Debtor-in-possession financing (“DIP financing”) is a critical issue that comes up at the beginning of most large to mid-sized bankruptcy cases. Companies filing bankruptcy are typically doomed to a rapid liquidation if they are unable to obtain new financing to support them through the bankruptcy process. The risks associated with lending to a company already in bankruptcy are readily apparent. To deal with this risk, DIP lenders demand a number of different protections. Chief among these protections are a first priority lien on collateral and an order of the bankruptcy court finding that the DIP lender has acted in good faith. The good faith finding is important because a final DIP financing order may only be reversed on appeal if the appellate court overturns the good faith finding made by the bankruptcy court. To the DIP financer, who has already advanced funds based upon the bankruptcy court’s order, a subsequent appellate decision overturning the bankruptcy court’s finding that the DIP lender acted in good faith is a disaster.
On September 3, 2014, the Fifth Circuit directly addressed the issue of good faith DIP financing in In re TMT Procurement Corp. The TMT case involved the stock of an offshore drilling company called Vantage Drilling Company (“Vantage”). In 2012, Vantage issued 100 million shares of its stock to a company called F3 Capital as part of a deal to contract with drilling companies owned by F3 Capital’s principal, Nobu Su. Vantage later filed suit in Texas state court against Su, referred to as the “Vantage Litigation,” alleging that Su made misrepresentations to Vantage to induce Vantage to issue the stock.
In 2013, a number of shipping companies owned by Su (the “Debtors”) filed voluntary Chapter 11 bankruptcy cases in the Bankruptcy Court for the Southern District of Texas (the “Bankruptcy Court”). F3 Capital was not one of the Debtors. Certain of the Debtors’ creditors filed pleadings in the Bankruptcy Court alleging that the bankruptcy cases were filed in bad faith. Su responded by offering to place 25 million shares of Vantage stock held by F3 Capital into the Bankruptcy Court’s registry to act as collateral to secure the Debtors’ obligations to comply with court orders and to serve as collateral for a possible DIP loan. Vantage appeared in the Bankruptcy Court and vigorously opposed this arrangement, arguing that the Vantage Litigation was on-going and that F3 Capital had no legal right to the stock. The Bankruptcy Court overruled Vantage’s objection and entered an order allowing for the escrow of the stock in the court’s registry. The Debtors later sought a $20 million DIP loan made by Macquarie Bank Limited (the “DIP Lender”) that was to be secured by a first priority lien in the Vantage stock. Vantage objected to the DIP loan as well. The Bankruptcy Court again overruled Vantage’s objection and entered an order (the “DIP Order”) that provided the DIP Lender with a first priority lien in the Vantage stock and determined that the DIP Lender had acted in good faith.
Vantage appealed directly to the Fifth Circuit arguing, among other things, that the DIP Lender could not have acted in good faith because the DIP Lender was well aware of Vantage’s allegations regarding ownership of the stock. The Fifth Circuit noted that a good faith finding is required under both Bankruptcy Code sections 363(m) (dealing with purchasers) and 364(e) (dealing with DIP lenders). The Fifth Circuit further stated that the typical “misconduct that would destroy a purchaser’s good faith status . . . involves fraud, collusion between the purchaser and other bidders or the trustee, or an attempt to take grossly unfair advantage of other bidders.” The court recognized that there was no suggestion of such misconduct in this case. The court also recognized that mere knowledge of objections to a DIP order by other parties is insufficient to constitute a bad faith finding. Nevertheless, the court found that the DIP Lender in this case did not act in good faith because it had knowledge of an adverse claim to the relevant collateral, as opposed to merely an objection to the overall DIP financing transaction. For this reason, the Fifth Circuit found that the DIP Lender had not acted in good faith and reversed the DIP Order.
The underlying facts of the TMT case are somewhat unusual and are important to fully appreciate the potential impact of Fifth Circuit’s opinion. For example, the collateral at issue clearly was neither owned by the Debtors nor free from adverse claims of ownership by another non-debtor party. Moreover, the party asserting an interest clearly was not a creditor in the bankruptcy case. That said, the holding raises a number of potential issues for both debtors and DIP lenders. Where exactly will courts draw the line between knowledge of an adverse claim and knowledge of mere objections? It is not difficult to imagine any number of scenarios where a debtor and a DIP lender are aware of tenuous and unproven claims in collateral made by third parties. Does such knowledge put DIP lenders at risk of having a DIP financing order overturned on appeal? The Fifth Circuit provides no guidance on these troublesome concerns. Going forward, both debtors and DIP lenders will need to tread carefully to ensure that the necessary financing is provided, and that it is provided in such a way that protects the DIP lender to its satisfaction.