Bankruptcy Financing – Definition

Cite this article as:"Bankruptcy Financing – Definition," in The Business Professor, updated October 22, 2019, last accessed August 9, 2020, https://thebusinessprofessor.com/lesson/bankruptcy-financing-definition/.

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Bankruptcy Financing Definition

Bankruptcy financing refers to special financing from a lender to a company that is in the process of chapter 11 restructuring. The lender gives out the money to a firm to help it fund its business operations as it goes through financial distress. The debt is given repayment priority over other debts.

So, if a company happens to place any new financing debt payment ahead of this one, then it becomes a violation of this priority rule. Another term for bankruptcy financing is debtor-in-possession financing.

A Little More on What is Bankruptcy Financing

Generally, bankruptcy financing gives a company going through a financial distress a new start. However, this kind of financing has strict conditions. Bankruptcy is a common activity for financial institutions and is also part of a bankruptcy process that is important in the corporate world.

As the name suggests, chapter 11 bankruptcy is a bankruptcy rule included in chapter 11 of the United States Bankruptcy Code of chapter 11. The rule allows a company to file chapter 11 bankruptcies when it is not able to pay back in full of its debts and wants a federal judge to oversee the restructuring of its debts.

Congress did recognize the possibility of lenders’ becoming hesitant to lend money to a business that has made a bankruptcy declaration. For this reason, it went ahead to allow federal court judges to declare bankruptcy financing, putting a condition that financing should be given the first priority when it comes to debt repayment.  It applied to any debt, whether it is for employees, previous lenders, or supplies.

Bankruptcy Financing Example

Let’s 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.

Key Takeaways

  • Bankruptcy financing refers to special financing from a lender to a company that is in the process of chapter 11 restructuring.
  • Bankruptcy financing gives a company going through a financial distress a new start but with strict conditions.
  • Bankruptcy financing is given the first priority over other debts when it comes to debt repayment.
  • Where large bankruptcy is involved, there is an arrangement of bankruptcy financing by the company ahead of the bankruptcy filing, where it also makes its plan public.

Reference for “Bankruptcy Financing”

https://www.investopedia.com/terms/b/bankruptcyfinancing.asp

https://gudcapital.com/business-loans-during-after-bankruptcy/

https://en.wikipedia.org/wiki/Debtor-in-possession_financing

https://economictimes.indiatimes.com › Definitions › Finance

https://financial-dictionary.thefreedictionary.com/bankruptcy

Academics research on “Bankruptcy Financing”

The effects of post-bankruptcy financing on going concern reporting, Abbott, L. J., Parker, S., & Peters, G. F. (2003). The effects of post-bankruptcy financing on going concern reporting. Advances in Accounting20, 1-22. We examine whether auditors appear to use information related to client debtor-in-possession (DIP) financing in the going concern decision. DIP financing consists of post-bankruptcy financing 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 Review35(4), 31-50. We analyze whether the build‐up of financial vulnerabilities led listed Korean companies to bankruptcy. We find that pre‐crisis leverage is systematically high for both poor performing/slow growing firms and for profitable/fast‐growing firms. Pre‐crisis leverage raises the probability of bankruptcy, which is lower for firms: (1) relying more on (renegotiable) bank credit; (2) with less inter‐firm debt; and (3) having higher interest coverage ratios. Finally, none of these liquidity variables help predict bankruptcies for chaebol‐firms, suggesting that liquidity constraints are more stringent for non‐chaebol. 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 LJ125, 199.

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