When a business enters Chapter 11 bankruptcy, securing cash flow becomes a paramount concern. After all, ongoing operational expenses need to be paid even as the company restructures.
Matt Christensen, partner at Johnson May, notes that there are two principal ways a debtor funds itself during Chapter 11: (1) using cash generated by the business (cash collateral) or (2) borrowing new funds through ‘Debtor-in-Possession (DIP) Financing.’
Cash collateral includes cash or cash equivalents that are subject to a secured lender’s lien. This might include proceeds from accounts receivable, inventory sales, or rents from property. Use of this cash is restricted under Section 363 of the Bankruptcy Code and requires court approval because the creditor must be ‘adequately protected’ from a loss in the value of its collateral. According to Christensen, this means the debtor must often file a ‘cash collateral motion’ immediately after the bankruptcy is filed to continue using this revenue stream.
If there isn’t enough operating cash, or if using it is contested, then the company must seek DIP financing.
What Is DIP Financing, Exactly?
DIP financing is new credit extended to a company after it files for bankruptcy under Chapter 11. As the name suggests, the borrower remains ‘in possession’ of the business and uses this financing to support operations during reorganization. The financing can come from existing lenders, third-party financial institutions, or even company insiders.
The DIP lender typically negotiates strict conditions, including liens on assets and high interest rates, to mitigate their risk. Section 364 of the Bankruptcy Code outlines special protections for DIP lenders, including super-priority of repayment, meaning DIP debt takes precedence over all pre-bankruptcy debt, including secured debt in many cases.
Throughout the DIP financing process, a debtor will have to navigate a myriad of complications and considerations including:
- A lender with a sour relationship with the debtor may refuse to cooperate at all.
- In multi-lender situations, parties jockey for position, and marshaling rights may come into play (i.e., requiring the debtor to exhaust certain assets first).
- A court may allow funding in tranches — approving, say, $5 million upfront and reserving judgment on the rest — so it can monitor cash usage.
The Priming Lien Debate
A particularly controversial feature of DIP financing is the ‘priming lien.’ This is a lien granted to the DIP lender that has priority over existing liens on the same collateral. As Robert Glantz of Much Shelist explains, these arrangements can be alarming for prepetition lenders who suddenly find themselves pushed down the repayment hierarchy.
Under Section 364(d) of the Bankruptcy Code, the court can authorize a priming lien only if the existing lender is either (a) ‘adequately protected’ or (b) consents to being primed.
As Evan Hill, a restructuring partner at Skadden, explains, ‘adequate protection,’ as outlined in Section 361 of the Bankruptcy Code , ensures that the secured creditor does not suffer a loss in the value of its collateral.
Protection may be offered in various forms including
- Replacement liens on unencumbered property,
- Periodic cash payments, or
- Superpriority administrative claims, which grant higher repayment priority than other claims.
Role of the Unsecured Creditors Committee
Unsecured creditors often get left out of the early negotiations over DIP financing or cash collateral. As Glantz notes, courts usually allow interim approval of these motions to keep the business running, but will schedule a final hearing after a creditors committee is appointed. The committee can then review:
- The validity and extent of the secured creditor’s liens,
- The fairness of the proposed protections, and
- Whether the DIP terms unduly favor insiders or suppress value-maximizing alternatives.
The committee may also seek to carve out some unencumbered value to benefit general creditors or push for an equity committee if the debtor has significant remaining value.
DIP Financing: Debtor and Lender Perspectives
From the debtor’s perspective, DIP financing is often a last resort — a necessary ‘lifeline’ to keep the business afloat. As a last resort a DIP debtor inherently finds itself in a weak negotiating position where it will have to be willing to accept such conditions as high interest rates and tight operational covenants to secure the financing needed.
From the lender’s perspective, the key objective is to minimize risk. According to Hill, a DIP lender, especially a third-party lender, wants assurance they’ll be repaid regardless of the outcome. This ‘assurance’ is typically secured by such terms and conditions as:
- High interest rates (often in the mid-teens)
- Exit and commitment fees
- Waivers of certain debtor rights under the Bankruptcy Code (e.g., §506(c) surcharge waivers)
- Liens on all available assets
- Tight budget adherence requirements
Many DIP lenders also require milestone provisions. These clauses create deadlines for the debtor to file a Chapter 11 plan, obtain court approvals, or close a sale. If the debtor misses a milestone, it may trigger a default, giving the lender leverage to demand repayment or convert their debt into equity.
Strategic Uses: From ‘Loan-to-Own’ to Exit Financing
Not all DIP lenders are looking to get repaid in cash. Some aim to convert their DIP loan into ownership of the company — a strategy known as ‘loan-to-own.’ This tactic is particularly popular among hedge funds and private equity firms, which may buy out the debtor’s prepetition secured debt and offer a DIP loan structured to lead to a Section 363 sale, or plan confirmation, where the DIP debt converts to equity.
Hill notes that these strategies often come with their own legal controversies. Courts may question whether the process gives other creditors a fair shot, or whether it effectively bypasses the Chapter 11 plan process. These ‘sub rosa’ plans — agreements that pre-determine outcomes without going through proper voting — can be challenged by creditors committees and other stakeholders.
A High-Stakes Balancing Act
DIP financing is one of the most powerful tools in the bankruptcy process — and as such, one of the most contentious. In DIP financing, debtors, creditors, and courts must weigh immediate survival against long-term recovery. Here, Maria Carr of McDonald Hopkins LLC, emphasizes the importance of a measured strategy where all stakeholders work toward a practical, value-preserving outcome. In the end, the success of a Chapter 11 reorganization often hinges on how the DIP financing is structured — and how fairly it treats all parties at the table.
To learn more about this topic view The Nuts & Bolts of Chapter 11 (Series I) / The Nuts & Bolts of DIP Financing. The quoted remarks referenced in this article were made either during this webinar or shortly thereafter during post-webinar interviews with the panelists. Readers may also be interested to read other articles about DIP financing.
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