/>iWhen a business files for Chapter 11, it doesn’t stop needing cash. In fact, its need for cash becomes even more pressing and complicated, which is why on the first day of a bankruptcy case, debtors often seek interim approval to use cash collateral or obtain debtor-in-possession (DIP) financing.
While these initial arrangements in a bankruptcy petition’s early days can include terms that are later revisited once a creditors’committee is formed and the US Trustee gets involved, cash collateral and debtor-in-possession (DIP) financing orders are powerful tools that can keep a distressed company alive while its stakeholders sort out who gets paid what and when.
What Is Cash Collateral?
‘Cash collateral’ is more than cold, hard cash. Section 363(a) of the Bankruptcy Code defines ‘cash collateral’ as including assets like:
- Deposit accounts
- Proceeds from inventory
- Rents and profits from income-producing properties
- Receivables
- Hotel fees
Secured creditors have liens that attach to bank accounts, receivables, and other cash-like assets like those listed above through instruments like UCC-1 financing statements or rent assignments. And, as James Sullivan, secured lender’s counsel with Seyfarth Shaw LLP, observes, “unless the secured creditor says otherwise, a debtor can’t touch that cash without their okay — or a court order.”
In short, if a lender has a security interest in it, and the debtor wants to use it, it’s cash collateral.
Adequate Protection
In cases where a secured lender is willing to let the debtor use cash collateral, they want something in return: ‘adequate protection.’
Adequate protection provisions may include:
- Replacement liens on post-petition collateral
- Periodic cash payments
- A ‘superpriority’ administrative claim
- Access to books and records
- Control rights via milestones and reporting requirements
Defining ‘adequate protection’ can be a hotly contested topic, which can consume valuable time during a critical process. The question of what constitutes ‘adequate protection’ raises many complicated, nuanced questions upon which the debtor and lender must agree, with one of the most fundamental being asset value. As Richard Corbi, debtor’s counsel with the Law Offices of Richard J. Corbi, points out, “Valuation fights are not simple ‘then-and-now’ comparisons. They often involve dueling experts and differing appraisals.”
DIP Financing
Corbi emphasizes that while a debtor might sometimes run for a time on cash collateral, as in the case of a hotel pulling in steady revenue, it is rare. After all, companies in bankruptcy are there for a reason: they’re usually burning cash, not generating it.
Most of the time, debtors will also need ‘DIP financing,’ which is a loan extended to the DIP during the bankruptcy case. These loans, or lines of credit, are governed by financing agreements, which the bankruptcy court reviews. They are most commonly issued by the DIP’s pre-bankruptcy petition lender — likely the only lender familiar with the DIP and its circumstances well enough to assess risk under the time constraints. Section 364 of the Bankruptcy Code outlines several special protections for DIP lenders.
Without DIP financing, even a short delay in funding can mean game over for the debtor.
The Hierarchy of DIP Financing Options
Under Section 364 of the Bankruptcy Code, DIP financing options escalate in priority and risk:
- Unsecured debt in the ordinary course of business (364(a))
- Unsecured, out-of-the-ordinary debt, with court approval (364(b))
- Secured debt on unencumbered property or junior liens (364(c))
- Priming liens that override existing liens (364(d))
Priming liens are powerful, but the most risky and controversial. They can upend existing lender priorities and require strong evidence that the debtor can’t get credit on any less aggressive terms. Still, Sullivan notes, “Priming liens are fairly common today — especially when there’s no unencumbered collateral and the debtor is desperate.”
Key Considerations in a Cash Collateral or DIP Financing Order
In approaching an order, each side has its own priorities: debtors want flexibility, lenders want control, and creditors’ committees want oversight. “If there’s money for investigations, that’s a win for the committee,” Lauren Macksoud, committee counsel with Dentons, explains. “If not, we may end up with no real ability to challenge liens or uncover fraudulent transfers.”
Typical flashpoints in the order drafting process include:
- Budget: Every cash collateral or DIP financing order hinges on a budget. Typically, this takes the form of a 13-week cash flow forecast, which must be detailed, accurate, and constantly updated. ‘Carveouts’ for professional fees or investigations are often fiercely negotiated.
- Adequate Protection Provisions: Such provisions can include superpriority claims, reporting requirements, and replacement liens. Defining ‘adequate protection’ can be a contentious topic as previously mentioned.
- Milestones: These include deadlines for filing plans, conducting sales, or getting confirmation. Milestones can often shift leverage from debtors to lenders.
- ‘Roll-ups’ and Cross-Collateralization: Both tools improve a lender’s position post-filing.
- Waivers and Releases: Bankruptcy Code Sections 506(c) or 552(b) waivers can cut off recovery avenues for other stakeholders.
- Fiduciary Out Clauses: Clauses that give the debtor the ability to pivot to a better deal if one emerges.
In negotiating order terms, critical leverage can shift from debtor to lender. To that end, Corbi warns, “Debtors shouldn’t be forced into bad deals just because they’re desperate. The court needs to ensure fairness in the process.”
Avoidance Actions: Don’t Let the Lender Grab Them
One of the few unencumbered assets in bankruptcy is avoidance actions, especially preference and fraudulent transfer claims. These can be a lifeline for unsecured creditors.
Both Macksoud and Sullivan note that lenders sometimes try to gain indirect control over these through superpriority claims or roll-ups. Committees fight hard to preserve them, often insisting on express carveouts to keep these assets off-limits.
Final Thoughts
Cash collateral and DIP financing orders are at the heart of every Chapter 11. They’re complex, controversial, and often make the difference between a successful reorganization and a crash-and-burn liquidation.
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To learn more about this topic, view Advanced Bankruptcy Transactions / Negotiating and Drafting Cash Collateral/DIP Financing Orders.The quoted remarks referenced in this article were made either during this webinar or shortly thereafter during post-webinar interviews with the panelists. Readers may also be interested to read other articles about cash collateral and DIP financing orders.
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