Bankruptcy Financing: Meaning, Example, FAQs

What Is Bankruptcy Financing?

Bankruptcy financing, or debtor-in-possession (DIP) financing, is a loan or line of credit provided to a company going through a Chapter 11 bankruptcy reorganization. This money will be used by the company to fund its operations during the bankruptcy process so that it doesn't have to shut down.

How Bankruptcy Financing Works

It may seem odd that a company going through bankruptcy would be able to borrow more money. After all, the company has filed for bankruptcy because it is unable to pay back its existing debts. But bankruptcy financing, or debtor-in-possession financing, is a relatively common activity for financial institutions to engage in, and it's an essential part of the Chapter 11 bankruptcy process. 

Chapter 11 is a form of "reorganization" bankruptcy. Rather than have its assets liquidated (sold off) in order to pay its creditors, the company is allowed to retain them while it works out a plan to satisfy its debts under the supervision of a federal court and appointed bankruptcy trustee. To keep its operations up and running, the company is allowed to continue borrowing money. This is where bankruptcy financing comes in.

Because lenders may be reluctant to lend to a business that is filing for bankruptcy, judges can establish that the lender of bankruptcy financing will be repaid before many other creditors, such as previous lenders, employees, or suppliers. Typically, that will take the form of a first lien on a company's receivables—the money it is owed by its customers—and a second lien on real property like buildings and machinery.

For large bankruptcy cases, a company will typically arrange bankruptcy financing prior to filing for bankruptcy and making those plans public. Bankruptcy financing of this type tends to be larger in size than the expected needs of the company, to account for any unforeseen circumstances that might arise during the bankruptcy process. The funding may take the form of a loan or a line of credit that the company can draw on as needed.

Bankruptcy financing can be arranged with an existing lender of the company, provided the lender agrees to it. The lender may have a goal, further down the road, of seeing the company sold, so it might make sense to contribute to the company's turnaround and ensure that it emerges from bankruptcy as a viable business.

An existing lender can also object to a company receiving bankruptcy financing. The lender might, for example, have a lien against a secured asset with the bankrupt company. In such cases, the company will have to convince a bankruptcy court judge that the asset will not lose value during the term of the bankruptcy.

Example of Bankruptcy Financing

Let's say that the Tallahassee Widget Company has issued $1 million in bonds at 6% interest, unsecured against any capital, and has taken out a $2 million bank loan at 4%, secured against its Tallahassee factory. The company's sales plummeted after its rival, the Albuquerque Widget Company, introduced a new widget that is half the price and twice as effective. The decline in sales has made it impossible for the Tallahassee Widget Company to keep up with its bond and loan payments, and the company has decided to file for Chapter 11 bankruptcy. 

The company believes it can make a comeback if it's able to refurbish its factory so that it can make a similar product to its Albuquerque rival, and has convinced a lender to provide it with bankruptcy financing so it can make those improvements.

The bank issues a loan to Tallahassee Widget at 10% interest, which it must begin repaying in three years. During the course of the bankruptcy process, the judge forces bondholders and the original lending bank to accept a delay in payments so that the company can reorganize and try to fight its way back to profitability.

The Bottom Line

Bankruptcy financing, or debtor-in-possession financing, is a loan given to a company that is filing or planning to file for Chapter 11 bankruptcy. The cash from bankruptcy financing allows the company to continue operations and restructure with the goal of emerging from bankruptcy able to make a profit once more or in sufficient shape to be sold. Lenders may agree to provide bankruptcy financing because they will be repaid first among the company's other creditors.