1. Remember: “Cash is King”
The old saying “Cash is king” is never more relevant than in the chapter 11 bankruptcy world. The Debtor needs cash to operate its business and the creditors need the Debtor to have it for them to get paid. There are two primary sources of cash in bankruptcy: what the Debtor generates from its business and, if that is insufficient to meet the needs of the Debtor and the case, then the funds the Debtor borrows. It is not surprising that there is an inherent tension among the key players in any case where there are limited resources for distribution as each vies to maximize its recovery. Briefly outlined here are the basic rules of engagement between the secured lender and trade creditors in the critical early stages of a bankruptcy case. Remember- the early bird gets the worm.
A general principle in bankruptcy is to incentivize outsiders to deal with the Debtor in bankruptcy. To promote this principle the Bankruptcy Code establishes payment priorities. By way of example, a secured party with liens properly perfected on its collateral under state law – accounts receivable, real estate, etc. generally has first recourse against its collateral or a claim for the value of its collateral and the right to payment for use of its collateral during the case. Vendors that provide goods or services to a debtor in bankruptcy generally have an administrative expense priority for payment ahead of creditors who provided goods and services that were unpaid for at the time of the bankruptcy filing. A limited exception exists for creditors who provide goods within 20 days before the bankruptcy filing in the ordinary course of the debtor’s business, which may also enjoy a payment priority.
2. Understand: Use of Cash Collateral and Adequate Protection Requirements
To ensure an orderly process, the Bankruptcy Code permits the debtor to make payments in the ordinary course of its business, provided it has an unfettered right to use its cash. The debtor who remains in control of its business and property is known as a “Debtor-in-Possession. “ Obviously a Debtor-in-Possession needs access to its cash to make payroll and to pay for goods and services necessary to its business operations. Typically a Debtor arrives in bankruptcy with a lender who has a lien on its accounts receivable, inventory and their proceeds which generate what is known as “cash collateral.” A Debtor may not use cash collateral without the secured party’s consent or court order. A party with an interest in cash collateral is entitled to adequate protection for the use of its collateral in the bankruptcy case to protect against a diminution in its value. Adequate protection may take the form of interest payments, replacement liens (in new accounts as old accounts are collected and cash consumed) and administrative expense claims. To protect against a decline in the value of its collateral during the case, a secured lender may also seek a super-priority administrative claim that trumps all other administrative claims in the event other forms of adequate protection prove inadequate compensation.
Generally, before a bankruptcy case is filed, the Debtor and secured party agree on an interim budget which addresses how cash collateral will be used in the first weeks of the case and the forms of adequate protection for its use that are incorporated into an interim cash collateral order. The cash collateral motion and proposed order and budget are presented to the court along with a packet known as “First Day Motions”. As noted above, a secured lender may ask for different forms of adequate protection for the debtor’s use of its cash collateral and often seeks recognition of its lien priority in the interim period before the court approves the final order that will govern the case. Creditors with a significant stake in the case should be vigilant in their review of what the secured party is requesting that might impact their recovery since often the distressed debtor has significantly reduced bargaining power with the secured party but a pressing need for use of its cash. As a general practice, the interim order should not permanently fix the secured party’s lien position or create liens in unencumbered assets during the interim period. In other words, the interim order should be truly interim and there to protect the lender but not improve its position at such an early stage of the case before any creditors’ committee has a chance to form to protect unsecured creditor interests going forward or to investigate the bona fides of the secured lender’s liens. In smaller cases, a statutory creditors’ committee charged with representing the interests of unsecured creditors may not be cost-effective and therefore may never be formed leaving the unsecured trade creditor on its own in protecting its rights.
3. Be Mindful: Key Concerns About Bankruptcy Borrowing
If existing loans are insufficient to keep the debtor viable a debtor may seek additional loans from its current or a new lender known as “Debtor-in-Possession or DIP financing.” Often in distressed times, the best source of new money is the prepetition lender. The prepetition lender may already have liens in substantially all of the debtor’s assets and in addition to the super-priority status previously discussed may condition further financing on a “roll-up” of the prepetition debt. In a “roll-up” the new DIP facility buys out /pays off the prepetition secured debt. While a roll-up may be preferable to a liquidation it should be carefully scrutinized by general creditors who should ask: Are the financial terms such as interest rate and fees at or above market? Is the requested additional security truly a necessary condition of financing? Are funds being lent for the benefit of the estate or to accelerate payment of pre-petition debt with the add-on of fees? Other areas of concern are the granting of liens in avoidance action (preferences, fraudulent transfers) and assignment of claims against third parties that are often the only remaining unencumbered assets of potential value from which general trade creditors could recover. A proposed DIP order with performance benchmarks imposed on the Debtor should be carefully reviewed for feasibility so that liquidation does not become a foregone conclusion at the trade creditors’ expense.
Both the secured creditor and trade creditors have legitimate interests to protect in a bankruptcy case. The reality is that the bankruptcy process is fluid especially in its earliest stages and the party who controls the cash has the most leverage. General creditors may need to decide early on whether to take a more active role themselves and when to avoid any inadvertent prejudice to their interests and recoveries. All key players should understand the key terms and implications of the loan documents, the potential vulnerability of lien positions, and the Debtor’s budgetary needs to get to goal- a sale, a reorganization or a liquidation. General creditors with significant stakes but less obvious leverage may benefit from consulting with experienced bankruptcy counsel as early as possible.
If you have any questions about this topic or any other bankruptcy matter, please contact Joyce at firstname.lastname@example.org.
ABOUT JOYCE KUHNS
With extensive experience at the national and regional levels, Joyce Kuhns brings her in-depth knowledge in delivering creative solutions to help transform financial challenges to successful outcomes. Whether representing debtors, creditors, creditors committees or equity committees, trustees or regulators, Joyce’s understanding of the complexities of financial and business structures and her skill with in court and out-of-court resolutions enables her to provide critical strategic advice from the boardroom to the courtroom and to a broad spectrum of clients including buyers and sellers of distressed assets and debts as well as directors and officers of companies in crisis. A pragmatic problem-solver, Joyce uses her cross-disciplinary legal skills to meet the daily business needs of her clients and to help reshape their future.
Joyce is frequently invited to lecture before national and international trade groups on restructuring issues and has published in regional and national publications on these issues. She has testified before Congress on key legislation in the restructuring industry.
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