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Home , Debtor, Debtor in possession

Debtor-in-Possession Financing

by Marshall S. Huebner an you imagine the reaction the first time a lender said, “Hey, let’s lend large sums of money to a bankrupt Ccompany!”? As it turns out, lending to a debtor in posses- sion can be a smart move. This article explains, in general terms, the hows and whys of DIP lending. t may seem counterintuitive In Chapter 11, pre-bankruptcy Chapter 11 debtors on C.O.D. or that and other institu- are, for the most part, C.B.D. until the company stabi- I tions would compete fiercely stayed from enforcement reme- lizes and working capital financ- to provide to companies that dies and do not receive payment ing for the company’s ongoing have recently filed for protection of principal or while the operations is available. under Chapter 11 of the U.S. company seeks to rationalize its DIP loans are typically asset- Bankruptcy Code. But they do— business and formulate a plan of based, revolving working-capital and often. Indeed, “DIP loans,” reorganization to restructure its facilities put into place at the out- as they often are called, are big balance sheet. set of Chapter 11 to provide both business and can range from tens The DIP typically finds itself immediate cash as well as ongoing of thousands to billions of dollars. in need of immediately working capital during the reorga- Moreover, lending institutions of after initiating a Chapter 11 case. nization process. Perhaps most all sizes may be called on to While most of its pre-bankruptcy important, DIP financing helps extend further credit to a - liabilities are frozen, the company the company restore vendor and ruptcy debtor to “protect” an is likely to need cash immediately customer confidence in the com- existing position. to cover payroll and the up-front pany’s ability to maintain its liq- Companies that enter into costs of stabilizing the business. uidity. Chapter 11 reorganization contin- Although post-bankruptcy credit ue to be run by their existing extended by vendors is granted Protections for DIP Lenders management in virtually all cases. administrative expense priority Congress understood that The ongoing entity is known as over all pre-bankruptcy unsecured lenders might well be skittish the debtor in possession, or DIP. claims, vendors typically place about extending credit to a com-

© 2005 by RMA. Marshall Huebner is a partner with Davis Polk & Wardwell, New York, New York, and specializes in and . He has participated in two RMA round tables on bankruptcy issues.

30 The RMA Journal April 2005 Debtor-in-Possession Financing pany that has filed for bankruptcy, their interest (and thus must be applied to reduce the so the bankruptcy court extends their recovery) will plummet DIP loans and commitments. to DIP lenders a number of pow- unless new money is lent to the 3. That the primed pre-bank- erful protections. If the debtor can debtor to maintain operations and ruptcy lenders cannot exer- demonstrate that financing could inspire vendor and customer confi- cise remedies until the DIP not be procured on any other dence. has been repaid. basis, the court can, subject to cer- In common bankruptcy parl- 4. That certain events, like con- tain limitations, authorize the ance, a DIP loan provided by the version of the case to Chapter debtor to grant the DIP lender a existing secured lenders is referred 7 or appointment of a lien that has priority over pre- to as a defensive DIP while a loan in bankruptcy, permit the bankruptcy secured creditors from a new third party lender is DIP lender to call the loan. (priming lien) and a claim with called an offensive or new money DIP. super-priority over administrative Creditors secured by isolated DIP Loan Negotiation and expenses (including vendor and assets often do not consent to Pricing employee claims) incurred during being primed, and, assuming the In larger cases, DIP loans typ- Chapter 11 and over all other DIP lender is satisfied with its ically are negotiated over a one- or claims. other collateral, the DIP lender two-week period just prior to the The DIP lender typically will often does not seek to prime commencement of Chapter 11 insist on a first-priority priming existing lenders with respect to proceedings. The lender arranging lien on the debtor’s inventory, these assets. the DIP loan typically first enters receivables, and cash In addition to collateral and a into an engagement letter provid- (whether or not previous- super-priority claim, DIP loans are ing for an advance against expens- ly encumbered), a second typically designed with covenants es and then sends internal or lien on any other encum- external experts to conduct an bered property, and a first-priority expedited review of the working- lien on all of the debtor’s unen- capital collateral and the debtor’s cumbered property. post-Chapter-11 cash flow projec- A priming lien can be granted tions. Once the lender satisfies only with the consent of the itself regarding the collateral and secured creditors who are being the DIP financing has been primed or if the court finds that “sized” based on the debtor’s the creditors are adequately pro- expected needs, the parties pro- tected despite the granting of the ceed to a commitment letter priming DIP lien. In many cases, and final documentation. pre-bankruptcy inventory and In some cases, where receivables lenders consent to there is time pres- being primed and to the use of sure, the commit- their cash collateral in exchange for ment-letter stage a package of protections specified is bypassed. in the court order approving the DIP loans are financing (DIP Order). These pro- and other protections to often sized to be tections typically include a second permit the DIP lender a full somewhat—or far— lien on unencumbered assets recovery even if the debtor larger than the (behind the DIP loan) and, quite liquidates. The loan documents expected needs of the often, current cash payment of and/or the DIP Order, for exam- debtor because interest. One reason secured ple, will typically provide: announcing a large facility may lenders often consent to being 1. For a borrowing base. inspire vendor and customer con- primed is because the value of 2. That all asset-sale proceeds fidence and actually reduce the

