Test Your Expertise ' DIP Financing

The debtor about to become a DIP in a Chapter 11 proceeding must utilize one of the methods provided by the Bankruptcy Code to obtain working capital for continued operations. (See, Bankruptcy Code ” 363 and 364; Federal Rule of Bankruptcy Procedure 4001) It may look to its existing lender (the pre-petition lender) or to others who view DIP financing as an attractive, low risk, profitable business line.

DIP financing generally poses less risk of loss for a lender than non court-approved asset based or middle market secured lending.

Primarily due to the Bankruptcy Court approved super priority claims on assets of the DIP as well as the tight controls that may be imposed by a lender, DIP lenders may expect significantly less losses. But, you ask, suppose the DIP financing order is appealed and overturned by a higher court? The drafters of the Bankruptcy Code anticipated this issue and provided a safe harbor provision.

If a DIP financing order is reversed or modified on appeal, the lender is protected as to any debt extended in good faith unless the order was stayed pending appeal. (Bankruptcy Code ' 364(e)).

Note that this safe harbor does not include special fees levied by the lender or other provisions in the financing arrangements but extends only to the actual debt, liens, and priority and, only to any debt extended in good faith. Also, as might be expected, the safe harbor does not apply to terms of a financing order that go beyond the authority of the Bankruptcy Court. (In re Saybrook Mfg. Co., Inc., 963 F.2d 1490 (11th Cir. 1992))

Even a DIP lender may suffer a loss if the value of its collateral drops below the DIP debt.

Oh well, you can't have everything. There are a number of ways in which a DIP in a Chapter 11 proceeding may obtain financing, ranging from unsecured credit to secured credit that takes priority over the lien of an existing lender. (Bankruptcy Code ' 364(a)-(d)) This article deals with financing option that is secured by otherwise unencumbered assets of the estate. (Bankruptcy Code ' 364(c)) The DIP lender may be the existing pre-petition lender or it may be a totally new lender. The pre-petition lender may extend financing by 1) allowing the DIP to use cash collateral (eg, proceeds of accounts receivable and inventory) (Bankruptcy Code ' 364(c)), or 2) entering into a new financing arrangement and obtaining a financing order. (Bankruptcy Code ' 364(c))

Generally, obtaining a new financing order is better for the lender than allowing use of cash collateral.

Even though the negotiating leverage of a pre-petition lender is somewhat compromised by its pre-petition position, it can gain many protections in a financing order that are not necessarily available to it in an order for use of cash collateral.

The pre-petition lender that is new to the DIP may extract a greater financial return and more extensive protections than the pre-petition lender. The new lender, having no prior investment in the DIP, will not be obligated to make the loan until it is satisfied with all of the terms of the transaction and the documentation thereof. The pre-petition lender, however, in order to protect its pre-petition loan, may feel compelled to accept a post-petition financing arrangement on terms, conditions and documentation that are less than satisfactory.

On the other hand, a pre-petition lender with a guaranty that does extend to loans made to a DIP may prefer a cash collateral order. If a financing order were used, the guarantors could argue that new loans were made which were not covered by the guaranty. Use of a cash collateral order might avoid such an argument. If they can operate without borrowing, debtors may also prefer cash collateral orders which could provide them with both increased control over cash and leverage on valuation issues.

In recognition of the need for DIP financing when the trustee cannot obtain unsecured credit, the Bankruptcy Code authorizes the incurring of debt secured by a lien on property of the estate that is unencumbered, with priority over all administrative expenses specified in ” 503(b) (costs of preserving the estate) and 507(b) (failed adequate protection claims). (Bankruptcy Code ' 364(c)(1), (2))

Legend has it that when Michelangelo was asked how he sculpted David, he replied that he simply carved out everything that was not David. The question as to what constitutes 'David' in the Chapter 11 context is often hotly disputed among trustees, unsecured creditors, and DIP lenders. The non-DIP lender groups seek to chip away as much as possible at the lender's position in order to preserve their own rights. DIP lenders, however, generally seek to extend their super priority position, eg, to all other administrative expenses, including but not limited to professional fees. Where the bankruptcy court is unwilling to extend the super priority to professional fees (ie, carve out professional fees from the super priority) DIP lenders may be successful in limiting the extent of such fees. DIP lenders also attempt to have the super priority extend to administration expenses allowed under ' 503(b) in a Chapter 7 ('burial expenses'). Finally, it is important that the DIP lender attempt to extend the super priority to claims under ' 506(c) so that its claim to the collateral will be prior to claims of a trustee for costs of preserving such collateral for the benefit of the DIP lender, etc. Generally, the lien granted to the DIP lender remains subject to claims of prior secured lenders, to burial expenses and to fees of the U.S. Trustee.

Other than extending super priorities, there is not much a DIP lender can do to protect its position.

