Debtor in Possession Financing in the Spotlight
Does DIP Lending Guarantee Payment of Your Postpetition Credit Sale?
By Scott E. Blakeley

"Debtor in possession financing" is a phrase frequently heard by the credit professional these days with a customer filing Chapter 11. A corporate customer who seemingly has run out of cash to pay its debts and finance operations, suddenly announces that it has arranged a new credit line with its lender by virtue of filing Chapter 11 -the so-called DIP financing or DIP facility. Lenders prefer to finance existing customers in financial difficulty using a DIP facility as it puts them in first position at assets, allows greater control over the company and provides higher interest rates and fees.

Key vendors to the customer filing Chapter 11 are often approached by the customer requesting credit sales postpetition. The customer often exclaims there is no credit risk for the vendor as it now has a DIP facility to pay vendors' postpetition credit sales. But is there risk for the vendor with the postpetition credit sale, even with DIP financing in place? What happens where the vendor sells on credit postpetition, the DIP lender refuses to continue financing and the vendor goes unpaid. Does the DIP lender, in effect, guarantee the vendor payment on its credit sale?

The bankruptcy court in In re Forman Industries, Inc., 280 B.R. 609 (WD Penn. 2002), ruled that a DIP lender was not liable to vendor where postpetition credit sale went unpaid.

In Forman Industries, the debtor encountered financial difficulties and was forced to file Chapter 11 to orderly liquidate its assets. It obtained DIP financing that permitted it to purchase goods in the ordinary course of business. The DIP lender had a lien covering all of the debtor's assets, including inventory shipped to the debtor postpetition on credit.

A vendor sold custom-ordered goods on credit postpetition for the debtor's going-out-of-business sales and received a DIP check from the debtor for the sales. However, the debtor defaulted on the DIP financing, and the DIP lender pulled the financing and refused to honor the debtor's check to pay the vendor for the postpetition sales. The case converted to Chapter 7. The vendor went unpaid for the postpetition credit sales.

As the debtor had no assets to pay the vendor, the vendor sued the lender to recover for the unpaid shipments. The vendor claimed, among other things, that: (1) the DIP lender was obligated under the DIP financing to provide financing for the debtor to purchase goods in the ordinary course; and (2) the DIP lender was unjustly enriched by its shipment of goods and refusal to honor the check; and (3) the DIP lender breached a duty of good faith and fair dealing with the vendor by failing to honor the check; and (4) and that the DIP lender fraudulently induced the vendor to sell goods on credit to the debtor.

The bankruptcy court rejected the vendor's argument that the DIP lender was absolutely obligated to finance the debtor's purchase of vendors' goods. Rather, the court reviewed the court order (a public document) and determined that the DIP lender had discretion in financing and the events of the debtor's default. The DIP lender could pull the financing, the court ruled, and vendors would be at risk for the postpetition credit sales.

As to the vendor's claim that the DIP lender was unjustly enriched, the unjust enrichment rule provides that when a vendor's goods or services that preserve the value of the secured creditor's collateral, the secured creditor's acceptance may be a basis to hold the lender liable for the value of goods or services. Courts look to either inequitable conduct by the secured creditor or the nature of the unsecured creditor's contribution to the collateral.

Where a lender encourages transactions between the debtor and unsecured creditor and benefits from the goods and services, there may be an opportunity for the unsecured creditor to recover from the secured creditor. If the lender has an active hand in promoting a credit transaction that goes unpaid, courts reason that the lender should not escape when a vendor is left with unpaid invoices. However, the Forman Industries court found:

"We are not, however, willing to assert as a general proposition that a secured lender who refuses to provide debtor with postpetition financing to pay for goods that is used to liquidate the lender's collateral thereby necessarily is unjustly enriched." Forman Industries, 280 B.R. at 615.

The vendor contended that the DIP lender had a duty to deal fairly with vendors extending credit postpetition and the DIP lender breached this duty when it failed to honor the check payable to them. The court rejected the argument finding that the DIP lender was not absolutely obligated to finance the debtor's postpetition debts, but had discretion if the debtor defaulted on the financing terms. Further, the court found there was no evidence that the DIP lender decided which vendor should be paid, but rather it was the debtor's decision.

As for the vendor's claim that the DIP lender fraudulently induced it to sell on credit, the court rejected the claim finding that DIP financing order did not absolutely obligate the lender to finance the debtor's postpetition purchases. The court did not find any evidence that the lender misled vendors or made false misstatements to vendors.

Protecting Your Postpetition Credit Sales

The Forman Industries ruling reminds creditors that DIP financing does not necessarily guarantee payment of postpetition credit sales. The Bankruptcy Code encourages vendors to sell on credit postpetition by offering an administrative priority claim (administrative priority means payment before general unsecured creditors) should the postpetition sale go unpaid. But as Forman Industries shows, an administrative claim for a postpetition credit sale may go unpaid if the debtor is administratively insolvent.

Given this risk, are there alternatives to reduce risk with a postpetition sales? A vendor may simply insist on COD and CIA sales, however, the customer may move its business to a competitor. Some Chapter 11 debtors are using trade liens to encourage vendors to sell on credit. The trade lien is usually junior to a DIP lender, which means that the vendor is paid only after the DIP lender. A vendor may insist on selling on a secured basis, such as with a purchase money security interest. The credit professional must weigh the alternatives before agreeing to sell on credit postpetition.

Corporate Credit Executive
Reprinted by permission from
Trade Vendor Quarterly, Spring 03