Debtor in Possession (DIP)

What Is a Debtor in Possession (DIP)?

A debtor in possession (DIP) is a person or corporation that has filed for Chapter 11 bankruptcy protection but still holds property to which creditors have a legal claim under a lien or other security interest. A DIP may continue to do business using those assets. However, it is required to seek court approval for any actions that fall outside the scope of regular business activities. The DIP must also keep precise financial records, insure any property, and file appropriate tax returns.

Understanding Debtor in Possession (DIP)

Debtor in possession (DIP) is typically a transitional stage in which the debtor attempts to salvage value from assets after bankruptcy. The most obvious reason for obtaining DIP status is that the assets are used as part of a functioning business with higher resale value than the assets themselves. DIP status lets bankrupt firms and individuals avoid liquidation at fire-sale prices, which helps both those who are bankrupt and their creditors.

Consider a mom-and-pop restaurant that was forced into bankruptcy during a recession. The restaurant may still have talented staff, a good reputation, and loyal customers. These could all be more valuable to the right buyer than the restaurant's building and equipment. However, it may take months or even years to find that buyer. A debtor in possession might be able to continue operating until they find the right buyer.

Alternately, debtor in possession status can be used to reorganize a business. Returning to the bankrupt restaurant example, they could eventually find a local investor willing to buy their building and rent it to them. The funds from the sale might be used to pay off all their creditors and emerge from bankruptcy. The restaurant would then be back in business on a different basis.

Although DIPs often exercise substantial influence over assets in their possession, it is essential to realize that they no longer own those assets. Creditors can ultimately use courts to force the sale of DIP assets.

Advantages of a Debtor in Possession (DIP)

The key advantage to DIP status is, of course, to be able to continue running a business, albeit with the power and obligation to do so in the best interest of any creditors. A DIP may also be able to secure debtor-in-possession financing (DIP financing) that can help to keep the business solvent until it can be sold.

A debtor in possession can sometimes even retain property by paying the creditor fair market value if the court approves the sale. For example, a debtor may seek to buy back their personal car (a depreciated asset), so they can use it to work or find work to pay off the creditor.

The ability to continue doing business as a debtor in possession is naturally limited by creditors. Creditors will eventually demand to be paid and force the sale of assets in the debtor's possession.

Disadvantages of a Debtor in Possession (DIP)

After filing for Chapter 11 bankruptcy, the debtor must close the bank accounts they used before the filing and open new ones that name the DIP and their status on the account. From that point on, many decisions the debtor might previously have made alone must now be approved by a court.

A debtor in possession must act in the best interests of both creditors and its employees. The DIP must pay wages and make appropriate withholdings. The firm must use withheld funds to deposit taxes and pay both the employee and employer share of FICA. Other spending is carefully regulated. For example, the debtor usually cannot pay off debts that arose before filing for bankruptcy. Debt payments that are permissible under the Bankruptcy Code or approved by the court are the exceptions. The DIP also cannot put up company assets as collateral or employ and pay professionals without court permission.

Similarly, unless the court rules otherwise, federal, state, and local tax returns must continue to be filed when due, or with extensions sought by the DIP as needed. The DIP also needs to maintain adequate insurance on estate assets — and to be able to document that coverage — and must provide periodic reporting on the financial health of the business.

Should the debtor not meet these obligations, or fail to follow court orders, the DIP designation can be terminated, after which the court will appoint a trustee to manage the business. That step can make it more difficult for the debtor to salvage its enterprise and deal with its debts.