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Introduction......................................................................................................................................1 Lending to Bankrupt Businesses Basics.......................................................................................1 Selling Assets Free of Any Competing Interest or Charge..............................................................4 Compelling Collateral Substitution..................................................................................................5 Administrative Super-Priority..........................................................................................................6 Consequences of Unauthorized Post-Petition Financing.................................................................7
Introduction Securing fresh funding for the exploitation of the business apart from preserving the current contractual relationships is a primary duty of the debtor. The difficulty arises due to the fact that new creditors are legitimately reluctant to deal with a bankrupt enterprise; especially when there are no good grounds or executory contracts to compel post-petition financing. In fact, the US Bankruptcy Code makes an exception with respect to the promises to lend money from the Codes dispositions with respect to assuming or assigning executory contracts. 1 Thus the object of bankruptcy law in this respect should be to protect the existing creditors while allowing the debtor to secure post-petition financing (while also encouraging such transactions through proper procedures). 2 Lending to Bankrupt Businesses Basics When theres no other choice than to file for bankruptcy protection, many businesses will file for a Chapter 11 reorganization rather than a Chapter 7 liquidation.
11 U.S.C. 365(c)(2) (2006) Azar, Ziad Raymond, Bankruptcy Policy: A Review and Critique of Bankruptcy Statutes and Practices in Fifty Countries Worldwide (May 2007). Available at SSRN: (last visited on 5th April 2011) 1
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In a Chapter 11 reorganization, the struggling business proposes a reorganization plan to keep it alive and (at least partially) pay creditors over time. During the reorganization, the business will require operating capital. The answer to obtaining such operating capital is a type of financing called debtor in possession (DIP) financing. Creditors that provide DIP financing arent acting irrationally; the U.S. bankruptcy code contains substantial protections for them. In most Chapter 11 cases, the company, called a debtor in possession (DIP), keeps possession and control of its assets, operates the business and performs many of the functions a bankruptcy trustee ordinarily performs. In typical Chapter 11 reorganizations, secured creditors have the first priority of repayment. The remaining creditors are repaid in an order determined by the bankruptcy court in accordance with the bankruptcy code. Certain expenses incurred during the reorganization process, called administrative expenses, will be paid ahead of general unsecured claims but after secured claims. Immediately upon filing bankruptcy and until the case is closed or dismissed, the DIP will enjoy the protection of an automatic stay, meaning all judgments, collection activities, enforcement activities, foreclosures and repossessions of property are suspended and may not be pursued by creditors (with certain exceptions or without relief from the automatic stay from the court). Creditors existing before the Chapter 11 case begins are referred to as pre-petition creditors. The bankruptcy court can generally avoid DIP financing arrangements if theyre entered into without prior court approval. Either a pre-petition creditor or a new one can provide DIP financing. A pre-petition secured creditor that wishes to provide DIP financing may obtain a lien against collateral (real or personal property) acquired by the DIP after the case begins (cross-collateralization). Generally, a bankruptcy court will only approve cross-collateralization if a pre-petition creditor makes a significant commitment to provide post-petition credit. Alternatively, a pre-petition secured creditor may seek to provide a roll-up loan facility, in which the DIP agrees to use cash generated post-petition to repay the creditors pre-petition debt, and the creditor/lender agrees to extend additional credit to the DIP secured by assets acquired post-petition. Over time, a roll-up loan facility converts pre-petition secured debt to a true DIP financing facility.


A variety of entities, on the other hand, may provide new credit to a DIP. Generally speaking, the bankruptcy code provides five levels of protection for such lenders, which it can issue separately or in some combination, depending on the circumstances: 1. Administrative expense claim: A post-petition creditor may provide unsecured credit in the ordinary course of business (such as trade credit) without the bankruptcy courts approval. The creditor may also provide an unsecured loan outside of the ordinary course of business after notice and a hearing. 2. Super-priority administrative expense claim: If the DIP can

