We have witnessed a sea change in Chapter 11 bankruptcy practice since its inception in 1978. A process that was once a safe haven for managers is now controlled largely by secured creditors through control of the debtor's access to bankruptcy financing. In this paper, we explore a recent development toward more direct creditor control over the bankruptcy process. In some cases, secured creditors do not merely steer bankruptcy outcomes through tight covenants and short timelines; instead, they drive cases more directly through agreements with the debtor to pursue a specific case outcome that creditor prefers—effectively, a sale of control over the bankruptcy process by the debtor to a creditor. These agreements are often tied to the debtor’s access to financing, whereby any attempt by the debtor to deviate from the creditor’s plan is an event of default under the loan.
But what exactly is wrong with selling control over the bankruptcy process to a creditor? We show that when the debtor is liquidity-constrained, the well-known debt overhang problem in corporate finance can stifle competition for DIP loans, thus conveying market power to a senior secured lender at the outset of a case. Tying financing to control at an early stage of the case can result in outcomes that benefit the controlling creditor at the expense of the creditors as a whole. The controlling creditor may use its market power to lock in a plan that it prefers, an effect we call “plan protection.” It may also use control to protect its claims against litigation, an effect we call “entitlement protection.” Both effects can cause distortions in bankruptcy outcomes to the detriment of overall creditor recovery.
We test our theory using a novel dataset of 278 large Chapter 11 cases in which all documents in the case have been converted to readable text. We identify allegations of secured creditor control, and show the prevalence of direct control tied to the DIP loan. Our theory predicts that direct control should occur more often when there is conflict between secured creditor classes, and when there is litigation challenging the secured lender's entitlement. We find empirical evidence consistent with these hypotheses. Normatively, we suggest that a temporary period whereby priming liens are permitted at the outset of the case under 364(d), while control terms are limited, can open up competition for DIP lending and limit inefficient sales of control over the bankruptcy process.