Business 101: A Basic Guide to Chapter 11 Bankruptcy

Whenever a recession takes place, you often hear the term “Chapter 11 bankruptcy” being thrown around a lot. This makes sense, considering Chapter 11 bankruptcy is basically meant to help struggling companies restructure their finances and maximize the return to their owners and creditors. In 2010 alone, thousands of businesses filed for Chapter 11 bankruptcy in the United States.

But what exactly is Chapter 11 bankruptcy? And how does it work? And should your business consider filing for it?

Continue reading and we’ll walk you through everything you need to know!

How a Chapter 11 Case Starts and Who Can Be a Chapter 11 Debtor

A Chapter 11 case starts by filing a petition in bankruptcy court. These kinds of cases are usually voluntary. When it’s a voluntary Chapter 11 case, the debtor is the one who takes the initiative and petitions for bankruptcy relief.

Sometimes, however, the creditors will join together and petition for an involuntary Chapter 11 bankruptcy against the defaulting debtor.

Many debtors tend to file Chapter 11 bankruptcy at the location of their primary place of business. Business debtors can also file for Chapter 11 where they’re “domiciled.” This is where they’re considered to be incorporated.

For example, a business might file bankruptcy in Delaware if that’s where they’re incorporated, as opposed to the state where they’re actually headquartered.

These kinds of cases tend to be filed by limited liability companies, partnerships, and corporations. If an individual has too much income or debt to qualify under Chapters 13 and 7, then they can file under Chapter 11. However, when possible, the majority of individual debtors tend to file under Chapter 13 or 7 in order to avoid the risk, cost, and time involved with Chapter 11 bankruptcy.

In 2010, more than 1.5 million Americans filed for bankruptcy under Chapter 13 and 7. That’s significantly higher than individuals who filed for Chapter 11 bankruptcy.

What Happens Before a Chapter 11 Plan Is Proposed

There’s no limit on how long a Chapter 11 bankruptcy can take. Some cases can be completed in just a couple of months. However, it usually takes between six months and two years for a Chapter 11 case to come to a close.

Debtor Continues With Business Operations

In the majority of Chapter 11 bankruptcies, there is no trustee appointed. Instead, business is run as usual by the debtor under the title of “debtor in possession” (aka “DIP”).

A trustee can be appointed by the bankruptcy court to take over the business from the debtor if there is a sufficient cause. These sufficient causes can include incompetence, dishonesty, fraud, and gross mismanagement of the affairs of the debtor.

Bankruptcy Court Has Control Over Major Decisions

While business is continued as usual by the debtor after he files for Chapter 11, the debtor loses control over major decisions to the bankruptcy court. The bankruptcy court, among other things, must approve:

  • the payment of expenses and fees to – and retention of – any bankruptcy attorney or other professional
  • modifying or entering into licensing, vendor, union, and other agreements and contracts
  • expanding or shutting down business operations
  • mortgage or other secured financing arrangements where the debtor is able to borrow money after the case is filed
  • breaking or entering into a lease of personal or real property
  • any sale of assets, such as real property

It should also be pointed out that shareholders, creditors, and other parties of interest may oppose or support actions that require bankruptcy court approval. The bankruptcy court will take into account the input from creditors and other parties when they decide how to proceed. However, formal votes by equity holders and creditors are only taken in connection with proposed Chapter 11 plans.

Unsecured creditors tend to participate in Chapter 11 cases via a committee that’s appointed to represent their interests. This committee representing the unsecured creditors can retain attorneys and other professionals in order to help it at the expense of the debtor. In some instances, equity security and other committees take on an active role.

Chapter 11 Reorganization Plans

Usually, the debtor has the exclusive right for four months after they file for Chapter 11 to propose a reorganization plan. Once they show good cause, the court can extend the debtor’s “exclusivity period” to file a Chapter 11 plan to up to eighteen months after the date of the petition.

After the exclusivity period has ended, the creditors’ committee or other parties can suggest a competing reorganization plan. Competing plans are fairly uncommon when it comes to Chapter 11 bankruptcy cases.

Sometimes, the creditors or other parties aren’t satisfied with the debtor’s progress. When this happens, they’ll usually move to convert the case to Chapter 7 or simply dismiss it.

A debtor is able to reorganize or restructure their financial affairs with a Chapter 11 plan. This kind of plan is essentially a contract between the debtor and their creditors. The plan goes over how they’ll operate and pay for their future obligations.

Many plans provide for at least some downsizing of the operations of the debtor. This is in order to free up assets and reduce expenses.

In some instances, “liquidating plans” are suggested. This is in order to provide for a complete shutdown of the debtor’s operations. It’s also to provide for the orderly sale of the debtor’s remaining property.

What can sometimes happen is that a Chapter 11 will provide for immediate and full payment of all of the creditors. Otherwise, the creditors will be entitled to vote on whether they accept the proposed bankruptcy plan.

At least one class of  “impaired” claims needs to vote in favor of a plan. Otherwise, it can’t be approved by the bankruptcy court. An “impaired” claim is an obligation that won’t be paid in full upon confirmation of the plan, or when originally due.

Confirmation of the Chapter 11 Plan

When a proposed plan is approved, it’s said to be “confirmed.” Ultimately, the confirmation of a proposed plan will rest with the bankruptcy court.

In order to confirm a Chapter 11 plan, the bankruptcy court needs to find that it meets certain requirements. Let’s look at some of those requirements below.

Feasibility

The bankruptcy court needs to find that the proposed Chapter 11 plan is feasible. In other words, it needs to have a likely chance of success.

The debtor has to prove to the bankruptcy court that it will be able to raise sufficient revenues over the plan term. This is in order to cover the debtor’s expenses, including payments to its creditors.

Good Faith

The court needs to find that the plan has been proposed in good faith. It could not have been proposed by any means that are illegal under applicable law.

Best Interests of Creditors

In order for a proposed plan to get confirmed, it has to be in the best interests of the creditors. When it comes to Chapter 11 bankruptcy, the “best interests” test requires that creditors get at least as much under a proposed plan as they would if the debtor’s case were converted to a Chapter 7 liquidation.

In some instances, the “best interests” test requires that the debtor pay all of its creditors in full. However, the majority of Chapter 11 debtors are financially underwater. They can meet the “best interests” test only by paying the creditors a fraction of what they actually owe.

Fair and Equitable

The proposed plan also has to be fair and equitable. This means a few things.

First, secured creditors have to be paid. They have to at least be paid the value of the collateral.

If a creditor has a lien against personal property or a mortgage against real property then they’re considered to be secured.

Also, the debtor’s owners aren’t able to retain anything on account of their equity interests unless all obligations are paid in full. This needs to happen either over time with interest or immediately after the proposed plan is confirmed.

The bankruptcy court can let equity holders keep their ownership interests in the debtor in exchange for “new money.” This new money is to be contributed to pay for reorganization costs. Otherwise, equity holders will lose all of their rights to ownership after the plan is confirmed.

Some confirmation requirements, like the fair and equitable test, only apply if the affected creditors vote against the proposed plan.

The Importance of Knowing About Chapter 11 Bankruptcy

While no one wants to end up in any kind of bankruptcy, it’s good to know that there are processes in place to make sure that debtors are protected. By knowing about how Chapter 11 bankruptcy works, you can make more educated and confident decisions about the future of your business.

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