demonstrate to the bankruptcy court that post-petition financing isnt otherwise available, it may obtain unsecured credit thats accorded administrative expense priority thats superior to all other administrative expense claims. A DIP seeking to provide a junior, senior or priming lien (discussed next) must also demonstrate this. Lenders generally seek greater protection than a super-priority administrative expense claim alone. 3. Junior lien on an encumbered asset: A DIP may seek to obtain credit secured by a junior lien against encumbered assets. But post-petition lenders are generally reluctant to provide DIP financing thats secured this way. 4. Senior lien on unencumbered assets: A DIP may seek credit secured by a senior lien against unencumbered assets. A typical DIP has few unencumbered assets and thus lenders rarely seek this level of protection. 5. Priming lien: The most sought-after level of protection is a lien thats equal or senior to an existing lien (priming). To provide one, the DIP must prove to the bankruptcy court the existing lienholder(s) will be adequately protected after the lien is granted. In general, post-petition creditors will only provide DIP financing if its secured by a priming lien. Other Negotiated Provisions in a DIP Financing Agreement A post-petition DIP lender will generally require the loan facility be secured by a priming lien and all amounts owed constitute a super-priority administrative expense claim. Such a lender will often seek relief from the automatic stay in


bankruptcy court (which temporarily prevents secured creditors from enforcing their liens) and pursue its rights, including liquidation of collateral or foreclosure, upon default. In addition to typical events of default, DIP financing loan agreements should contain the following so the DIP lender can enforce its rights (call the loan, foreclose on assets, etc.) if: the Chapter 11 case is dismissed or converted to a Chapter 7; the bankruptcy court appoints a trustee or an examiner with expanded powers; the DIP incurs additional post-petition debt outside the ordinary course of business; the bankruptcy court modifies the order in which it originally authorized the DIP financing facility; the bankruptcy court grants relief from the automatic stay to any holder of a junior lien in the collateral that secures the DIP facility; and any post-petition judgments are entered against the DIP. Although we banish the thought from our everyday reality, we know the number of companies seeking Chapter 11 bankruptcy protection will likely increase in the coming months as a result of the economic downturn. Creditors willing to navigate the recesses of the bankruptcy code may find that providing DIP financing on protected terms is a worthwhile and even profitable endeavor. I shall now discuss three important ways of post-petition financing in detail considering that the basic understanding is provided earlier.

Selling Assets Free of Any Competing Interest or Charge The first and foremost way out for a debtor is to let go of unprofitable ventures and sell unwanted assets that are not productive and expensive to maintain. The money generated raises a minimum finance. However, delays may be caused due to creditors claims of mortgage et al on the assets. Selling an asset which has claims over it is a difficult task for a bankrupt debtor and the one thing that the debtor can do is to request the court to allow the sale while keep enough of the proceeds in a bank account to protect the interests of the creditors. 3 This way the debtor can get the fresh cash without unreasonably infringing the rights of potential secured creditors whose interests are adequately protected. Yet courts in many countries would not allow the sale to take place before settling the litigation with respect to the validity of the mortgage.

See In re Snowshoe Company, Inc. 789 F.2d 1085 (1986) 4


Tunisia: Respondents expressed suspicion with respect to the debtors chances to succeed in its chase to sell the asset based on the traditional risk averseness of judges in bankruptcy. Between the competing interests of the debtor and the secured creditor, judges always prefer to err on the side of the latter, at least when dealing with real estate asset mortgages. Germany, Croatia & Korea: The law typically protects separate satisfaction creditors.4 Ireland: Rigid constitutional rights are involved; a mortgage is equivalent to an ownership transfer of the real estate property from the mortgagor to the mortgagee, and the mortgagee has a constitutional right to keep the ownership of its collateral in case the debtor defaults.5 Brazil, Hungary & Italy: The transaction can go through in liquidation only; in reorganization, the transaction cannot be done outside a duly confirmed reorganization plan. Compelling Collateral Substitution Under this situation, the debtor may not have enough assets to sell; or the assets are required for the running of the business. Post-petition credit constitutes then a necessary restructuring tool. New creditors, however, will not provide fresh loans without adequate guarantees for pay-back. First, they are not obliged to deal with the debtor and could look elsewhere. Second, creditors look for a profit on the loan, not the typical 10% recovery rate that unsecured creditors expect from a bankrupt debtor.6

