By Ramona Morgan, Senior Associate
Introduction
In line with the lyric from Freddie Mercury’s iconic 1991 anthem, some companies are seeking additional credit and entering into new commercial agreements even as they prepare for a bankruptcy filing. Very often, filing for bankruptcy is not the end- just the second act. Understanding key considerations for secured financing in this context has never been more crucial.
This article will discuss two strategies a business might consider when seeking financing as they progress towards a Subchapter V filing: (i) including debtor in possession (DIP) “roll-up” language in credit agreements under negotiation or (ii) strategically opting for preferred stock offerings rather than debt. Effective legal counsel plays an indispensable role in steering a company through this complex landscape and understanding the options that will enable a company to provide favorable terms to creditors despite an imminent bankruptcy filing.
The Rise in Subchapter V Filings
The increase in interest rates as part of the Federal Reserve’s efforts to curb inflation, along with tighter lending standards and higher operating costs, have hit small businesses disproportionately hard. Many small businesses are operating on slim profit margins and have limited cash reserves, making them more susceptible to adverse changes in economic conditions. As a result, small business bankruptcies have been on a steep rise, as noted in a recent Wall Street Journal article.
Current economic conditions are a result of systemic issues exacerbated by macroeconomic policies and regulatory changes. This impact is apparent in the significant uptick in small business filings, captured as Subchapter V elections within Chapter 11 of the federal bankruptcy code, a new provision that simplifies the restructuring process for small businesses. (For a description of Subchapter V, see note below.)[1]
According to data from Epiq Bankruptcy reported by the American Bankruptcy Institute, Subchapter V filings increased 41% in the first nine months of 2023 compared to the same period in 2022.
Strategies For Companies Facing Subchapter V
As mentioned before, there are two strategies that companies might seek to implement to make themselves attractive to potential financiers and safeguard against inadvertent Subchapter V ineligibility from exceeding maximum indebtedness.
Roll-up provisions. Roll-up provisions allow funds from prepetition lenders to “roll up” into postpetition financing that pays off (or “rolls up”) the prepetition secured debt. A roll-up effectively transforms the existing lenders’ prepetition claims into a postpetition, administrative expense, thereby providing a measure of financial stability during the restructuring process. A critical consideration in the Subchapter V filing process is the role of so-called roll-up DIP provisions.
Including a roll-up clause in a credit agreement can make the proposed borrowing more attractive to potential lenders to a distressed company looking for additional protections as the company prepares for a Subchapter V filing.
Note: Bankruptcy courts maintain rigorous oversight of DIP financing terms to ensure they are equitable and within the bounds of legal norms. Some jurisdictions, such as the 11th Circuit, have been less receptive to allowing DIP roll-up clauses. The viability of the contemplated roll-up, therefore, must be analyzed based on where the petition is expected to be filed.
Preferred shares. Companies might also consider issuing preferred shares rather than incurring additional debt, particularly if the additional debt could inadvertently cause a company to be ineligible for a Subchapter V filing with its debt limit of $7,500,000. Preferred shares serve as a financial hybrid—blending attributes of both common stocks and bonds—and have preferred status over common shares for bankruptcy.
Conclusion
Filing for bankruptcy under Subchapter V is a critical turning point. Skilled legal guidance is key to helping a company understand its choices and make smart decisions about entering into new commercial agreements, credit terms, or financing options. In addition, risk mitigation strategies, such as comprehensive compliance checks and contingency planning, are not just advisable but essential for any company actively continuing its business and negotiating new commercial and credit agreements.
In an era defined by economic complexity, informed and proactive decision-making can help companies avoid that final curtain call and, instead, enter into the second act.
If you have any further questions regarding securing financing while facing a Subchapter V filing, please contact Ramona Morgan and Eric Sleeper.
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