Debtor in Possession (DIP)

What Is a Debtor in Possession (DIP)?

A debtor in possession (DIP) refers to a business or individual that has filed for bankruptcy protection under Chapter 11 of the Bankruptcy Code and still owns the assets over which creditors maintain a lawful right, typically through a lien or other security interest.

DIPs are allowed to conduct their business using assets, but they must obtain court approval for significant actions extending beyond normal business activities.

They should maintain accurate financial documentation, secure insurance for all assets, and submit relevant tax filings. 

It plays a vital role in bankruptcy by allowing the company to maintain its business operations. It offers relief to creditors since the assets are secured and enhances the ability to arrange more favorable settlement negotiations with creditors.

The Unsecured Creditors Committee oversees actions taken by the debtor in possession. If the committee becomes doubtful about the debtor's ability to manage assets, they have the option to request the court to designate a trustee.

How Debtor in Possession (DIP) Works

The term 'debtor in possession' refers to the entity, typically a business undergoing bankruptcy that retains control over its assets.

One compelling reason to secure debtor in possession status is that the assets can be utilized within an operational business, potentially increasing their resale value compared to the intrinsic value of the assets alone. 

It allows bankrupt individuals and businesses to avoid selling assets at significantly discounted prices during bankruptcy proceedings. The individual or entity going through bankruptcy aims to extract value from their assets. 

The status gives the ability to continue running the business while holding the authority and responsibility to act in the best interest of creditors. However, any actions deviating from the usual business operations require approval from the court.

While DIPs can have significant control over their assets, ownership details can vary, and the debtor may still retain ownership in some cases. Creditors can go to court and compel the sale of DIP assets.

In certain situations, the debtor in possession may negotiate to preserve property ownership by compensating the creditor with the property's fair market value, subject to court approval.

Consider a debtor who owns a personal vehicle that has decreased in value since its purchase. The debtor must secure or maintain employment to settle debts. The debtor has the option to compensate the creditor an amount equivalent to the car's current fair market value to retain ownership.

Debtor in Possession (DIP) History

In the 1800s, many European countries and the United States saw a sharp rise in bankruptcies. 

This growing trend of businesses failing led to a demand for better organization and regulation to deal with financial insolvency.

In response to defaults, the common practice involved placing debtors and insolvent individuals in debtor's prisons. This approach proved ineffective in providing meaningful solutions for both debtors and creditors. 

Congress passed the U.S. Bankruptcy Act to enhance the management of financial struggles. Chapters 7, 11, and 13  were introduced to specify the rights and duties of debtors and creditors.

Chapter 11 specifically regulated the financing provided to a debtor in possession through the possession credit facility. The primary purpose was to safeguard creditors' concerns while enabling debtors to continue operating their businesses. 

Additionally, DIP financing allows debtors to emerge from financial difficulties. Chapter 7  focused on liquidation, and Chapter 13 dealt with individual debt adjustment plans, contributing to a more comprehensive and structured approach to bankruptcy within the legal framework.

Rules And Guidelines For DIP

Let's examine the rules and guidelines set forth by the Federal Court of Justice regarding the debtor in possession check:

1. Debtors must adhere to the regulations outlined in the Bankruptcy Code in every aspect.
2. Clear all outstanding debts and obligations arising after filing a petition, covering various business expenses, employee wages, payroll, property-related costs, and sales taxes if they are currently due.
3. Filing for all state, local, and federal taxes that are due.
4. Fees related to employment, both before and during the bankruptcy filing, are prohibited until court approval is granted, even if they arise from post-filing activities.
5. The disposal of any belongings or assets is prohibited until the settlement of creditor claims.
6. Continue making any necessary insurance payments. When filing for Chapter 11, the court requires the debtor in possession to provide evidence of insurance and a "Certificate of Holder."
7. Debtors are restricted from using cash collateral during bankruptcy without obtaining approval through a court order. They are not allowed to acquire any form of secured or unsecured credit or debt.
8. The instructions after filing require the debtors to close all current bank accounts promptly. Instead, they will establish a new account for debtor-in-possession purposes and another one specifically for payroll.
9. Funds held during bankruptcy must be placed in a new account according to the guidelines set by the United States Trustee. Ensuring that the deposited amount falls within the approved limits is essential.
10. The debtor must list the top 20 major creditors who have substantial claims on the debtor's assets.
11. Submit all necessary paperwork during the Debtors and Creditors conference.
12. As per the DIP assessment, debtors are required to make quarterly payments. The minimum DIP fee is $325 if there are no default payments.