Survey for Bankruptcy Study answered by Heinz Vallender, Head of Cologne Bankruptcy Court (March 19, 2005); Survey for Bankruptcy Study answered by Chiyong Rim, Judge, bankrutpcy division of Central District Court of Seoul (March 19, 2005) 5 See Jane Marshall, Ireland, in 2 COLLIER INTERNATIONAL, supra note 26, at 27, 27.06[7] (Richard F. Broude et al. eds., Lexis Publishing 2005) (A creditor holding a security in the nature of a mortgage or other form of fixed charge is entitled to be paid in full from the security The creditor is also entitled to retain the security but if the creditor wishes to claim for any unsecured surplus, the creditor must place an estimated value on the security and claim only the balance [Bankruptcy Act, 1988 First Schedule Rule 24].) 6 Lynn M. LoPucki, The Debtor in Full Control Systems Failure Under Chapter 11 of the Bankruptcy Code? 57 AM. BANKR. L.J. 99, 101 (1983) 5


Hong Kong & Malaysia: Those in charge of the estate could use debtors free assets to secure post-petition loans. However, post-petition financing does not per se get priority over pre-petition credit both in liquidation and in reorganization. 7 United States of America: Unsecured post-petition financing prime all prebankruptcy credit except secured creditors, who keep their right to absolute priority over the proceeds of their collateral. 8 Tunisia, Morocco & France: Post-petition loans are given automatic priority over secured and unsecured creditors alike in reorganizations. However these loans still rank below pre-petition unpaid wages that are paid in absolute priority. Giving unsecured post-petition credit priority over all pre-bankruptcy creditors, including secured creditors, does not substitute the inability of courts to compel collateral substitutions. Such priority hedges the new loan extender against prepetition creditors; it does not, however, hedge it against post-petition credit that could, potentially, grow so much as to threaten post-petition creditors recovery. Compelling collateral substitution does not guarantee debtors survival but it could, if adequately used, increase the availability of cheap post-petition financing and improve the debtors chances to restructure in particular circumstances. 9 Administrative Super-Priority Under this mechanism, if the debtor does not survive and is ultimately liquidated, an administrative super-priority loan will be paid first, before any other unsecured claim including administrative expenses, labour wages and government taxes. 10 This mechanism completes panoply of post-petition financing instruments that provide the debtor with enough flexibility to choose the most compatible funding scheme that best fits its particular economic needs. For example, the debtor might
Tom Vaizey, Hong Kong, in GETTING THE DEAL THROUGH 2004 132, 136 15; Michael Lim & Grace Yeoh, Malaysia, in GETTING THE DEAL THROUGH 2004 191, 194 15 8 See 11 U.S.C. 364 ((a) If the trustee is authorized to operate the business of the debtor [it] may obtain unsecured credit and incur unsecured debt in the ordinary course of business as an administrative expense. (b) The court, after notice and a hearing, may authorize the trustee to obtain unsecured credit or to incur unsecured debt other than under subsection (a) of this section as an administrative expense.); See also 11 U.S.C. 507 (2006). 9 Supra Note 2. 10 11 U.S.C. 364(c)(1) (If the trustee is unable to obtain unsecured credit allowable under section the court, after notice and a hearing, may authorize the obtaining of credit or the incurring of debt (1) with priority over any or all administrative expenses of the kind specified in section 503(b) or 507(b) of this title) 6


be a service company with no valuable assets to mortgage; an administrative super-priority could hence secure the creditor against other post- petition creditors and, by doing so, it could encourage it to make an otherwise improbable loan. A bankruptcy statute that provides for this additional financing mechanism better protects the going-concern value of debtors. 11

