit (standby letter of credit or limited line). According to Mitch Drucker of CIT, the predominant use of RLC along with a letter of credit facility and the short maturity of the loan shows that DIP loans are intended to match the cash flow cycles of business and to provide working capital. Indeed, a majority of the loans have clauses clearly stating that the DIP loan cannot be used for investments in projects and is to be used primarily for working capital needs. Over 63% of the sample restricts the use of proceeds to working capital needs and 22% of our sample restricts the proceeds to general corporate uses. In a few instances (13% of the cases), the use of proceeds is restricted to operating expenses. These restrictions probably intend to reduce managers incentives to invest in valuereducing projects and facilitate monitoring during Chapter 11. However, the most significant set of restrictions that more likely reflect the extent of the monitoring by DIP lenders is given by the structure and composition of the loan covenants.

5.2 Covenants in DIP loans Berlin and Mester (1992) show that covenants enhance the flexibility and efficiency of financial contracting. Similarly, Rajan and Winton (1995) show that covenants and collaterals are contractual devices that increase a lender's incentive to monitor. The filing of Chapter 11 activates the "automatic stay" provision in which the pre-petition lenders' contractual and legal rights are not enforceable unless permitted by the court. Also, the automatic stay greatly dilutes the monitoring and enforceability of pre-petition debt covenants. DIP loan covenants effectively reinstate the monitoring provisions of pre-petition debt that were suspended by the automatic stay. We find that DIP loans consistently include restrictive covenants that are similar to covenants of bank loans, presumably the type of pre-petition loans held by lenders. There are two major types of covenants: affirmative and negative. Affirmative covenants

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deal with financial reporting and define actions or activities with which a firm must comply. Negative covenants restrict the operating decisions of the firm. Information on covenants is obtained from court documents, DIP loan contracts, plan prospectuses, and reorganization plans. Results of the covenant analysis for a sample of 20 DIP loans with available data are presented in Table 4. Since it is not possible to obtain a sample of bank loans to non-DIP firms, we compare our results with a similar analysis of covenants for junk bonds and bank loans from Gilson and Warner (1997). --------------------Table 4 about here --------------------Similar to bank loans, affirmative covenants regarding financial reporting and disclosure are present in one form or another in all DIP loans.9 DIP lenders also require access to examine and inspect books and conduct physical inventory. The DIP lender closely monitors cash flows of the firm and the quality of the current assets used as collateral, such as inventory and accounts receivable.10 One manager at a large DIP lender stated that, it is typical for DIP lenders to have their representative control and monitor inventory and accounts receivable. This reflects the need for frequent and detailed reporting of the financial condition of the firm. This extensive and constant monitoring of the firm's performance and cash flow position is exactly the kind of

In our analysis of DIP loan prospectuses, we found that DIP lenders typically require weekly, monthly,

and annual financial reports, consultant and banker's reports, business plans, court motions, applications, and financial information filed during reorganization, and material adverse changes.
10

The monitoring also extends to the court process since there is always the risk (as unlikely as it can be)

that an appellate court reverses the borrowing order. The lender must follow all procedures regarding appeals of the borrowing order, events of default, reorganization plans, appointment of trustees, and any other documents served to the court, creditors, or any other party involved in the Chapter 11 reorganization.

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activity that creates value in the presence of information asymmetry.11 As pointed out in James (1987), a firm's commitment to periodic evaluations provides a positive signal of its future earnings prospects. For firms requesting DIP financing, this commitment is of the strongest form due to the extensive monitoring and evaluations performed by the DIP lender. The analysis also shows the extensive use of negative covenants. In 90% of the cases, DIP loans have restrictions on specified operating expenses and operating activities. This compares with only 6% for junk bonds and 67% for bank loans examined by Gilson and Warner (1997) in their sample. Negative covenants restricting capital expenditures and disposition of assets are found in 85% and 95% of the DIP loans respectively, the proportion of these restrictions is significantly greater than junk bonds and are similar to those for bank loans. In all cases where capital expenditure covenants exist, a maximum amount is specified. The restriction on disposition of assets is particularly valuable for the DIP lender since it prevents the firm from diverting collateral. All DIP loans have restrictions on financing activities, offering of liens is prohibited or heavily restricted (the latter is called a negative pledge). The use of negative pledges with superpriority may provide the DIP lender with better protection than a simple collateralized loan. Our analysis shows that DIP loans in our sample have extensive and comprehensive covenants similar to those for other private bank loans. Though we examine a small sample, the extensive array of covenants found is indicative of a monitoring role for DIP lenders.

