A Theory of the Regulation of Debtor-in-Possession Financing

The profile of Chapter 11 of the Bankruptcy Code in public consciousness has surged recently. Other than the automatic stay on the enforcement of claims, the most publicized feature of bankruptcy reorganizations is debtor-in-possession (DIP) financing. Indeed, along with the bankruptcy stay, DIP financing is the motivation for many Chapter 11 filings. Under Section 364 of the Code, a firm in bankruptcy (the debtor in possession) can finance its ongoing operations and investments by issuing new debt that enjoys any one of various levels of priority, all of which rank higher than the firm\u27s prepetition unsecured debt.\u27 The debtor\u27s financing arrangements under this section are subject to the oversight of the bankruptcy court; in fact, most arrangements require prior judicial authorization. Despite the frequency and significance of DIP financing, no coherent theory informs judicial determinations under Section 364. The conventional explanation for the provision is that it enables the debtor to offer inducements to lenders in the form of elevated priority without which the lenders would not be willing to invest. Yet, proponents of this rationale fail to explain the cause of this reticence, other than to imply that lenders associate a stigma with bankruptcy that causes them to shy away irrationally from financing profitable projects of firms in bankruptcy. However, DIP lending has expanded rapidly and a growing number of banks have departments that specialize in financing firms in bankruptcy, whether or not the bank has existing exposure to the debtor.\u27 The stigma of bankruptcy was probably an early casualty in the emergence of a competitive debt market in this area. The more serious problem with the conventional explanation is that it is incomplete. Even if priority debt is necessary to induce lending to firms in bankruptcy, this rationale for Section 364 provides no theoretical framework for the judicial oversight of financing arrangements that the section requires. It is not clear what factors the courts should refer to in determining whether a financing induced in this manner is desirable or not. To a large degree, the courts currently defer to the decisions of the debtor in possession and seek only to ensure that the parties negotiate DIP financing arrangements in competitive environments. History somewhat justifies their concern. In the past, DIP enders have reportedly enjoyed extraordinary rates of return as a result of the reduction in risk caused by the elevated priority and their ability to charge substantial up-front fees. More recently, however, the market has become much more competitive due to low barriers to entry into this sector and the growth in DIP lending opportunities