BEWARE OF DEBTOR-IN-POSSESSION FINANCING: THE RISKS TO EXISTING LENDERS AND VENDOR-TAKE-BACK MORTGAGEES

​Priority is a major consideration for any lender when evaluating risks associated with financing. This becomes all the more important when an insolvent debtor seeks to restructure and access debtor-in-possession (“DIP”) financing (also referred to as “interim financing”). DIP financing is financing obtained by an insolvent debtor when restructuring their business. It is unique because it provides DIP lenders with a “super-priority” over the claims of other creditors in the event the business is eventually forced to liquidate.

DIP financing is an attractive option for insolvent companies, as it allows them to retain possession of their assets during restructuring. DIP financing may be used to provide operating funding, money towards capital expenditures or maintenance of the debtor’s assets – all with the goal of allowing a debtor more time and flexibility to restructure.

A debtor can apply to the courts for DIP financing under section 11.2 of the Companies’ Creditors Arrangement Act (“CCAA”) or under section 50.6 of the Bankruptcy and Insolvency Act (“BIA”). The provisions and factors considered are generally the same for both the CCAA and BIA and apply to situations where a business is attempting to reorganize under a proposal with creditors. However, DIP financing is at the discretion of the courts and is usually restricted to the amount necessary to meet the debtor’s urgent needs.

Under the legislation, certain factors are considered by the courts when deciding whether to grant an order, including:

  • the period of time the company is expected to be subject to the CCAA or BIA proceedings;
  • how the debtor’s business and financial affairs are going to be managed during the proceedings;
  • whether the debtor’s management has the confidence of major creditors;
  • whether the loan would enhance the prospects of a viable compromise or arrangement;
  • the nature and value of the debtor’s property; and
  • whether a creditor would be materially prejudiced as a result.

Though the interests of existing creditors are considered in an application for DIP financing, an existing creditor still risks having its interest in the debtor’s property subordinated by a court order approving DIP financing. Existing creditors, whether secured or unsecured, have no veto power to prevent DIP financing.

For example, a creditor who once thought they had first priority by way of a vendor-take-back mortgage (“VTB”) may discover that, despite its objections during an application for DIP financing, its priority is now subject to the “super priority” of a DIP lender. If the mortgagor in the VTB scenario is eventually forced to liquidate, the DIP lender will be first in line during the liquidation process to collect on its outstanding debts, ahead of the VTB lender. This leaves the VTB lender with less assets to satisfy its own loan.    

With this reality in mind, how can an existing creditor protect its interests when a debtor becomes insolvent? Beyond increased scrutiny in lending practices, a lender needs to move quickly to enforce its security interests in the event a debtor defaults. Lenders should remain vigilant, gather information and be aware of signs that a debtor is struggling to meets its existing liabilities. Taking action before the debtor and other creditors may reduce exposure to the lender.

Alternatively, a current creditor may decide to extend its own DIP financing to a debtor, utilizing its existing knowledge of the debtor’s business to lower its own transactional costs and move quicker than an outside third party lender. This would provide an existing lender with their own “super priority”. 

Regardless of a lender’s decision, it is important to recognize and understand the consequences of DIP financing when a debtor becomes insolvent and seeks protection under the CCAA or BIA.

At KMB Law our real estate and bankruptcy and insolvency groups work together to protect your investment.  Please contact Wojtek Jaskiewicz to discuss further.

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