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March 1, 2011Robin Phelan, Ocean Tama

The Use of DIP Financing as a Mechanism to Control the Corporate Restructuring Process

Lenders routinely use debtor-in-possession (“DIP”) financing agreements to gain substantial control over debtors in Chapter 11 and the bankruptcy reorganization process. However, the currently accepted degree of lender control over the Chapter 11 process has evolved into a major de facto change in the bankruptcy process that inhibits rehabilitation of distressed companies. This evolution has been accelerated by the overleveraging of debtors, the proliferation of secured financing, restrictions on the time for debtors to assume or reject leases, the exorbitant cost of DIP financing, and the availability of forms of DIP financing documents on the Internet. Whether this change is bad policy, or merely an economically efficient reallocation of capital, is an issue that courts, scholars, and practitioners are struggling to address.

Financing Alternatives for Privately-Held Business

Financing for a business may include one of, or a combination of two forms: equity financing or debt financing. A new business may prefer equity financing in order to avoid paying frequent principal or interest payments during its start-up phase. Instead, a business will be able to use any profits generated to fund its operations. Additionally, investors typically take a long-term view, and do not expect a return immediately, which gives a new business some flexibility in growing its operations. There will be no ongoing requirement to repay investors should the business fail. Conversely, equity financing may ultimately require a new business to pay an even higher rate of return than would be charged under a typical bank loan, and requires a dilution of ownership and control of the company and management of its affairs. Debt financing may be preferential for a new business primarily because the lending institution typically has no direct or express control over the management of the affairs of the business. Further, the amount of principal and interest are typically set amounts, which can be factored into an operating budget, and the interest on the loan is usually tax-deductible. One of the most obvious disadvantages to debt financing is that a lender can foreclose on the assets of the business should the company experience cash flow problems. Also, debt financing may require the company to comply with more covenants and financial performance standards in order to avoid a default. Commonly, a new business will utilize a combination of both types of financing.