DEFINITION of Bankruptcy Financing

Bankruptcy financing is another term for debtor-in-possession 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. 

BREAKING DOWN 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 their 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. 

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 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.