What Is Bankruptcy Financing?

Bankruptcy financing is another term for debtor-in-possession (DIP) financing, or the money a lender provides to a company going through a Chapter 11 bankruptcy reorganization. This money is used by a company to fund its operations while it goes through the bankruptcy process.

Key Takeaways

  • Bankruptcy financing refers to the cash for operations that is made available to bankrupt companies by lenders. It is usually much larger in size than their anticipated needs.
  • The objective of bankruptcy financing is to ensure that companies are able to continue operations so that they can emerge healthy from a bankruptcy term.
  • Companies can seek bankruptcy financing from their existing lenders.

Understanding Bankruptcy Financing

It may seem odd that a company going through bankruptcy would be able to access bankruptcy financing. After all, the company has filed for bankruptcy because it is unable to pay back its debts. But bankruptcy financing, or debtor-in-possession financing, is a common activity for many financial institutions to engage in, and it's an essential part of the corporate bankruptcy process. 

Chapter 11 bankruptcy is so named because the rules for this process are enumerated in Chapter 11 of the United States Bankruptcy Code. A firm files for Chapter 11 bankruptcy when it cannot pay its debts back in full, and wants a federal judge to oversee the reorganization of the company's debts. Because Congress understood that lenders may be reluctant to lend to a business that just filed for bankruptcy, it has allowed judges to declare that the lender of bankruptcy financing will be repaid before many other creditors, like previous lenders, employees, or suppliers. Typically, debtor-in-possession financiers will require a first lien on a company’s receivables, or the money it is owed by its customers, and a second lien on real property like plants and equipment.

For large bankruptcy cases, a company will typically arrange bankruptcy financing prior to filing for bankruptcy and making those plans public. Bankruptcy financing of this type tends to be much larger in size than the expected needs of the company, to account for any unforeseen circumstances that may arise during the bankruptcy process.

Bankruptcy financing can be arranged with an existing lender of the company, provided the lender agrees to it. The lender may have a goal, further down the road, of making a company sale, and it might make sense for them to contribute to the firm's turnaround to ensure that it emerges from a bankruptcy.

Debtor-in-possession financiers will usually require a first lien on money a company is owed by its customers and a second lien on real property, like plants and equipment. 

An existing lender can also object to a bankruptcy finance. The lender might, for example, have a lien against a secured asset with the bankrupt organization. In such cases, the organization will have to convince a bankruptcy court judge that the asset will not lose value during the term of the bankruptcy.

Example of Bankruptcy Financing

Let’s say that the Tallahassee Widget Company has issued $1 million in bonds at 6% interest, unsecured against any capital, and has taken out a $2 million bank loan at 4%, secured against its Tallahassee factory. The company’s sales plummeted after its rival, the Albuquerque Widget Company, debuted a new widget that is half the price and twice as effective. The decline in sales has made it impossible for the Tallahassee Widget Company to service its bond and loan payments, and the company has decided to file for Chapter 11 bankruptcy. 

The company believes it can make a comeback if it's able to refurbish its factory so that it can make a similar product to its Albuquerque rival, and has convinced a lender to promise it bankruptcy funding so that it can make those improvements. The bank lends it bankruptcy financing at 10% interest, which it will begin repaying in three years. During the course of the bankruptcy process, the judge forces bond holders and the original lending bank to accept a delay in payments so that the Tallahassee Widget Company can reorganize and fight its way back to profitability.