When a debtor company files Chapter 11 bankruptcy, they usually get what’s called debtor-in-possession financing (DIP financing). DIP financing allows the debtor to file bankruptcy but maintain their daily operations and exit bankruptcy in a better position financially. But how does the bankruptcy lender benefit from the situation? Well under the bankruptcy code, DIP financers have the opportunity to become prime creditors in the case. In other words, they would gain seniority over the existing creditors in the bankruptcy.
Under § 364(d) of the Bankruptcy Code, after notice and hearing, the court may authorize a debtor to obtain credit or incur debt secured by a senior or equal lien on property of the estate that is already subject to a lien if the debtor shows two things:
(1) the debtor is unable to obtain such credit otherwise
(2) the interests of the current lien holder will be adequately protected should the proposed senior or equal lien be granted. The debtor, not the creditor, has the burden of proof on the issue of adequate protection. The most important question in this equation is whether the post-petition creditor is adequately protected in the bankruptcy. The protection must be enough so that it will sufficiently cover the value of the creditor’s pre-bankruptcy investment.
To insure that the creditor’s interest is not being unjustifiably jeopardized, most bankruptcy courts will order that the DIP loan is used to pay down the pre-petition creditor’s debt and that the debtor makes monthly payments to the creditor during their Chapter 11 bankruptcy and afterwards. The bankruptcy court will also investigate to see if an equity cushion exists for the creditor just in case things go wrong. The burden is on the debtor in Chapter 11 bankruptcy to prove that the requirements for making a DIP financer prime are met.