What is DIP Financing?
Debtor in Possession (DIP) financing describes the financing obtained by an insolvent debtor while that debtor is restructuring its business. The term DIP financing originated from the American practice in Chapter 11 proceedings under the U.S. Bankruptcy Code. During a Chapter 11 proceeding, the debtor is referred to as a debtor in possession or DIP, since the debtor is continuing “in possession” of the business while the business is being restructured. During this time, a DIP is empowered to continue to operate the business and may use, sell, or lease property to the extent that doing so is in the ordinary course of the debtor’s business.
DIP financing may be used to pay professionals (the debtor’s legal and financial advisors, the Monitor and its legal advisors and sometimes stakeholder’s legal and financial advisors), to provide operating financing to permit the continuation of the debtor’s business during the restructuring process, sometimes to finance necessary capital expenditures, to pay for the costs of necessary repairs or maintenance of the assets of the debtor, to fund the marketing of all or a portion of the debtor’s property. Often DIP financing is authorized or sought with all of these objectives in mind. Sometimes, super priority charges are sought in order to ensure that these costs, or specified categories of costs, are given a sufficient priority so that, at the end of the day, they will be paid even if no advances are made by a new or existing lender for these purposes.
In Canada, DIP financing refers to the debtor giving priority ranking security on assets in order to finance its ongoing operations during a restructuring. Unlike the United States, there is no statutory basis such as a formal Chapter 11 proceeding for DIP financing in Canada. A company has to make an application to the court and the court has jurisdiction to decide whether a DIP financing will be granted. Each application is made independently and is decided on a case by case basis. Generally, applications for DIP financing are made to the court while a company is undergoing a reorganization under the Company Creditors Arrangement Act (“CCAA”).
The CCAA provides a means of avoiding the devastating social and economic effects of bankruptcy or creditor initiated termination of ongoing business operations while a court-supervised attempt to reorganize the financial affairs of the debtor is pursued. Under the CCAA, the debtor company remains in possession of its assets and can apply to the Court for an order staying all proceedings against it pending a meeting of its creditors to vote on a proposed Plan of Arrangement. There is nothing in the CCAA with respect to DIP financing. In many CCAA cases, there is a chronic need to obtain interim operating financing to keep the debtor company in business. DIP Financing will only be provided by a lender if that lender is assured by way of Court Order that it will have a first ranking security interest and charge on the assets of the debtor company to secure the interim operating financing. The Canadian courts have granted DIP financing in some highly publicized cases. Cases such as Dylex , SkyDome and the Eaton’s , are all situations where DIP financing was used to provide interim financing.
What factors do the Canadian courts generally take into account when granting DIP financing?
1. The degree of probability that an acceptable plan can be developed;
2. The absence of alternative sources of funding for the debtor;
3. The careful monitoring by the court or an officer of the court of the use of funds;
4. The use of funds to preserve the value of the business or to create value, thereby not decreasing the potential recovery of senior creditors; and
5. The loan security which is given this status does not create the situation in which the newly subordinated creditors would be under-secured in a liquidation situation.
So who generally provides the DIP financing and why does this matter so much?
There are two types of DIP lenders:
1. Parties that do not have a prior interest in the restructuring; and
2. Existing creditors/stakeholders of the insolvent company.
A prospective DIP lender who does not have a direct or indirect interest in the outcome of a restructuring will be motivated by the opportunity to make a low risk loan for a reasonable rate of return. Any DIP loan by a third party will be conditional on obtaining a court ordered first priority charge on all of the property of the debtor. If priority is not provided no loan will be made. The third party will also want to be assured that new value will be generated resulting from DIP financing to ensure their return on investment. If new value is not generated then this third party gets priority in getting their money back over existing lenders and creditors.
Only an existing creditor with substantial and usually secured claims against the debtor will consider providing a DIP facility. The attractiveness for an existing lender to provide DIP financing is that if another person provides a DIP facility with priority over an existing lender the value of the lender’s security for pre-filing obligations may be reduced by the new charge. What this means is that if the DIP facility does not generate enough new value then the lender who has security (first priority) in existing collateral will be pushed down a notch when assets and money are being distributed during a bankruptcy.
The primary benefit to DIP financing is that by providing interim financing, it allows the debtor more time and flexibility to facilitate the restructuring during a financially volatile period. The flip-side of this debate is that if creditors and lenders know that there is a probability that their rank in priority interests in the debtor’s property may be subordinated by a court order then this could result in more rigorous scrutiny for lending practices. Creditors and lenders may use a more cautionary approach and stricter criteria in the initial lending phase.
Where does Canada go from here?
The balancing act between the objectives of facilitating restructurings and protecting the expectation interests of those who provide financing to businesses in Canada is what the government will consider over the next year. The government will be reviewing key legislation related to insolvency and restructuring and will be receiving recommendations on improvements and amendments to the Bankruptcy and Insolvency Act and the CCAA. Given the controversial debate around DIP financing, stakeholders are urging the government to specify the framework and rules to govern DIP Financing. In doing so, the government will have to maintain the balance and interests of all parties.
By: Mark Borkowski is president of Mercantile Mergers & Acquisitions Corporation. He can be contacted at [email protected] or (416) 368-8466 ext. 232 or www.mercantilemergersacquisitions.com