Obtaining DIP Financing and Using Cash Collateral

<b>Editor's Note:</b>

<i>
Cash is the lifeblood of any business enterprise. Few
companies enjoy a cash flow that is constant; most must periodically resort
to borrowings to meet everyday cash-consumption needs. This is particularly
true of chapter 11 debtors because most companies experience a
constriction of credit in the weeks and months leading up to a bankruptcy
filing and, at the same time, face additional expenses and/or loss of
revenue that tend to exacerbate matters as they enter bankruptcy. On top of
all this, a company under bankruptcy protection must comply with certain
legal requirements before it can borrow money and, in many cases, before
it can even use its cash. This month, in the 13th of their series, the
authors explain the basics of post-petition financing and use of cash
collateral.
</i>
</blockquote>

<p>For the outsider, one of the oddest things about chapter 11 is that one can make money by lending
money to a debtor in bankruptcy. But it's a fact. The Bankruptcy
Code's framework for so-called "debtor-in-possession (DIP)
financing," a.k.a. "post-petition lending," is one of the
most important (and revolutionary) innovations introduced in the 1978 Code.
Indeed, an entire industry has grown up around the rules authorizing
post-petition finance, and a good many chapter 11 cases would be impossible
without it. And—noteworthy for our purposes here—a good many
professionals in our field spend a good portion of their professional lives
conceiving, negotiating, papering (or challenging) these post-petition
financing arrangements.

</p><p>The centerpiece of the post-petition lending
apparatus is Code §364, which sets forth a scheme of escalating
priorities for post-petition financing. We begin this installment by
outlining §364. Then we turn our attention to the rules governing
"use of cash collateral." We include discussion of
cash-collateral usage because even a company whose operations produce cash
sufficient to enable it to self-fund cannot use its cash without complying
with these rules if the cash generated constitutes the cash collateral of
another entity. Moreover, as you will see below, there is a high level of
interrelatedness between the two topics.

</p><h4>Basic Substantive Framework Governing DIP Financing</h4>

<p>Section 364 authorizes "the trustee"
(read: DIP) to "obtain credit." More to the point, it outlines
four paths whereby a lender may achieve priority for money advanced to a
debtor after the petition date. They are:

</p><ul><li>If the DIP borrows "in the ordinary
course of business," then the lender's claim is a
first-priority administrative expense under §364(a). This priority is
perhaps best understood as a protection for post-petition trade vendors.

</li><li>Even outside the ordinary course of business,
the creditor may get an administrative priority if the post-petition
advance and the administrative priority are approved by a court order. This
is §364(b). But as a practical matter, it doesn't happen very
often because most creditors who want to do post-petition lending try to
squeeze themselves in under subsections (c) and (d).

</li><li>If the DIP can't get unsecured credit,
the court may authorize the lender to get a "super-priority"
administrative claim, or the court may authorize the lender to take a
security interest in unencumbered property (or a subordinate security
interest in encumbered property). This is §364(c). The Code seems to
suggest that a lender may obtain a super-priority administrative expense or a post-petition lien, but not
both. However, we have seen many situations in which both of these
protections were granted to a DIP lender.

</li><li>Finally, if the DIP cannot get credit
otherwise, the court may authorize a security interest that is
"senior or equal" to an existing security interest. A DIP loan
with a lien that is senior in priority to existing pre-petition liens is
sometimes referred to as a "priming lien." It is the most
extraordinary protection for a post-petition lender. It requires showing
that the lender whose lien is "primed" is adequately protected.
Priming liens are not often approved over the objection of the pre-petition
secured lender, but it does happen sometimes. In addition, the pre-petition
lender will often agree to the priming lien in order to induce a new lender
to advance money post-petition.
</li></ul>

<p>In order to obtain approval of one of these escalating
priorities, the DIP (or trustee) must show the court that financing was not
available with one of the lower priorities. At the hearing, the DIP (or
trustee) should be prepared to discuss its efforts to obtain financing on
less onerous terms.

</p><h4>Framework Governing the Use of Cash Collateral</h4>

<p>You learned in earlier installments that in chapter
11, the DIP can continue to operate its business without a court order
until the judge orders otherwise. But lawfulness is only one issue;
practicalities are another. The ordinary debtor won't make it to
lunchtime without some operating income. And, as explained above, this is
why a debtor that is strapped for cash must be able to borrow money. But
what if the debtor's operations produce sufficient cash so that it
does not need to borrow money? Well, even if it does have the cash, the
chances are that all of it was pledged, pre-petition, to secured
creditor(s).

</p><p>Security agreements typically give the secured
creditor a first-priority security interest in all of the debtor's
(a) inventory, (b) accounts receivable and (c) proceeds of inventory or
accounts receivable. In the ordinary course, this works fine: Inventory
becomes accounts, which becomes cash, which becomes new inventory and so
forth. But now in chapter 11, it means the creditor has its hands on the
debtor's throat: The debtor can't do anything without cash, and
he can't touch the encumbered cash or cash equivalents (cash
collateral) without the permission of the secured creditor or a court
order.

</p><p>Bankruptcy Code §363(c) provides that the DIP
may use "cash collateral" only with (a) creditor consent or (b)
a court order. In a contested hearing, the pre-petition lender has the
burden to prove the "validity, priority or extent" of its
interest in cash collateral. The debtor has the burden of proving that the
pre-petition lender is "adequately protected." Bankruptcy Code
§363(o) lays out these rules. Adequate protection is defined in
Bankruptcy Code §361.

