This post is part of a series of posts entitled First Considerations for the Financially Distressed Business. For a comprehensive list of articles contained in this series, click here.

Once a company or individual becomes a chapter 11 debtor, any financing arrangement that the debtor wishes to engage in must be approved by the Bankruptcy Court. This is true whether the financing is a continuation of an existing lending relationship or new financing.

a. Debtor-in-Possession (DIP) Financing

Many companies who file for chapter 11 bankruptcy are facing a liquidity crisis – they simply do not have enough cash to continue operating. Because of this, one helpful aspect of chapter 11 for a debtor is the potential of obtaining debtor-in-possession (DIP) financing.

For distressed companies, traditional financing can be extremely difficult (if not impossible) to acquire on reasonable terms. Through a chapter 11 filing, a chapter 11 debtor can take advantage of DIP financing, however, which provides the necessary capital to finance a business’s operations during the restructuring process. DIP lenders are incentivized through super-priority loans and claims (which are normally paid before any other claim in bankruptcy), attractive interest rates, and certain protections that minimize considered risks for the lender to provide financing to the chapter 11 debtor. The ability to obtain this emergency funding on an expedited basis is sometimes the driving force behind a company’s decision to file for chapter 11 protection.

b. Cash Collateral

When a debtor files bankruptcy, it immediately loses its right to use or spend any cash or cash equivalents in which a creditor claims an interest. Such cash and cash equivalents are called “cash collateral”. In order to use its cash collateral in its ongoing business operations in a chapter 11 or 13 case, the debtor must either obtain the consent of the creditors that hold interests in the cash collateral or obtain a bankruptcy court order authorizing its use of cash collateral. Typically, the debtor will do both; it will negotiate a cash collateral agreement with its secured creditor during the hours or days immediately before or after filing its bankruptcy case, and then request bankruptcy court approval of that agreement within the first few days after it filed bankruptcy.

If a bank or other secured creditor holds security interests in a business’s inventory or accounts receivable, the payments received by the business from inventory sales or accounts receivable collection will constitute cash collateral. Therefore, it is critical that businesses operating on a going concern obtain the right to use their cash collateral so that the business can continue to operate and to pay any amounts that become due during the bankruptcy case.