Having identified and examined in Part I of this article the motivations of a lender to make essentially a new and risky loan to a company already in bankruptcy, Part II will explore the mechanics and fundamentals of DIP lending, including a profile of a typical “institutional” DIP lender, i.e., those lenders with no prior lending relationship with a debtor. It will also consider and explore the often serious implications for existing creditors when outside DIP lenders enter into the bankruptcy fray.

I.     The DIP Lending Process
An existing secured creditor or equipment lender of a debtor in bankruptcy, a debtor that has obtained or is expected to obtain DIP funding, needs to understand exactly what will transpire in the DIP process in order to understand how best to proactively protect its interests. Conversely, a prospective DIP lender will ordinarily become involved almost immediately in the bankruptcy process, because this is the point of maximum need and leverage: the debtor is in need of immediate financing, often unavailable from any other financial source, and a DIP lender has all the leverage. It therefore will be most advantageous for the DIP lender to secure the most favorable lending terms and protections at the outset of a bankruptcy.

The first round of DIP negotiations are with the debtor (and possibly the U.S. Trustee) to address most of the terms of the proposed financing. Section 364 of the Bankruptcy Code provides a series of financing options for debtors-in-possession, each of which must be sought successively and each with increasingly more severe financial obligations on the debtor and its creditors. First, the debtor may seek financing on an unsecured basis, with the promise of administrative expense treatment for the prospective unsecured lender. As an administrative expense, the loan would have to be paid back in full by the estate before other unsecured creditors were repaid. This provides some protection, in that other administrative creditors include the professionals to be paid from the bankruptcy estate. Lending to a debtor on an unsecured basis is, however, generally not advisable. If the debtor is unable to obtain unsecured financing on an unsecured basis, the debtor may, with court approval, seek financing that provides the prospective lender with priority over all other administrative expenses, that is secured by a new lien on property of the estate not otherwise subject to a lien, or that is secured by a new lien on property of the estate that is already subject to a lien (which would be subordinate to the existing lien(s)). Finally, if the debtor is unable to secure financing through the manners described above, the debtor may seek authorization from the Court to obtain “superpriority” financing, secured by a lien that “primes” or supersedes the existing liens on the property of the estate. This rarest and most onerous form of financing is only available if the debtor is otherwise unable to obtain credit on the earlier stated terms and the interests of the lienholder creditor to be “primed” are adequately protected. Existing secured creditors and equipment financiers generally are excluded from this stage of the process, unless the nature of their collateral or seniority of their lien priority compels their participation.

The second round of negotiations typically occurs after the entry of the initial interim financing order and the appointment of a committee of unsecured creditors, but before the Court gives final approval to the DIP loan. The committee’s counsel will usually seek revisions to the DIP financing agreement and the proposed financing order to more fully protect the interest of unsecured creditors. These negotiations can sometimes involve a certain degree of brinkmanship, with the DIP lender threatening to withdraw the proposed financing if the bankruptcy court sustains the committee’s objections and the committee professing indifference if the unsecured creditors stand to benefit little from the financing. Almost always, however, the DIP lender and committee resolve their differences, typically in a “carve-out” to protect the fees of the Committee’s professionals, since it is usually in both parties’ interest that the post-petition financing be approved.

A critical part of the DIP lending relationship is the DIP loan agreement entered into between the debtor-in-possession and DIP lender and, ultimately, approved by the Bankruptcy Court. The vast majority of DIP loan agreements today, especially those involving outside lenders, provide for the debtor-in-possession to meet certain bargained-for milestones in the case after the Chapter 11 is filed. These milestones generally include the establishment of deadlines for filing a plan of reorganization, for court approval of a disclosure statement, for a hearing on confirmation, and for entry of a confirmation order. Missing a milestone on the timeline often results in a default under the DIP loan agreement, giving the lender control over the direction of the restructuring and, in effect, over the bankruptcy itself. The milestones also prevent the debtor from allowing the bankruptcy case to extend for a period of time longer than the DIP lender bargained for, and are designed to ensure prompt repayment of the DIP loan and a swift exit from bankruptcy. Similarly, a DIP lender needs to protect its investment against action taken against the Debtor: a secured creditor getting relief from the automatic stay to foreclose; the appointment of a Chapter 11 Trustee or conversion to a Chapter 7 liquidation; and the filing of a competing plan of reorganization. Typically, each of these events also will trigger a DIP default.

DIP financing agreements may also incorporate additional provisions designed to benefit the DIP lender and provide it with additional control, including (1.) capital expenditure limitations, (2.) business plan approval requirements, (3.) weekly financial budgets, and (4.) the right to appoint upon default a lender-approved CEO and/or CRO. Essentially, the DIP financing agreement provides for expensive financing and draconian terms that allow the DIP lender to minimize its’ risk.

II.     Institutional DIP Lenders and the DIP Lending Business
Prior to the 2008 financial crisis, large commercial banks were the most common DIP lenders. After the financial crisis, many of the large banks that had regularly been involved in DIP lending for existing customers significantly reduced the number of DIP loans they extended to distressed companies. Stepping into that void, private equity firms and hedge funds -- with no prior lending relationship -- have become significant players in the DIP financing market, attracted by the higher yield of DIP loans and the special priority treatment that DIP loans receive in a bankruptcy matter. Although large banks have returned to the DIP financing arena now that the economy has improved, private equity firms and hedge funds still play a large role in DIP lending. Ironically there is at least some empirical support for the proposition that debtors securing DIP financing from existing lenders tend to emerge from Chapter 11 more quickly than firms obtaining DIP financing from lenders with whom they did not have a prepetition relationship.(1.) While there could be many explanations for this discrepancy, the preexisting relationship between the debtor and the lender, as well as the lender’s greater interest in more than simply a financial windfall from the debtor’s emergence from bankruptcy, are both plausible reasons.

Additionally, after the financial crisis, the maturity dates of the typical DIP loan were dramatically reduced. DIP loan maturity dates often extended up to two years prior to the 2008 crisis, but now DIP loans often mature in a year or less.(2.) Several recent developments could explain these reduced maturity periods, including the 2005 amendments to the Bankruptcy Code and a recent Supreme Court case continuing a trend of favoring secured creditors’ rights in bankruptcy disputes.(3.)

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