Chapter 11 DIPs, DIP Loans, and Exit Loans


Defining debtor in possession:

What is Debtor In Possession?
“DIP”

Retains control and runs the
business

Chapter 11 allows the business debtor, represented by its
owner(s), to retain possession and control of the business’s property/assets and continue running the business while the bankruptcy case is being settled. Debtor In Possession is a
unique status only granted in Chapter 11 cases.

However, if the court becomes concerned about fraud or misconduct, or gross
incompetence, the court will appoint a bankruptcy trustee to represent and run
the business

The moment the chapter 11 petition is filed, the business debtor becomes a debtor in possession (DIP).

The DIP is also a fiduciary
who must protect the
interests of the creditors.

The moment the Chapter 11 petition is filed, the business debtor becomes a
Debtor in Possession (DIP). In that same moment, the DIP also becomes a fiduciary
charged with a duty to protect the interests of the creditors. The DIP has nearly all
the powers, authority, duties, and responsibilities that a court-appointed case
trustee would have. The U.S. Trustee designated by the court in every Chapter 11
case, will closely monitor the activities of the DIP to make certain that business
property/assets are fully insured and that the duty to protect the interests of the
creditors is fulfilled.

What are the limitations?

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!

So, your bankruptcy attorney will file “First-Day Motions” along with your
bankruptcy petition asking the court (in addition to other requests) to preapprove certain uses of cash, such as paying wages, purchasing supplies, and
other necessities the business uses.

When a bankrupt business needs cash on hand

An urgent need for cash

Not surprising, at the time a business files for Chapter 11 bankruptcy, it has an
urgent need for liquidity – cash – which it does not have. For example, if the
business needs its employees to remain open, it must pay them. It may not have
enough cash on hand, if any at all, to pay them.

How does a bankrupt business get a loan to keep operating?

Fortunately, the Code and court recognize that using credit and borrowing funds
are a necessary part of normal business operations. More importantly, the court
knows that the best way to protect creditors is for the business to get back on a
sound financial footing, if it can. But given the bankrupt state of the business, who
is going to lend it the cash it needs to continue to operate, make payroll, and
remain a going concern until the reorganization Plan gets confirmed?

Business loans during chapter 11 bankruptcy

“DIP Loans”

The Code allows a special form of credit known as “DIP Financing” (a/k/a DIP
Loans).

A lifeline for liquidity

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 and may
even grant a super-priority that places a superior lien on secured property to
protect the DIP lender. As a result, lenders are more than willing to offer these
loans because of these protections. Not only is DIP Financing available (in the
form of cash loans, revolving credit, overdraft checking), there is a competitive
market for a business that can demonstrate it has a viable plan to return to
profitability.

How to get approved for a DIP loan

You must work to get it,

To get DIP Financing, the business must submit a highly detailed monthly budget
(in addition to extensive supporting documents) for the period from petition filing
through estimated Plan confirmation.

and the court must approve
it.

If the DIP lender finds the plan and budget to be realistic and capable of restoring
the business to a profitable state, it will be submitted to the court for approval. (If
not, your business is headed for termination and liquidation.)

Benefits of DIP financing

A DIP Loan has additional
benefits.

There are added benefits if DIP financing is approved by the court prior to
negotiating settlements with the debtors.

Approval of a DIP loan means that the lender, an independent entity that has
scrutinized the financial picture and operating plans of the business, is willing to
take the risk of lending money to the business. This is a comforting sign to
creditors that the business is, according to plan, financially viable and capable of
meeting its obligations. Suppliers/vendors should feel more comfortable
continuing to deal with the DIP. Also, Creditors should be more willing to
negotiate.

Limitations of DIP loans

DIP Loans are only to be
used for limited purposes.

The Code limits the use of DIP financing to specific purposes, during a limited
window of time. These purposes involve the normal operating expenses of the
business that are incurred AFTER the filing date of the petition for bankruptcy,
and BEFORE the time of Plan confirmation. Unless the court makes an exception
(usually for a priority or secured claim), DIP loans cannot be used to pay prepetition debts.

DIP Loans should be applied
for as soon as possible

You want/need the court to approve the DIP loan as soon after filing the
bankruptcy petition as possible. The DIP Loan approval process takes a long time.
Typically, the bankruptcy attorney will prod you to complete the application for a
DIP Loan as soon as possible. If the lender approves the application before the
petition is filed, the bankruptcy attorney will file a First-Day motion requesting
court approval for DIP financing along with the Chapter 11 petition.

Objections to DIP loans

Secured creditors may
object to the DIP Loan

Since the DIP Loan is granted a superior lien on business property, secured
creditors may object to their claim being subordinate to the DIP lender. This may
require several rounds of negotiations with the secured creditors before they
agree to the business taking the DIP Loan. However, it is ultimately the court that
has the final say whether to approve the DIP Loan or not.

Benefitting from low rates

Given the circumstances,
DIP Loan interest rates are
lower than you might
expect

Because of the protections the bankruptcy Code gives to DIP lenders, DIP
financing is typically, quite reasonable given the bankrupt state of the business.
The interest rate charged on DIP financing depends on the prevailing money
supply and the type of financing applied for (revolving credit versus term loan).

Typically, the interest rate charged will range from LIBOR plus 700 to 1,000 basis
points depending on the type of financing needed and the money supply at the
time.

You can check the LIBOR rate. Be sure to select the results to be shown in U.S.
Dollars: USD and look at the rate 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.

DIP loan payment requirements

Payment in full is due at
before your Plan Effective
Date

The Code requires that the DIP Loan be repaid in full as a condition to exit
bankruptcy.

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, or
  • Continue contracted services

… any past due amounts owed to the lienholders or service providers must also be
paid in full (or the amount they agreed to accept as full payment) at the time of
Plan confirmation or shortly thereafter.

The approval to pay them, and the source of funds used to pay them is part of the
confirmation decision of the court.

It is unlikely that the business will have sufficient cash, if it has any at all, to make
full payment of all the above. But once again, the Code recognizes the problem
and a potential solution to this dilemma.

What is an Exit Loan?

“Exit Loans”

An Exit Loan provides the liquidity needed to repay the DIP Loan as well as the
settlements owed to those secured creditors and contract service providers
whose property or services your reorganized business will continue to use.

The court will approve the
Exit Loan as part of the Plan
confirmation

Often, the court will require proof of adequate exit funding to pay off these debts
as a pre-condition to Plan confirmation. The court will approve appropriate exit
financing as part of the Plan confirmation.

Exit loan risks

Risky Business

Unless your business can pledge marketable assets as collateral worth at least as
much as the amount it needs to borrow, net of any liens, it represents the highest
possible credit risk.

Exit Loans can be shockingly
expensive!

Unlike DIP Loans, Exit Loans are NOT granted superiority over other debts. The
Exit Loan lenders are not protected as they are with DIP Loans.

Surprisingly, there is no shortage of lenders for companies exiting bankruptcy.

If the business has property/assets with marketable value, net of any liens, equal
to or greater than the amount to be borrowed, the interest rate and terms for the
Exit Loan can be “tolerable.” Otherwise, expect to be shocked.

Annual loan interest rates of 25%, 35%, and even 50% are not unusual.

Exit Loan rates change weekly.

Expert TIP

A “tip”

If your business is pursuing a DIP loan, it should also negotiate a “DIP to Exit”
provision so that the Exit loan can occur automatically (provided the business
faithfully fulfills its obligations under the DIP loan) upon Plan confirmation.

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