How the Automatic Stay in Bankruptcy Can Affect Net Asset Value Facilities

Executive Summary

In net asset value (NAV) facilities, the borrowing capacity typically adjusts to reflect changes to the value of the underlying investment portfolio, and borrowers face the risk of potential borrowing base deficiencies or minimum net asset value/loan-to-value covenant breaches if the value of such assets sharply drops. These risks can become particularly pronounced during a financial downturn or in the event of a bankruptcy or other credit event relating to a borrower or an underlying portfolio asset. In either circumstance, the automatic stay can inhibit a borrower’s access to distribution proceeds, affecting its liquidity and ability to meet financial obligations. In this Legal Update, we discuss the purpose of the automatic stay, share options for relief from the stay, and offer recommendations for navigating the complications that the automatic stay can create for NAV facility lenders.

Background: Overview of Bankruptcy Proceedings and the Automatic Stay

NAV facilities allow investment funds to manage cash flow fluctuations and meet investor redemptions without selling underlying assets, which enables funds with illiquid investments to maintain their investment strategies and avoid forced liquidations during periods of repayment pressure.

Financial institutions may also use NAV facilities to optimize capital usage and enhance liquidity management. By leveraging their investment portfolios, institutions can access additional funding at favorable terms, enabling them to deploy capital more efficiently while maintaining diversified asset holdings.

In NAV facilities, the borrowing capacity typically adjusts to reflect changes to the value of the underlying investment portfolio, but borrowers face the risk of potential mandatory repayments if the value of pledged assets sharply drops. These risks become particularly pronounced in the event of significant financial downturns. In such circumstances, it is possible that either the borrower or certain of its underlying investments could become the subject of bankruptcy proceedings.

As a general rule, US bankruptcy proceedings aim to facilitate the debtor’s financial rehabilitation by allowing them to reorganize their capital structure in an organized manner and potentially obtain a “fresh start” by deleveraging pursuant to a court-ordered reorganization plan. Bankruptcy proceedings also strive to achieve fairness and equity in the treatment of both debtors and creditors, balancing the interests of all parties involved.

When a debtor files a bankruptcy petition, Section 362 of the US Bankruptcy Code imposes an “automatic stay” with respect to a debtor. The automatic stay is effectively a statutory injunction that prohibits creditors from taking most actions to collect against or obtain possession or control over the debtor’s property; among other things, the stay will prevent lenders from repossessing or foreclosing on collateral pledged by a debtor, otherwise perfecting or enforcing liens, or commencing or continuing litigation against the debtor or its assets (including its owned investment portfolio) until the bankruptcy proceedings are completed, unless the lender obtains “relief” from the automatic stay through a bankruptcy court order.

The automatic stay applies across the principal chapters of the US Bankruptcy Code both for individual and corporate debtors, but does not extend by its terms to non-debtor entities such as officers, guarantors, or non-debtor corporate affiliates.¹

What to Know: The Intersection of Automatic Stays and NAV Facilities

As a general rule, the automatic stay remains in place as long as the bankruptcy proceeding is ongoing, and the debtor can seek substantial sanctions (including punitive damages) against parties that violate the automatic stay. However, creditors can request the bankruptcy court to lift the automatic stay “for cause,” which can include situations in which the debtor’s assets are expected to substantially devalue before the case is resolved or if there is inadequate protection of the creditors’ interests in collateral. In the context of a NAV borrower’s bankruptcy proceedings, lenders that have obtained a pledge of equity in underlying investments may be able to argue that the stay should be lifted to allow the sale of such investments in an orderly fashion to avoid risks of further decline in value, particularly if the borrower is unable to effectively manage or operate such assets because of its own bankruptcy.

Moreover, creditors and debtors may agree to allow relief from the automatic stay to potentially liquidate collateral on a negotiated basis, along with an agreement that the proceeds of the sale may be applied to the secured debt. Such agreements are often reached in exchange for consideration or concessions to the debtor, which could include additional financing or the use of cash collateral to facilitate the debtor’s reorganization.

In the context of an underlying asset’s bankruptcy proceeding, the automatic stay could potentially inhibit a NAV borrower’s continuing access to liquidity and ability to meet financial obligations, particularly because the risk of fluctuations in asset values during bankruptcy makes it difficult to accurately assess the collateral’s worth and consequent borrowing capacity. Additionally, where an underlying asset has become the subject of a bankruptcy, it likely will have entity-level debt (secured and unsecured) that will need to be paid or satisfied before any distribution can likely be made to the NAV borrower.

Mitigating Risks and Strategies for NAV Facilities

To mitigate risks associated with potential NAV borrower bankruptcies, NAV facility lenders should conduct thorough due diligence on the borrower’s financial health and the underlying asset quality before extending credit. By regularly monitoring asset values and ensuring sufficient collateral coverage, lenders can potentially detect early indicators of financial distress at the borrower and investment level and implement proactive measures to safeguard their interests in case of borrower default, including the potential bankruptcy of the borrower or an underlying asset.

During bankruptcy proceedings, NAV debtors can negotiate with creditors to propose viable repayment plans or asset- restructuring alternatives aimed at safeguarding the interests of both parties while maximizing asset value. In such circumstances, adhering to the legal mandates and regulations regarding any automatic stay is essential to mitigate legal risks and uphold stakeholders’' interests. To ensure compliance with relevant laws and protect against potential liabilities and disputes, lenders and borrowers should consult with an attorney when navigating the intricacies of insolvency or bankruptcy proceedings involving a NAV borrower or one of its underlying investments.

Key Takeaways

Successfully managing bankruptcy proceedings that involve NAV facilities requires a sound understanding of bankruptcy laws to tackle challenges such as the scope of the automatic stay, potential grounds for stay relief, bankruptcy financing, and treatment of competing claims and interests. Stakeholders should implement advanced risk assessment models to evaluate the effects of potential bankruptcies and delays in enforcement due to the automatic stay. Alternative financing structures, including hybrid models, can also be considered as a way to diversify bankruptcy risk. But in the event of a bankruptcy, lenders should be mindful of the likely need for cooperation with the borrower and other stakeholders to maximize recoveries, particularly given the leverage that the automatic stay provides. In sum, understanding the impact of potential bankruptcy scenarios, including at various levels of the structure, is critical to the effective management of NAV facilities.

¹ Section 105 of the US Bankruptcy Code does allow the automatic stay to be extended by courts to non-debtors, but such relief is rarely granted and requires a heightened showing that such relief is warranted and necessary to protect and preserve assets of the debtor’s estate.