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Chapter 11 Corporate Bankruptcy

Chapter 11 is a chapter of Title 11 of the United States Bankruptcy Code, which permits reorganization under the bankruptcy laws of the United States. Chapter 11 bankruptcy is available to every business, whether organized as a corporation, partnership or sole proprietorship, and to individuals, although it is most prominently used by corporate entities. In contrast, Chapter 7 governs the process of a liquidation bankruptcy (although liquidation can occur under chapter 11), while Chapter 13 provides a reorganization process for the majority of private individuals.  The Callan Law Firm, P.C. represents businesses reorganizing in chapter 11, as well as creditors dealing with chapter 11 debtors.  To schedule an appointment to speak with an attorney, contact us now.  To learn more about Chapter 11, read on.

Chapter 11 in general

When a business is unable to service its debt or pay its creditors, the business or its creditors can file with a federal bankruptcy court for protection under either Chapter 7 or Chapter 11.

In Chapter 7, the business ceases operations, a trustee sells all of its assets, and then distributes the proceeds to its creditors. Any residual amount is returned to the owners of the company. In Chapter 11, in most instances the debtor remains in control of its business operations as a debtor in possession, and is subject to the oversight and jurisdiction of the court.

Who Can File Chapter 11?  Where Can You File?

Chapter 11 cases begin in federal bankruptcy court, with the filing of a voluntary petition by the party.

While Chapter 11 cases are generally filed by corporate entities, partnerships, and limited liability companies, individuals can and do sometimes file under Chapter 11 if they find themselves in too much debt to qualify under Chapters 7 and 13 or if the intricacies of their financial situation can justify the associated cost of filing Chapter 11. (In most cases, individuals elect to file for Chapter 7 or Chapter 13.  Learn more about Chapter 7 and Chapter 13 by clicking here).

Debtors will generally file Chapter 11 where their primary place of business is located. Business debtors may also elect to file where they are “domiciled” – i.e., incorporated or otherwise organized.

Features of Chapter 11 reorganization

Chapter 11 retains many of the features present in all, or most, bankruptcy proceedings in the U.S., but it provides additional tools for debtors as well. Most importantly, 11 U.S.C. § 1108 empowers the trustee to operate the debtor’s business. In chapter 11, unless a separate trustee is appointed for cause, the debtor, as debtor in possession, acts as trustee of the business.

Chapter 11 affords the debtor in possession a number of mechanisms to restructure its business. A debtor in possession can acquire financing and loans on favorable terms by giving new lenders first priority on the business’s earnings. The court may also permit the debtor in possession to reject and cancel contracts. Debtors are also protected from other litigation against the business through the imposition of an automatic stay. While the automatic stay is in place, creditors are stayed from any collection attempts or activities against the debtor in possession, and most litigation against the debtor is stayed, or put on hold, until it can be resolved in bankruptcy court, or resumed in its original venue. An example of proceedings that are not necessarily stayed automatically are family law proceedings against a spouse or parent. Further, creditors may file with the court seeking relief from the automatic stay.

If the business is insolvent, its debts exceed its assets and the business is unable to pay debts as they come due, the bankruptcy restructuring may result in the company’s owners being left with nothing; instead, the owners’ rights and interests are ended and the company’s creditors are left with ownership of the newly reorganized company.

Chapter 11 plan

Chapter 11 usually results in reorganization of the debtor’s business or personal assets and debts, but can also be used as a mechanism for liquidation. Debtors may “emerge” from a chapter 11 bankruptcy within a few months or within several years, depending on the size and complexity of the bankruptcy. The Bankruptcy Code accomplishes this objective through the use of a bankruptcy plan. The debtor in possession typically has the first opportunity to propose a plan during the period of exclusivity. This period allows the debtor 120 days from the date of filing for chapter 11, to propose a plan of reorganization before any other party in interest may propose a plan. If the debtor proposes a plan within the 120 day exclusivity period, a 180 day exclusivity period from the date of filing for chapter 11 is granted in order to allow the debtor to gain confirmation of the proposed plan. With some exceptions, the plan may be proposed by any party in interest.  Interested creditors then vote for a plan.

Confirmation

If the judge approves the reorganization plan and if the creditors all agree the plan can be confirmed. If at least one class of creditors votes against the plan and thus objects, the plan may nonetheless be confirmed if the requirements of “cramdown” are met. In order to be confirmed over their objection the plan must not discriminate against that class of creditors, and the plan must be found fair and equitable to that class.