</p><p>Negotiated cash-collateral orders are fairly common.
This is predictable for several reasons. First, use of cash is essential to
preserve going-concern value. Thus, there is typically a strong unity of
interest on this matter between a debtor and its pre-petition lender, even
where there are other disagreements. Second, courts tend to understand the
need, and so are inclined to allow cash collateral use. Finally, a lender
can enhance its position by negotiating certain terms into an
"agreed" cash-collateral order.

</p><p>This last point requires amplification: A
pre-petition lender is also often the DIP lender in a chapter 11 case.
Thus, a single motion often combines a request to use cash collateral with
a request to incur DIP financing. A common tactic of such pre-petition
lenders/DIP financiers is to characterize a contemplated DIP financing that
includes permission to use cash collateral as purely a DIP financing.
However, bankruptcy courts understand that different rights ought to inure
to a lender who makes a truly new advance of funds as opposed to a lender
who is merely permitting the use of cash collateral (more on this below).

</p><h4>Procedural Overview (of DIP Financing and Cash-collateral Motions)</h4>

<p>Requests for approval of cash-collateral usage and
DIP loans often come to the court on a very expedited basis—within
the first few days of the case. In the extreme (but not unusual) case, the
debtor and the secured creditor show up in court on an emergency motion,
filed moments after the case was filed, seeking an instant authorization
for a post-petition line of credit. The request arrives accompanied by an
annex about the size of the Topeka (Kan.) phonebook, outlining the terms
and conditions to which the DIP and the creditor agreed. In addition (the
secured creditor and DIP repeat in unison), the judge needs to sign the
order now, so the business can continue to operate.

</p><p>Judges (not to mention U.S. Trustees) are often
concerned that (1) they don't have sufficient time to review and
develop an understanding of what they are being asked to approve; (2)
creditors don't have an opportunity to review the arrangement, even
though it can have a substantial impact on the rest of the case; and (3) no
creditors' committee is in place. Courts struggle to balance the
legitimate interests of the parties with these concerns.

</p><p>Bankruptcy Rule 4001 addresses these concerns. First,
it provides for an interim hearing at the beginning of the case, followed
by a full-blown hearing at least 15 days' notice later. At the
interim hearing, the court may authorize DIP financing and/or cash
collateral use only to the extent necessary to avoid irreparable damage
pending the final hearing. Some courts impose additional requirements that
have the effect of causing a further delay before a final hearing can take
place. For example, some courts will not conduct a final hearing on DIP
financing before a committee is appointed and has had the opportunity to
engage counsel.

</p><p>Even within the framework of Rule 4001, courts have
expressed a good deal of anxiety over the content of DIP financing and
cash-collateral orders. One remarkable emblem of this concern is an open
letter that Bankruptcy Judge <b>Peter J. Walsh</b> wrote to the Delaware Bar. In his letter (dated April
2, 1998), Judge Walsh itemized a number of provisions that, he said,
parties should ordinarily avoid seeking in interim DIP and cash-collateral
motions. These include:

</p><ul><li>provisions that are "just too verbose and
cover unnecessary matters;"

</li><li>provisions that incorporate specific sections
of underlying loan documents without a statement of the sections'
import;

</li><li>provisions that state the court has examined
all of the underlying loan documents or that it approves of their terms;

</li><li>lengthy recitations of fact concerning the
relationship between the debtor and the lender (and suggesting instead the
use of stipulations);

</li><li>statements that parties in interest have been
afforded "sufficient and adequate notice" (and suggesting that
the order recite instead that the hearing is being held pursuant to
Bankruptcy Rule 4001(c)(2) and listing the parties to whom notice was
given);

</li><li>provisions that grant the lender a lien on
avoidance actions;

</li><li>any attempt to limit the committee's
right to challenge a lender's pre-petition position to less than 60
days (and in most cases to less than 90 days) or to not grant committee
counsel a carveout; and

</li><li>provisions that expressly or by their terms
have the effect of divesting a debtor of any discretion in formulating a
plan.</li></ul>

<p>We recommend that you read Judge Walsh's
letter.<small>^{<a href="#1" name="1a">1</a>}</small> Other courts have local rules or other written guidance along
the same lines. One common requirement is that specific provisions (such as
cross collateralization, §506(c) waivers, lien on avoidance actions
and the like) be identified in a motion, so the judge does not
inadvertently miss seeing them.

</p><h4>Bedrock Planning Steps</h4>

<p>The first steps in thinking about cash-collateral
and/or DIP-financing issues should involve thorough due diligence of
existing loan documents. Not surprisingly, a pre-petition lender's
attitude in negotiations can change dramatically when it learns that it did
not properly perfect or has some other problem of which it was previously
unaware.

</p><p>The development of a budget of cash expenditures is
also essential. First, as described above, the court has to be able to
review it to make sure that it approves only that which is essential at the
initial hearing stage. Just as importantly, lenders demand it because they
want to make sure that cash is being spent in a way they think makes sense
(<i>i.e.,</i> in a way
that will maximize the likelihood of their getting repaid). Liquidation
valuations are also likely to be demanded by pre- and post-petition lenders
alike: Pre-petition lenders need them to weigh the desirability of a
liquidation against a reorganization; post-petition lenders need them to
assess the collateral base of their loans.

</p><hr>
<h3>Footnotes</h3>

<p>^{<small><a href="1">1</a></small>} Feel free to e-mail Jonathan Friedland if you would like a copy of the Walsh letter. <a href="#1a">Return to article</a>