5.3 Pricing and fees of DIP loans The cost of DIP loans consists of the loan rate and a variety of fees. Generally, there is a commitment and facility (origination and management) fee and an upfront fee expressed as a

11

There is a large literature on signaling and information asymmetry. See Leland and Pyle (1977),

Campbell and Kracaw (1980) and Diamond (1984) among others.

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percentage of the loan.12 A DIP loan is typically a floating-rate instrument indexed to the bank's base rate, or LIBOR, or prime rate. A spread rate is obtained by subtracting the prevailing T-bill rate at the time of the DIP loan from the DIP loan rate we computed. In order to compare these data to other regular RLC bank loans, we obtained a sample of bank loans for non-bankrupt firms and matched the characteristics of these loans to those of DIP loans. The match is based on industry (two-digit SIC code), type of loan (primarily revolving line of credit that is senior and secured), purpose of loan (for working capital), and maturity (1 to 3 years). This matching process does not account for the implicit default risk for DIP loans (however the problem may not be severe since DIP loans have super-priority status and are secured.13 DIP loans are unlikely to default and must be paid before the reorganization plan becomes effective.14 An analysis of interest rates, spreads, and fees for 106 DIP loans and 186 matched loans (not reported in table form) shows that in our sample, the median interest rate charged on the DIP loans is 9.75%, which represents a median spread over the T-bill rate of 4.60%. The median interest rate for the matched sample is 7.25% with a spread of 3.53%. The median commitment and upfront fees are 0.50% and 1.06% for DIP loans and 0.38% and 0.33% for the matched sample respectively. For all the above categories the median for DIP firms is significantly greater than that for the control sample at the 1 percent level. The higher spreads and fees of DIP loans are consistent with the
12

DIP loans also have letter of credit fees when the facility has a letter of credit. We do not present these

fees since we did not have data for the matched loans.
13

During the early 1990s Fitch Investors Services began rating DIP loans as investment grade (primarily A

ratings) but subsequently discontinued rating DIP loans. Nevertheless, we need to interpret the results with some caution.
14

In fact, we found only one instance of default on a DIP loan. Biomedical Waste Systems defaulted on

their DIP loan but repaid it at the reorganization plan with preferred (75% of 350,000 shares) and common stock (75% of 1,925,000 new shares) of the reorganized company. Nevertheless, caution should be exercised in interpreting the results since the probability of default, though rather small, is reflected in the spread.

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hypothesis that the higher spreads are a compensation for higher monitoring cost. However, the results are also consistent with the market power of DIP lenders and/or higher default risk of DIP loans. We attempt to test the relationship between pricing and fees of DIP loans and the extent of covenants by comparing, for a smaller sub-sample, the spreads and fees of DIP loans with covenants data to similar bank loans given to non-DIP firms during their financial distress period prior to Chapter 11. We found 18 such firms with data available in our sample. To obtain a matched sample we use the Securities Data Corporations (SDC) syndicated loans database and compile a list of all loans to non-DIP firms within 3 years prior to the Chapter 11 filing. Then, we identified from Lexis-Nexis financial distress events for these non-DIP firms within this period and selected a non-rated loan that more closely match the characteristics of DIP loans in terms of maturity, type of revolver, seniority and security. A distress event includes defaulting on one of the firms obligations, violation of a covenant, public and/or private workouts, a renegotiation of lines of credit and/or loans to avoid defaults and/or avoid violations of covenants and/or improve liquidity. We only selected non-rated senior secured revolving loans to closely match the nonrated DIP loans. The syndicated loans database did not have a large number of this type of loans and the resulting sample is comprised of 14 pre-filing distressed non-DIP loans.

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In our analysis of DIP loan prospectuses, we found that DIP lenders typically require weekly, monthly,

and annual financial reports, consultant and banker's reports, business plans, court motions, applications, and financial information filed during reorganization, and material adverse changes.
16

The monitoring also extends to the court process since there is always the risk (as unlikely as it can be)

that an appellate court reverses the borrowing order. The lender must follow all procedures regarding appeals of the borrowing order, events of default, reorganization plans, appointment of trustees, and any other documents served to the court, creditors, or any other party involved in the Chapter 11 reorganization.
17

There is a large literature on signaling and information asymmetry. See Leland and Pyle (1977),

Campbell and Kracaw (1980) and Diamond (1984) among others.

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The median (average) spread over T-bill is 4.63% (4.75%) for DIP loans and 4.09% (4.07%) for non-DIP loans. These percentages are significantly different from each other at the 5 percent level (Median test value of 2.61). Again, even though these results are consistent with a monitoring role, they are also consistent with a higher risk of DIP loans and our approach is not able to distinguish between these alternative explanations. Development of a more sophisticated methodology and measurement may shed more light on this issue in future research.