I hope you didn't check this one, because it is incorrect. There are a number of additional protections the DIP lender may require. They include; a prohibition against the ability of another creditor to prime the DIP lender's position; the right to obtain additional collateral if its lending formulas are violated; the ability to apply proceeds first to any pre-petition loans if cross-collateralized; protection against claims established by the bankruptcy courts exercise of its general equity powers and from claims such as reclamation claims.

While DIP lenders still seek cross-collateralization, bankruptcy judges are reluctant to grant it except in special circumstances.

The general thinking is that: 1) cross-collateralization is not authorized by the Bankruptcy Code, and 2) by converting an unsecured claim into a secured claim, it would create an improper modification of priorities and thus even fall beyond the equitable powers of the court. (In re Saybrook 963 F.2d at 364) Cross-collateralization had been permitted where 1) the business will fail if the proposed financing is not obtained, 2) the debtor is unable to obtain alternative financing on acceptable terms, 3) the proposed lender will not accept less preferential terms, and 4) the proposed financings in the best interests of the creditor body, or some variation of the foregoing. (In re Vanguard Diversified, Inc., 31 B.R. 364 (Bankr. E.D.N.Y. 1983))

There are at least ten other provisions that could benefit DIP lenders, but upon which bankruptcy judges frown.

One of these is a provision or finding of fact that binds the estate or all parties in interest with respect to the validity, perfection, or amount of the secured party's lien or debt. Another is a provision or finding of fact that releases the lender from liability to the estate for tort, breach of contract, or lender liability. Another is a finding without testimony to the effect that, in consenting to the use of cash collateral or post-petition financing, the lender is acting in good faith. Yet another is an artificially short period of limitations for any party to bring claims against the lender. If you know the remaining five, give yourself an additional three checks.

Bankruptcy courts understand the role of the DIP lender and, within limits, are willing to approve DIP financing agreements that disproportionately favor the DIP lender over the debtor.

Courts will allow the DIP lender to impose reasonable reporting requirements and budgets, and use restrictions. They will, with certain exceptions, permit the DIP loan to be documented by the DIP lender as if the loan were one made outside of the bankruptcy arena. They often recognize the need of a DIP lender to act quickly and will approve provisions that permit the DIP lender to exercise specific rights upon the occurrence of a default, appointment of a trustee, or the conversion to a Chapter 7. They will allow a finding, with testimony, that the DIP lender is acting in good faith.

DIP financing requires a unique set of defaults.

There are a number of occurrences that materially change the playing field on which the DIP lender agreed to do its financing. For example, the appointment of a trustee for the DIP may indicate fraud or some other need to control the actions of the DIP. Conversion of the Chapter 11 proceeding to a Chapter 7 generally signifies that there is no need for continued financing. Failure by the DIP to meet the budget or projections may increase the risk of the DIP lender. The remedies to be sought as a result of the default may include the right to modify the lending formula or to terminate the making of loan advances. Although, DIP lenders often seek to include a provision in the financing order granting the DIP lender relief from stay upon the occurrence of a default without further court consent, such relief, when granted, is normally accompanied by some period for notice and hearing. As with the other categories, default provisions may or may not be granted depending upon the policy of the particular bankruptcy judge.

'He who asketh not, receiveth not.'

Based upon this principle, the drafter of a DIP financing motion should request every protection that he or she can think of, even though the bankruptcy judge has refused certain provisions (eg, cross collateralization) since the day the judge took the oath. Those big dippers who checked this box would argue that you owe it to your client to obtain as much protection as you can. If you are shot down on a particular provision, no harm has been done. In fact, you may be able to use such refusal for negotiating leverage on another issue. Your motion should therefore protect against every DIP risk you and your partners have encountered in your respective careers, whether or not such risk is likely to be faced in the matter in question. How better to impress the bankruptcy judge than to file the most extensive and inclusive motion ever filed by a prospective DIP lender?

Those big dippers who did not check the box would disagree. They would point out that you may have lost the good will of the judge by requesting provisions that said judge has consistently denied in the past.

The correct position probably rests somewhere in the middle. It would not seem objectionable to ask for a provision that is normally a 'no-no' if you are able to, in good faith, show a specific set of facts and a reason why such provision should be applicable notwithstanding prior precedent.

William Barnett, Esq. chairs the Commercial Finance Division of the Financial Institutions Practice Group at Herrick, Feinstein LLP in New York City. He has lectured and written extensively on many aspects of commercial finance, and was the author of a regular monthly column entitled 'Line Items' for the Banking Law Journal.

For the reader who has been involved in more debtor-in-possession (DIP) financings than he or she can remember, please treat this article as the opportunity to impress yourself with just how much you know about it. Check off each category if you can truthfully say 'I knew that!' A sum of eight or more checks makes you a big dipper.

