Lenders to ATP Oil & Gas have had precious little certainty to cling to over the past few years. The one thing that secured lenders thought at least they could depend on was that in a bankruptcy, there were hard assets that would back up their claims and make them whole in the end – given that ATP extracts fuels from underwater sites with proven reserves in the Mediterranean Sea, the Gulf of Mexico and the North Sea.

Now that fuel producer ATP is in bankruptcy, however, even that certainty has been wiped away, and perhaps the most secure type of lending facility that lenders could hope to participate in for a restructuring company has started to trade at a discount to par: Debt investors have traded portions of the $643 million debtor-in-possession financing – a loan arranged for a company proceeding through bankruptcy in order to allow it to continue to operate while it works its way through court – at between 84 and 86 cents on the dollar over the past week.

For a DIP loan to trade down to the mid-80s is “very rare and obviously it’s not supposed to happen,” comments Jamie Sprayregen, partner in the restructuring practice at Kirkland & Ellis. DIP lenders are typically protected ahead of other creditors in a bankruptcy by the priority status afforded to such debt by the Bankruptcy Code and priming liens arranged by lenders, but this all depends on the value of the assets, according to Sprayregen. “A DIP’s got incredibly powerful legal protections, but if the value’s not there, there’s nothing you can do,” he says.

What’s even more confounding is that the drop happened so quickly for a credit facility specifically designed to be temporary and ensure a full recovery upon the company’s exit from bankruptcy. The heavy discounting comes less than four months after the Houston-based company negotiated the loan via underwriter and lender Credit Suisse. Other original lenders to the DIP include investment funds of computer magnate Michael Dell, distressed investing firm Fortress Investment Group, the credit investing hedge fund KLS Diversified, investment advisory Trilogy Capital, and international investment bank Macquarie, among others, according to documents filed in bankruptcy court.

The impairment is so rare in fact, ATP’s is the only DIP facility of more than $100 million in 2012 to be quoted below 90 cents on the dollar, and is one of just two in the past two years to be quoted so low – the other being for Lee Enterprises, which was repaid at par – according to an S&P Capital I.Q. LCD analysis of data compiled by Markit.

DIP perception

Secondary price instability in DIPs is nominally caused by one of two factors.

First, there could be limitations in the agreement that are moving the company towards a non-monetary default, and therefore the DIP needs to be amended, according to Mitchell Seider, a global co-chair of Latham & Watkins restructuring practice. Such a circumstance shouldn’t threaten recovery, but could affect the timing in which lenders expected to be paid back.

“As a DIP lender dependent on a going concern rather than liquidation you may have to keep the borrower alive longer than you initially anticipated in order to get that recovery from the going concern value,” says Seider. “Any time you’re making a loan that’s based upon assumptions that have to do with the continuing operations of the debtor, it would seem to mean there’s more risk as well,” he said.

Indeed, at least four of the 12 most distressed DIP facilities from the past four years depended on the continuing services for the majority of the company’s value, including casino operator Greektown Casino, poultry company Pilgrim’s Pride, restaurant chain Buffets Inc., and to a certain extent chemical maker Wellman Inc. and commercial-printing company Quebecor World, according to LCD and Markit.

The second reason for the discounting of a DIP is the more significant one, namely, where the lender assessment about the value of the collateral supporting it proves incorrect. This was more prevalent early in the most recent bankruptcy cycle, late 2008 to 2009, when the credit crisis led to wide fluctuations in the market value for distressed companies and assets. Indeed, 10 of the 12 DIP facilities of more than $100 million that have been bid at lower than 90 cents on the dollar since 2008 were put in place in late 2008 and 2009.

