What you need to know as a secured lender to a borrower who goes into bankruptcy you should know already, well in advance. If your borrower’s bankruptcy filing has taken you by surprise, please refer to my next article in this series, in which I will discuss the tactics and strategies in the contested case context. The present article assumes you saw the bankruptcy coming.
Let us presume therefore that, from consultations with your borrower, it is clear that borrower is in distress: likely unable to repay the loan and struggling with basic periodic payments. Borrower has engaged bankruptcy counsel and so should you. Borrower wants to commence a bankruptcy case in order to restructure or sell the company. Not only that, but borrower wants you to allow it to use your cash collateral (typically the proceeds of accounts receivable and sales of inventory and other assets, which are all pledged to you), and perhaps even to have you lend MORE money in the bankruptcy case (by what is known as a DIP – for “debtor-in-possesion” – loan).
You have two choices in this scenario. Choice one: refuse to cooperate and try instead to foreclose on your collateral, with the attendant costs, expenses and risks, including delay. Choice two: cooperate, protect your collateral, and possibly earn some new lender’s fees, and try to help the bankruptcy case to produce a sale or reorganization that gives you a higher recovery on your lending.
When a borrower goes into bankruptcy, a lender must choose its battles. It is generally less wise to take on the debtor in the first days of a case when a bankruptcy court is highly focused on giving the company a chance to succeed. Did I mention that if you refuse to cooperate, the borrower’s bankruptcy filing will halt or bar your foreclosure efforts unless (after a motion and contested hearing, with witnesses, expert witnesses, documents, evidence, and all the fees implied) you convince the bankruptcy court to lift the automatic stay that prevents such actions? Further, borrower (after assuming its bankruptcy identity as a “debtor”) can try to win the right to use cash collateral over your objection on the grounds that borrower gives you “adequate protection.” (More on that below.) At least the court cannot compel you to extend new financing to a debtor.
Every case is unique and nothing I say here can be uniformly applied to all cases. As my posing of the choices suggests, in most cases the most advantageous course is to cooperate, and to use your cooperation to gain cash and control. In exchange for providing DIP funding or permission to use cash collateral, you can gain lender’s fees or adequate protection payments. You may bargain for protections against being sued or having your liens challenged. Also, you can gain additional means to keep close tabs on the borrower’s performance, and clear authority to pull the plug if your position deteriorates.
Whether or not you permit debtor’s use of your cash or other collateral, you are absolutely entitled to adequate protection. In plain English, adequate protection is any reasonable means to ensure that the value of your collateral does not diminish from the value it had as of the date of the bankruptcy filing. If you oppose the use of cash collateral, the debtor will be denied use unless it can persuade the court that it affords you adequate protection. Adequate protection may take many different forms. Sometimes, to protect the value of cash collateral, the debtor must pay you cash, in what are often called “adequate protection payments” – such as continued periodic interest payments on the loan principal – plus grant you liens (often called “replacement liens”) on post-bankruptcy receivables and collections. If the debtor has any unpledged assets, it may also grant you liens on such assets to the extent that the value of the collateral as of the beginning of the case diminishes from the debtor’s use. By requiring rigorous budgeting and monitoring the debtor’s use of cash and other collateral, you can determine whether such diminution is occurring and take prompt action to protect your position.
Your cooperation may amplify the debtor’s chances of success. Because of the stay on all creditor collection established automatically at the outset of the bankruptcy, the borrower will be able to conduct ordinary course business without fighting foreclosure or other creditor actions. The borrower’s focus on cash use and operational efficiency – enforced by the arrangements for DIP financing or the use of cash collateral – should improve the borrower’s cash flow. The desired result is that the borrower will thus improve its chances for a successful restructuring or sale. For you that means a better borrower (under a restructuring) or a return to lender (from sale) superior to the likely net result of a foreclosure and sale.
All that said, it remains a matter of choosing battles, which hardly does away with uncertainty. Even cooperative bankruptcy cases sometimes go awry despite a lender’s best efforts and most considered strategy.