31 Debtor-in-Possession Financing need for use of the facility. become part of the underwriting creditors (the Creditors Sometimes the DIP lender, group. Committee) is appointed. through various mechanisms, will If objections are made at the limit use of some part of the facili- DIP Loan Approval Process interim DIP hearing, they usually ty so the lender is comfortable it Approval of priming liens and come from the U.S. Trustee. will be protected if the debtor super-priority claims in connec- While the timing and amount of seeks to exceed the forecasted tion with a DIP loan requires fees paid to the DIP lender are usage. Besides the important bor- “notice and hearing” under the sometimes an issue, more typical- rower benefits, a larger facility Bankruptcy Code, and it is the ly the U.S. Trustee raises issues benefits the DIP lender because debtor’s burden to demonstrate relating to the adequate protec- commitment and facility fees that lenders who are being primed tion package being offered to the apply to the full facility, whether are being “adequately protected.” pre-bankruptcy lenders being or not the debtor ever uses it all. However, because the debtor typ- primed by the DIP. Occasionally, Pricing on DIP loans has his- ically needs to draw on the facility there will be a dispute over torically been relatively high for at the outset of the Chapter 11 whether the terms of the pro- first-lien working-capital financ- proceeding and because it is posed DIP are the best available. ing, but the DIP lending business desirable to obtain early approval Assuming the judge is satisfied, has become more competitive of the DIP financing to restore an interim DIP Order is entered, during the past 10 years and pres- vendor confidence, DIP loans are and the loan documents are sure on pricing has increased. typically approved in a two-step signed promptly to make a por- Lately, hedge funds and other process during the first month of tion of the DIP facility available new entrants in the DIP lending the Chapter 11 case. to the debtor. The interim DIP market have further increased 1. In the first step, an interim Order will specify the date of the competition. Pricing will often DIP hearing is held within a final DIP hearing. include a fee paid at the time of couple of days after the The balance of the commit- the initial commitment letter, fur- Chapter 11 petition is filed, ments under the DIP facility will ther fees paid at the time the loan on notice to 1) the lenders be approved at the final DIP hear- is closed, ongoing commitment who are being primed, 2) the ing, after the Creditors fees, and, of course, interest on 20-50 largest unsecured credi- Committee has had time to the loans themselves. The pricing tors of the debtor (depending review the deal. Syndication of can be affected by a number of on the size of the case), and the DIP loan, if the arranger factors, such as whether the facili- 3) the office of the U.S. decides to do so, typically is com- ty is a defensive DIP (where pric- Trustee (a division of the U.S. pleted by the time of the final ing will tend to be somewhat Department of Justice that is hearing. lower) and whether the DIP designated in the Bankruptcy On occasion, the Creditors lender is the only available source Code to perform a number of Committee will object to some of funds (where pricing will likely functions in bankruptcy terms of the deal or the adequate be somewhat higher). cases). At the interim DIP protection package, and the Syndication of larger DIP hearing, the debtor seeks Committee’s objections will have facilities often waits until after approval to use only that por- to be resolved by negotiation or Chapter 11 proceedings begin. tion of the DIP commitments overruled by the court. In many Sometimes the lead arranger it will need until a final DIP cases, the Creditors Committee underwrites the entire facility; hearing can be held. recognizes the need for the DIP other times a small group of ini- 2. The final DIP hearing will facility, and any objections it has tial participants is included. The generally be scheduled within are resolved before the final hear- early entrants are, of course, able 30 to 45 days after the official ing. At the hearing, the court will to obtain a larger share of the up- committee representing the then enter the final DIP Order. front fees, inducing lenders to of unsecured

32 The RMA Journal April 2005 Debtor-in-Possession Financing

If a DIP Order Is Overturned on debtor’s property, DIP Orders usu- cle does not address the numer- Appeal ally contain a provision stating that ous technical aspects of debtor-in- Orders approving DIP financ- the DIP liens are perfected with- possession financing. As with any ings are rarely appealed. However, out further action under state law. other extension of credit, each given the litigation overlay of a However, while the order is occa- DIP lending opportunity should bankruptcy proceeding, a prospec- sionally relied on without further be carefully evaluated from a tive DIP lender may legitimately lien filings, in most cases DIP business and legal perspective. ask what happens in the unlikely lenders take the further steps of Particular attention should be event an appeal is taken and the signing customary collateral docu- focused on the quality of the liq- DIP Order is reversed. mentation and completing neces- uid collateral, the credibility of Anticipating concerns among sary filings. Often this is accom- debtor’s projections, the rights of lenders on this score, Congress plished in due course after closing, third-party creditors, and the atti- included a provision in the and the DIP Order typically con- tudes of the U.S. Trustee’s office Bankruptcy Code stating that tains “further assurances” lan- and the court where the bank- reversal or modification of the guage requiring the debtor to ruptcy case is pending. That said, DIP Order (including the granting complete this documentation. One in many cases, it can be an emi- of priority and liens) “does not of the reasons DIP lenders typical- nently logical and profitable affect the validity of any so ly decline to rely solely on the endeavor. Indeed, because of the incurred, or any priority or lien so DIP Order is the possible need to many lender protections granted, to an entity that extend- enforce their liens in a forum other enshrined in the U.S. Bankruptcy ed credit in good faith” unless the than the Bankruptcy Court. If this Code to induce DIP lending, the effect of the DIP Order was becomes necessary, it is helpful to safest loans in a troubled industry stayed pending appeal. Most DIP have already completed the neces- may well be those made to bank- Orders therefore contain an sary state law filings. ruptcy debtors. ❒ express good-faith finding. Visit Davis Polk & Wardwell’s Web Conclusion site at www.dpw.com. Perfecting a DIP Lender’s Lien Lending to a company in Because the Bankruptcy Chapter 11 is complex from a vari- Court has jurisdiction over the ety of perspectives, and this arti-