A. The Roll-Up DIP Loan
A DIP loan may be conditioned on the debtor agreeing to collapse all or a portion of the existing pre-petition secured debt into the post-petition DIP loan. In effect, the pre-petition secured debt is “rolled up” into the DIP loan by using the DIP proceeds to satisfy the pre-petition secured loan. A roll-up DIP loan for the entire debt (including the pre-petition secured debt) is treated under the Bankruptcy Code as a super-priority administrative claim that must be paid in full upon confirmation of the Chapter 11 plan, before all other administrative claims. (2.)   Not surprisingly, the use of roll-up DIP loans became more prevalent after the 2008 financial crisis.

A roll-up DIP loan can place a significant burden on a debtor-in-possession, given the potential for a huge superpriority administrative claim, but it may be a debtor-in-possession’s only recourse to avoid conversion to a Chapter 7 bankruptcy and liquidation. In such circumstances, it may be advantageous even for creditors – those who will be subordinated in their ability to recover by the new super-priority administrative claim – to support approval of a roll-up loan in order to avoid forced liquidation and a virtual guarantee of no repayment of their claims.

B. Cross-Collateralization
Cross-collateralization of a DIP loan is a benefit conferred in return for extending new loans to a debtor-in-possession that might otherwise be unavailable – credit wise – while in bankruptcy. Through a court-blessed cross-collateralization transaction, a DIP lender may receive a security interest in all assets of the debtor, both those existing at the date of the bankruptcy filing and those assets generated during the Chapter 11 proceeding (the latter generally being unavailable to a pre-petition lender). Cross-collateralization allows a pre-petition lender to improve the collateral value for its secured interest in the bankruptcy, but is controversial, since it severely impacts the recoveries of other creditors, and may not always be permitted by the courts. (3.)  Cross-collateralization may be achieved by other means as well. For example, another form of cross-collateralization involves securing post-petition debt with pre-petition collateral. (4.) This type of bankruptcy relief is far less likely to cause prejudice to creditors of the bankruptcy estate, as the existing lender already holds liens on the pre-petition collateral.

III.  Pre-Petition Lender’s Offensive Strategies of Loan-To-Own & Credit Bidding
Pre-petition lenders may use DIP lending to improve their secured position as part of a strategy to obtain equity in the reorganized debtor, a “loan-to-own” scenario, or to purchase the debtor’s assets by “credit bidding” the amount of their secured claim at a sale of their collateral. In most of these instances, the lender already has a buyer in mind and will seek to “flip” the assets rather than operate the business.

A. Loan-to-Own
DIP loans may have clauses that allow lenders, upon default, to “swap” senior secured debt for newly issued equity upon the resolution of the bankruptcy case. This concept is known as “loan-to-own” (“LTO”). LTO allows lenders to participate in the restructuring process, through the potential control over management and the board. Accordingly, this approach requires that the lender actually have an economic exit strategy before taking a more active role in the reorganization process.

B. Credit Bidding
Chapter 11 has become the forum of choice for significant public and private companies to merge or sell their assets under section 363 of the Bankruptcy Code. The reason is simple: a section 363 sale, blessed by a Court Order, is effectively free and clear of any claims – in the very broadest sense – against the assets. At the extreme end of that spectrum, for example, is a sale free and clear of successor liability claims. To maximize a recovery for creditors, these sales are almost always the product of an auction process in bankruptcy. 

In a section 363 sale process, a lender requires protection at least to the extent of the value of its collateral; otherwise it may risk losing its collateral to an inadequate sale price at auction. Consequently, section 363 of the Bankruptcy Code recognizes the “credit bid.” Generally, secured creditors are permitted to credit bid the amount of their secured claim at a sale of their collateral. In essence, this mechanism allows a secured creditor to bid for its collateral using the debt it is owed to offset the purchase price. Other bidders must provide new consideration to bid. This ensures that, if the highest bid price at the sale is less than the amount of the claim secured by collateral, the secured creditor can, if it chooses, bid up the price to as high as the amount of its secured claim. (5.) A pre-petition lender intending to purchase its collateral (or, if its claim is secured by a blanket lien, all of the assets of the debtor) may consider DIP financing as a means to increase the amount of its secured claim and thereby increase the value of its credit bid. Credit bidding, however, is not an absolute right. Courts may deny the right to credit bid or limit the amount of the credit bid in the interest of public policy, fairness, or to foster a competitive bidding environment. (6.)

In sum, the pre-petition lender that is contemplating extending DIP financing will weigh the risks and benefits from both a defensive and offensive perspective. In the next and last installment of this article (to be published in the coming weeks), we will examine the offensive risk/reward analysis of a DIP lender with no prior lending relationship with the debtor.

ENDNOTES:

1. Li, Kai and Wang, Wei, Debtor-in-Possession Financing, Loan-to-Loan, and Loan-to-Own (2016).
2. Chatterjee, Sris, Dhillion, Upinder, and Ramirez, Gabriel, Debtor-in-Possession Financing (2005).
3. Compare Shapiro v. Saybrook Manufacturing Co., Inc., 963 F.2d 1490 (11th Cir. 1992) (disallowing cross-collateralization) with Otte v. Manufacturers Hanover Commercial Corp. (In re Texlon Corp.), 596 F.2d 1092, 1094 (2d Cir. 1979) (allowing cross-collateralization).
4. See, e.g., In re Antico Manufacturing Co., 31 B.R. 103, 105 (Bankr. E.D.N.Y. 1983).
5. In re The Free Lance-Star Publishing Co. of Fredericksburg, VA , 512 B.R. 798, 804-05 (Bankr. E.D. Va. 2014) (internal quotations omitted).
6. In re Philadelphia Newspapers, 599 F.3d 298, 316, n.14 (3d Cir. 2010).