An equipment lessor’s failure to understand the nuances, traps and pitfalls of Chapter 11 DIP lending (i.e., a debtor-in-possession “DIP”) is a prescription for disaster. An active and legally informed involvement by an equipment lessor at the outset of a Chapter 11, when DIP lending is often teed-up for the Court’s consideration within days of the bankruptcy filing, should serve well to protect the lessor’s rights. Lending to an entity already in Chapter 11 bankruptcy and in possession of its assets seems counterintuitive. After all, where is the benefit in rescuing a “sinking ship?” Certainly, DIP lending is dangerous and not for the faint hearted. A successful bankruptcy, in which secured lenders are made whole, is never guaranteed.

On the other hand, DIP lending provides unique opportunities to lenders that only exist in bankruptcy. DIP loans typically have premium interest rates and high yields with a shorter maturity – often a year or less – with the added benefit of Bankruptcy Court oversight and approval. DIP loans, which are relatively insulated from legal challenge, can increase a lender’s bottom line and should not be overlooked as a profitable, albeit risky, credit tool.

For a pre-petition lender, or more likely consortium of lenders, the decision to lend additional funds to a customer that is now a debtor in bankruptcy is a defensive action designed to protect, if not maximize, a recovery on your pre-petition loan. The decision is also an aggressively offensive play for the opportunity to extend new credit on more profitable terms, while potentially controlling the destiny of the debtor and ownership of its assets. For a traditional DIP lender, one that is unrelated to the original financing transaction, the calculus is slightly different: it’s an opportunity to make a lucrative loan, one that may even prime – leap frog in priority over – existing secured lenders to their potential detriment. Consequently, the mere act of avoiding a priming loan is strong motivation for an existing lender to at least consider extending further credit to a debtor, in essence doubling down on your borrower by becoming a reluctant DIP lender.

This article examines the benefits and detriments of DIP lending, both by a pre-petition lender and a lender engaged principally in DIP financing that is entirely unrelated to the original financing transaction. The subject is vast and nuanced. Accordingly, this article will be presented in two parts; the first part addresses the pre-petition lender contemplating a post-petition DIP loan to its erstwhile solvent borrower, while part two will address the unique risks and potential advantages entertained by a strict DIP lender with no prior lending relationship with the debtor.

Part One:
Part one of this article explores the pre-petition lender’s (i) considerations for making a DIP loan, (ii) defensive protection of its pre-petition secured debt, including the “roll up” DIP loan and cross-collateralization, and (iii) offensive strategies of a loan-to-own DIP facility and credit bidding at a sale of collateral.

I. Considerations for a Pre-Petition Lender Making a Post-Petition DIP Loan
A debtor that files Chapter 11 without financing in place is akin to a ship adrift in a hurricane at sea without a sail or rudder. Not surprisingly, about 60% of all large, public U.S. businesses that filed for Chapter 11 since the early 1990s obtained post-petition financing, primarily from their pre-bankruptcy bank lenders. (1.)
 
When extending post-petition credit, a pre-petition lender must consider whether an additional loan to an existing customer – one that is now in bankruptcy – will enhance the likelihood of repayment of the original loan. Another important consideration is the risk of loss if the debtor fails to reorganize or liquidate successfully as a going concern, i.e., if the case is converted to Chapter 7 liquidation. So the DIP credit analysis, in part, considers whether that risk of loss might by minimized, or even eliminated, if the debtor is extended credit to continue its operations, retain its customers, and fund a plan of reorganization or orderly liquidation. In the absence of DIP financing, there is usually a high probability that the debtor cannot continue operations and will be forced into Chapter 7 liquidation, which may threaten repayment in full of the original loan in full. Fundamentally, a lender contemplating extending post-petition financing to a debtor-in-possession must engage in a risk-benefit analysis: Do the advantages outweigh the risk of being saddled with an even greater loss? Fortunately, section 364 of the Bankruptcy Code provides powerful protections and incentives to a lender extending post-petition DIP financing.

Section 364 of the Bankruptcy Code mitigates the enhanced credit risk of lending to a company in bankruptcy. That section authorizes the court, after notice and a hearing, to grant to a post-petition lender (1) a superpriority administrative claim against the debtor (having priority over all other administrative expenses), (2) a lien on the property of the bankruptcy estate that is not otherwise subject to a lien, (3) a junior lien on property of the estate that is subject to a lien, or (4) a “priming” lien, one that is senior or equal to a preexisting lien on property of the estate. A priming lien requires that the preexisting lienholder be granted adequate protection of its interest in such property, such as a second lien on unencumbered assets behind the DIP loan and, sometimes, current cash payments of interest. To avoid a priming fight and adequate protection litigation (which can be costly at the outset of a Chapter 11 case), an existing pre-petition lender may seek to protect its original investment (i.e., the existing pre-petition debt) on its own terms by becoming the DIP lender.

II:  Pre-Petition Lender’s Defensive Protection of its Original Investment
One major advantage of DIP financing (unavailable outside of bankruptcy) is the opportunity for the existing lender to “clean up” pre-petition loan documents through the court-approved post-petition DIP loan. This is especially useful when, arguably, there is ambiguity in the documents underpinning the pre-petition loan, or if there is a dispute regarding the perfection or priorities of two or more secured prepetition lenders. A DIP loan may be conditioned on the debtor-in-possession reaffirming its obligations under the pre-petition loan and waiving any rights to contest the validity of the original loan. Once the court gives final approval to the DIP loan, the validity of both the new DIP loan and the pre-petition loan will no longer be subject to legal challenge by the debtor or its creditors. Two additional defenses that pre-petition lenders can consider in the post-petition DIP lending context to ensure the protection of their original investment are the “roll-up” DIP loan and cross-collateralization.

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