It may seem counterintuitive for banks and other lenders to provide loans to companies in bankruptcy, but they often do. All companies, especially those in bankruptcy, need liquidity to continue operating. Ensuring the availability of cash is one of the most important considerations in a Chapter 11 reorganization because debtors are often unable to reorganize without adequate cash flow.
The market for debtor-in-possession (“DIP”) financing is significant. In 2019, DIP financing volume was over $18 billion, compared to about $10 billion in 2018. DIP lenders are typically secured creditors who have an interest in the outcome of the bankruptcy case and lend to enhance their own recovery. There has, however, been an increase in the number of DIP facilities funded by third parties for investment and more strategic purposes, such as acquiring a debtor’s assets in a “loan to own” transaction. Regardless of a lender’s goals, DIP lenders continue to enjoy very favorable treatment in bankruptcy.
Types of DIP financing
Congress anticipated that lenders may be nervous extending credit to companies in bankruptcy, and as a result, the Bankruptcy Code gives DIP lenders some powerful protections. These protections include:
- If the trustee or DIP is otherwise unable to obtain unsecured debt, the court can authorize the trustee or DIP to obtain such debt and may:
- Treat such debt as an administrative claim having priority over most other administrative claims [11 U.S.C. § 364(c)(1)];
- Grant a lien on unencumbered assets [11 U.S.C. § 364(c)(2)]; or
- Grant a junior lien on encumbered assets [11 U.S.C. § 364(c)(3)].
- If the trustee or DIP is still unable to obtain debt, the court may grant a lender a lien that is senior or equal to existing liens on estate assets [11 U.S.C. § 364(d)].
The strongest of these protections is the “priming lien” under section 364(d). A priming lien is typically only available as a last resort and will only be granted if the holders of existing liens consent or if the trustee or DIP can demonstrate it has equity in its assets above the existing secured debt, or the existing lienholders are adequately protected from diminution in the value of their collateral. Existing lenders will often insist on obtaining a priming lien and superpriority administrative claims, providing the maximum protection possible for their DIP financing facility.
Benefits to Being a DIP Lender
DIP lenders can receive an excellent premium over their normal interest rates. DIP loans are often in amounts substantially higher (sometimes 25% to 50%) than the debtor’s projected needs. DIP lenders benefit from large loans because they earn facility, ongoing commitment, and other fees based on the amount of the loan.
DIP loans with priming liens are generally paid before any other stakeholder, unless they agree to carve funds out of their collateral for the payment of certain estate expenses or court-approved professionals. DIP lenders stand an excellent chance of realizing a return on their investment for several reasons, including:
- DIP loans are typically secured with sufficient collateral to pay the balance in full;
- The DIP lender’s priming lien and superpriority claim ensures that it is paid first;
- Liens granted to DIP lenders are typically not subject to challenge once approved by the court;
- DIP lenders can insist on covenants and other protections that borrowers may not agree to outside of bankruptcy, including:
- frequent and detailed financial reporting;
- maintaining collateral ratios;
- lender approval of the use of loan proceeds;
- additional influx of capital from sponsors and third parties;
- strict milestones for the sale of estate assets or implementation of a plan of reorganization; and
- tight control over the reorganization process, approval or veto-authority over a plan of reorganization or liquidation.
- Provisions in the DIP financing order typically give the DIP lender immediate relief from the automatic stay (to the extent applicable) to exercise remedies without court approval on the occurrence of an event of default.
DIP lending also gives secured creditors a unique ability to protect their pre-bankruptcy claims. While controversial, some bankruptcy courts allow secured creditors to get additional protections not contemplated by the Bankruptcy Code. For example, some courts allow DIP lenders to “roll up” their existing secured claims into the DIP loan, giving both the pre- and post-petition credit the additional protections discussed above. DIP lenders also often condition these loans on the entry of orders finding their existing liens to be valid and unassailable. And many courts will even permit DIP lenders to obtain liens on collateral that would not otherwise be available to them, such as the proceeds of claims arising solely under the Bankruptcy Code (such as avoidance actions, fraudulent conveyance claims, etc.).
Sometimes lenders provide DIP financing as part of a “loan-to-own” strategy. DIP loans may have clauses that allow lenders, upon a default or under a plan (which must be subject to its approval), to “swap” senior secured debt for newly issued equity, giving the lender a controlling ownership interest in the company following emergence from bankruptcy. Alternatively, the DIP lender’s control over a debtor’s asset sale process can give it an advantage over other potential bidders in an auction of the debtor’s assets. If the lender does not win the auction, and depending on how the transaction is documented, lenders may require termination fees, and expense reimbursements, and insist that the loan be repaid on the sale of assets to a third party.
Ultimately, DIP financing provides willing lenders a variety of options that creditors should consider when the right opportunity presents itself. If you have questions regarding DIP financing, please contact Ice Miller’s Distressed Investments Group. Ice Miller represents both for-profit and not-for-profit companies in financial distress and restructuring due to insolvency and regularly counsels individuals and corporations as creditors, investors, lenders and debtors regarding corporate, governance, tax issues for tax-exempt entities, as well as gift, estate, trust taxation, estate planning, estate and trust administration and charitable giving for nonprofit organizations.