Debtor in Possession Financing and Chapter 11 Exit Financing

Exit Financing

“Exit financing” is a term used to describe new credit extended to a debtor-in-possession that allows it to fund its chapter 11 plan and exit its bankruptcy case. Thus, while a debtor must typically file a motion to enter into an agreement outside of the ordinary course of business (see 11 U.S.C. § 363(b)), the “exit” is made via the chapter 11 plan confirmation process. The real challenge then, would remain plan confirmation (and meeting the 16 requirements of 11 U.S.C. § 1129(a)).

Debtor in Possession Financing

A debtor-in-possession (“DIP”) in a chapter 11 case can also seek to obtain financing prior to plan confirmation. DIP financing is governed by 11 U.S.C. § 364. Section 364(a) allows a debtor in possession to obtain unsecured credit in the ordinary course of business (e.g., a DIP that has NET30 terms with a vendor can continue to order inventory from that vendor without first seeking court approval). Section 364(b) deals with unsecured credit outside the ordinary course of business–that requires the approval of a bankruptcy court, on notice and with a hearing but entitles the creditor extending credit to administrative priority status for repayment of its loan pursuant to 11 U.S.C. § 503(b)(1). Subsections (c) and (d) of section 364 deal with post-petition, secured debt. Subsection (c) addresses circumstances in which a DIP cannot get obtain credit on an unsecured basis. With court approval after notice and a hearing, a DIP can use one more more of the following tools to improve the position of its prospective lender: (i) a priority position over some or all administrative expense claims; (ii) a security interest in unencumbered assets of the DIP; and (iii) a junior lien on already encumbered, assets of the DIP. The Order granting authorization to enter into a loan agreement under 364(c) should explicitly address which of the incentives the lender is to be granted (and which if any administrative claims are subordinate to the lender). Subsection (d) allows a DIP to go even further to obtain financing and to prime the rights of existing lien holders notwithstanding protections those prepetition lenders might have in their loan documents. However, the ability to prime an existing lien is an extraordinary remedy. The DIP must show, not only that it would be otherwise unable to obtain credit, but also that it is providing adequate protection to the affected, subordinated lien holders. A DIP can adequately protected a primed lender by providing it with a replacement lien on other unencumbered property. However, when the effect of the DIP financing is merely to shift the risk of being unsecured or undersecured to the prepetition lender from the DIP lender, the court should deny the request for DIP financing. 3 Collier on Bankruptcy ¶ 364.05 (16th ed. 2013) citing In re Mosello, 195 B.R. 277, 293 (Bankr. S.D.N.Y. 1996). The burden of proving adequate protection of the affected lien holder is on the DIP. Id. In the end, DIP financing can be a very potent tool but it is vulnerable to many of the same challenges that a DIP proposing a chapter 11 plan that crams down on the rights of prepetition secured creditors (compare “adequate protection” required under section 364 to “realization… of the indubitable equivalent” in 1129(b)(2)(A)(iii) required to cramdown a plan over the objection of a secured creditor).

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