A Guide to Chapter 11 of the Bankruptcy Code
This is guide to chapter 11 of the Bankruptcy Code. Chapter 11 is to where businesses (and, occasionally, wealthy individuals) turn when they can no longer pay their debts. The goal of chapter 11 is to reorganize the financial affairs of the debtor so that it can reemerge as a going concern.
IntroductionThe United States Bankruptcy Code is a federal statute that affords relief to individuals, businesses, and municipalities that are in financial distress. "Financial distress" generally refers to the uncomfortable position of owing more money that one has the means to repay.
Financial distress is often accompanied by frenzied creditor activity seeking, through various remedies, immediate repayment of all or a part of amounts owed. The embattled target of this creditor activity (also known as the "debtor") often will have no other choice but to manage the attendant disruption by invocation of the protections available under the Bankruptcy Code.
Bankruptcy relief may be sought under chapters 7, 9, 11, 12, 13 or 15 of the Bankruptcy Code. Chapters 7 and 11 are available to individuals and businesses, chapter 9 is available to municipalities only, chapter 12 may be invoked by "family farmers," and chapter 13 is open to individuals with regular income. A chapter 15 case may only be commenced by a "foreign representatives" in furtherance of his or her duties under foreign (non-US) insolvency laws.
This article's focus is chapter 11 of the Bankruptcy Code for business (non-individual) debtors. My intent is to highlight the key principles of chapter 11 without getting too deep "into the weeds" or burdening the reader with numerous exceptions, nuances and complexities that are not applicable in many cases.
A chapter 11 bankruptcy case enables a business to reorganize its business and financial affairs, or liquidate, while protected against virtually all creditor enforcement action. The business seeking chapter 11 protection may be a sole proprietorship, a corporation, a limited liability company, or a partnership.
Commencement of a Chapter 11 CaseA business enterprise is eligible to be a debtor and therefore file for bankruptcy protection if it has a domicile, place of business, or property in the United States.
A bankruptcy case is commenced by the filing of a petition, either voluntarily, through the debtor's filing of a voluntary petition with a bankruptcy court, or involuntarily by petitioning creditors. The filing of a voluntary petition results automatically in an order for relief. Upon the filing, an "estate" is created comprised of all of the debtor's legal and equitable interests in property. Contrary to the expectation of many, there is no statutory requirement that the debtor allege or prove insolvency to commence a chapter 11 case.
Venue of a Bankruptcy CaseIn general, venue of a bankruptcy is proper where a corporate debtor is domiciled (i.e., the state of incorporation), or has a principal place of business or principal assets in the United States for the 180-day period preceding the filing of the bankruptcy petition.
The Automatic StayThe filing of a chapter 11 case immediately and automatically stays (that is, enjoins) all foreclosures, collection actions, civil litigation, and other creditor actions of any kind against the debtor or the debtor's property. This so-called "automatic stay," which arises by operation of law and requires no judicial action, also acts as a temporary moratorium against the payment of many of the debtor's debts.
The scope of the automatic stay is extremely broad -- it applies to virtually every type of action, whether formal or informal, against a debtor or property of the estate. The stay is designed to provide a debtor with a breathing spell from its creditors and immediate relief from the financial pressures that necessitated the bankruptcy filing. As a result, an entity that files a chapter 11 petition is given the opportunity to address its business problems and formulate a plan of reorganization to satisfy the claims of its creditors.
The automatic stay is not permanent and can be modified by order of the bankruptcy court for cause, after notice and a hearing, upon the motion of any party-in-interest.
There are several exceptions to the automatic stay. For example, criminal actions, certain notices, governmental actions that are not pecuniary in nature, actions against non-debtor parties (including subsidiaries who have guaranteed debtor's obligations, but who have not commenced their own chapter 11 cases), draws upon letters of credit and other specified types of proceedings may go forward notwithstanding the existence of the stay. Most environmental remediation actions are not stayed with respect to properties maintained or operated by the debtor. Also excluded from the automatic stay is the right of swap participants, commodity brokers and forward contract merchants to cause the liquidation, acceleration, termination and setoff of certain swap, commodity and forward contracts.
The Status, Rights and Duties of Debtors-in-PossessionUpon the filing of a voluntary petition for reorganization, the filing entity will become a "debtor-in-possession." A debtor-in-possession is, in many respects, considered a separate legal entity from the pre-petition business entity. Pursuant to the Bankruptcy Code, a debtor-in-possession will remain in possession of its property and, subject to certain limitations described below, is authorized to operate and manage its business. Thus, current management would continue to run the business during a chapter 11 case and could exercise its usual judgment in making normal business decisions. This includes making day-to-day decisions with respect to non-debtor subsidiaries.
