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.
