Nobody wants to contemplate bankruptcy. To many people, bankruptcy means liquidation and liquidation means the end of the business. Businesses file chapter 7 or 11 bankruptcy often as a last resort. What people fail to realize is that there are different types of bankruptcy. Depending on the type of bankruptcy you file, you will either liquidate or reorganize. Under Chapter 11 of the bankruptcy code, small businesses and mid-sized businesses need not close their doors and hand over their assets.
Chapter 11 is a form of business reorganization which allows a debtor to restructure its debt and at the same time continue to operate its business, subject to bankruptcy law and the bankruptcy court’s over site. Bankruptcy laws and courts can facilitate this process in various ways.
A debtor commences a Chapter 11 bankruptcy case by filing a petition with the bankruptcy court and paying a relatively modest administrative fee ($1,717). The petition typically includes the following things:
Within fifteen days after filing of the bankruptcy petition, the debtor must also file sworn schedules of its assets and liabilities, although this period may be extended for cause.
Once the petition is filed, the debtor’s board of directors (or other parties with analogous rights) and management remain in place and continue to operate the business. Under Chapter 11, no trustee is appointed, unless after notice and a hearing on a motion by party in interest, the bankruptcy court determines there is cause to appoint a trustee. This is rare, however. In lieu of appointing a trustee, the bankruptcy court appoints the directors and management of the business as the debtor in possession (DIP).
The DIP generally has the same rights and obligations as a bankruptcy trustee. Some of the powers of the trustee/DIP include the following:
In addition to the DIP, the bankruptcy court may also create an official committee of unsecured creditors that is comprised of the debtor’s creditors who have the largest unsecured claims who are willing to serve. The committee is appointed to represent the interest of the unsecured creditors as a group. Unofficial committees of creditors, including committees of secured creditors, bondholders, employees and lessors, may also be formed. As a practical matter, official creditor committees are not formed in all Chapter 11 cases. In most Chapter 11 cases, especially those involving small firms, there may be only a handful of creditors, or one significant creditor and a few unsecured creditors with relatively small claims. In any event, there is often insufficient creditor interest to form an official committee.
Whenever a debtor files bankruptcy case—under any chapter—an estate is created consisting of all the debtor’s interests in property, wherever located, legal and equitable, tangible and intangible. Additionally, all actions aimed at enforcing or collecting a pre-bankruptcy claim are statutorily enjoined by the bankruptcy code’s automatic stay, subject to limited exceptions. By staying any prepetition actions, the bankruptcy court facilitates the debtor’s reorganization and promotes the equitable payment of creditors. Without the automatic stay, creditors could seize assets in an effort to maximize their recovery or effectively undermine any effort by the debtor to reorganize their business.
Although the Bankruptcy Court has jurisdiction of the Chapter 11 debtor and its assets, the Court does not operate or usually even interfere with the everyday operations of the debtor’s business. Instead, the DIP is allowed to operate the business in the ordinary course of business. If anything is outside the ordinary course business, the DIP must file a motion with bankruptcy court on notice to parties in interest seeking authority to enter into the proposed transaction, and, if there is no objection to such motion by a party in interest, obtaining the court’s permission, after a hearing, to take the action. If there are no objections, courts will generally approve the debtor’s transaction if the proposed transaction is fair and equitable and is supported by sound business reasons.
The most common limitation stems from a secured creditor’s right to demand adequate protection in connection with the value of their collateral. A secured creditor may be able to seek relief from the automatic stay if it can establish that their interest in the collateral is not adequately protected from diminution in value. Typically, a debtor can prove that a secured creditor is adequately protect by showing that the secured creditor is oversecured (that the value of the collateral exceeds the value of the collateral), or by the fact that the debtor has offered to cross collateralize its loan with the secured creditor by offering another piece of unencumbered property to secure the loan.
Additionally, the debtor may face some challenges in operating their business if they want to use “cash collateral.” Cash collateral is cash and equivalents collected and held for the benefit of creditors during Chapter 11 bankruptcy proceedings. Cash and cash equivalents include negotiable instruments, documents of title, securities, and deposit accounts. Cash collateral receives extra protection under the bankruptcy code because it so easy to liquidate. Under the code, a debtor cannot use cash collateral unless the secured creditor consents or is provided with adequate protection against the diminishment of cash.
Finally, unless there is some property that is unencumbered by a senior lien, a debtor may struggle to obtain necessary postpetition financing from creditors. However, the bankruptcy court can incentivize certain creditors to extend postpetition financing through various provisions even though the debtor may lack unencumbered property. In furtherance of this goal, the court may, in certain circumstances, permit lenders who provide such credit to do the following things:
In bankruptcy court, creditors, secured or unsecured, are allowed to assert claims against the bankruptcy estate to get paid. In order to do so, they must file a proof of claim within a statutory time period. The bankruptcy code has an expansive definition of a claim. A claim is a right to repayment, whether or not such right is reduced to judgement, liquidated, unliquidated, fixed, contingent, matured, unmatured, disputed, undisputed, legal, equitable, secured or unsecured. Certain provisions of the bankruptcy code made limit or disallow certain claims. For example, unsecured claims for interest accrued during the bankruptcy case are typically precluded.
In addition to filing the petition and schedules, the debtor must also file also file a disclosure statement and plan of reorganization. The Disclosure Statement provides creditors and other parties in interest a summary of the company’s history, financial standing, and operations, and the Plan of Reorganization outlines how the company intends to reorganize its business debt. In order for the Debtor Chapter 11 bankruptcy to continue, the Disclosure Statement and Plan of Reorganization must be approved by the bankruptcy court and a certain number of creditors must “accept,” or vote in favor of the proposed Plan of Reorganization.
The bankruptcy code generally provides that the confirmation of a plan discharges the debtor from any debt that arose before the date of confirmation.