cross-collateralization

USA

cross-collateralization, Also known as bootstrapping.

A practice used in DIP financing arrangements in which a debtor grants its existing prepetition lender a security interest in assets acquired after the bankruptcy filing (such as additional inventory) to secure both debt incurred prepetition and debt to be incurred postpetition.

Cross-collateralization improves the prepetition lender's collateral position and is used to induce it to extend new postpetition loans to the debtor. Absent cross-collateralization, postpetition assets (except for the proceeds of prepetition collateral) are not subject to the lender's prepetition lien (§ 552(a), Bankruptcy Code).

Courts are reluctant to approve cross-collateralization because of the Bankruptcy Code's clear distinction between prepetition and postpetition assets and liabilities. Courts approving cross-collateralization have done so reluctantly with certain requirements, including requiring notice to affected parties and a showing that the debtor will not survive without the proposed financing. The main objections against cross-collateralization are that it is:

• Not authorized as a method of DIP financing under the Bankruptcy Code.

• Directly contrary to the fundamental priority scheme of the Bankruptcy Code, which generally requires that creditors within a given class are to be treated equally. Cross-collateralization results in favoring certain creditors within the same class over others.

Closely related to cross-collateralization are roll-ups, which have the same effect as cross-collateralization because they result in prepetition debt becoming secured with postpetition collateral. This cross-collateralization effect is a common objection to roll-ups.

Outside of bankruptcy, cross-collateralization is a common commercial practice.