Commercial and business attorneys who do not practice in the Bankruptcy Court may have come across the term “DIP financing” in connection with Chapter 11 bankruptcy filings by businesses. Another practice-specific term in bankruptcy is “cash collateral.” This article will provide a brief overview of the meaning and practical application of the use of cash collateral as a subset of DIP financing in the context of the United States Bankruptcy Code and practice in Chapter 11 bankruptcy cases.
DIP financing means “debtor-in-possession” financing. Debtor-in-possession is the term of art for a company(1) that files for protection under Chapter 11 of the United States Bankruptcy Code, 11 U.S.C. § 101 et seq., but does not have a trustee appointed for it and thus remains “in possession” of its businesses and assets. As provided in Section §1101 of the Bankruptcy Code, “‘debtor in possession’ means the debtor except when a person that has qualified under section §322 of this title is serving as a trustee in the case.”
One of the purposes of Chapter 11 bankruptcy is to allow a financially troubled company the opportunity to gain a breathing spell from the enforcement of existing debts while it assesses its business operations and finances and ultimately determines whether the present value of those businesses and assets is greater than their value in liquidation. If the going-concern value is greater than the liquidation value, then it makes economic sense for the company to utilize Chapter 11 to restructure its finances.
However, to do so, the company must maintain its ability to operate while in Chapter 11. It must remain liquid enough to pay its post-bankruptcy expenses in the ordinary course of business, fund the legal and administrative costs of Chapter 11 and accumulate sufficient cash to allow it to emerge from Chapter 11. Very often, this liquidity is provided by DIP financing.
The great majority of companies that enter Chapter 11 have some financing in place already and even more are in need of additional financing in order to stay in business, even while operating within Chapter 11 and enjoying the breathing spell from enforcement of existing debts. Often, the most challenging problem that a company faces in deciding whether to enter Chapter 11 is the question of how it will emerge from Chapter 11, the so called “exit strategy.” The availability and cost of DIP financing plays a crucial role in this decision.
Why would a commercial lender provide financing to a troubled company that is entering bankruptcy? The answer is that these companies often provide excellent credit risk for the lender, the opportunity to earn above-market return on the investment and substantial additional returns in the form of fees. Businesses entering Chapter 11 are good credit risks because the Bankruptcy Code provides a high degree of legal protection to the lender providing DIP financing. Another reason for providing financing to a company entering Chapter 11 is for the lender to protect an existing investment in the company.
One form of DIP financing is really not new financing, but rather permission from the lender to use the cash generated from the company’s operations to continue to finance the business during Chapter 11 bankruptcy. This is known as “use of cash collateral” and is governed by several sections of the Bankruptcy Code, including Sections 361, 362, 363 and 552. To illustrate this process, assume that a manufacturer of widgets finds itself increasingly unable to pay its bills as they become due. The company has a revolving line of credit provided by its lender that is secured by a blanket security interest in all of the company’s assets. The company determines that the long term value of its assets and businesses is greater if it continues as a going concern than if it liquidates immediately. It files a Chapter 11 petition in order to gain an opportunity to restructure its balance sheet by reducing debt.
The most severe immediate consequence that results from the company’s commencement of a Chapter 11 case is that, immediately upon filing for bankruptcy, it loses the ability to gain access to and use in operations its existing cash and proceeds of its accounts receivable. Where, prior to bankruptcy, the company had use of these funds for operations pursuant to the terms of its agreement with its lender, now, upon filing Chapter 11, such right is taken away from the company by operation of law under the Bankruptcy Code. Under §363(a) of the Bankruptcy Code, entitled “Use, sale or lease of property,” “cash collateral” is expansively defined as
- cash, negotiable instruments, documents of title, securities, deposit accounts, or other cash equivalents whenever acquired in which the estate and an entity other than the estate have an interest and includes the proceeds, products, offspring, rents or profits of property. . . subject to a security interest as provided in section 552(b) of this title, whether existing before or after the commencement of a case under this title.
See, e.g., In re Q-C Circuits Corp., 231 B.R. 506, 511 (E.D.N.Y. 1999); In re the Colad Group, Inc., 324 B.R. 208, 217 (Bankr. W.D.N.Y. 2005).
Section 363(c) of the Bankruptcy Code then sets the rules governing the use of cash collateral as an asset of the debtor:
- If the business of the debtor is authorized to be operated . . . and unless the court orders otherwise, the trustee may enter into transactions, including the sale or lease of property of the estate, in the ordinary course of business, . . .
- The trustee may not use, sell, or lease cash collateral under paragraph (1) of this subsection unless —
(A) each entity that has an interest in such cash collateral consents; or
(B) the court, after notice and a hearing, authorizes such use, sale, or lease in accordance with the provisions of this section.
