Debtor In Possession: Everything You Need to Know
A debtor in possession (DIP) is an individual or corporation that has filed for Chapter 11 bankruptcy protection.3 min read
2. How It Works
3. Why It Matters
4. Breaking Down DIP
5. Staying Liquid
6. When Liquidity Is in Trouble
7. Insider Loans
8. DIP Financing as a Potential Solution
9. Why Use Chapter 11?
What Is a Debtor In Possession?
A debtor in possession (DIP) is either an individual or a corporation that has filed for bankruptcy protection under Chapter 11. They either keep control of a property against which a creditor has a lien, or they keep their power to run the business. The DIP continues running their business and has the abilities and responsibilities of a trustee so that they can operate in their creditors’ best interests. A DIP can run their business on a normal course but must seek court approval for any actions that would fall outside the range of normal business activities. The DIP must also keep detailed financial records and file the proper tax returns.
How It Works
During the reorganization process, the bankruptcy court allows the business to secure additional financing from lenders in order to continue its operation. Under the jurisdiction of the bankruptcy court, such post-bankruptcy lenders assume a senior position on liens and security interests in the business assets, normally by consent of the pre-bankruptcy senior lenders.
Why It Matters
DIP financing is important since it extends a lifeline to any business under Chapter 11 bankruptcy, enabling it to maintain payroll and suppliers, stabilize operations, restructure its balance sheet, and eventually repay creditors and recover from bankruptcy. A business in bankruptcy can usually obtain DIP financing only by giving its post-bankruptcy lenders a senior lien position. While a senior lien position ensures that the lender will be repaid fully, even in the case of liquidation, it also limits the business with strict payment terms, which can slow the reorganization process. Strict oversight by the bankruptcy court serves as an additional protection to DIP financing lenders, helping to make sure that new credit can be extended to businesses in bankruptcy.
Breaking Down DIP
After a Chapter 11 filing, new bank accounts get opened that name the debtor as being in possession of those accounts. A DIP can be terminated, and the court will appoint a new trustee if assets are found to be improperly managed or the DIP is not following court orders. The duties of a DIP are specified by guidelines laid out by the United States Trustee’s office.
Liquidity keeps a business financially afloat. Beyond cash flow from sales or other revenue, numerous companies have the following as typical sources of liquidity:
- Banks or other secured lenders offering financing options
- Credit from vendors that can reduce immediate liquidity needs
- Loans from owners, investors, or other insiders, as needed
When Liquidity Is in Trouble
Companies that have hit dire financial straits often find that they need their liquidity to increase just when their traditional financing starts to dwindle. Their borrowing base might shrink, they’ve been cut off from getting further advances, or they might have defaulted on loans. To make matters worse, new lenders might not be willing to give out loans because of this financial distress. For such distressed businesses, revenues may also be going down and they can’t cover their expenses without additional financing.
The company’s financial status might also deter an owner, investor, or other insider to make a loan. The added scrutiny would mean too much risk for them. Insiders might also worry that, if they offer a loan, creditors or a bankruptcy trustee could later challenge it.
DIP Financing as a Potential Solution
A company facing such financial woes is most likely already considering restructuring or even selling the business. Out-of-court workouts are another option and might succeed. However, sometimes a Chapter 11 filing can provide powerful options, including the ability to facilitate financing. If a company needs a loan but a potential lender isn’t willing to provide it or has a concern about a legal challenge, the Bankruptcy Code offers a way to assure a lender that the loan won’t be challenged. This would remain true even if the lender is an insider or potential purchaser.
Why Use Chapter 11?
One of the major reasons companies file for Chapter 11 bankruptcy is because the process does provide special legal protections. These protections for the company include an automatic stay and sometimes the ability to restructure debts through a Chapter 11 plan of reorganization. These protections for purchasers of assets can sometimes lead to a sale price that would have never been realized without bankruptcy.
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