Debtor In Possession, DIP Loans, & Exit Loans
What is a Debtor-in-Possession (“DIP”)?
A Debtor-in-Possession is a new legal entity with a unique status.
“Debtor-in-Possession” (a/k/a “DIP”) is a legal entity created the moment a Chapter 11 petition is filed. And the legal name of this new entity will be: “(name of your business) – Debtor-in-Possession.” Also, Debtor-in-Possession enjoys the advantages of a unique status granted under Chapter 11.
The Debtor-in-Possession retains control and runs the business.
The Debtor-in-Possession retains possession and control of the business’s property/assets while the bankruptcy case is being settled. And the business owners, as representatives of the DIP, continue running the business.
However, the court may appoint a bankruptcy trustee if it suspects fraud, misconduct, or gross incompetence. In that case, the trustee is the sole representative of the Debtor-in-Possession and oversees the running of the business.
But a serious responsibility comes with this advantageous DIP status. And that is you, the authorized representative of your business, immediately become a fiduciary.
What does it mean to be a fiduciary?
The DIP has a legal duty to protect the interests of the creditors.
The DIP is created the moment the Chapter 11 petition is filed.
In that same moment, the Debtor-in-Possession becomes a fiduciary charged with a duty to protect the interests of the creditors.
The Debtor-in-Possession has almost all the powers, authority, duties, and responsibilities that a court-appointed case trustee would have.
The role of the U.S. Trustee
The U.S. Trustee serving your federal district, manages the administration of your bankruptcy case on behalf of the court. Also, the U.S. Trustee closely monitors all the activities of the DIP.
All Chapter 11 filers are required to attend an “Initial Debtors Interview” (a/k/a “IDI”) with the U.S. Trustee. This meeting typically occurs within one week following the filing of the bankruptcy petition, if not sooner.
What must the DIP do prior to meeting with U.S. Trustee?
A “heads-up”
Your attorney will give you explicit instructions as to what you must do in preparation for the IDI meeting.
However, there are a few critical things listed below that we want to call to your attention now. But do not act upon them until you have guidance from your attorney.
“Day One Requirements”
The following represent statutory duties the DIP MUST complete prior to the IDI meeting with the U. S. Trustee (quoted from the U.S Department of Justice, Guideline and Requirements for Chapter 11 Debtors in Possession):
- Close out all existing books and records as of the date of the petition is filed.
- Open a new set of “DIP” books and records as of the day after the petition is filed. These books and records will be kept throughout the bankruptcy.
- Close all existing bank accounts immediately upon filing of the petition.
- Open new General, Payroll, and Tax bank accounts at a bank approved by the U.S. Department of Justice (Your attorney will know and recommend an approved bank to you). These accounts must be registered in the name of the DIP. The name of the DIP and bankruptcy case number must be pre-printed on the check as per the sample below.
- Maintain or obtain ALL forms of insurance normally carried by the debtor’s type of business. There are requirements for insurance. Refer to the document accessed with the link above for more details.
Are there limits to what a Debtor-in-Possession can do?
Limitations?
The business owners are empowered to operate the normal, ordinary course of business.
However, there are two important exceptions that require the court’s pre-approval before the owner(s) can act:
- Any activity outside the ordinary course of conducting the business, AND
- Any use of cash, collateral, or any form of credit
How can a business operate without using cash or credit?
It can’t!
Your attorney will file “First-Day Motions” along with your bankruptcy petition asking the court (in addition to other requests) to pre-approve certain uses of cash, such as paying wages, purchasing supplies, and other business necessities.
How can my business get the cash and credit it needs to operate?
An urgent need for cash!
Not surprisingly, a business has an urgent need for cash at the time it files for bankruptcy. For example, if the business needs its employees to remain open, how does it pay them if it does not have enough cash on hand?
How does a bankrupt business keep operating without liquidity?
Who would be willing to lend money to a business that is filing for bankruptcy? Without liquidity, how will the business continue to operate, make payroll, and remain a going concern throughout the bankruptcy?
Fortunately, the Code recognizes that using credit and borrowing funds are a necessary part of normal business operations. The bankruptcy court knows that keeping the business operating is in the best interests of the creditors.
How can my business get the cash and credit it needs to operate?