A debtor-in-possession does not, however, have unlimited discretion in the operation and management of its business. First, certain transactions such as retaining and compensating professionals and compromising lawsuits or other controversies require bankruptcy court approval. Second, a debtor's ability to use cash that is subject to the claim of a secured creditor is limited. Finally, every transaction "out of the ordinary course" of a debtor's business, such as the sale of significant assets or obtaining credit or a priority basis, must be authorized by the bankruptcy court before the transaction proceeds.
Funding the Administration of the Bankruptcy CaseThere are three principal means for a debtor to fund its post-petition operations: (a) through the debtor's own unencumbered cash and cash flow (including sale proceeds) from unencumbered assets; (b) where the debtor's cash is encumbered by security interests of pre-petition lenders, through consent by the secured lenders or by obtaining bankruptcy court approval of the debtor's use of "cash collateral," pursuant to section 363(c)(2) of the Bankruptcy Code; or (c) through debtor-in-possession financing on a secured or unsecured basis, which entails obtaining new credit from either a pre-petition lender or a new lender, pursuant to section 364 of the Bankruptcy Code.
A debtor may use, sell, or lease property (other than cash collateral) in the ordinary course of its business during the chapter 11 case unless the bankruptcy court rules otherwise. The debtor may only use "cash collateral" (that is cash in which the debtor and another party have an interest) if the other party consents or the court approves such use after notice and a hearing. A debtor must seek prior court approval to use, sell or lease property outside the ordinary course of the debtor's business.
After the commencement of a chapter 11 case, without prior approval of the bankruptcy court, a debtor is prohibited from making any payment or rendering performance on account of unsecured debts, claims or other obligations which arose prior to the commencement of the case. The vehicle for satisfying such claims is usually the plan of reorganization (discussed below).
It is nevertheless possible to obtain bankruptcy court permission for paying certain pre-petition claims during the bankruptcy. Courts have frequently granted such relief under the "necessity of payment" doctrine. Unlike the treatment of unsecured creditors, payments to secured creditors during the course of the case will likely be governed by bankruptcy court orders relating to collateral and/or borrowing.
Parties-in-Interest in a Chapter 11 CaseIn addition to the debtor-in-possession, numerous additional parties are generally active in a chapter 11 case.
The United States Trustee
The Office of the United States Trustee, an arm of the Department of Justice, is responsible for supervising the administration of a chapter 11 case. The United States Trustee is also charged with the responsibility of establishing certain reporting and disclosure requirements.
One or more representative committees may be appointed by the United States Trustee in a chapter 11 case. Generally, the official committee of unsecured creditors is comprised of the creditors (who agree to serve) holding the seven largest unsecured claims against the debtor. Additional creditors' committees and/or committees catering to specially situated groups, such as bondholders, trade creditors, retirees, or equity security holders may also be appointed in certain cases in the discretion of the United States Trustee.
An official committee is a party-in-interest and may appear and be heard with respect to any issue in a chapter 11 case. Committees, and the professionals they employ, monitor and scrutinize the activities and operations of the debtor by reviewing the reports filed by the debtor with the court and the United States Trustee, obtaining access to the debtor's books, records and other internal information, employing accountants to review such information and appearing and being heard with respect to all matters for which bankruptcy court approval is required.
The fees, costs and expenses incurred by professionals employed by official committees, and certain expenses of the committees' members, are paid for by the debtor.
Secured creditors, those creditors whose claims are collateralized by property of the debtor, may also have a significant involvement in the administration of a chapter 11 case. Generally, if a creditor is fully or over-secured, namely, if it has collateral of a value in excess of its claims, the fees, costs and expenses of the creditor's professionals are borne by the debtor to the extent set forth in the loan documents, and interest will continue to accrue on the secured creditor's claim. With respect to unsecured claims, such as trade debt, interest, fees and other charges stop accruing immediately upon the commencement of a chapter 11 case.
Parties-in-interest in a Chapter 11 Case (continued)Trustees
An operating trustee, as distinguished from the United States Trustee, may, in unusual circumstances, be appointed in a chapter 11 case. There is a presumption under the Bankruptcy Code that a debtor will remain in possession (and no trustee will be appointed) unless there is a showing of "cause, including fraud, dishonesty, incompetence or gross mismanagement" or "if such appointment [of a trustee] is in the interests of creditors, any equity security holders, and other interests of the estate."
