Vol 8 (2011) - Issue 4

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DIP Lending and the Death of Emergence: Reorganisation Outcomes Post-Crisis

Introduction

The bankruptcy process has evolved during the last century to provide economically sound businesses with a mechanism for dealing with temporary financial distress. Although the amount of time a company must spend in bankruptcy has decreased, the process remains lengthy and companies seeking to emerge turn to debtor-in-possession ('DIP') financiers to fund ongoing operations. To incentivize DIP financiers to lend to troubled companies, the Bankruptcy Code dangles a carrot by providing automatic administrative expense priority for DIP loans. Further, if the DIP loan is difficult to obtain, the court grants the loan super-administrative expense priority or even secures the loan with a senior lien. Many courts encourage existing lenders to provide new funding by allowing the proceeds of the DIP loan to be applied against pre-petition debt, in effect 'rolling up' pre-petition debt into post-petition debt with administrative priority.

The social benefit of DIP loans is intensely debated. Some scholars have opined that DIP loans effect a transfer of wealth from existing debt holders to the DIP lender, and induce managers to undertake excessively risky negative NPV projects. Other scholars have found that the use of DIP loans results in faster resolution of the Chapter 11 process, greater likelihood of emergence, and liquidity for those firms unable to borrow on an unsecured basis. Regardless of whether DIP loans are socially optimal, DIP lending has increased dramatically over the last decade.