Editors’ Note: We started this series with Dealing with Distress for Fun & Profit, a broad overview of business bankruptcy and its alternatives. Our last few installments have focused on explaining how a creditor can, when its customer files bankruptcy, collect as much as possible on what it is owed (read about How To Protect Your Claim and about Priorities). In this installment, we turn to how distressed companies seek liquidity in the bankruptcy context: DIP Financing and Cash Collateral Motions.
Chapter 11 is expensive. There is a seeming irony here in that a company that files for bankruptcy often does not have the cash to do so. How, then, does such a company file bankruptcy? And, what is the true cost of obtaining bankruptcy financing?
Most businesses of any real size have some sort of outside debt financing. This commonly takes the form of a line of credit with a bank or other lender. Often, these lines of credit are secured by substantially all of the assets of the borrower.
All assets means just that—all assets, including cash and receivables. The Bankruptcy Code dictates that a company in bankruptcy cannot use the cash collateral of a secured creditor without either (i) the consent of that secured creditor; or (ii) the approval of the bankruptcy court over the secured creditor’s objection. As a practical matter, a secured creditor will only agree to allow its cash collateral to be used if it can extract certain concessions in return; something that the debtor cannot agree to without court approval.
What all this means is that even if a would-be Chapter 11 debtor has enough cash to satisfy administrative costs (such as professionals and ongoing business expenses), it has to file a motion to use that cash. Such a motion is commonly filed at the very beginning of a Chapter 11 case on an emergency basis. The motion is usually accompanied by a proposed budget.
Even assuming the use of cash collateral, companies that are about to file bankruptcy are often cash poor. So what is a company to do when it needs money to operate during bankruptcy and to pay the extraordinary administrative case expenses, but doesn’t have the funds? The answer is borrow it.
But who would loan to a company about to file bankruptcy? As counterintuitive as the answer may seem to appear at first blush, the answer is plenty of parties. Some potential sources include:
Debtors can borrow money on an unsecured basis in the ordinary course of business without obtaining court approval, and such loans are allowable as an administrative expense. As a practical matter such loans occur when a vendor provides post-petition credit terms. A lender making a cash loan, however, typically will not do so on the mere basis of getting an administrative expense claim.
A debtor that wants to borrow money out of the ordinary course of business or on a secured basis must get court approval to do so. And, the hoop that a debtor must jump through in order to obtain such approval depends on the lien priority that the debtor wants to grant the would-be DIP lender. Bankruptcy Code §364 governs this. To obtain unsecured credit outside of the ordinary course of business, the DIP must first seek and obtain the consent of the court after notice and a hearing.
If the DIP is unable to obtain unsecured credit, then, after notice and hearing, the court may authorize the DIP to obtain credit backed by a superpriority administrative expense claim, a secured lien on unencumbered property of the estate, or a junior lien on already encumbered property of the estate.
If, and only if, the DIP is unable to obtain credit by any of the means listed above, the court may authorize post-petition financing secured by a first-priority lien on property of the estate that is already encumbered (a “priming lien”), provided there is adequate protection for the holder of the lien being primed. Such relief is rare.
In any case, DIP lenders generally extract as many protections as they can before subjecting themselves to the risks attendant in bankruptcy financing. These lender-friendly provisions are often rebutted not by the DIP itself, who does not have proper leverage to negotiate with a DIP lender, but instead by creditors’ committees, the U.S. Trustee or even the bankruptcy court.
Courts are typically concerned in the context of cash collateral and/or DIP financing motions that (1) they lack time to properly review and develop an understanding of the issues; and (2) creditors and creditors’ committees don’t have an opportunity to review the arrangement, even though it can have a substantial impact on potential creditor recoveries.
The Bankruptcy Code provides guidance concerning post-petition financing agreements and the protections afforded to secured creditors. Specifically, Bankruptcy Rules 4001(b) and (c) provide for the interim use of cash collateral and DIP financing, respectively. In other words, a debtor can receive court approval for the temporary use of cash without binding itself to final terms or denying other parties in interest (such as a creditors’ committee) a chance to weigh in. Rule 4001 provides for an interim hearing at the beginning of the case, followed by a full hearing at least 15 days later. At the interim hearing, the court may authorize DIP financing and/or cash collateral use only to the extent necessary to avoid irreparable harm pending a final hearing. This is often necessary for a DIP to make payroll, pay for post-petition goods or services, or otherwise maintain the DIP’s value as a going concern.
Even within the framework of Rule 4001, courts have expressed concern over the content of DIP financing and cash collateral orders. In his letter to the Delaware Bar, Bankruptcy Judge Peter J. Walsh outlined unfavorable provisions that should be excluded from interim DIP and cash collateral motions such as:
Many other courts have established local rules or other written guidance along the same lines, such as the requirement is that specific provisions (such as cross collateralization, §506(c) waivers, lien on avoidance actions, etc.) be identified in a motion, so the judge does not inadvertently miss them. For an example of such local rules, see Delaware Local Rule 4001-2(a)(ii).
The DIP’s first steps when contemplating post-petition financing should come as soon as a bankruptcy filing proves likely. Pre-filing (if possible), debtors should begin their due diligence of existing loan documents and cash flow needs.
The development of an initial budget is also essential to obtaining court authority for post-petition financing. Likewise, lenders require budgets to ensure that cash is spent prudently and with an eye towards repaying the lender in full (with interest). Post-filing, unsecured creditors must also scrutinize budgets and planned expenditures for any excessive spending, such as high interest rates or unnecessary expenditures.
Next, the court must assess the overall structure and proposed use of post-petition funds. This is where the court will scrutinize the many lender-friendly protections insisted upon by the post-petition lender. For instance–how much of the liquidity injection is truly “new money” as opposed to a rollup of prepetition debt? What protections are being granted to DIP financiers, such as adequate protection liens or superpriority administrative expense claims, that may affect the lender’s rights relative to other creditors? Is there more than one lender, or tiers of lenders, providing first- and second-priority DIP financing? Do the debtors even need DIP financing, or could their going concern be preserved through use of cash collateral alone?
Answering these questions will prove essential for a debtor to pay for the privilege of financing its bankruptcy case.
To read other installments in this series, click here
Michael A. Brandess, a partner at Husch Blackwell and part of the Bankruptcy, Reorganization and Creditors’ Rights practice group, is consistently recognized for his dedicated and zealous representation of his clients, finding the most efficient and creative solutions, securing his clientele the most value for their claims. Michael’s practice focuses on the representation of asset…
Luke Smith graduated from the University of Tennessee College of Law with a concentration in Business Transactions and now works for Kirkland & Ellis. Smith is the Editor-in-Chief of Transactions: The Tennessee Journal of Business Law, and recently co-authored an article titled "Perfect Civil Enforcement? Litigation Financing in the Wake of Gawker Media v. Bollea." Academically, Smith…
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