Debtor-in-Possession Financing

DIP financing refers to a financing arrangement provided to a borrower operating as a debtor under
Chapter 11 bankruptcy. A borrower that successfully petitions for Chapter 11 bankruptcy is afforded
a stay of legal action from creditors to provide time to formulate and submit a plan of reorganization
to the bankruptcy court. As part of the bankruptcy, the borrower retains control of its business assets
and operations as a DIP.

DIP financing is often provided by the same bank that financed the company before the company
filed its petition for bankruptcy. This commonly occurs because the special rules and procedures in
bankruptcy can provide the bank with certain benefits and protections that are not available outside
of bankruptcy, including protection of collateral values—by allowing the bankrupt business to
continue as a going concern—and protection of the bank’s lien.

A DIP loan is collateralized by specific assets and generally assumes priority in payments and
collateral lien position over all other obligations of the debtor. This is known as a superpriority claim.
When the DIP loan is solely to provide new funding, the collateral may be composed of
unencumbered assets or assets acquired post-petition. A DIP facility also may replace, or be
consolidated with, some pre-petition debt. In this case, collateral may include a combination of pre-
petition and post-petition assets. A pre-petition lender that also provides the DIP facility may cross-
collateralize loans, subject to court approval.
A DIP financing arrangement is often structured as an ABL revolver with a borrowing base commonly
consisting of accounts receivable and inventory. The lender monitors the collateral and administers
collections through a comprehensive control structure that includes frequent collateral reporting and
borrower certifications along with periodic field audits of the borrower’s financial records and
physical inventory. Self-liquidation of the credit facility may be enabled through

• lender control and application of cash receipts through a cash dominion account.
• lender control of loan advances through a borrowing base formula that incorporates
conservative advance rates, appropriate eligibility requirements for receivables and
inventory, and availability sub-limits and reserves, when prudent.

The strict controls and monitoring provided by an ABL structure are central to DIP risk management,
but the controls should not be used as a substitute for credit due diligence. The lender should seek
the counsel of experienced bankruptcy attorneys before engaging in a DIP financing arrangement. A
DIP lender needs to determine whether

• the borrower’s reorganization plan is likely to be approved by the courts.

• additional borrowing beyond the DIP financing may be required.
• the lender is likely to receive repayment upon the court’s confirmation of the
reorganization plan.
• the plan protects the lender’s collateral if the bankruptcy filing becomes a Chapter 7
liquidation case.
• the plan assigns priority lien status to the post-petition DIP financing.

 Lenders also need to be aware of the following factors that can impair the pre-petition debt:
 • Without post-petition financing, the company may be forced to liquidate. Forced
liquidation may result in lower collateral proceeds and creditors will likely incur higher
losses.
• Although a secured creditor may be deemed to be adequately protected under the plan,
the company’s use of the lender’s collateral may diminish the value of those assets.
• Under certain conditions, the court may bestow a superior lien for DIP financing that
enables the DIP lender to supersede the pre-petition lender’s lien.

Ideally, if the borrower’s reorganization plan is successful, the company should achieve sufficient
financial stability to emerge from bankruptcy and resume operations as a going concern. Successful
reorganization typically results in full repayment of DIP loans. An unsuccessful reorganization may
result in the sale of the company or asset liquidation under which it is unlikely that all DIP debts
would be fully satisfied.