DIP Account Requirements

Let's explore the criteria for a debtor in possession account in the procedure:

1. It is essential to close any pre-existing bank accounts once the entity undergoes a conversion into a debtor in possession.
2. Following this, new accounts for the debtor in possession of the loan need to be opened as needed.
3. Every account should clearly express the intended purpose for its creation.
4. The case number from Chapter 11 must be included in the account and clearly stated in printed form on the checks. 
5. The Declaration Regarding Compliance will include information such as the depository's name, the bank account's name and number, and the specified amount designated as the initial deposit.
6. While the legal proceedings persist, the debtor must ensure that the funds from the estate remain in the designated accounts held by approved depositories. This responsibility involves the ongoing maintenance of cash by the debtor throughout the case.
7. If the debtor closes an account or opens a new one, they must notify the U.S. Trustee in writing.

Chapter 11 Reorganization Plan and Confirmation

After filing for Chapter 11 and resolving agreements, the debtor gets a four-month window to put forward a reorganization plan. If, for some reason, the debtor can't meet this deadline, they can request an extension by providing a valid explanation.

Here are the crucial elements necessary to verify a reorganization plan: 

• After the plan is presented, creditors have the opportunity to express their approval or disapproval through voting on the proposed Chapter 11 plan. 
• The bankruptcy court requires assurance that the reorganization plan is practical. The debtor must show that the company can generate enough revenue to cover its expenses.
• The restructuring proposal should ensure fairness and equity. This implies that secured creditors must receive at least the value of their collateral. The debtor cannot retain any ownership stake until all obligations are completely settled. 
• The reorganization plan must comply with the law in a manner consistent with good faith.
• For the "best interest" standard, the debtor must compensate the creditor an amount equivalent to what they would receive in a Chapter 7 liquidation, should the plan be converted to such a scenario.
  • The bankruptcy court needs strong evidence to ensure the organization's successful recovery.

Key Considerations for Funding Approval

After the reorganization plan is approved, lenders evaluate various factors before providing capital funding:

1. Ensure that the recently subordinated creditors are not left unprotected in the event of liquidation.
2. Lenders need to carefully monitor the utilization of funds to ensure their optimal and effective use.
3. The reorganization plan should have a solid structure and demonstrate financial viability.
4. As a lender, you aim to ensure the business gets out of Chapter 11 bankruptcy swiftly. Before giving funds, it's important to check various factors to ensure you get a good return.

Priming a DIP Loan

If all other attempts to secure funding prove unsuccessful, the bankruptcy court has the authority to approve a "priming DIP loan."

• Priming DIP Loan: A priming DIP loan, approved by the bankruptcy court, enables the debtor in possession to secure funds through borrowing.
• Lenders Rights: The bankruptcy court approves a priming lien for the lender, providing the creditor with a legal entitlement to sell the debtor's collateral if they fail to meet their financial obligations, giving lenders a measure of security and recourse in the event of default.

Avoidable Transfers

The debtor in possession or the trustee, as applicable, holds what is referred to as "avoiding" powers. They can be used to reverse the transfer of funds or assets conducted within a specific timeframe leading up to the submission of the bankruptcy petition. 

If a debtor in control avoids giving away certain property, they can nullify the transaction, compelling the return or "disgorgement" of payments or property. This recovered value can then be used to pay off all creditors.

Typically, and unless specific defenses apply, the ability to undo transfers applies to transfers made by the debtor within the 90 days leading up to the filing of the petition.

This timeframe is designed to prevent preferential treatment of certain creditors before the bankruptcy filing. 

