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 well in advance the necessary details if a borrower files bankruptcy. Let us presume therefore that, from consultations with your borrower, it is clear that the borrower is in distress:

• 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 it to use your cash collateral (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 (by what is known as a DIP or “debtor-in-possesion” loan).

You have two choices in this scenario:

1. Refuse to cooperate and try instead to foreclose on your collateral, with the attendant costs, expenses, and risks—including delay.
2. Cooperate, protect your collateral, and possibly earn some new lender’s fees to try to help 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 goes into bankruptcy, a lender must choose its 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. Did I mention that if you refuse to cooperate, the borrower’s bankruptcy filing will halt or bar your foreclosure efforts unless you convince the bankruptcy court to lift the automatic stay that prevents such actions?

Further, the borrower (after assuming its bankruptcy identity as a “debtor”) can try to win the right to use cash collateral over your objection on the grounds that the borrower gives you “adequate protection.” (More on that below.) At least the court cannot compel you to extend new financing to a debtor.

Every case is unique, and nothing I say here can be uniformly applied to all cases. As my posing of the choices suggests, 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. Also, you can gain additional means to keep close tabs on the borrower’s performance, and 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 the value it had as of the date of the bankruptcy filing. If you oppose the use of cash collateral, the debtor will be denied use unless it can persuade the court that it affords 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,” such as continued periodic interest payments on the loan principal. In addition, you are granted liens (often called “replacement liens”) on post-bankruptcy receivables and collections. If the debtor has any unpledged assets, it 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. Because of the automatic stay on all creditor collections established at the outset of the bankruptcy, the borrower will be able to conduct ordinary course business without fighting foreclosure or other creditor actions. The borrower’s focus on cash use and operational efficiency—enforced by the arrangements for DIP financing or the use of cash collateral—should improve the borrower’s cash flow. The desired result is that the borrower will thus improve its chances for a successful restructuring or sale. For you, that means a better borrower (under a restructuring) or a return to lender (from sale) superior to the likely net result of a foreclosure and sale.

All that said, it remains a matter of choosing battles, which hardly does away with uncertainty. Even cooperative bankruptcy cases sometimes go awry despite a lender’s best efforts and strategy.

We think you’ll also like:

1. 90 Second Lessons: Virgin Lender, Virgin Land: When the Collateral is Dirt
2. Lender vs Debtor on the Payment of Post-Petition Interest
3. 90 Second Lesson: Is a Business Turnaround Still Possible?

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

1. Negotiating and Drafting Cash Collateral/DIP Financing Orders
2. Basic Concepts Applicable to All Borrowers & Lenders
3. Dealing With Defaults

This is an updated version of an article originally published on February 1, 2019 and previously updated June 20, 2021.]

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