Background to Debtor in Possession (“DIP”) Finance in USA
The Common Law Origins of Debtor Financing
In the USA the modern Bankruptcy Code’s DIP financing provisions are codifications of practices developed in the common law era prior to the enactment of a national bankruptcy law.
Modern DIP financing grew out of practices developed in nineteenth-century railroad receiverships, which were governed by a special body of common law.
When a large rail company became insolvent back then the bondholders would approach the courts appoint a receiver. The receiver took control of the rail company’s property as the “hand of the court.”
Akin to a moratorium under the modern Bankruptcy Code this stayed the process while a recapitalization of the railroad was being formulated.
The receiver was authorised to issue new debt in the form of “receivers’ certificates” which were made attractive to new and existing investors by securing a first lien on the bankrupt rail company’s assets.
This was the background that led to the introduction of debtor financing into the Bankruptcy Act in the 1930s.
Pre 2011 – in South Africa
In cases of financial distress prior to the enactment of the Companies Act of 2008 and a restructuring of its affairs was possible, a moratorium was achieved by the granting of a provisional order of liquidation.
When a provisional liquidator was appointed to the company and found that there was merit in continuing with a company’s trading operations, leave to borrow money was obtained by applying to court.
Such loans became a cost of administration and were repayable as a first charge and protected by the Order of Court.
Ensuring access to finance is available for businesses in business rescue
Where does a Business Rescue Practitioner (“BRP”) look to obtain Post Commencement Finance? Shareholders, creditors or the companies’ customers?
In South Africa, BRP’s came to the conclusion that they must look elsewhere than to commercial banks for PCF funding.
Much has been said about the formation of funds here in SA such as distressed hedge funds in other jurisdictions but not much of it has been seen.
The challenges for BRP’s in obtaining PCF are:
- The majority of funders that are prepared to provide funding, mostly proved too slow in making decisions.
- The harsh reality is that PCF is mostly required at a time when a company is almost at the end of its ability to provide security.
- Where the PCF funder cannot secure his PCF and have only the relative cold comfort of ranking ahead of all pre commencement creditors the appetite to provide PCF seems to be waning.
- There is also uncertainty as to whether a PCF funder will rank ahead of a secured creditor under circumstances where they provided funding to maintain or preserve a secured creditor’s security. This position should surely be akin to section 89 of the Insolvency Act where the costs of maintaining and preserving security rank ahead of the claim of the secured creditor?
- The reality is therefore that PCF will only be attracted where the business model is sound, where there is a prospect that the business will be a going concern going forward.
Understanding current decisions from Financial Institutions and Courts on Funding
In our Law reports until 31 December 2016 the mention of PCF is limited to three cases and also not really relevant to funding as such.
These cases are:
Copper Sunset Trading 220 (Pty) Limited v Spar Group Limited and another 2014 (6) SA 214 (LP)
In this case the BRP contended that the procuring of PCF was conditional upon a business rescue plan being adopted.
The respondents voted against the plan and upon application the court set that vote aside as inappropriate and adopted the BR Plan. It would be interesting to hear as to whether PCF was ever procured.
Prior to the above mentioned case, there were the cases of Commissioner South African Revenue Services v Beginsel NO and another 2013(1) SA 307 (WCC) and the Cape Point Vineyards case. In both cases the references to PCF was obiter.
Suffice to say that our law has not as yet developed much and we are therefore bound to look at what happened in other jurisdictions.
What transpired under Chapter 11 in the USA is no different from what happens here and the Americans refer to “defensive DIP Financing” as the typical DIP financing situation.
This happens when a pre-commencement lender (pre-petition in the USA) secured by a form of security over the assets of the company under Chapter 11 is faced with two primary choices:
- extend additional financing post-business rescue to permit the company to either reorganize, or sell its assets in an orderly fashion under Chapter 11, or, alternatively,
- risk the uncertainty of a piecemeal liquidation of the debtor’s assets.
Therefore, rather than taking a chance with a fire sale, many lenders conclude that financing a case is more likely to protect the going-concern value of the borrower.
American studies have shown that commercial banks have provided the majority of DIP financing in the USA by way of such “defensive DIP Finance”.
The experience in SA to date, would also appear to indicate that the banks and financial institutions involved in matters where business rescue was filed, have reluctantly agreed to provide post commencement finance and mostly only because they had to protect their pre-business rescue debt and/or maintain their security.
By HANS KLOPPER