Transfers to "insiders," including relatives, general partners, and company directors or officers, within the year prior to filing for bankruptcy can be set aside or invalidated within the year before filing for bankruptcy. 

The trustee has the authority to nullify transfers in accordance with relevant state laws, which may stipulate longer durations. These avoidance powers aim to prevent unjust payments to a single creditor before a bankruptcy filing, ensuring a fair distribution among all creditors.

Debtor in Possession Example

The following are some of the examples of DIP:

Example 1

In 2009, General Motors underwent a major bankruptcy in the U.S., overseen by a New York court. 

It sold assets and formed NGMCO Inc. under Chapter 11 to navigate the crisis. With $33 billion in government support, General Motors successfully reorganized, marking a crucial turning point in its history.

The company made this move right on the deadline to present a workable plan to the U.S. Treasury. In their submission, they disclosed having assets totaling $82.29 billion but were also grappling with debts amounting to a hefty $172.81 billion. 

Interestingly, they made a strategic decision to exclude their operations outside the United States from the court filing, ensuring that business would continue as usual in those regions.

During the bankruptcy proceedings, which maintained normal operations, GM received support for employee compensation, warranties, and other customer services. 

The company's removal from the Dow Jones Industrial Average on June 8, 2009, symbolized a significant shift, with Cisco Systems taking its place. Meanwhile, old GM stock began trading over the counter under symbols such as GMGMQ and MTLQQ.

On July 10, 2009, a new entity completed the acquisition of GM's continuing operations, assets, and trademarks, marking the conclusion of the 'pre-packaged' Chapter 11 reorganization. 

It planned to issue an initial public offering (IPO) of stock in 2010, emphasizing a new beginning for General Motors. 

The intricate financial and legal maneuvers involved in GM's transformative bankruptcy addressed pre-petition creditors' claims using the assets of the former corporation, illustrating the complexity of the DIP process.

Example 2

In October 2022, LATAM Airlines Group successfully concluded its bankruptcy proceedings by obtaining the necessary financial support. As per the Santiago-based airline, they secured $5.4 billion in funding from lenders acting as debtors in possession. 

Moreover, they successfully decreased the debt by as much as 35%. Additionally, in the same month, another company involved in the production of e-cigarettes, Juul Labs Inc., secured debtor-in-possession financing.

Advantages of Debtor in Possession (DIP)

The following are some of the disadvantages of debtor in possession:

1. Business Continuity: The primary advantage of this status is the ability to continue business operations. This is crucial for maintaining customer relationships, preserving the value of the business, and potentially maximizing returns for creditors.
2. Operational Control: The debtor maintains authority over the daily activities of the business. This includes choices related to staffing, contracts, and strategic endeavors, which are crucial in achieving a successful restructuring.
3. Access to Financing: DIP status allows the debtor to secure new financing, known as DIP financing, which takes priority over existing debts. This financing is critical for meeting operating expenses, paying off existing debt, and facilitating the overall restructuring process.
4. Asset Retention: In some cases, a debtor in possession can retain assets by negotiating with creditors and the court. This may involve paying the fair market value of the assets, allowing the debtor to keep essential property crucial for the business's ongoing operations.
5. Sale of Assets: This status allows for the possibility of selling assets with court approval. This can be advantageous for streamlining operations, eliminating non-core assets, and generating funds to repay creditors.
6. Negotiation Power: With DIP status, debtors have increased negotiating power with creditors. They can propose a reorganization plan and negotiate terms to reach more favorable agreements.
7. Customer and Supplier Confidence: Business continuity can help maintain confidence among customers, suppliers, and other stakeholders. This is important for preserving relationships and the overall reputation of the business.
8. Potential for Ownership Retention: In certain situations, the current management or ownership may retain authority over the business following bankruptcy, contingent on the terms outlined in the court-approved reorganization plan.

Authored and researched by Rani Thakur⎮LinkedIn

Reviewed and edited by Parul Gupta | LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• 5 Cs of Credit

• Debt Overhang

• Bank Credit Analysis

• Bank Credit Analysis Training

• Corporate Credit Analysis