Consequences of Unauthorized Post-Petition Financing The distinction between ordinary and non-ordinary course borrowing is sometimes murky. Courts have devised a number of tests to make this determination. Two of the most frequently cited ones are the vertical and horizontal dimensions tests. Under the former, the court examines the reasonable expectations of creditors in light of their past relationship with the debtor and its incurrence of debt, including the amount, terms, frequency, sources and timing of pre-petition extensions of credit from various sources. By contrast, the horizontal dimensions test inquires whether the terms and circumstances of an extension of credit were consistent with practice in the DIP's industry. As indicated by the bankruptcy courts ruling in Ockerlund,12 a great deal can depend on whether or not borrowing is deemed to be ordinary course. Ockerlund Construction Company filed a chapter 11 petition in 2003 shortly after its pre-bankruptcy lender unexpectedly set off funds in one of Ockerlunds bank accounts to satisfy an overdue loan. Confronting a severe cash shortage that would have prevented completion of a valuable school construction project and left employee insurance premiums unpaid, Ockerlunds president provided the company with emergency financing in the amount of nearly $60,000. Only after the loan had been funded did Ockerlund seek court authority to repay the advances as administrative expenses, explaining that the exigencies of the situation made prior court approval impracticable. Two of Ockerlunds creditors objected, including another lender whose advances to Ockerlund had been authorized by the court. At the outset, the bankruptcy court emphasized that the issue before it was not whether the presidents claims qualified as actual and necessary expenses of administering Ockerlunds estate with priority
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Supra Note 2. In re Ockerlund Construction Company , 308 B.R. 325 (Bankr. N.D. Ill. 2004) 7


under sections 503(b) and 507 of the Bankruptcy Code. Instead, the court observed, the question is whether this advance qualifies as a valid post-petition extension of credit to the debtor in accordance with section 364. The court concluded that it was not. First, it reasoned that the advance did not pass muster under the vertical dimensions test and could not qualify as an ordinary course credit transaction that did not require court approval. The court then discussed the circumstances under which some courts find that retroactive approval might be justified. Remarking that even courts that deem such approval to be within a bankruptcy courts broad equitable powers grant it only under truly extraordinary and unusual circumstances, the court opted for a more restrictive approach. Congress, it observed, clearly delineated the requirements for non-ordinary course loans in section 364, and a bankruptcy courts general equitable powers should not be used to alter what the statute clearly and unambiguously mandates. The court accordingly denied Ockerlunds motion to repay the advance as a priority administrative claim. But the court did not stop there. It proceeded to address whether Ockerlunds president had any kind of enforceable claim against the estate at all. Examining the Codes definitions of claim and creditor and concluding that both depend on the existence of a pre-petition right to payment, the court ruled that Ockerlunds president, who advanced funds post-petition, could not hold a general unsecured claim against Ockerlunds estate. According to the court, it had no apparent authority in light of the language and structure of the Bankruptcy Code to create some type of post-petition general unsecured claim for loans that fail to qualify for priority under sections 503(b) and 507(a). Though it appears to be an anomaly among decisions addressing the consequences of an unauthorized post-petition loan, Ockerlund highlights the need for careful attention to the requirements governing credit transactions during a bankruptcy case, whether in the form of DIP financing or otherwise. Many courts confronted with an unauthorized post-petition loan will consider the propriety of retroactive approval in keeping with the standard articulated by the Second Circuit Court of Appeals in In re American Cooler Co.13, Inc. Under that test, a court may grant retroactive approval of post-petition financing if:

In re American Cooler Co., Inc., 125 F.2d 496 (2d Cir. 1942) 8


(i) the court is confident that it would have authorized the financing if a timely application had been made; (ii) no creditor has been harmed by the continuation of the business made possible by the loan; and (iii) the debtor and the lender honestly believed that they had the authority to enter into the transaction. However, because American Cooler was decided prior to the enactment of the Bankruptcy Code (including section 364) in 1978, many courts find that it is no longer good authority and the equitable discretion it presumes no longer exists. Ockerlund falls into this category. Ockerlund reaches a harsh result. The fact that Ockerlunds estate appeared to be administratively insolvent may have buoyed the courts resolve to strip the lender of any recourse whatsoever for repayment of funds that no one denied were necessary to operate Ockerlunds business. Still, the arguably fairer approach would be to determine whether the funds advanced benefited the estate and creditors, and if so, to confer administrative priority on the lenders claims. Other courts that have found unauthorized post-petition credit transactions not worthy of retroactive approval have at least left the lender with an unsecured claim. Whether or not this approach comports with the strict requirements of the Bankruptcy Code, it certainly seems to be more equitable than the view espoused in Ockerlund.14

Mark G. Douglas, Harsh Consequences of Unauthorized Post-Petition Financing , Business Restructuring Review, Vol. 3 No. 2, Jones Day, June/July 2004, p.4 9