Copyright 2009, Blake, Cassels & Graydon LLP
Originally published in Blakes Bulletin on Business/Restructuring & Insolvency, March 2009
This article provides a basic primer on DIP financing in Canada, followed by a discussion of the most recent developments affecting the structure of DIP credit agreements and the priority of DIP lenders charges. Unique issues that arise in connection with cross-border DIP financings will also be addressed.
What is DIP Financing?
Debtor in possession or "DIP" financing is the bridge financing provided to a company while it is subject to a formal insolvency proceeding. DIP Financing is usually needed where the company plans to continue to operate through the proceeding and intends to restructure or sell as a going concern. The term, now widely used in Canada, originated in the United States where a debtor company reorganizing under Chapter 11 of the U.S. Bankruptcy Code is referred to as a "Debtor in Possession", that is, the debtor stays in possession of its assets throughout the insolvency proceeding, as opposed to a proceeding where a third party, such as a trustee in bankruptcy, is in possession of the assets.
The functional equivalent to Chapter 11 in Canada is the Companies' Creditors Arrangement Act (CCAA). Like Chapter 11, the CCAA, and court orders issued pursuant to it provide for a broad stay of proceedings preventing creditors from taking any action against the debtor company, a general moratorium on the payment of debt existing at the date the debtor filed for protection, and authority for the debtor company to pursue a plan of compromise and arrangement with its creditors. CCAA debtors can also be authorized to sell their assets through a court-supervised process. The initial order granting protection to the debtor company will also appoint a monitor. A monitor, usually a licensed insolvency professional in an accounting or financial advisory firm, is the court-appointed officer that plays a supervisory role in the restructuring.
When Will a Company Need DIP Financing?
At the time of the CCAA filing, the debtor company is required to file cash flow statements with the court. These cash flow statements will indicate expected revenue and expected expenses on a rolling 13-week basis. Before granting relief, the court will need to be satisfied that the debtor company has sufficient resources to meet its post-filing obligations. The debtor may have access to sufficient cash on hand to pay these post-filing obligations as they become due. In Chapter 11 proceedings, this is known as the use of "cash collateral". Recent examples of large debtors that have relied solely on cash collateral to support themselves at the time of the CCAA filing include Nortel Networks and the SemCanada Group. If the debtor company does not, however, have sufficient access to cash collateral, it will need to obtain DIP financing to meet its post-filing obligations.
Why Provide DIP Financing?
The most likely candidate to provide DIP financing is the debtor company's existing lender. The lender may be willing to provide further financing in order to protect its existing position, that is, by financing a restructuring of the company's operations, the lender may be able to obtain a greater return on its investments than if it simply refused to provide further funding, causing the business to liquidate immediately. By providing DIP financing, the lender can also negotiate a more prominent role in the restructuring. DIP lenders are often granted extensive rights to receive information, the ability to provide input into any orders issued by the court during the proceedings and the right to approve any sales or expenditures out of the ordinary course of business. Any plan of arrangement issued in the proceedings may also be subject to DIP lender consent. Recent examples of existing lenders providing DIP financing include the Bombay Furniture restructuring and the InterTan (The Source/Circuit City) restructuring.
New lenders with no prior relationship with the debtor have also provided DIP financing. DIP lenders and administrative agents acting on behalf of a syndicate can command significant fees and aggressive pricing (higher than usual interest rates). The lenders also get the benefit of a court blessing of the credit and security documents, insulating them from any subsequent challenge. A recent example of a new lender providing DIP financing is the Quebecor World restructuring.
Particularly in the automotive industry, customers of debtor companies often provide DIP financing in order to ensure a stable and uninterrupted supply of required goods.
In certain circumstances, a potential purchaser of a debtor company will fund the debtor's operations during the proceedings in order to ensure that there is a viable business to be acquired at the end of the court-sanctioned sales process (see, for example, the sale of Destinator Technologies).
What is the Priority of the DIP Lenders Charge?
In Ontario, as is the case with most other provinces, the standard form model CCAA initial order authorizes the court to grant a DIP lenders charge against the debtors to secure repayment of the DIP financing. The DIP lenders charge will be subject in priority to a court-ordered administration charge, which secures the payment, up to a certain amount, of professional fees for the debtor's counsel, the monitor and the monitor's counsel. The DIP lenders charge may also be subject to a court ordered directors charge which secures the indemnity provided by the debtor to its directors and officers. The priority of the directors charge, relative to the DIP lenders charge, is the subject of negotiation between the parties.
The DIP lenders charge can be granted priority over pre-existing security interests. As a general rule, a creditor that first perfects its security under the relevant personal property security act (or the Civil Code in the province of Quebec) has priority over creditors that subsequently perfect their security (subject to certain exceptions, for example, creditors entitled to purchase money security interest priority). The court supervising a CCAA proceeding, however, has inherent and/or discretionary authority to grant a DIP lenders charge ranking in priority of all other secured creditors irrespective of the date of perfection of their security and notwithstanding the fact that the existing secured creditors object to being "primed".
