What is Debtor in Possession (DIP)?
A debtor in possession (DIP) is a person or corporation that has filed for Chapter 11 bankruptcy protection but still holds property to which creditors have a legal claim under a lien or other security interest. A DIP may continue to do business using those assets.
However, it is required to seek court approval for any actions that fall outside the scope of regular business activities. The DIP must also keep precise financial records, insure any property, and file appropriate tax returns.
Understanding Debtor in Possession (DIP)
Debtor in possession (DIP) is typically a transitional stage in which the debtor attempts to salvage value from assets after bankruptcy. The most obvious reason for obtaining DIP status is that the assets are used as part of a functioning business with higher resale value than the assets themselves.
DIP status lets bankrupt firms and individuals avoid liquidation at fire-sale prices, which helps both those who are bankrupt and their creditors.
Consider a mom-and-pop restaurant that was forced into bankruptcy during a recession. The restaurant may still have talented staff, a good reputation, and loyal customers. These could all be more valuable to the right buyer than the restaurant’s building and equipment.
However, it may take months or even years to find that buyer. A debtor in possession might be able to continue operating until they find the right buyer.
Alternately, debtor in possession status can be used to reorganize a business. Returning to the bankrupt restaurant example, they could eventually find a local investor willing to buy their building and rent it to them. The funds from the sale might be used to pay off all their creditors and emerge from bankruptcy. The restaurant would then be back in business on a different basis.
Although DIPs often exercise substantial influence over assets in their possession, it is essential to realize that they no longer own those assets. Creditors can ultimately use courts to force the sale of DIP assets.
How Does Debtor in Possession (DIP) Work?
Most business owners file for DIP status so they can continue operating their business and avoid selling off or liquidating the company. This move is also beneficial to its creditors, since a functioning business is more valuable than its individual assets.
For example, let’s say your business ran into financial trouble during the COVID-19 pandemic, and you filed for bankruptcy. After receiving DIP status, you could continue to run your business and use company resources.
In the meantime, you can propose a restructuring plan or look for a buyer willing to purchase your company. And while you’re able to continue using the business assets, it’s important to remember that you no longer technically own them.
If you’re a sole proprietor, you might consider filing for Chapter 13 bankruptcy, which provides a path to restructure your personal and business debts.
Why It Matters Debtor in Possession
DIP financing is important since it extends a lifeline to any business under Chapter 11 bankruptcy, enabling it to maintain payroll and suppliers, stabilize operations, restructure its balance sheet, and eventually repay creditors and recover from bankruptcy.
A business in bankruptcy can usually obtain DIP financing only by giving its post-bankruptcy lenders a senior lien position. While a senior lien position ensures that the lender will be repaid fully, even in the case of liquidation, it also limits the business with strict payment terms, which can slow the reorganization process.
Strict oversight by the bankruptcy court serves as an additional protection to DIP financing lenders, helping to make sure that new credit can be extended to businesses in bankruptcy.
Obtaining Debtor-in-Possession (DIP) Financing
DIP financing usually occurs at the beginning of the bankruptcy filing process, but often, struggling companies that may benefit from court protection will delay filing out of failure to accept the reality of their situation. Such indecision and delay can waste precious time, as the DIP financing process tends to be lengthy.
Once a company enters into Chapter 11 bankruptcy and finds a willing lender, it must obtain approval from bankruptcy court. Providing a loan under bankruptcy law provides a lender with much-needed comfort in providing financing to a company in financial distress.
DIP financing lenders are given first priority on assets in case of the company’s liquidation, an authorized budget, a market or premium interest rate, and any additional comfort measures that the court or lender believes warrants inclusion. Current lenders usually have to agree to the terms, particularly in taking a back seat to a lien on assets.
The approved budget is an important aspect of DIP financing. The “DIP budget” can include a forecast of the company’s receipts, expenses, net cash flow, and outflows for rolling periods. It must also factor in forecasting the timing of payments to vendors, professional fees, seasonal variations in its receipts, and any capital outlays.
Once the DIP budget is agreed upon, both parties will agree on the size and structure of the credit facility or loan. This is just a part of the negotiations and legwork necessary to secure DIP financing.
Types of Loans
DIP financing is frequently provided via term loans. Such loans are fully funded throughout the bankruptcy process, which means higher interest costs for the borrower. Formerly, revolving credit facilities were the most utilized method, which allows a borrower to draw down the loan and repay as needed; like a credit card.
This allows for more flexibility and therefore the ability to keep interest costs lower, as a borrower can actively manage the amount of the loan borrowed.
Breaking Down Debtor in Possession
After a Chapter 11 filing, new bank accounts get opened that name the debtor as being in possession of those accounts. A DIP can be terminated, and the court will appoint a new trustee if assets are found to be improperly managed or the DIP is not following court orders. The duties of a DIP are specified by guidelines laid out by the United States Trustee’s office.
Pros and Cons of Chapter 11 Bankruptcy
- The company can continue to operate
- Provides relief from creditors
- Can negotiate with creditors
- Comes with restrictions
- Can be lengthy and expensive
The company can continue to operate: If you file for Chapter 11, you can stay in business and resume normal business operations.
Provides relief from creditors: After filing for Chapter 11, your creditors are required to cease all debt collection activities.
Can negotiate with creditors: As you restructure your business, you renegotiate your debt obligations with creditors.
Comes with restrictions: The courts have the right to impose restrictions on the DIP.
Can be lengthy and expensive: Filing for Chapter 11 can be complex, and it comes with a number of administrative and legal fees.
Advantages of a Debtor in Possession (DIP)
The key advantage to DIP status is, of course, to be able to continue running a business, albeit with the power and obligation to do so in the best interest of any creditors. A DIP may also be able to secure debtor-in-possession financing (DIP financing) that can help to keep the business solvent until it can be sold.
A debtor in possession can sometimes even retain property by paying the creditor fair market value if the court approves the sale. For example, a debtor may seek to buy back their personal car (a depreciated asset), so they can use it to work or find work to pay off the creditor.
Disadvantages of a Debtor in Possession (DIP)
After filing for Chapter 11 bankruptcy, the debtor must close the bank accounts they used before the filing and open new ones that name the DIP and their status on the account. From that point on, many decisions the debtor might previously have made alone must now be approved by a court.
A debtor in possession must act in the best interests of both creditors and its employees. The DIP must pay wages and make appropriate withholdings. The firm must use withheld funds to deposit taxes and pay both the employee and employer share of FICA.
Other spending is carefully regulated. For example, the debtor usually cannot pay off debts that arose before filing for bankruptcy. Debt payments that are permissible under the Bankruptcy Code or approved by the court are the exceptions. The DIP also cannot put up company assets as collateral or employ and pay professionals without court permission.
Similarly, unless the court rules otherwise, federal, state, and local tax returns must continue to be filed when due, or with extensions sought by the DIP as needed. The DIP also needs to maintain adequate insurance on estate assets—and to be able to document that coverage—and must provide periodic reporting on the financial health of the business.
Should the debtor not meet these obligations, or fail to follow court orders, the DIP designation can be terminated, after which the court will appoint a trustee to manage the business. That step can make it more difficult for the debtor to salvage its enterprise and deal with its debts.