Chapter 11 Bankruptcy Revisited
By: PAUL B. JONES & CLINTON E. CUTLER
March 2002
"DIP Financing"
The last two articles in this series dealt with "cash collateral" - a secured lender's rights in protecting its position in cash collateral based on the debtor's pre-petition indebtedness to that secured lender. This article will deal with post-petition lending to the debtor in possession ("DIP") on a secured basis.
In order to understand post-petition secured lending, all of the subsections of Section 364 of the Bankruptcy Code need to be reviewed. Section 364 deals with the DIP's ability to obtain post-petition credit. Under subsection (a), the DIP can obtain unsecured credit in the ordinary course of business, without bankruptcy court approval, with the unsecured debt so incurred entitled to treatment as an administrative expense. Administrative expense treatment is important; it allows the claim to be paid prior to all other priority claims and all unsecured claims. Administrative expense claims are also required to be paid upon the effective date of confirmation of the Chapter 11 Plan. Unfortunately, however, administrative expense claims are junior to secured claims. Trade creditors and other vendors traditionally used by the DIP extend credit to the DIP under this subsection.
Subsection (b) deals with unsecured debt incurred outside the ordinary course of business. Under this subsection, the DIP must obtain Bankruptcy Court approval prior to incurring the debt. As with debt incurred or credit extended under subsection (a), claims based on debt incurred under this subsection are entitled to administrative expense treatment. Vendors of products or services that are not ordinarily part of the DIP's business (financiers of insurance premiums, nonprofessional consultants, etc.) usually extend credit to the DIP under this subsection.
Subsection (c) deals with circumstances in which the DIP is unable to obtain unsecured credit based on an administrative expense claim. This subsection allows the DIP, after Bankruptcy Court approval, to obtain credit which can be: a claim with priority over other administrative expense claims (the so-called "super-priority claim"), secured by a lien on the DIP's property not otherwise subject to a lien, or secured by a junior lien on the DIP's property already subject to a lien. At the hearing for Bankruptcy Court approval, the DIP must establish that it cannot obtain unsecured credit based solely on the administrative expense priority. The creditor usually seeks a lien or a combination of a super-priority claim and a lien under this subsection. As with subsection (b), vendors that sell products or services that are not part of the DIP's business and who do not want to rely on an administrative expense claim usually extend credit to the DIP under this subsection.
Subsection (d) deals with circumstances in which the DIP is unable to obtain credit under any of the previous subsections. This subsection allows the DIP, after Bankruptcy Court approval, to obtain credit secured by a senior or equal lien on the DIP's property already subject to a lien if the DIP can demonstrate it is unable to obtain credit in any other manner and that the creditor holding the existing lien on the DIP's property will be "adequately protected." The DIP must establish that it cannot obtain credit from any other source (under any other circumstances), and the DIP has the burden of establishing that the holder of the existing lien will be "adequately protected." In the context of Section 364(d), "adequate protection" generally means that the holder of the existing lien is over-collateralized. In other words, the value of such creditor's collateral exceeds the amount of such creditor's secured claim. This subsection allows the DIP to incur post-petition secured debt which is secured by the DIP's property that supercedes existing liens on that same property. Secured debt incurred under this subsection is what is usually meant by the term "DIP Financing."
Section 364(d) provides a powerful tool for the DIP in its efforts to secure post-petition financing; conversely, 364(d) also provides powerful protections for post-petition secured lenders. The DIP can use 365(d) either to find a new post-petition lender or as leverage to negotiate post-petition financing with its pre-petition lender. Several lenders have units that specialize in DIP financing, and borrowers usually negotiate DIP financing terms with these lenders prior to filing Chapter 11. The borrower may initially approach its pre-petition lender requesting DIP financing. This request may serve two purposes: one, the borrower is attempting to establish the prerequisite to attempting DIP financing from another lender (under 364(d), the DIP must demonstrate that it cannot obtain post-petition credit from any other source before it becomes eligible for DIP financing under 364(d)); or two, the borrower is using the implicit threat of DIP financing from another secured creditor to persuade its pre-petition lender to become the post-petition DIP lender. Since most lenders do not want to have their collateral subject to senior lien, this implicit threat is taken seriously.
When approached by a borrower with this request, the pre-petition secured lender should analyze the risks and, if appropriate in light of the risks, be prepared to take advantage of the protections of 364(d). The risk analysis involves the adequate protection concept inherent to DIP financing. The pre-petition lender should review its current collateral position to determine if it is over-secured (collateral is worth more than debt) or under-secured (collateral is worth less than debt) valuing the collateral on a going-concern (as opposed to liquidation) basis. If this review indicates that the pre-petition lender is over-secured, the borrower will probably be entitled to DIP financing from some source and at least to the extent the pre-petition lender is over-secured. In this circumstance, and absent other extenuating circumstances (such as fraud or other deceitful actions by the borrower), the pre-petition lender should become the borrower's DIP financing source. The DIP financing would provide a post-petition lien on the existing collateral and also a post-petition lien on any new collateral obtained by the DIP or generated by the DIP's assets.
If the review of the pre-petition collateral indicates that the pre-petition lender is under-secured, the pre-petition lender should decline to become the borrower's DIP financing source and should prepare to object to any attempts by the borrower for DIP financing under 364(d) since the pre-petition lender's existing lien will not be adequately protected.
The next article in this series will deal with the rights of the secured creditor in the Chapter 11 plan process.