Debtor-in-possession (“DIP”) financing, also known as “interim financing” or “DIP financing,” describes an increasingly common situation where an insolvent company is allowed to remain in possession of its assets during the restructuring process and receive additional financing in order to stay afloat while it attempts to become solvent again. A hallmark of DIP financing is that the DIP lender will often be granted “super-priority” status over the claims of other creditors, meaning that the DIP lender will likely have first claim to the assets of the insolvent company in the event that the restructuring is unsuccessful and the company is forced into liquidation.
By way of background, the Bankruptcy and Insolvency Act (“BIA”) is a federal statute that sets out Canada’s bankruptcy regime. It is used to liquidate an insolvent business and contains a proposal regime under which debtors can reorganize and reach compromises with their creditors. The Companies’ Creditors Arrangement Act (“CCAA”) is only applicable to insolvent companies with debts totalling over $5 million, and deals strictly with restructuring insolvent companies as well as court supervised sales of insolvent companies. Both statutes have been amended in recent years to explicitly address DIP financing (although the statutory language refers instead to “interim financing”). The circumstances in which DIP loans may be approved and the factors considered by the courts in authorizing DIP loans are almost identical under the BIA and the CCAA.
Generally speaking, a company’s assets have more value as a going concern than they do in liquidation. Thus, the objectives of Canada’s insolvency legislation are to preserve a firm’s going concern value where possible, maximize creditor recovery, and minimize the potential damage to employment and communities that may be caused by bankruptcy. To this end, DIP financing is a useful and increasingly popular tool that may help companies survive insolvency.
A brief history of DIP financing
DIP financing first arose in the context of judicial receiverships, but the legal principles were equally applicable to situations under the CCAA. In judicial receivership cases, DIP financing was included in the expenses of the receiver and allowed to have super-priority if the following conditions were met: (a) the existing secured creditors consented; (b) the receiver was named to preserve and realize the assets of the insolvent company for the benefit of all interested parties, including secured creditors; and (c) the receiver expended money for the necessary preservation and improvement of the company’s property. This approach was followed until the early 1990s, when it was rejected by the courts in the CCAA context in favour of a more permissive approach.
As noted above, initially DIP financing was only available with the consent of all of the debtor company’s secured creditors. In the mid-1990s, the courts began to grant DIP financing orders in circumstances where a secured creditor objected to the order. Rather than categorically rejecting DIP financing proposals in the face of objections by creditors, the courts began to weigh prejudice to creditors against the consequences of disallowing the financing and the benefits of allowing it. Over time, the common law developed much of the criteria that are still considered in these cases. Eventually, in the mid-2000s, the courts extended DIP financing and the granting of super-priority to insolvency situations under the BIA, thereby increasing its potential application.
In response to the increasing popularity of DIP financing, amendments to the BIA and the CCAA which came into force in late 2009 gave this important insolvency tool a statutory basis. These amendments codified many of the common law developments in DIP financing that had occurred in the earlier years. Since 2009, the courts have had several opportunities to continue to develop the law of DIP financing under the new statutory regime. Some of those developments with be reviewed below, under the heading “Recent Case Law”.
Statutory basis for DIP financing
The statutory basis for DIP financing under the CCAA is found in section 11.2. This section allows the court to approve an order for “interim financing” (synonymous with DIP financing) on application by a debtor company and with notice to any secured creditors likely to be affected. The court has discretion to approve the amount required by the debtor company, with the caveat that the court must consider the debtor company’s cash flow statement. The court also has discretion to declare that some or all of the debtor company’s property is subject to a security or charge in favour of the DIP lender, in whatever amount the court considers appropriate.
The court may order that the security or charge be granted priority over any other secured creditors of the borrowing company (often referred to as “priming”, or granting “super-priority” status). There is an exception, favourable to early DIP lenders, to the court’s ability to grant super-priority: section 11.2(3) provides that subsequent DIP financing cannot be given priority over an earlier DIP lender’s security or charge unless the previous DIP lender consents. It should also be noted that a DIP financing order cannot give a DIP lender super-priority with respect to amounts loaned to the insolvent company prior to a CCAA proceeding. This is in contrast with the DIP financing regime in the United States, where courts may approve “rollup DIP loans” in which the super-priority charge secures pre-filing debts.
Section 11.2(4) codifies certain factors previously considered at common law with respect to common law DIP financing. In deciding whether to make an order, the court is to consider, among other things:
(a) the period during which the company is expected to be subject to proceedings under the CCAA;
(b) how the company’s business and financial affairs are to be managed during the proceedings;
(c) whether the company’s management has the confidence of its major creditors;
(d) whether the loan would enhance the prospects of a viable compromise or arrangement being made in respect of the company;
(e) the nature and value of the company’s property;
(f) whether any creditor would be materially prejudiced as a result of the security or charge; and
(g) the monitor’s report, if any.
