Vol 7 (2010) - Issue 4

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Repair or Recycle? Some Thoughts on DIP Financing and Pre-Packs

Debtor in Possession financing or more accurately post petition financing is one of the most discussed topics in the Restructuring world. Often cited as the single most beneficial aspect of US Chapter 11 turnarounds, many have called for the lawmakers of Europe to make it available on the Eastern side of the Atlantic.
In the US DIP financing can be created with court consent over assets not subject to prior security and can also be used to perfect previously taken security.

The matter is a particular hot topic in the UK, often seen to be a close cousin of the US in legal and financial matters, not least because the absence of DIP financing is often given as a reason for the need for a pre-packaged sale of a business under Administration In reality the situation is far more complicated than that.

In fact the UK law does not prevent such financing. The UK legal position is that almost all matters relating to the restructuring or insolvency of an entity are essentially contractual matters knowingly and willingly entered into by free parties. The role of the courts is therefore largely limited to ensuring that pre-existing contractual conditions are implemented in accordance with those contracts. It is not the role of the courts to impose new contractual condition on parties.

When bringing in changes to the insolvency law in what became the Enterprise Act 2002, the UK Government considered amending the legislation and concluded that 'the matter was one of too great complexity which required a wider consultation, particularly of it were intended that the UK courts would have a role in approving the grant of super-priority funding on a case by case basis'.
Hence it is the structure of lending in the UK and, it must be said, market practice during restructurings that has prevented the development of DIP financing.

Most UK lending is structured around a fixed charge over certain identifiable assets and a floating charge over everything else. Since the enterprise Act abolished preferential creditors, the floating charge holder would enjoy the full benefits of the proceeds of floating charge realisations subject only to a relatively small deduction for unsecured creditors (the Prescribed Part – currently up to a maximum of GBP 600,000) and, critically for this discussion, the costs of the Administration. The costs of Administration include the fees of the administrator, the costs of ongoing trading and also any DIP financing.

In other words DIP financing in the UK ranks as an automatic super priority over floating charge assets and any other assets not caught by a fixed charge. However since the those are already spoken for on most cases by the sweep up of the existing floating charge, no such financing can be given without the consent of the banks. The UK courts do not consider it their place to upset this contractual arrangement.

At this point we must return to the question of the pre-packaged sale. Despite the instruction of the Enterprise Act to consider the rescue of the Company as a going concern as the primary reason for entering Administration, old habits die hard. The philosophy of the UK, since before the time of Charles Dickens, was to remove the assets from a bankrupt enterprise and hand them over to someone else for cash. That cash went to (part) pay off the creditors. The new owner of the assets was expected to price his offer for the assets at a level that made his reward for taking them as high as possible.

There is an obvious conflict of interest here with maximising the return to creditors. However since the new enterprise seemed likely to succeed there developed the practice for the creditors (more especially the lending creditors rather than the trade creditors) to finance the new vehicle and make up their losses through profits that way. Controversially the management often takes the same view and becomes the 'new' entrepreneurs. As a result we see more and more pre-packed administrations with the management keeping the business and the previous lenders backing them.