From time to time, businesses can run into liquidity problems. Often, the reason for the cash crunch is due to some external problem and not the fault of management. Nonetheless, companies that find themselves with a cash shortage might recover if they can arrange additional financing. But how does a company in financial distress entice a lender to extend additional credit, especially when lenders are so credit conscious? Frequently, the answer is DIP financing under Chapter 11 bankruptcy.
What is DIP Financing?
DIP financing stands for debtor-in-possession financing. This means that the debtor still has possession of the collateral that secures its debt. Importantly, DIP financing is only available under Chapter 11 bankruptcy, which debtors use to restructure their debt. A company files bankruptcy under Chapter 11 when it wants to reorganize the business instead of liquidating it. Inevitably, liquidation occurs when creditors seize and sell your assets, including the collateral that secures debt.
DIP financing has one unique aspect that makes it desirable to lenders. In many cases, providers of DIP financing have top priority over claims against the debtor and its collateral. In other words, DIP financing displaces other lenders and creditors. However, beware of some misleading statements in articles on this topic. Further, as we’ll address below, the top priority of DIP financing is not ironclad.
Video: DIP Financing in Recent News
The DIP Financing Process
The debtor-in-possession financing process begins with filing for Chapter 11 bankruptcy. Under the bankruptcy rules, the debtor receives an automatic stay preventing creditors from seizing collateral. Once the court accepts the bankruptcy application, a debtor can begin arranging DIP financing. This requires the debtor to prepare a DIP budget that contains forecasts of expenses, receipts, and net cash flows. For instance, the debtor should keep the information current over rolling 13-week periods. Also, make sure to include plans for paying vendors, capital expenditures and fees. A lender or creditor wishing to provide DIP financing will negotiate the budget with you until you reach an agreement.
From there, both parties agree to a suitable loan or credit facility, that is, a revolving credit line. Specifically, the goal is to have the bankruptcy judge accept the DIP financing deal. However, existing lenders and creditors might object to the plan, especially if they lose the senior lien on collateral. Ultimately, as one would anticipate, the judge gets the final say.
Considerations for DIP Financing Providers
Often, existing lenders are willing to extend DIP financing. Conceivably, their motivation might be to protect their pre-petition claims through the practice of “defensive DIP financing.” Frequently, the DIP loan provider will commit to a DIP rollover, in which DIP financing includes an exit facility. Usually, when negotiating a DIP financing agreement, an existing pre-petition secured-loan provider will insist on several features, including:
- Paying pre-petition secured debt first with proceeds from DIP financing. Normally, courts will approve this provision only if the pre-petition secured loan was over-collateralized.
- The debtor agreeing to release claims that dispute the right of pre-petition secured lenders to receive collateral or liquidation proceeds. However, courts might not uphold the claim releases.
- The lender might seek to limit a carve-out on its lien that allows professionals to receive their fees. Unsurprisingly, professionals include lawyers and accountants of the debtor and the unsecured creditors.
- Placing a lien on any money the debtor recovers due to avoidance actions such as fraudulent conveyance and preferences. The liens require recovered money to flow to the DIP lender’s administrative expenses.
- Requiring a waiver that would disallow pre-petition lenders from receiving surcharges from the DIP loan. These surcharges (called “Section 506(c) surcharges”) for reasonable and necessary administrative expenses.
- Setting specific income and expense targets, as well as deadlines, in the DIP budget. The deadlines are dates that trigger certain actions, such as sales of debtor assets or production of final plan.
- Relief from the automatic stay if the debtor breaches any agreements regarding cash collateral or DIP financing order.
Courts have the right to strike down any of these agreements but frequently allow them to stand.
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An exit facility is the funding a debtor company needs to operate after emerging from Chapter 11. Specifically, the funds from an exit facility fulfill the terms of the reorganization plan. In addition, exit funds pay for ongoing operation of the reorganized company. A DIP rollover occurs when a creditor negotiates DIP financing and an exit facility at the same time.
The DIP Financing Priority Controversy
One source of controversy regarding DIP financing is whether existing lenders receive fair treatment. For example, consider it from the point of view of the pre-bankruptcy secured lender. The lender ensured that the pledged collateral was more than enough to cover the loan amount. Clearly, the lender had every right to assume it had handled any default risk. Suddenly, the borrower enters into Chapter 11 and a DIP finance provider appears, big-footing the senior lender’s liquidation priority. Experts call the practice “priming the lien.” This is the “super priority” that DIP lenders invoke in bankruptcy court. Factually, does the pre-filing senior lender have any recourse?
According to the American Bankruptcy Institute, a secured lender with a perfected lien won’t be displaced by DIP financing. In other words, a pre-filing secured lender with a perfected lien will not lose priority to the DIP lender. To perfect the lien, the secured lender must take several steps:
Attach a Security Interest
This security interest is the loan collateral. To attach a security interest, the creditor must give value to the debtor. In other words, the creditor lends money to the debtor. In addition, the debtor must have rights to the collateral it pledges and must sign a security agreement. Clearly, the agreement gives the creditor a security interest in the collateral. Also, it identifies and describes the collateral.
Perfect the Lien
Normally, creditors perfect liens by filing financing statements with a public state office (i.e., Secretary of State). Typically, the financing statement is a standard form, known as Form UCC-1. Commonly, it contains the names of the debtor and secured party, and information about the collateral.
Act Before the Filing
Crucially, the creditor must perfect the lien before the debtor petitions for bankruptcy. Otherwise, the DIP lender would most probably prevail.
Note that bankruptcy laws vary by state. You should work with a qualified attorney to ensure you have perfected the lien properly for your state.
FAQs for Debtor-in-Possession Financing
What is the meaning of “debtor in possession”?
Debtor in possession, or DIP, refers to an individual or company that retains its loan collateral through bankruptcy. Chapter 11 automatically stays creditors and lenders from seizing collateral, so that it remains with the debtor. A debtor in possession in Chapter 11 can arrange DIP financing to reorganize and emerge from bankruptcy.
What is exit financing?
Exit financing, also called an exit facility, is financing that enables a debtor to emerge from Chapter 11 bankruptcy. The debtor pays off creditor claims using the money from exit financing. Exit financing is usually a prerequisite for creditors to confirm the debtor’s reorganization plan. The debtor also uses exit financing for ongoing operations.
What is the absolute priority rule in Chapter 11?
The absolute priority rule clarifies when junior creditors and equity holders cannot receive debtor property. Senior classes of creditors must first receive full payment or agree to a plan that includes junior classes. In fact, the rules stem from Section 1129 of the Bankruptcy Code mandating fair and equitable treatment.
What is the liquidation order of priority?
Courts order the liquidation of a bankrupt company if they can’t arrange a viable reorganization plan. Inevitably, the liquidation order of priority states that liquidation proceeds first go to secured creditors/lenders, then unsecured ones. Afterward, the court distributes any leftover monies to preferred equity holders, then to holders of common shares. Truthfully, the IRS has top priority, for collecting any back taxes.
What is distressed investing?
In distressed investing, an investor buys the debt of a company in trouble, usually at a discount. The distressed company might be bankruptcy-bound. The investor snaps up the discounted debt on the hopes that the debtor recovers and fully repays the debt. If the debtor fails to survive, the distressed investor might gain control of the company and all of its assets.