DIP Financing: What Is It? Who Provides It? What If You Filed a UCC?
DIP stands for Debtor in Possession. When a business files for chapter 11 bankruptcy protection, the existing management or ownership maintains possession and control of its business. However, the bankrupt entity needs financing to keep its business operational throughout the bankruptcy process. One way for a bankrupt entity to obtain cash is through DIP Financing.
Unfortunately, if a business is on the brink of bankruptcy, lenders aren’t usually eager to extend a loan to the business. To be fair, a lender’s hesitation to lend to a bankrupt entity is not unlike my hesitation to touch a hot stove – you know the risk and you know the consequences.
Given the risks of lending to bankrupt businesses, the Bankruptcy Code affords would-be lenders various perks, often including the benefit of a priority security interest.
“When the debtor company has lined up a lender, it files a motion seeking Bankruptcy Court approval of the DIP financing. Typical DIP financing terms include a first priority security interest, a market or even premium interest rate, an approved budget, and other lender protections.”
The concept of priority over subsequent creditors may be referred to as a priming lien. Marshall S. Huebner, in Debtor-in-Possession Financing, further advises lenders may “insist on a first-priority priming lien on the debtor’s inventory, receivables, and cash (whether or not previously encumbered), a second lien on any other encumbered property, and a first-priority lien on all of the debtor’s unencumbered property.”
Who Provides DIP Financing?
Does this financing come from a random bank? Not necessarily. In fact, DIP financing often comes from prepetition lenders. According to Market Trends, Recent Deal Terms in Retail DIP Financing, author Jordan Myers refers to this as “defensive” financing.
“Prepetition lenders, rather than new third-party lenders, are a frequent source of DIP financing to retail debtors. They do so, in part, to protect their position against possible priming liens—a practice known as “defensive” DIP financing. “
What About Creditors with a Properly Perfected Security Interest: UCCs?
The American Bankruptcy Institute states a creditor with a properly perfected security interest has priority over DIP.
“…[I]f a secured creditor is perfected as of the petition date, its security interest trumps the DIP, and the estate benefits from the secured creditor’s collateral only after the secured creditor is repaid. However, if the secured creditor is not perfected as of the petition date, then the DIP prevails and the secured creditor shares pro rata with other unsecured creditors.”
Confused? ABI has a bubbly example!
“Consider this hypothetical: Donald the debtor owns a case of fine champagne. Your client, Cartman Corp., just won a lawsuit against Donald. You send out the sheriff to pick up the champagne to satisfy the claim. Under California law, once the sheriff lays his hands on the champagne, you’ve got a lien; other states may date the lien from the time you send your order to the sheriff, or perhaps even from the time you win your lawsuit. To recap: If some secured creditor is perfected before Cartman Corp. gets its lien, then that secured creditor gets first dibs in the champagne. Otherwise, first dibs go to the Cartman Corp.”
Takeaway? While DIP Financing holds significant benefits for the lender, a properly perfected security interest is certainly in a better position than an unsecured creditor. File UCCs!