For those readers who know in advance that they would not qualify as big dippers or even little dippers, treat this article not as an exhaustive treatise on DIP financing, but as 1) a review of the areas with which to be concerned when involved with DIP financing, and 2) a sampling only of the numerous examples that comprise each category.

Contrary to popular belief, the bankruptcy court does not lend money.

The debtor about to become a DIP in a Chapter 11 proceeding must utilize one of the methods provided by the Bankruptcy Code to obtain working capital for continued operations. (See, Bankruptcy Code ” 363 and 364; Federal Rule of Bankruptcy Procedure 4001) It may look to its existing lender (the pre-petition lender) or to others who view DIP financing as an attractive, low risk, profitable business line.

DIP financing generally poses less risk of loss for a lender than non court-approved asset based or middle market secured lending.

Primarily due to the Bankruptcy Court approved super priority claims on assets of the DIP as well as the tight controls that may be imposed by a lender, DIP lenders may expect significantly less losses. But, you ask, suppose the DIP financing order is appealed and overturned by a higher court? The drafters of the Bankruptcy Code anticipated this issue and provided a safe harbor provision.

If a DIP financing order is reversed or modified on appeal, the lender is protected as to any debt extended in good faith unless the order was stayed pending appeal. (Bankruptcy Code ' 364(e)).

Note that this safe harbor does not include special fees levied by the lender or other provisions in the financing arrangements but extends only to the actual debt, liens, and priority and, only to any debt extended in good faith. Also, as might be expected, the safe harbor does not apply to terms of a financing order that go beyond the authority of the Bankruptcy Court. (In re Saybrook Mfg. Co., Inc., 963 F.2d 1490 (11th Cir. 1992))

Even a DIP lender may suffer a loss if the value of its collateral drops below the DIP debt.

Oh well, you can't have everything. There are a number of ways in which a DIP in a Chapter 11 proceeding may obtain financing, ranging from unsecured credit to secured credit that takes priority over the lien of an existing lender. (Bankruptcy Code ' 364(a)-(d)) This article deals with financing option that is secured by otherwise unencumbered assets of the estate. (Bankruptcy Code ' 364(c)) The DIP lender may be the existing pre-petition lender or it may be a totally new lender. The pre-petition lender may extend financing by 1) allowing the DIP to use cash collateral (eg, proceeds of accounts receivable and inventory) (Bankruptcy Code ' 364(c)), or 2) entering into a new financing arrangement and obtaining a financing order. (Bankruptcy Code ' 364(c))

Generally, obtaining a new financing order is better for the lender than allowing use of cash collateral.

Even though the negotiating leverage of a pre-petition lender is somewhat compromised by its pre-petition position, it can gain many protections in a financing order that are not necessarily available to it in an order for use of cash collateral.

The pre-petition lender that is new to the DIP may extract a greater financial return and more extensive protections than the pre-petition lender. The new lender, having no prior investment in the DIP, will not be obligated to make the loan until it is satisfied with all of the terms of the transaction and the documentation thereof. The pre-petition lender, however, in order to protect its pre-petition loan, may feel compelled to accept a post-petition financing arrangement on terms, conditions and documentation that are less than satisfactory.

On the other hand, a pre-petition lender with a guaranty that does extend to loans made to a DIP may prefer a cash collateral order. If a financing order were used, the guarantors could argue that new loans were made which were not covered by the guaranty. Use of a cash collateral order might avoid such an argument. If they can operate without borrowing, debtors may also prefer cash collateral orders which could provide them with both increased control over cash and leverage on valuation issues.

In recognition of the need for DIP financing when the trustee cannot obtain unsecured credit, the Bankruptcy Code authorizes the incurring of debt secured by a lien on property of the estate that is unencumbered, with priority over all administrative expenses specified in ” 503(b) (costs of preserving the estate) and 507(b) (failed adequate protection claims). (Bankruptcy Code ' 364(c)(1), (2))

Legend has it that when Michelangelo was asked how he sculpted David, he replied that he simply carved out everything that was not David. The question as to what constitutes 'David' in the Chapter 11 context is often hotly disputed among trustees, unsecured creditors, and DIP lenders. The non-DIP lender groups seek to chip away as much as possible at the lender's position in order to preserve their own rights. DIP lenders, however, generally seek to extend their super priority position, eg, to all other administrative expenses, including but not limited to professional fees. Where the bankruptcy court is unwilling to extend the super priority to professional fees (ie, carve out professional fees from the super priority) DIP lenders may be successful in limiting the extent of such fees. DIP lenders also attempt to have the super priority extend to administration expenses allowed under ' 503(b) in a Chapter 7 ('burial expenses'). Finally, it is important that the DIP lender attempt to extend the super priority to claims under ' 506(c) so that its claim to the collateral will be prior to claims of a trustee for costs of preserving such collateral for the benefit of the DIP lender, etc. Generally, the lien granted to the DIP lender remains subject to claims of prior secured lenders, to burial expenses and to fees of the U.S. Trustee.