Upon its confirmation, the plan becomes binding and identifies the treatment of debts and operations of the business for the duration of the plan.

If a plan cannot be confirmed, the court may either convert the case to a liquidation under chapter 7, or, if in the best interests of the creditors and the estate, the case may be dismissed resulting in a return to the status quo before bankruptcy. If the case is dismissed, creditors will look to non-bankruptcy law in order to satisfy their claims.

Creditors, shareholders, and any other parties who maintain an interest may elect to support or oppose any actions that require the approval of the bankruptcy court.  Before proceeding, the court will consider input given by creditors and other parties.  However, formal votes by creditors and equity holders are only taken in connection with proposed Chapter 11 plans. 

In most cases, any unsecured creditors will participate in the Chapter 11 case via an appointed committee tasked to represent their interests. This committee can, in turn, retain attorneys and additional professionals to assist it at the cost of the debtor.  Shareholders and other committees can also take an active role in some cases. 

Confirmation of the Chapter 11 Plan

Confirmation of a proposed plan rests with the bankruptcy court.  In order to confirm a Chapter 11 plan, the court must find that the plan meets certain requirements, including:

Good Faith. The plan must be found to have been proposed in good faith, concurrent with and abiding by applicable law. 

Feasibility.  The bankruptcy court must find that the plan is indeed pragmatic and thus likely to succeed.  The debtor must demonstrate that it will be able to raise sufficient revenue over the duration of the plan in order to settle its expenses, including payments to creditors. 

Best Interests of Creditors.  In order for a plan to be confirmed, it must be in the best interest of its creditors.  Under Chapter 11, a “best interests” test maintains that creditors must receive at least as much under the proposed plan as they would if the case were converted to Chapter 7.  While some cases require the debtor to pay in full in order to meet the “best interests”, generally, these requirements can be met by paying only a fraction of the total amount owed. 

Fair and Equitable.  Chapter 11 plans must be deemed “fair and equitable”, so that:

  • Secured creditors must be paid at least the value of their collateral.  Creditors are to be considered secured if they possess lien against personal property, i.e. inventory or equipment, or have mortgages against real property. 
  • The debtor’s owners are unable to retain anything due to their equity interests unless their obligations are paid in full, either upon plan confirmation or over time.  In exchange for new money devoted to paying reorganization expenses, the court can may allow equity holders to retain ownership interests in the debtor.  Otherwise, equity holders forfeit all rights of ownership upon plan confirmation. 

Certain confirmation requirements, such as the fair and equitable test, are only applicable if the affected creditors choose to vote against the proposed reorganization plan. 

Automatic stay

Like other forms of bankruptcy, petitions filed under chapter 11 invoke the automatic stay of § 362. The automatic stay requires all creditors to cease collection attempts, and makes many post-petition debt collection efforts void or voidable. Under some circumstances, some creditors, otherwise the United States Trustee can request for the court converting the case into a liquidation under chapter 7, or appointing a trustee to manage the debtor’s business. The court will grant a motion to convert to chapter 7 or appoint a trustee if either of these actions is in the best interest of all creditors. Sometimes a company will liquidate under chapter 11, in which the pre-existing management may be able to help get a higher price for divisions or other assets than a chapter 7 liquidation would be likely to achieve. Appointment of a trustee requires some wrongdoing or gross mismanagement on the part of existing management and is relatively rare.

Executory contracts

Some contracts, known as executory contracts, may be rejected if canceling them would be financially favorable to the company and its creditors. Such contracts may include labor union contracts, supply or operating contracts (with both vendors and customers), and real estate leases. The standard feature of executory contracts is that each party to the contract has duties remaining under the contract. In the event of a rejection, the remaining parties to the contract become unsecured creditors of the debtor.

Priority Claims

Chapter 11 follows the same priority scheme as other bankruptcy chapters. The priority structure is defined primarily by § 507 of the Bankruptcy Code (11 U.S.C. § 507.)

