What Is a Debtor-in-Possession (DIP) Loan?

A Debtor-in-Possession (DIP) loan represents a specialized form of financing extended to companies operating under Chapter 11 bankruptcy protection. This credit facility provides essential liquidity, enabling a distressed business to continue operations during reorganization. Its primary objective is to sustain the company as a going concern, preventing immediate liquidation and allowing it to restructure debts and its business model. Distinct from traditional lending, it functions within the legal framework of bankruptcy proceedings. It provides capital when conventional credit sources become unavailable due to the company’s financial distress.

Key Characteristics

A primary characteristic of DIP loans is their “superpriority” status, meaning these loans receive repayment priority over most pre-bankruptcy debts, including existing secured debt. This elevated position incentivizes new lenders. If a company liquidates, DIP lenders are among the first to be repaid from proceeds.

DIP loans are secured by the debtor’s assets, even those already encumbered by pre-bankruptcy creditors. The court may grant a “priming lien,” allowing the DIP lender’s claim to take precedence over existing liens on the same collateral, provided original lienholders receive adequate protection. This ensures the DIP lender has a strong claim on assets, reducing risk.

Interest rates and terms associated with DIP loans reflect the inherent risk of lending to a bankrupt entity. While rates vary based on market conditions, the debtor’s financial health, and likelihood of successful reorganization, they are higher than conventional lending rates. Loan terms are structured as short-term bridge financing, designed to carry the company through the bankruptcy process until it can emerge or be sold. Common types include term loans or revolving credit facilities, providing flexibility for operational needs.

The proceeds from DIP loans are earmarked for expenses necessary to maintain the debtor’s operations and facilitate reorganization. This includes working capital, payroll, essential suppliers, and administrative costs. The funds are not intended to pay off pre-bankruptcy debts directly, but to stabilize the business.

DIP financing is provided by various sources, including existing lenders protecting prior investments, or new financial institutions. Distressed debt funds, hedge funds, and invoice factoring companies are common providers. Some pre-petition lenders may provide DIP financing as a “defensive” strategy to maintain influence over the reorganization and improve recovery on existing claims, sometimes through “roll-up” provisions where pre-petition debt is converted into post-petition debt with superpriority status.

DIP Loans in Chapter 11

DIP loans play a fundamental role in Chapter 11 bankruptcy proceedings. Chapter 11 is designed for reorganization, allowing a business to continue operating while developing a plan to repay its debts. New financing is necessary because, upon filing for bankruptcy, traditional credit lines dry up, leaving the company without capital for day-to-day operations. Without new funds, the business would likely face immediate liquidation, which often yields a lower recovery for creditors than a successful reorganization.

The “debtor-in-possession” concept is central to Chapter 11. It means existing management generally remains in control of the business and its assets, rather than a court-appointed trustee. This management team assumes fiduciary duties to creditors, operating the business for their benefit. To fulfill these duties and navigate the restructuring process, the debtor-in-possession requires capital.

DIP financing enables the business to maintain its value as a going concern. By providing liquidity for essential expenses like employee wages, utility payments, and supplies, the company can continue to operate, generate revenue, and preserve its customer and supplier relationships. This continuity is crucial for creating a viable reorganization plan and maximizing returns for all stakeholders, including creditors and employees. Keeping the business operational and avoiding a fire sale of assets is a core benefit of DIP financing in Chapter 11.

DIP loans address the challenge posed by pre-petition debt and unwilling lenders. When a company files for Chapter 11, its pre-petition lenders may be unwilling to extend further credit or have already fully collateralized the debtor’s assets, leaving no unencumbered assets for new borrowing. DIP financing provides a solution by offering superpriority status and new liens, making it attractive for new or existing lenders to inject capital. This capital allows the debtor to fund reorganization, pay administrative expenses, and continue operations, even when existing creditors are hesitant to provide support.

Obtaining and Monitoring DIP Financing

Securing a DIP loan is highly regulated and requires explicit bankruptcy court approval. Court oversight ensures financing serves the bankruptcy estate’s and creditors’ best interests, not unduly favoring the debtor or new lender. The court evaluates if the loan is necessary for the debtor’s reorganization and if its terms are fair and reasonable to all parties.

To obtain DIP financing, the debtor files a formal motion with the bankruptcy court, detailing proposed loan terms, the necessity of funds, and how proceeds will be used. Often, interim approval for a portion is sought immediately upon filing to address urgent cash needs, followed by a final hearing for the full amount. Creditors, particularly those whose claims might be affected, receive notice of this motion and can review the terms.

Existing creditors, especially those whose collateral might be primed or recovery might be impacted, can object to the proposed DIP financing. Objections may concern interest rates, fees, collateral scope, or provisions granting excessive control to the DIP lender. The bankruptcy court considers these objections and may modify loan terms to ensure adequate protection for all creditor classes.

Once approved, the court issues an order granting specific protections to the DIP lender, such as superpriority status and liens on the debtor’s assets. This court order provides legal enforceability, making DIP financing a viable option despite the debtor’s distressed financial condition. These protections are codified under Section 364 of the U.S. Bankruptcy Code, incentivizing lenders to provide capital to companies in Chapter 11.

Throughout the bankruptcy process, the debtor-in-possession is subject to strict reporting requirements to the court, the U.S. Trustee, and the DIP lender. These reports detail the company’s financial performance, cash flow, and how DIP funds are utilized. The DIP lender often imposes covenants and milestones, such as deadlines for filing a reorganization plan or achieving financial targets. Failure to meet these conditions can trigger a default, giving the DIP lender increased leverage or the ability to demand immediate repayment. This oversight ensures accountability and helps manage lending risks to a bankrupt entity.