If a bankruptcy court makes such findings, a trustee will be appointed, the debtor-in-possession will be terminated and the trustee will assume control of the debtor's property and the operation and management of the debtor's business. The appointment of a trustee is considered an extraordinary remedy and is rarely granted by a bankruptcy court in the early stages of a chapter 11 case.
Generally, in large chapter 11 cases, the bankruptcy court must appoint an "examiner" upon the request of a creditor or other party-in-interest. An examiner's powers are usually limited to conducting investigations of all aspects of a debtor's business and financial affairs and filing a report with respect thereto, but the bankruptcy court has the discretion to tailor the examiner's powers to the requirements of a given case. If an examiner is appointed, the debtor remains in possession of its property and continues to operate its business.
Unexpired Leases and Executory ContractsUnder the Bankruptcy Code, a debtor may assume (adopt) or reject (disavow) executory contracts or unexpired leases. The Bankruptcy Code also renders unenforceable any provision purportedly terminating a lease or executory contract by virtue of a debtor's financial condition or the commencement of its bankruptcy case.
A lease or contract is assumed with all of its benefits and burdens. Thus, changes or modifications of an executory contract or unexpired lease cannot be made without the consent of all parties to the contract or lease. A debtor will ordinarily assume a contract if the continuation of the contract confers some benefit on the estate.
A unique benefit of chapter 11 is the ability to assign most leases and contracts, on a non-recourse basis, to third parties notwithstanding the existence of anti-assignment provisions. The effect of such assignment would be to release the debtor/assignor from further liability and transfer all past and future obligations to the assignee. Indeed, numerous reorganizations have been funded by the debtor's ability to assign below-market leases for value. Thus, to the extent that assignment of leases is critical to the sale of certain assets, a debtor will be able to accomplish this result in chapter 11.
In the context of a chapter 11 case, a debtor will also have the extraordinary power to reject a lease or contract if it is burdensome to the estate and, in the debtor's business judgment, it is appropriate to do so. If a lease or contract is rejected, it is deemed to be a court-authorized breach of the contract giving rise to a pre-petition general unsecured claim for damages. The damage claims arising from the rejection of real estate leases and employment contracts are limited by certain provisions of the Bankruptcy Code.
Finally, under certain circumstances, collective bargaining agreements can be rejected. However, prior to a bankruptcy court authorizing such rejection, there are specific and detailed procedures that the debtors will be required to follow and there must be substantial negotiations with the representative of the employees.
Bankruptcy Related LitigationThe filing of a bankruptcy case is often followed by the commencement of a variety of litigation, some of which is unique to the bankruptcy arena. The most common forms of actions brought are claims of preference and fraudulent conveyance.
Preference claims and fraudulent conveyance claims are also known as "avoidance actions" because in bringing such claims, the debtor's estate seeks to avoid or unwind a transfer that was made to or for the benefit of a non-debtor party prior to the commencement of a chapter 11 case.
A preferential transfer is a transfer made by the debtor on account of an antecedent debt while the debtor was insolvent which enables the transferee/creditor to receive more than it would receive in a chapter 7 liquidation of the debtor. The creditor has numerous defenses to a preference action available to it, including that the transfer was made in the ordinary course of business on ordinary terms and that the creditor provided new value to the debtor in exchange for the transfer. The look-back period for a preference is the 90 days immediately preceding the petition date, but is enlarged to one year for transfers to or for the benefit of "insiders."
A fraudulent conveyance is a transfer of property by the debtor for which the debtor received less than fair consideration at a time when the debtor was insolvent, unable to pay its debts as they matured or left with unreasonably small capital to conduct its business. A showing of insolvency is not required, however, when the property transferred is conveyed with the intention of hindering, delaying or defrauding creditors or where the estate is seeking recovery of certain transfers to insiders. The look-back period for fraudulent conveyance actions is two years under the Bankruptcy Code but can be extended by virtue of any applicable state's statute of limitations under fraudulent conveyance laws. New York, for example, has a six-year limitation on the bringing of such actions.
The Plan of ReorganizationIntroduction
The ultimate goal of a Chapter 11 case is a court-approved plan of reorganization or liquidation that is binding on all creditors and equity security holders, whether or not these stakeholders have voted to accept the plan. Reorganization may take the form of partial debt forgiveness, the extension of debt maturities, reduction in the amount and delay in the timing of installment payments, the conversion of debt into equity and the modification of contracts and leases. If reorganized, creditors' existing entitlements are extinguished and creditors may only collect on their claims to the extent provided in the plan. If the business reorganizes, it may continue to operate as before, or may function in some revised format.
