While Chapter 11 helps companies deal with their debt through restructuring, many companies are unable to raise or borrow the capital needed to execute a reorganization plan to where they become fully operational. That’s where Debtor in Possession (DIP) financing under restructuring comes in as a source of financing available under bankruptcy laws designed specifically for companies in financial distress.
What Exactly is DIP Financing Under Restructuring?
The term “Debtor in Possession” is derived from the understanding that, even if a company is in bankruptcy, the management and board of directors still retain possession of the company so they can operate it through restructuring. Companies in DIP status are afforded the opportunity to obtain special financing specifically allowed under bankruptcy laws, which can be used as part of their plan to turn themselves around. DIP financing is not available to companies that intend to liquidate. Rather it is only available to companies deemed to have a viable reorganization plan with a solid chance of emerging from bankruptcy fully and profitably operational.
Lenders often view DIP financing as an attractive opportunity because of the special treatment DIP loans receive under U.S. bankruptcy law, which gives DIP creditors senior lien position. Their downside is further limited due to the fact that they are working with a company that has had its debt restructured or eliminated. Should the reorganization fail, forcing the company to liquidate, DIP creditors are repaid before other creditors. Ironically, it is highly unlikely that a lender that commits to a DIP loan would make loan commitment to the same company had it not filed for bankruptcy.
In some cases, a company’s senior debt holder or primary lender will take the lead in providing DIP financing because it ensures they retain senior position. However, where a current lender does not step in, there are other lenders that will under the right circumstances.
How Does DIP Financing Work?
Although any company in bankruptcy or in the process of restructuring debt can seek DIP financing, it must first seek approval from the Bankruptcy Court. The process for obtaining a DIP loan is guided by the law which has established strict requirements.
• Assets pledged by the company as collateral must be sufficient to cover the loan.
• The DIP lender assumes a first priority security interest in the collateral.
• The company’s reorganization plan and budget must be approved by the court.
• Companies with existing secured loans that want to borrow on a secured basis must obtain consent to the new loan from the existing lender or prove to the court that it will be adequately protected.
• DIP loans approved by the court are not subject to legal challenge.
For the company to emerge from Chapter 11, it needs to pay off its DIP loan or convert it to into an existing facility that can be repaid to the satisfaction of senior secured lenders. Alternatively, the lender may offer the option to convert the DIP loan into equity.
How Much Does DIP Financing Cost?
In most cases, DIP loan interest rates are established based on the prime market rate with a premium added. DIP lenders can charge additional fees on top of interest charges. Although DIP financing is more expensive than conventional financing, it is in the interest of the DIP lender to make the loan terms manageable for the company to ensure a successful outcome.
For companies in financial distress, debt restructuring under Chapter 11 offers the opportunity to breathe new life into the business. However, efforts to successfully reorganize and emerge as a viable enterprise often fall short due to a lack of capital. DIP financing, which is baked into bankruptcy law, can be the essential source of capital a company needs when investment or conventional financing is unavailable.