6. Conclusions In this paper, we report the stock and bond price reaction to the announcement of DIP financing. To the best of our knowledge, this is the largest event-study sample reported so far in the DIP-financing literature. We document a significantly positive stock and bond price reaction to the announcement of DIP financing. We do not find evidence of significant wealth transfers from senior to junior bondholders. Thus, DIP financing is beneficial to both equityholders and creditors. We then examine the institutional features of DIP loans and show that DIP loans mostly take the form of short-term revolving lines of credit that restrict the use of proceeds to working capital. We find that DIP loans incorporate a significant number of affirmative and negative covenants and that DIP loans have significantly higher spreads and fees when compared with other closely matched loans. The existence of strict covenants (in addition to elaborate cash-flow estimation as reported to us by industry professionals) indicate a significant monitoring role by DIP lenders and is consistent with the advantage of bank and private debt in terms of monitoring efficiency (Diamond (1984)) as well as access to private information (Fama (1985)).

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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 19881997.
Panel A: Distribution of firms by year DIP Percent of DIP Firms 9.5 14.3 26.5 29.3 20.7 28.4 30.6 47.5 45.2 43.4 30.4% Firms Amount of DIP loan in millions $ 145 148 1,402 2,023 1,548 547 669 1,368 1,767 1,181 $10,798

Year

1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Total

Number of Firms Filing for Chapter 11 21 56 68 92 82 67 49 59 62 53 609

Number of Non-DIP Firms 19 48 50 65 65 48 34 31 34 30 424

Number of DIP Firms 2 8 18 27 17 19 15 28 28 23 185

Mean loan to total assets 22.5% 30.4% 25.2% 36.9% 36.4% 24.4% 32.6% 43.3% 39.2% 57.7%

Panel B: Industry distributiona DIP Percent of DIP Firms 25.3 29.8 31.8 49.3 21.2 Firms Amount of DIP loan in millions $ 392 588 473 6,698 2,647 $10,798

Industry

Industrial manufacturing Consumer manufacturing Air Transportation Retail Others Total

Number of Firms Filing for Chapter 11 87 104 22 146 250 609

Number of NonDIP Firms 65 73 15 74 197 424

Number of DIP Firms 22 31 7 74 53 185

Mean loan to total assets 20.7% 38.2% 29.3% 48.2% 34.8%

a SIC codes are classified as manufacturing industrial (2000-2141, 2800-2899, 3200-3599), manufacturing consumers (2200-2399, 3000-3199, 3600-3999), air transportation (4500-4599), retail (5200-5999), and others (1700, 4100-4199, 4900-5000, 6500-6599, and 8000-8199).

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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. Firms with simultaneous Chapter 11 and DIP announcements are excluded from the analysis.

Panel A: Standardized Cumulative Abnormal Returns (SCAR)


Trading Days Standardized Cumulative Excess Returns (SCAR) Z Statistic

[-1,0,+1]

3.40

3.73

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 -5 -4 -3 -2 -1 0 1 2 3 4 5 Excess return -0.24 -0.03 -0.11 0.01 -0.52 0.46 0.37 0.29 0.09 0.09 0.14 z-statistic -1.71 -0.21 -0.80 0.06 -3.80 3.36 2.67 2.14 0.71 0.66 1.01

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Table 3 Structure of DIP loans This table presents the structure of DIP loans during the period 1988-1997. 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 Maturity One year or less Between 1 and 2 years Over 2 years Type of DIP Facility Revolving line of credit for less than one year Revolving line of credit for over a year Loan (term, demand, bridge) Others (limited line, stand by letter) Number of DIP facilities with revolving line of credit and/or term loan Restrictions on use of proceeds Working capital General corporate purposes Allowed operating expenses Real estate loan Borrowing base Inventory Inventory and accounts receivable Cash or other assets

Number of firms

38 (35%) 47 (43%) 24 (22%) 109 24 (25%) 59 (60%) 7 (7%) 8 (8%) 98 25 (25%)

29 (63%) 10 (22%) 6 (13%) 1 (2%) 46 8 (38%) 11 (52%) 2 (10%) 21

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Table 4 Covenants in DIP loansa 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 Junk Bonds

Type of covenants Affirmative covenants Financial reporting and disclosureb 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 lenders collateral and/or seniority Changes in management, control, and ownership Parent-subsidiary transactions
a

DIP Loans

Bank loans

95 100

42 8

100 100

90 85 95 100 95 90 100 95 85

6 6 17 50 33 69 44 89 28

67 97 92 100 86 81 100 98 53

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.