Bankruptcy Financing - Definition
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What is Bankruptcy Financing?
Bankruptcy financing refers to special financing from a lender to a company that is in the process of reorganization under Chapter 11 of the US Bankruptcy code. The lender gives out the money to a firm to help it fund its business operations as it goes through the bankruptcy process and seeks to confirm a plan of debt reorganization.
Bankruptcy financing is a form of preferred debt that is given repayment priority over other debts. Bankruptcy financing is also commonly referred to as debtor-in-possession financing.
Bankruptcy Financing Example
Lets assume that the XYZ Company dealing with widget has issue bonds worth $1 million at an interest of 6%, which is unsecured against any given capital. The bank has also secured a bank loan worth $2 million at an interest of 4%. Company XYZ later falls out as a result of its competitor Company ABC, creating a widget that is more effective and sells at half the price. Due to this, there has been a decline in sales, which has made it difficult for Company XYZ to service its loan payment as well as bond. As a result, the Company resolves to file for Chapter 11 bankruptcy. The company has faith that it will be able to revive and restore its manufacturing factory and make the same product and come back in the market again. So, the company goes ahead to convince the lender to extend bankruptcy funding to enable work on those improvements. Finally, the lender who, in this case, is a bank agrees to lend the company bankruptcy financing at a 10% interest rate. The bank also gives the company a grace period of 3 years. As the company works through the process of bankruptcy, the judge puts the initial lending bank as well as the bondholders on notice regarding payments. He or she lets them know that there will be a delay in payments to enable Company XYZ to reorganize and work towards stabilizing itself in terms of profits. Generally, where large bankruptcy is involved, a company usually arranges bankruptcy financing ahead of the bankruptcy filing, where it also makes its plan public. Note that this kind of bankruptcy financing happens to be larger and may surpass the needs of the company's needs. The reason is to enable the company to cater to any unforeseen situations that are likely to come up while the company is the process of reorganizing itself.
Academics research on Bankruptcy Financing
- The effects of post-bankruptcy financingon going concern reporting, Abbott, L. J., Parker, S., & Peters, G. F. (2003). The effects of post-bankruptcy financing on going concern reporting.Advances in Accounting,20, 1-22. We examine whether auditors appear to use information related to client debtor-in-possession (DIP) financing in the going concernmdecision. DIP financing consists ofpost-bankruptcyfinancing which is positively associated with bankruptcy emergence. Statement on Auditing Standards No. 59 (SAS 59) directs auditors attention to debt restructuring to mitigate financial distress. Accordingly, we hypothesize that auditors interpret DIP financing as a mitigating factor and are thus less likely to modify the audit opinions of firms receiving DIP financing. We find that auditors are less likely to issue a modification for clients receiving DIP financing, consistent with auditors treating its receipt as a mitigating factor in the going concern decision.
- The past, present and future of debtor-in-possession financing, Skeel Jr, D. A. (2003). The past, present and future of debtor-in-possession financing.Cardozo L. Rev.,25, 1905.
- Corporate bankruptcy in Korea: Only the strong survive?, Bongini, P., Ferri, G., & Hahm, H. (2000). Corporate bankruptcy in Korea: Only the strong survive?.Financial Review,35(4), 31-50. We analyze whether the buildup of financial vulnerabilities led listed Korean companies to bankruptcy. We find that precrisis leverage is systematically high for both poor performing/slow growing firms and for profitable/fastgrowing firms. Precrisis leverage raises the probability of bankruptcy, which is lower for firms: (1) relying more on (renegotiable) bank credit; (2) with less interfirm debt; and (3) having higher interest coverage ratios. Finally, none of these liquidity variables help predict bankruptcies for chaebolfirms, suggesting that liquidity constraints are more stringent for nonchaebol. Thus, in a systemic crisis it is not only the strong/healthy that survive.
- Postpetition Financing: Is There Life After Debt, Henoch, B. A. (1991). Postpetition Financing: Is There Life After Debt.Bankr. Dev. J.,8, 575.
- The Lender's Guide to Second-Lien Financing, Singer, G. H. (2008). The Lender's Guide to Second-Lien Financing.Banking LJ,125, 199.