As a general rule, administrative expenses (the actual, necessary expenses of preserving the bankruptcy estate, including expenses such as employee wages, and the cost of litigating the chapter 11 case)are paid first. Secured creditors—creditors who have a security interest, or collateral, in the debtor’s property—will be paid before unsecured creditors. Unsecured creditors’ claims are prioritized by § 507. For instance the claims of suppliers of products or employees of a company may be paid before other unsecured creditors are paid. Each priority level must be paid in full before the next lowest priority level may receive payment.

Rationale

In enacting Chapter 11 of the Bankruptcy code, Congress concluded that it is sometimes the case that the value of a business is greater if sold or reorganized as a going concernthan the value of the sum of its parts if the business’s assets were to be sold off individually. It follows that it may be more economically efficient to allow a troubled company to continue running, cancel some of its debts, and give ownership of the newly reorganized company to the creditors whose debts were canceled. Alternatively, the business can be sold as a going concern with the net proceeds of the sale distributed to creditors ratably in accordance with statutory priorities. In this way, jobs may be saved, the (previously mismanaged) engine of profitability which is the business is maintained (presumably under better management) rather than being dismantled, and, as a proponent of a chapter 11 plan is required to demonstrate as a precursor to plan confirmation, the business’s creditors end up with more money than they would in a Chapter 7 liquidation.

How long does Chapter 11 take?

There are no explicit timelines for cases filed under Chapter 11.  While some may last only a few months, generally the process takes at minimum six months up to two years for Chapter 11 reorganization to be settled. 

“Ordinary Course of Business”

The debtor will generally continue to operate in a manner similar to the ways in which it did prior to filing for Chapter 11, i.e. “business as usual”, known as operating as a “debtor in possession” (or “DIP”).  If the bankruptcy court finds that the Debtor can no longer manage business operations adequately, it has the authority to appoint a trustee to assume all aspects of operations for the business.  Reasons for this court ruling include fraud, incompetence, dishonesty, and poor handling of the debtor’s affairs.

Bankruptcy Court Has Authority Over Decisions Outside the Ordinary Court of Business

Although the DIP maintains operations upon filing Chapter 11, it nonetheless relinquishes any control over decisions that fall outside the ordinary course of business.  For example, the bankruptcy judge must approve:

  • sales of assets, including land or other property or other items not sold in the ordinary course of business
  • deciding to continue or breach a lease
  • procure financing, such as new equity sales or mortgages
  • opening, closing, or expanding business operations
  • modifying or entering into new contracts and agreements, and
  • the payment of attorneys and other administrative expenses

Chapter 11 Reorganization Plans

It is common that the debtor maintain the exclusive right to propose a restructuring plan for four months after it files Chapter 11.  This “exclusivity period” may be extended up to 18 months after the petition date by the court in the event the debtor illustrates good cause. The court also has the authority to shorten the exclusivity period as it sees fit. 

Upon expiration of the exclusivity period, the creditors’ committee can propose additional and competing plans of reorganization.  More often, however, those parties not satisfied by the debtor’s progress will move to either dismiss the case or convert to Chapter 7.

The Chapter 11 plan is effectively a contract between debtor and creditor, allowing the debtor to restructure its financial affairs in such a way as to enable it to more adequately operate and pay its obligations moving forward.  Generally, plans will outline some sort of downsizing of operations in order to unlock assets and reduce expenses.  “Liquidating Plans” may be proposed to allow for a total shutdown of operations and sale of remaining property. 

In rare instances, a Chapter 11 plan will offer full and instantaneous payment to all creditors.  Otherwise, it is within the creditors’ scope to vote on the Chapter 11 proposal.  Obligations not paid in full upon proposal confirmation are deemed “impaired claims”.  For a Chapter 11 plan to be approved by the court, at least one class of impaired claims must vote in favor of the plan.   

Chapter 11 Efficacy

10 to 15% of all Chapter 11 cases are reported to result in successful reorganizations.  Largely, cases are dismissed upon agreement of the parties or converted to Chapter 7 liquidations.  Such conversion or dismissal requires the approval of the bankruptcy court.  The court has the power to either dismiss or convert a Chapter 11 case for a number of reasons, including the debtor’s failure to demonstrate that it can reorganize successfully.   Having the right attorney guide you through the Chapter 11 process is an important part of any successful chapter 11. To speak with an experienced chapter 11 attorney, click here.

Bankruptcy law includes special provisions to expedite Chapter 11 cases that involve small business debtors and single-asset real estate.  To learn more, read on about Chapter 11 bankruptcy.