In the leading case, Re United Used Auto, the British Columbia Supreme Court held that before the court could exercise its inherent authority, it should be satisfied that the benefit to the debtor and its stakeholders substantially outweighs the prejudice that would be suffered by the "primed" secured creditors. The court reasoned that, in certain circumstances, the financing would be necessary to "keep the lights on" at the debtor company and it would be necessary for the court to exercise its authority to achieve that end – a DIP lender may be unwilling to provide further financing on a junior basis. The authority should be exercised only following full consideration of the impact of the DIP lenders charge on other secured creditors.
The pending amendments to the CCAA that are awaiting proclamation will codify a court's right to prime existing lenders; however, under these provisions, notice will first have to be given to these creditors before the order will be effective against them.
As a practical matter, only a handful of DIP loans are advanced over the objection of existing operating lenders. DIP financing in Canada is typically provided on a consensual, negotiated basis.
Can a DIP Lenders Charge Rank Ahead of Statutory Liens?
The CCAA model initial order provides that a DIP lenders charge will not only rank ahead of secured creditors but shall have priority over all statutory liens and deemed trusts. Historically, insolvency lawyers were concerned about the effectiveness of this provision against certain superpriority claims in favour of the Crown, such as claims for collected but unremitted GST and claims for deductions at source from employee wages (income tax, CPP, EI). A recent case in Alberta, Re Temple, however, concluded that the court did have jurisdiction to prime the Crown's deemed trust claim for collected but unremitted GST.
Out of an abundance of caution, most DIP financings still provide for reserves against the borrowing base for these and other "priority payables".
How are DIP loans structured?
It is common where the existing lender is also the DIP lender for the DIP loan to provide for a refinancing of the existing loan. Generally, this can be done in one of two ways. A rolling DIP, or creeping DIP, is a facility that provides for new advances to the debtor company under the DIP facility, while revenues that come in following the filing pay down the pre-existing facility. Eventually, the pre-existing facility will be paid off and the pre-filing debt will roll, or creep over, into the DIP facility. Another alternative is the take-out DIP. In a take-out DIP, the first advance is made in an amount which is sufficient to pay off all obligations outstanding under the pre-filing facility and fund going-forward operations of the debtor company.
Lenders often prefer to roll up or take out the existing facility because there are certain efficiencies that are realized by having a single facility govern the entire relationship between the parties. The continued use of roll-ups are in doubt in Canada, as pending amendments to the CCAA, not yet in force, prohibit the court from granting a court-ordered charge to secure pre-filing debt.
What Cross-Border Issues Exist?
It is quite common to have a single DIP credit agreement govern the terms of the DIP financing for related Canadian and U.S. borrowers. A fundamental problem arises, however, where a Canadian debtor is asked to provide a new secured guarantee of the obligations of its U.S. affiliate or parent, including the obligations that have been rolled up into the DIP. Under both U.S. and Canadian law, providing security for pre-existing or "antecedent debt" is problematic, as there is arguably no fresh consideration for this security. Collateral value that may otherwise be available for unsecured creditors in Canada would, instead, be made available to benefit a U.S. parent. In the InterTan restructuring, the Ontario Superior Court of Justice authorized a guarantee of this nature by InterTan, the Canadian subsidiary, of the obligations of its U.S. parent, Circuit City, but only on the basis that the DIP lender would not advance funds in the absence of the guarantee. Subsequent developments in the U.S. case, however, caused the court to provide further comment on the appropriateness of the guarantee.
After the initial order was granted, the Unsecured Creditors Committee (the UCC), appointed in the Chapter 11 case to protect the interests of unsecured creditors in the proceeding, raised certain concerns about the roll-up DIP. Prior to the filing, the existing loan was not secured by furniture, fixtures and equipment of Circuit City. The superpriority lien granted in the U.S. securing the DIP financing, including the roll-up of the pre-existing debt, attached to all assets of the debtor, including furniture, fixtures and equipment. As a result, the DIP lender expanded the collateral that was subject to its security, leaving less value available for unsecured creditors.
The UCC objected on this basis. In a negotiated resolution with the UCC, the DIP lender agreed, among other things, that 50% of any value obtained from the collateral value in Canada would be paid to the unsecured creditors. When the agreement was brought before the court in Ontario for approval, the court expressed concern it had previously been advised that the DIP loan was not possible without the full strength of the Canadian guarantee, only to subsequently be advised that 50% of the value of that guarantee was negotiated away. The monitor in the case also noted that unsecured creditors in the United States could be paid prior to unsecured creditors in Canada, from the collateral value in Canada. It considered that result to be problematic. The court extended an already existing status quo order, and required that no payments be made from the collateral value of Canada to the U.S., pending further order of the court.
Although current credit market conditions have restricted the availability of DIP financing, there are still a number of opportunities to be realized. It is critical that not only potential lenders, but all constituents in an insolvency whose rights and interests may be impacted by DIP financing, are aware of current trends, developments and controversies in this area.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.