The statutory basis for DIP financing under the BIA is found in section 50.6. This section is virtually identical in substance to section 11.2 of the CCAA, albeit with an added provision dealing with individuals (i.e., natural persons). Subsection 50.6(2) provides that an individual may not make an application for DIP financing unless the individual is carrying on a business and that only property related to the business may be subject to a security or charge. In Re P.J. Wallbank Manufacturing Co. Limited, 2011 ONSC 7641, the Court noted that the analysis when considering a DIP financing order under Section 50.6 of the BIA is similar to the analysis to be carried out under the corresponding provision in the CCAA — an unsurprising conclusion considering the similarity of the two provisions.
DIP orders
Court orders respecting DIP financing may address only the issue of DIP financing, or, perhaps more commonly, they may be a part of broader orders dealing with several issues. Generally, a DIP financing order will approve the DIP loan and the related security, establish the priority of the DIP lender to that security, and approve the terms of the DIP loan. The order can also assert the validity of the DIP loan agreement even where it violates the terms of the debtor company’s existing loan agreements with its pre-insolvency creditors. In some cases, the order will require that the DIP lender pay out an existing priority creditor or creditors.
It is interesting to note that insolvency financing can occur on some level without an order for DIP financing, assuming priority status is not sought against the objection of other creditors. In some cases, it may even be possible for a lender to obtain priority status on a consensual basis, provided that other creditors are convinced of the importance of the financing. However, even where consensual re-ordering of priority is available, there are reasons why a DIP financing court order may be preferable. A court order will ensure that no questions arise as to the debtor company’s authority to approve the financing, that the financing is not seen as a fraudulent preference or an act of bad faith, and that the rights of the lender are not affected by a stay order under bankruptcy and restructuring proceedings. In addition, registration in a personal or real property registry is not required in order for the lender to obtain priority over the security for the loan.
DIP lenders
Lenders may be understandably hesitant to extend credit to insolvent companies. However, the protection of super-priority status combined with the potential opportunities arising out of DIP financing may encourage some lenders to extend credit during the restructuring process. Perhaps in the majority of cases, DIP financing will be supplied by a pre-bankruptcy creditor of the insolvent company. It has been said that such lenders have an informal right of first refusal on the loan, although there may be no legal basis for such a right. New lenders may also choose to speculate on the future of the company and offer up funds. This may be because successful DIP financing can be a highly profitable venture, with the risk of lending to an insolvent company allowing DIP lenders to charge high fees and rates of interest.
Existing lenders have certain advantages in DIP financing situations, namely in-depth knowledge of important aspects of the insolvent company’s business and industry. This pre-existing knowledge positions these creditors to make quick decisions at lower transaction costs, unhindered by the need to perform extensive due diligence. A DIP lender may take on a greater role in restructuring an insolvent company, which in the case of an existing lender, may allow it the opportunity to better protect its initial investment. For example, the terms of the DIP lending agreement can be tailored to give the DIP lender significant control over the restructuring process. In the event that the debtor company cannot regain solvency, the DIP lender is better positioned to control the liquidation process as a secured lender with super-priority status.
Notwithstanding the above, there are situations where an existing creditor might decline to provide DIP financing. For example, where the lender lacks confidence in the management of the company (including where the directors have all resigned in anticipation of insolvency), or where liquidation would more or less satisfy the outstanding debt. In such cases, an existing creditor may prefer to allow someone else to take the risk of keeping the company afloat, or to push the company toward liquidation.
Recent case law
Since the amendments to the BIA and CCAA with respect to DIP financing, the courts have considered and clarified the application of the new provisions on several occasions. The following is a brief summary of some of the developments in recent case law.
Factors to be considered
The first case to consider interim financing under section 11.2 of the CCAA was Canwest Global Communications Corp. (Re), 2009 CanLII 55114 (ON SC). In that case, the Court set out several issues to be considered in an application for DIP financing. Of obvious importance are the factors enumerated in subsection 11.2(4) of the BIA (referenced earlier in this article). Additionally, the court must consider whether notice has been given to secured creditors likely to be affected by the security or charge, and whether the amount of the DIP financing is appropriate and required, having regard to the debtors’ cash flow statement. Consistent with subsection 11.2(3) of the CCAA, the court must ensure that the DIP charge does not secure an obligation that existed before the order was made.
The considerations above were expanded upon in Re Canwest Publishing Inc., 2010 ONSC 222, where the Court considered evidence of the reasonableness of the DIP financing terms and the fees charged by the DIP lender in association with the loan. Additionally, in determining whether to grant super-priority status to the lender, the Court gave weight to indications by the lender that they would be unwilling to provide a DIP financing facility without a priority charge.
Immediate necessity not a requirement
Interestingly, in Re Canwest Publishing Inc., it was not anticipated that the DIP funds would be immediately necessary. However, the cash flow statements projected a good likelihood that the entities in question would require the additional liquidity afforded by the DIP credit facility. The Court nevertheless approved the DIP credit facility, noting that the ability to borrow funds secured by a priority charge would help retain the confidence of the entities’ trade creditors, employees and suppliers. A similar result was achieved in Re Cinram International Inc., 2012 ONSC 3767, where a credit facility was approved despite the fact that there was no immediate requirement for the interim financing.