Disclosure, Solicitation and Acceptance
Creditors' claims and equity security holders' interests are classified by type. Only classes of claims and interests that are "impaired" by the plan may vote to accept or reject the plan. A claim or interest is "impaired" if the legal or equitable rights of the holder of such claim or interest are altered. The votes of impaired creditors and equity security holders are solicited pursuant to a disclosure statement (somewhat analogous to a prospectus), approved by the bankruptcy court. In order to approve the disclosure statement, the bankruptcy court must find that it contains "adequate information" which would allow a reasonable creditor or other party-in-interest to make a fully informed judgment as to whether to vote for or against the plan of reorganization.
In making this determination, the court must consider "the complexity of the case, the benefit of additional information to creditors and other parties in interest, and the cost of providing additional information." After such a finding is made, the plan and disclosure statement are disseminated to creditors and equity security holders for a vote.
In order to confirm a plan of reorganization, of those creditors who vote, more than one-half in number and two-thirds in amount of each impaired class of claims must vote in favor of a plan. Classes of equity interests must vote in favor of the plan by two-thirds in amount. If these levels of votes are attained, those voting against the plan are nonetheless bound by the terms thereof, provided they are to receive under the plan at least as much value as they would have received in liquidation of the debtor.
The Plan of Reorganization (continued)Confirmation Standards
The culmination of the chapter 11 process is the confirmation (i.e., bankruptcy court approval) of a plan of reorganization. Regardless of whether the plan is "prepackaged," "pre-negotiated," traditional, consensual or contested, it must satisfy certain common requirements to be confirmed. Section 1129 provides a list of such requirements, all of which must be satisfied prior to confirmation of any plan of reorganization.
Among the most significant of these tests are "best interests" and "feasibility." Under the best interests test, the bankruptcy court must find that creditors will receive at least as much under the plan as they would receive in a hypothetical liquidation. Under the feasibility test, the bankruptcy court must find that the confirmation of the plan is not likely to be followed by a liquidation or further reorganization of the debtor -- in other words, that the plan will work.
Even if one or more impaired classes reject the plan, it may still be confirmed, through the invocation of the cram-down power contained in section 1129(b) of the Bankruptcy Code, over the objection of the dissenting class(es). Pursuant to section 1129(b), a bankruptcy court may "cram down" a plan over the dissent of an impaired class or classes as long as the plan does not "discriminate unfairly" and is "fair and equitable" with respect to the dissenting class(es). Substantial litigation may ensue in the bankruptcy case when the debtor attempts to "cram down" the plan over the dissent of classes of creditors that have not voted to accept the plan.
The Plan of Reorganization (continued)Liquidation
Despite the best efforts of management to stabilize the debtor's operations, sometimes liquidation of all of the debtor's assets is the only reasonable alternative. As stated above, debtors with significant assets and complex operations will often liquidate under chapter 11 but could do so under chapter 7. There are many reasons why the management of a substantial business enterprise would rather not liquidate under chapter 7, some of which are mentioned below. A chapter 7 liquidation commences with the appointment of a trustee who typically marshals and sells all of the debtor's assets in the most expeditious manner possible. This may involve the maintenance of limited operations to allow sales of facilities or business segments as going concerns. This does not usually result in the greatest possible recoveries. Ordinarily, no creditors' committee is appointed in a chapter 7 case and the trustee is empowered to bring, on behalf of the estate, all of the typical litigation actions described in this memorandum.
Chapter 11 liquidations are usually favored for large corporations because of the flexibility to enhance liquidation recoveries by conducting a more orderly liquidation. In addition, corporations are not entitled to a discharge of their unsatisfied obligations as a result of the administration of a chapter 7 bankruptcy case. Chapter 11 may also be favored by corporations to keep their own management in place during the liquidation. Management is displaced by the trustee. The trustee is a fiduciary of the bankruptcy estate and creditors.
One important thing to keep in mind is that a chapter 7 trustee's compensation increases commensurately with the ultimate size of the estate and, assuming the estate has the necessary resources, the chapter 7 trustee has ample incentive to exhaust all avenues of recovery for the bankruptcy estate.
From a creditor's perspective, in some situations, a chapter 7 may be the most expedient and least costly way to liquidate a business enterprise that is "worth more dead than alive." That is, where the debtor's "liquidation value" is greater than its "going concern value."
ConclusionChapter 11 of the Bankruptcy Code is a powerful tool that, when skillfully employed, can promote (a) an efficient resolution of the many legal problems that arise when a business has lost its way because of too much debt; (b) equitable treatment of creditors, equity security holders and other parties in interest, and (c) a "fresh start" for the debtor that may pave the way for renewed prosperity.