Yet even so, of those there was only one situation in which the DIP loan wasn’t eventually repaid or taken out by an exit loan upon the company’s exit from bankruptcy. And in that one situation – Delphi Automotive, which declared bankruptcy in 2005 — DIP lenders participated in a credit bid for the company and accepted equity, which wound up being even more profitable as the company recovered. For the record, the C tranche of Delphi’s DIP issued at 98 in May 2008, and sank as low as 14 cents on the dollar before recovering to the mid-50s by the time of the company’s 2009 exit and subsequent conversion to equity; A and B tranches had also been impaired but received full recovery above the lower tranche.

Double DIP trouble

ATP faces both problems. Most critically, the company needed to amend its DIP in order to avoid default following a shift in the valuation of the company’s oil reserves. The DIP was based on, among other factors, a reserve report filed by the company with the SEC as an exhibit to its 2011 Form 10-K, but subsequent to placing the facility, lenders received a new report from their own consulting firm, Netherland, Sewell & Associates (NSAI), showing significantly lower reserve levels in some of the company’s key wells.

While the DIP amendment was designed to give the company a bit of breathing space, it suggested an ominous end-game for the company’s Chapter 11.

A remarkable motion filed in the bankruptcy case requesting an examiner on behalf of the stockholders explained the situation as follows: “Barely three months after the debtor commenced this case claiming that the company suffered from a mere liquidity hiccup, we are now told that the debtor’s reserves are valued drastically less than what the debtor has previously reported publicly and that, now, the only way forward is a fire-sale liquidation to satisfy the demands of the DIP lenders. It doesn’t add up.”

The contents of the report have not yet been disclosed, despite numerous court filings urging that the report be unsealed. And while ATP had initially stood by its earlier reserve report attached to the SEC filing, when the company filed its motion to amend the DIP, it indicated the company itself now believed the NSAI report.

ATP and its outspoken founder T. Paul Bulmahn have long made headlines for brash moves: In 2006, headier times for the company, it once bought a Volvo car for every employee, along with providing them a Swedish vacation, as a bonus for achieving certain milestones. When the company filed for bankruptcy in August, Bulmahn famously blamed the Obama administration, which had place a moratorium on drilling in the Gulf of Mexico in 2010 after the Deepwater Horizon explosion.

While he remains the chairman and the largest individual shareholder, Bulmahn was replaced as CEO in June. But his chosen successor, Matt McCarroll, quit just 8 days after the company had announced his hire, something that drove the $1.5 billion in second-lien notes to new lows at the time, less than 50 cents on the dollar.

Following the new reserve report those bonds, which fall behind the DIP facility, subsequently traded even lower, at less than a dime to every dollar. With the DIP price going down because the company may be forced to sell assets that , first, may not be worth as much as the company and lenders thought, and second, may have to be marketed and sold under fire-sale conditions imposed by DIP milestone deadlines, some estimates have the second-lien bonds worth nothing.

It is virtually impossible to see any value for the company’s equity in that scenario.

Historical shift

Over the long-term, the element that has changed the most in DIP lending is the amount of secured debt that companies will already have by the time a DIP is being put in place.

There used to be next to none – such as in the case of K-Mart – according to multiple sources interviewed for this article. But following the credit boom leading up to the crisis, companies started to go into bankruptcy with balance sheets more highly leveraged with secured debt. As a result, bankrupt borrowers in the last cycle had little collateral free from existing liens for prospective DIP lenders to turn to for security.

Pre-2008 crisis, there was a more robust DIP market as the lifesaving secured debt could be put in place with minimal fuss, but between 2008 and 2010, DIPs became defensive facilities for senior secured lenders in the capital structure to protect themselves. Even though there was increased third-party interest in participating in DIPs as the cycle progressed, DIP providers continue to come predominantly from the senior ranks of bankrupt companies’ capital structures, although the motive can sometimes be as opportunistic as it is defensive.

“While liquidity has opened back up you still don’t see them being provided by strangers to the capital structure,” according to Kirkland & Ellis’ Sprayregen. “You have to underwrite the DIP in a way that it will be safe… While the legal projections reduce the risk, there’s always some,” he says.  – Max Frumes