How does a bankrupt business keep operating without liquidity?
Who would be willing to lend money to a business that is filing for bankruptcy? Without liquidity, how will the business continue to operate, make payroll, and remain a going concern throughout the bankruptcy?
Fortunately, the Code recognizes that using credit and borrowing funds are a necessary part of normal business operations. The bankruptcy court knows that keeping the business operating is in the best interests of the creditors.
What is DIP Loan Financing?
A liquidity lifeline!
The Code allows a special form of credit known as “DIP Loans” (a/k/a DIP Financing).
A DIP Loan is a special type of financing that is only available to businesses that have filed for a Chapter 11 reorganization.
The purpose of the DIP Loan is to provide funds that allow a business to continue operating until the Plan of Reorganization is confirmed.
DIP lenders are protected.
The court incentivizes DIP lenders by granting priority on these loans.
However, existing creditors have a say in the court’s approval of a DIP Loan because the DIP lender’s priority is ahead of all other creditors. This may require several rounds of negotiations with the secured creditors before they agree to the business taking the DIP Loan. However, it is the court that has the final say whether to approve the DIP Loan or not.
The existing creditors will object to a DIP Loan if the business’s assets, net of existing liens, are not sufficient to secure the DIP Loan. But even in this case…
What is a “Priming Lien?“
If you can prove there is no alternative financing available, the court may grant the DIP Lender a “super-priority.” This is known as a “priming lien.” A super priority gives the DIP lender a priority claim even on already secured property.
As a result, lenders are more than willing to offer DIP Loans because of these protections. DIP Financing is typically available in the form of term loans. Some lenders may also offer revolving credit and overdraft checking.
No shortage of DIP lenders.
In fact, there is a competitive DIP Loan market for a business that can demonstrate it can return to profitability. DIP Loans charge much higher rates than what a more creditworthy borrower would pay. But the rate is not “terribly” higher.
How do I get a DIP loan for my business?
Your business applies for a DIP Loan.
The DIP lender needs critical information and confidence in your business’s ability to pay it back. Your business applies for a DIP Loan. It’s not automatic and there are stringent requirements that must be met.
You need to prove the amount needed and what it’s for
Your application requires detailed financial projections, documentation, and explanations, justifying the loan amount needed and how it will be repaid.
And you must show how your business will be able to pay it back.
- You must submit highly detailed projected monthly budgets for the period from petition filing through estimated Plan confirmation, AND
- The projected monthly budgets must be supported with documented, credible, accurate, revenue and expense assumptions, AND
- You present a complete, credible, and convincing explanation of how you will increase revenue and/or decrease expenses.
What does it take to get the DIP Loan approved?
First, the lender approves the DIP Loan.
- Lender-approval is conditioned on the budget and documentation being realistic and likely to restore the business to profitability. (If not, your business is headed for termination and liquidation.)
Then the court must also approve the DIP Loan.
- The funds will only be used for purposes allowed by the Code, AND
- Your basis for anticipating revenue increases and/or expense decreases are reasonable and credible, AND
- a DIP Loan will enable the business to operate profitably and repay the loan by the time of Plan confirmation, AND
- The court finds the lender’s terms and conditions for the DIP Loan acceptable under the Code.
Are there other advantages to a DIP Loan?
A DIP Loan implies Credibility and Viability.
A DIP Loan approval makes an important statement to your creditors and suppliers.
DIP Loan approval means an independent lender scrutinized your business’s financial prospects and is willing to risk lending you the money.
This is a comforting sign to creditors. It implies that the business is financially viable and capable of meeting its obligations to creditors.
A DIP Loan may restore your supply chain and vital contract services.
- Suppliers/vendors should be willing to continue supplying your business (but may require cash on delivery). The DIP Loan will supply the cash.
- Creditors should be more willing to negotiate the repayment of your debts. DIP Loan approval suggests creditors should have more confidence that whatever repayment plan they agree to, they will get paid.
Can the DIP Loan be used to pay off all the business debts?
DIP Loans may only be used to pay operating expenses and administrative fees.
- Normal Business Operating Expenses incurred AFTER the petition filing date and BEFORE the Plan of Reorganization confirmation date. However, the court may grant an exception to this rule and allow payment of pre-petition claims in certain instances. Exceptions may be granted for amounts owed to a critical, not readily replaceable vendor, supplier, or service provider.
