Bankruptcy Financing

What Is Bankruptcy Financing?

Bankruptcy financing, or debtor-in-possession (DIP) financing, is a loan provided 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.

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. If the firm, or debtor, remains in control of its operations and financial activity, it is allowed to continue borrowing money, known as bankruptcy financing or debtor-in-possession financing.

Because lenders may be reluctant to lend to a business that just filed for bankruptcy, judges can establish that the lender of bankruptcy financing will be repaid before many other creditors, like previous lenders, employees, or suppliers.

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 bankruptcy.

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 bondholders 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.

The Bottom Line

Bankruptcy financing, or debtor-in-possession financing, is a loan given to a company that is filing or is planning to file for Chapter 11 bankruptcy. The cash from bankruptcy financing allows the company to continue operations and restructuring with the goal of emerging from bankruptcy able to make a profit once more.

Lenders agree to provide bankruptcy filing because they will be repaid first among the company's other creditors. If the lender was already working with the company filing for bankruptcy, providing financing can help the lender make a profit on their previous investment in the company.