(4) the trustee shall segregate and account for any cash collateral in the trustee’s possession, custody, or control.
See, e.g., In re Blackwood Associates, L.P., 153 F.3d 61, 67 (2d Cir. 1998); In re Colad Group, 324 B.R. at 217.
These provisions of the Code set up the dynamic that is seen repeatedly in bankruptcy cases where the debtor has a pre-petition loan facility secured by assets upon which the debtor is dependent for cash flow to maintain its business cycle. The law recognizes that the proceeds of collateral, including cash in the bank, accounts receivable and the proceeds to be derived from them, that are in existence on the date of the commencement of the bankruptcy case, in essence “belong” to the lender who has a valid perfected security interest in them. The debtor is legally denied permission to use such funds without permission of the lender and/or approval of the Bankruptcy Court.
To maintain its viability in Chapter 11, the debtor must assure itself of access to this cash flow. One way to do so is to obtain new financing in Chapter 11 from a new lender who will provide a replacement revolving credit facility under which the old lender will be paid off. Because this is often difficult to achieve, especially under the time strain and economic distress of a troubled company needing to file for Chapter 11 relief, debtors often look to the existing lender to work out a deal under which the lender will consent to provide continued access to the lender’s cash collateral in order to maintain operations of the company.
The lender often has a strong incentive to work out such an arrangement. As is often the case, if the lender’s collateral is limited to assets that are part of the debtor’s business cycle, such as inventory, equipment and receivables, the value of the enterprise as a going concern usually offers the lender the best chance of recovery of its loan amount as compared to the immediate liquidation that would have to result if the lender or the Bankruptcy Court did not grant the debtor access to its cash collateral.
adequate protection may be provided by
(1) requiring the trustee to make a cash payment or periodic cash payments to such entity, to the extent that . . . use, sale, or lease under section 363 of this title . . . results in a decrease in the value of such entity’s interest in such property;
(2) providing to such entity an additional or replacement lien to the extent that such . . . use, sale, lease . . . results in a decrease in the value of such entity’s interest in such property; or
(3) granting such other relief . . . as will result in the realization by such entity of the indubitable equivalent of such entity’s interest in such property.
As shown by the statutory language, adequate protection is a flexible concept whose goal is to maintain the economic status quo for an entity that consents, or that is compelled by the court, to have its property used by the debtor in the Chapter 11 case. Such entity should not suffer an economic loss due to the debtor’s use of its property. See In re Timbers of Inwood Forest Assocs. Ltd., 484 U.S. 365, 108 S.Ct. 626, 98 L.Ed.2d 740 (1988).
In the context of the debtor’s use of the lender’s cash collateral, settlements between the lender and the debtor are often achieved based on the parties’ respective leverage, including the debtor’s need for the funds to maintain business operations and the lender’s aversion to liquidation. Adequate protection is provided to the lender in a number of ways, including agreement upon an operating budget and the debtor’s adherence thereto; periodic cash payments to the lender representing interest on the funds used; the granting of additional liens to the lender; and structuring the use of cash collateral as a repayment to the lender of amounts outstanding to it as of the petition date and providing for the lender to make equivalent new advances secured by all property of the debtor and entitled to priority of repayment in the bankruptcy case.
It is important to remember that, under §552 of the Bankruptcy Code, the lender’s lien extends only to property of the debtor that was in existence on the petition date and to the proceeds thereof even if such proceeds are realized post-bankruptcy. See, e.g., In re Bennett Funding Group, Inc., 255 B.R. 616, 631 (N.D.N.Y. 2000); In re Nittolo Land Development Ass’n, Inc., 333 B.R. 237, 241 (Bankr. S.D.N.Y. 2005). For most companies, the unavailability of the use of funds in existence on the petition date and the proceeds of accounts receivable in existence on the petition date would fatally impact the continuation of operations and, thus, a cash collateral agreement is necessary.
Where the debtor and the lender are not able to agree upon the consensual use of cash collateral and the provision of adequate protection to the lender, the debtor can ask the bankruptcy court to allow it to use the lender’s cash collateral over the lender’s objection. This will require an evidentiary presentation by the debtor as to the core economics of its business cycle, including justification for the budget for the time period for which authorization is sought, in order to show that continuation of the business is economically worthwhile and will preserve, if not increase, the value of the lender’s collateral. In addition, the debtor must be prepared to offer adequate protection to the lender, which could include the fact that continuation of the business cycle will preserve and possibly increase the value of such collateral, but usually requires more protection for the lender such as periodic cash payments and/or a lien on additional property in favor of the lender.