Proper notice is essential
As noted above, ensuring that affected parties have notice is an important part of a DIP financing application. This is illustrated byWhite Birch Paper Holding Company (Arrangement relatif à), 2010 QCCS 1176, where defective notice resulted in a new hearing with respect to a previously granted DIP financing order and the Court’s earlier decision to grant super-priority to the lender. However, assuming notice is properly given, the notice period required may be extremely short. In Re P.J. Wallbank Manufacturing Co. Limited, 2011 ONSC 7641, an application for interim financing under the BIA was brought on less than 24 hours’ notice to the affected creditors. This was viewed by the Court as adequate in the circumstances.
Super-priority over deemed statutory trusts
In Re Timminco Limited, 2012 ONSC 948, the Court considered whether a DIP loan could be granted priority over amounts owing to a pension plan. By way of background, there are certain interests that rank ahead of secured creditors in insolvency law. These include amounts owing under certain statutes, such as tax legislation, employment legislation, and pension legislation, and are referred to as “deemed statutory trusts”. Generally, proceeds of liquidation will be paid out to these particular deemed statutory trusts before any leftovers are distributed among the secured creditors. Nevertheless, the Court in Timminco held that it had the power to give the DIP lender priority over deemed statutory trusts, finding that it would be unreasonable to expect any commercially motivated DIP lender to advance funds without receiving such priority, or that any such party would make advances to the insolvent company for the purposes of making payments under the company’s pension plan. A similar result was reached in Sun Indalex Finance, LLC et al. v United Steelworkers et al., 2013 SCC 6, where, despite the Court’s finding that a deemed trust had arisen under the Ontario Pension Benefits Act in favour of the pension holders for the wind-up deficiency payments, it held that the deemed trust would not be granted super-priority over the DIP lenders. Under the “doctrine of paramountcy,” a conflict such as this between valid but overlapping provincial and federal legislation is to be resolved in favour of federal law. Accordingly, since the statutory trust arose under provincial legislation, it was found not to supersede an order made under federal insolvency legislation.
Creeping rolls and partial rollups
In Re Cow Harbour Construction Ltd., (28 April 2010), Edmonton 1003 05560, EVQ10COWHARB (Alta QB), the Court considered the application of Section 11.2(1) of the CCAA, which disallows extending super-priority to loans made by a DIP lender prior to the debtor company’s insolvency. The Court held that section 11.2(1) is to be interpreted narrowly and literally to prohibit extending the security or charge to pre-filing obligations. However, the Court also held that so long as the interim financing is used to fund the operations and restructuring of the debtor, section 11.2(1) is not violated by collections of pre-filing and post-filing receivables being used to permanently reduce the balance of a secured pre-filing working capital line — referred to as a “creeping roll”. In such a case, the terms of the loan agreement will provide that funds coming in to the debtor company will be applied to the creditor’s pre-filing loans, rather than being used to pay down the DIP credit facility. In this way, the pre-filing loan will gradually be paid down and possibly eliminated, leaving the creditor with only the better-secured DIP loan. This is distinguished from a “rollup,” where funds from the DIP loan are used to pay off the earlier indebtedness, either in full or in part (a “partial rollup”). Interestingly, in Re Hartford Computer Hardware Inc., 2012 ONSC 964, the Court recognized a US DIP order containing a “partial rollup” provision, despite the fact that such a provision would not be allowed under 11.2 of the CCAA. Unlike in Canada, such orders are not disallowed by statute in the US. There have been other recent developments in Canadian case law with respect to cross-border insolvency issues; however, they are beyond the scope of this article and will not be addressed here.
No deference to debtor company’s directors
Re Crystallex International Corporation, 2012 ONCA 404, considered whether the court should consider or defer to the business judgment of the debtor company’s directors when making a determination on granting DIP financing. In other words, should director approval weigh in favour of granting the order? The Court determined that it should not; rather, the court must make an independent determination and arrive at an appropriate order having regard to the factors in the CCAA. The court may consider the recommendation of the board, but it is not fettered by and may not defer to such a recommendation.
Choosing between competing DIP lenders
Where more than one lender puts forward a DIP financing proposal, the court will have the task of determining which proposal should be accepted and on what terms the financing should be provided. When faced with such a situation, the Court in Great Basin Gold Ltd. (Re), 2012 BCSC 1773, held that the factors in section 11.2(4) of the CCAA should be applied. In the analysis, special emphasis was placed on which proposal would most likely enhance the prospects of a viable compromise or arrangement, whether any creditor would be materially prejudiced as a result of the security or charge, and the opinion of the monitor. In this case, one proposing party alleged that the other party’s proposal would cause it to be prejudiced. The court reasoned that while it is required to consider prejudice to other creditors, the prejudice must be weighed against the benefits of obtaining the financing.
If you require further assistance, please contact Patrick Cleary.
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