What Secured Lenders Should Know If Their Borrower Files for Bankruptcy

When a Borrower Files for Bankruptcy, How Can Secured Lenders Protect Their Position?

As a secured lender, you should know when the borrower is in distress well before they file for bankruptcy.  Consultations with your borrower should reveal clear signs of their distress, such as when:

• The borrower is likely unable to repay the loan and struggling with basic periodic payments.
• The borrower has engaged bankruptcy counsel (and so should you).
• The borrower wants to commence a bankruptcy case in order to restructure or sell the company.
• The borrower wants you to allow them to use your cash collateral. This is typically the proceeds of accounts receivable and sales of inventory and other assets, which are all pledged to you.
• The borrower may even have you lend more money in the bankruptcy case (through a DIP or ‘debtor-in-possesion’ loan).

You have two choices when the borrower files bankruptcy:

1. Refuse to cooperate. Instead, try to foreclose on your collateral, with the attendant costs, expenses, and risks — including delay.
2. Cooperate and protect your collateral. Potentially earn some new lender’s fees by helping the bankruptcy case to produce a sale or reorganization that gives you a higher recovery on your lending.

Lenders, Pick Your Battles in a Borrower’s Bankruptcy

When a borrower files bankruptcy, a lender must choose their battles.

It is generally less wise to take on the debtor in the first days of a case when a bankruptcy court is highly focused on giving the company a chance to succeed. Crucially, an automatic stay is put in place after a bankruptcy filing, which will halt or bar all creditor collections. If you choose to refuse to cooperate, you will need to convince the bankruptcy court to lift the automatic stay before any foreclosure efforts.

After assuming their bankruptcy identity as a ‘debtor,’ the borrower can also try to win the right to use cash collateral over your objection. They can do this by arguing on the grounds of giving you ‘adequate protection.’ (More on that below.) While it may permit the debtor to use collateral, however, the court cannot compel you to extend new financing to the debtor.

Every case is unique, and nothing I say here can be uniformly applied to all cases. In most cases, the most advantageous course is to cooperate, and to use your cooperation to gain cash and control.

In exchange for providing DIP funding or permission to use cash collateral, you can gain lender’s fees or adequate protection payments. You may bargain for protections against being sued or having your liens challenged. You can also gain additional means to keep close tabs on the borrower’s performance, and the clear authority to pull the plug if your position deteriorates.

Adequate Protection

Whether or not you permit a debtor’s use of your cash or other collateral, you are absolutely entitled to adequate protection. In plain English, adequate protection is any reasonable means to ensure that the value of your collateral does not diminish from its value at the date of the bankruptcy filing. If you oppose the use of cash collateral, the debtor will be denied use unless they can persuade the court that they will afford you adequate protection.

Adequate protection may take many different forms. Sometimes, to protect the value of cash collateral, the debtor must pay you cash in what are often called ‘adequate protection payments.’ These may be continued periodic interest payments on the loan principal.

You are also granted liens (often called ‘replacement liens’) on post-bankruptcy receivables and collections. If the debtor has any unpledged assets, they may also grant you liens on such assets to the extent that the value of the collateral at the beginning of the case diminishes from the debtor’s use.

By requiring rigorous budgeting and monitoring of the debtor’s use of cash and other collateral, you can determine whether value has diminished and take prompt action to protect yourself.

A Creditor’s Cooperation Increases the Chances of Success

Your cooperation may amplify the debtor’s chances of success.  The automatic stay on all creditor collections placed at the outset of the bankruptcy allows the borrower to conduct ordinary course business without fighting foreclosure or other creditor actions. With their focus turned to cash use and operational efficiency — enforced by the arrangements for DIP financing or the use of cash collateral — the borrower should improve their cash flow.

The desired result is that the borrower improves their chances for a successful restructuring or sale. For lenders, that means a better borrower (under a restructuring), or a return from sale that’s superior to the likely net result of a foreclosure and sale.

With all that said, choosing your battles wisely doesn’t completely remove uncertainty. Even cooperative bankruptcy cases sometimes go awry, despite a lender’s best efforts and strategy.

We think you’ll also like:

1. Dealing with Corporate Distress 15: Digging into DIP Financing & Cash Collateral Motions in Bankruptcy
2. Valuation: The Pillar of Corporate Restructuring
3. Dealing with Corporate Distress 14: The Secured Creditor’s Perspective About its Debtors

[Editors’ Note: To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can view at your leisure, and each includes a comprehensive customer PowerPoint about the topic):

1. Business Borrowing Basics: Dealing With Defaults
2. Business Borrowing Basics: Basic Concepts Applicable to All Borrowers & Lenders
3. Bankruptcy Transactions 301: Negotiating and Drafting Cash Collateral/DIP Financing Orders

This article was originally published on February 1, 2019 and updated on October 23, 2023.]

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