- Administrative and non-tax related Priority Claims
- Unless the court makes an exception, DIP loans cannot be used to pay pre-petition debts or non-ordinary business expenses.
How soon should my business apply for the DIP Loan?
You want and need the court to approve the DIP loan as soon as possible after filing the bankruptcy petition.
DIP Loans should be applied for as soon as you hire a bankruptcy attorney.
The DIP Loan approval process can take some time. Your bankruptcy attorney has worked with DIP lenders and will recommend one or more to you. Also, your attorney will prod you to complete the application for a DIP Loan as soon as possible. Ideally, you will apply soon enough so that the loan is approved before the bankruptcy petition is filed. In that case, the bankruptcy attorney will file a First-Day motion requesting expedited court approval for the DIP financing. The First-Day motion will accompany the Chapter 11 petition.
What interest rate will the DIP lender charge?
The rate depends on the prevailing money supply and type of financing applied for.
DIP financing is typically quite reasonable given the bankrupt state of the business.
The interest rate is usually based on the LIBOR rate, increased by 700 to 1000 basis points. Your rate will depend on the money supply at the time and the type of financing needed (term loan or revolving credit).
LIBOR rate PLUS 700 to 1000 basis points.
You can check the LIBOR rate. Look for the rates shown in U.S. Dollars: USD and for a 12-month term. Rates change daily.
You should also expect to pay a one-time financing fee of 2% to 4% of the loan amount.
When and how does my business repay the DIP Loan?
Monthly payments begin immediately, and full repayment must be made by the time of Plan confirmation.
Monthly payments begin within one month of receipt of the loan proceeds.
The Code requires full repayment of the DIP Loan as a condition to exit bankruptcy. This is usually by the Plan of Reorganization confirmation date or within a few days thereafter.
In addition …
Certain other debts must also be paid in full by the Plan confirmation date.
In addition, if the business intends to continue to use any of the following …
- secured property that has a lien on it
- leased or rented property
- continue contracted services
… all past due amounts owed to the lienholders or service providers must also be paid in full at that time. (The amount owed is what the lienholders and executory contract providers agree to accept as payment in full.)
The court reviews and approves the repayments and the source of funds used to pay them as part of the confirmation decision.
How can my business afford to repay the DIP Loan and those other debts so soon?
It can’t!
It is unlikely your business will have sufficient cash on hand to make full repayment of all the above. But once again, the Code recognizes the problem and allows a potential solution to this dilemma.
What is an Exit Loan?
Liquidity just in time!
The court will review and approve the Exit Loan as part of the Plan confirmation.
The court will require proof of adequate Exit Loan funding to pay off these debts as a pre-condition to Plan confirmation. Also, the court will approve appropriate exit financing as part of the Plan confirmation.
Risky Business
An Exit Loan is very risky for the lender.
Exit Loan lenders are NOT protected.
Exit Loan lenders do not get the protections that are enjoyed by DIP Loan lenders. They are NOT granted superiority over other debts. Unless your business has lien-free marketable assets equal to the loan amount needed, it represents the highest possible credit risk. And your business will be charged accordingly.
Exit Loans can be shockingly expensive!
If the business can offer collateral to secure the loan, the interest rate and terms can be “tolerable.” Otherwise, expect to be shocked.
Annual Exit Loan interest rates of 25%, 35%, and more are not unusual. Obviously, you want to borrow no more than your business absolutely needs.
Exit Loan rates change weekly.
“Tips”
There is a great disparity between DIP and Exit Loan interest rates. If the DIP Loan will be repaid using Exit Loan proceeds, you want to minimize the amount of the DIP Loan. Borrow no more than your business absolutely needs to operate.
Don’t try to squeeze all that you can into a DIP Loan. Instead, cover as much of the operating expenses as you can from operating revenue. Otherwise, the cost of an Exit Loan to repay your DIP Loan will come back to bite your business where it hurts most.
If your business is pursuing a DIP loan, it should negotiate a “DIP to Exit” provision. The Exit Loan will automatically fund all the required repayments that are due at Plan confirmation. This assumes the business has fulfilled all its obligations under the DIP loan on a timely basis.
