Debtor in possession financing in the spotlight: does a DIP lender guarantee payment of your postpetition credit sale? (Legal Corner).

"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 of 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 when the vendor sells on credit postpetition, or 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 the vendor where the 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; (2) the DIP lender was unjustly enriched by its shipment of goods and refusal to honor the check; (3) the DIP lender breached a duty of good faith and fair dealing with the vendor by failing to honor the check; and (4) 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 the vendor's 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 ...