Other than extending super priorities, there is not much a DIP lender can do to protect its position.

I hope you didn't check this one, because it is incorrect. There are a number of additional protections the DIP lender may require. They include; a prohibition against the ability of another creditor to prime the DIP lender's position; the right to obtain additional collateral if its lending formulas are violated; the ability to apply proceeds first to any pre-petition loans if cross-collateralized; protection against claims established by the bankruptcy courts exercise of its general equity powers and from claims such as reclamation claims.

While DIP lenders still seek cross-collateralization, bankruptcy judges are reluctant to grant it except in special circumstances.

The general thinking is that: 1) cross-collateralization is not authorized by the Bankruptcy Code, and 2) by converting an unsecured claim into a secured claim, it would create an improper modification of priorities and thus even fall beyond the equitable powers of the court. (In re Saybrook 963 F.2d at 364) Cross-collateralization had been permitted where 1) the business will fail if the proposed financing is not obtained, 2) the debtor is unable to obtain alternative financing on acceptable terms, 3) the proposed lender will not accept less preferential terms, and 4) the proposed financings in the best interests of the creditor body, or some variation of the foregoing. (In re Vanguard Diversified, Inc., 31 B.R. 364 (Bankr. E.D.N.Y. 1983))

There are at least ten other provisions that could benefit DIP lenders, but upon which bankruptcy judges frown.

One of these is a provision or finding of fact that binds the estate or all parties in interest with respect to the validity, perfection, or amount of the secured party's lien or debt. Another is a provision or finding of fact that releases the lender from liability to the estate for tort, breach of contract, or lender liability. Another is a finding without testimony to the effect that, in consenting to the use of cash collateral or post-petition financing, the lender is acting in good faith. Yet another is an artificially short period of limitations for any party to bring claims against the lender. If you know the remaining five, give yourself an additional three checks.

Bankruptcy courts understand the role of the DIP lender and, within limits, are willing to approve DIP financing agreements that disproportionately favor the DIP lender over the debtor.

Courts will allow the DIP lender to impose reasonable reporting requirements and budgets, and use restrictions. They will, with certain exceptions, permit the DIP loan to be documented by the DIP lender as if the loan were one made outside of the bankruptcy arena. They often recognize the need of a DIP lender to act quickly and will approve provisions that permit the DIP lender to exercise specific rights upon the occurrence of a default, appointment of a trustee, or the conversion to a Chapter 7. They will allow a finding, with testimony, that the DIP lender is acting in good faith.

DIP financing requires a unique set of defaults.

There are a number of occurrences that materially change the playing field on which the DIP lender agreed to do its financing. For example, the appointment of a trustee for the DIP may indicate fraud or some other need to control the actions of the DIP. Conversion of the Chapter 11 proceeding to a Chapter 7 generally signifies that there is no need for continued financing. Failure by the DIP to meet the budget or projections may increase the risk of the DIP lender. The remedies to be sought as a result of the default may include the right to modify the lending formula or to terminate the making of loan advances. Although, DIP lenders often seek to include a provision in the financing order granting the DIP lender relief from stay upon the occurrence of a default without further court consent, such relief, when granted, is normally accompanied by some period for notice and hearing. As with the other categories, default provisions may or may not be granted depending upon the policy of the particular bankruptcy judge.

'He who asketh not, receiveth not.'

Based upon this principle, the drafter of a DIP financing motion should request every protection that he or she can think of, even though the bankruptcy judge has refused certain provisions (eg, cross collateralization) since the day the judge took the oath. Those big dippers who checked this box would argue that you owe it to your client to obtain as much protection as you can. If you are shot down on a particular provision, no harm has been done. In fact, you may be able to use such refusal for negotiating leverage on another issue. Your motion should therefore protect against every DIP risk you and your partners have encountered in your respective careers, whether or not such risk is likely to be faced in the matter in question. How better to impress the bankruptcy judge than to file the most extensive and inclusive motion ever filed by a prospective DIP lender?

Those big dippers who did not check the box would disagree. They would point out that you may have lost the good will of the judge by requesting provisions that said judge has consistently denied in the past.

The correct position probably rests somewhere in the middle. It would not seem objectionable to ask for a provision that is normally a 'no-no' if you are able to, in good faith, show a specific set of facts and a reason why such provision should be applicable notwithstanding prior precedent.

William Barnett, Esq. chairs the Commercial Finance Division of the Financial Institutions Practice Group at Herrick, Feinstein LLP in New York City. He has lectured and written extensively on many aspects of commercial finance, and was the author of a regular monthly column entitled 'Line Items' for the Banking Law Journal.