What is Chapter 11, Anyway?
© 2010 Cohn Whitesell & Goldberg
What are the consequences of a Chapter 11 filing? What does
it mean to be a "debtor in possession"? If all of the
assets are covered by liens, how does the Chapter 11 debtor get
the cash to keep operating? How can the Chapter 11 debtor deal
with contracts-favorable and unfavorable? How can secured debt
be restructured under a Chapter 11 plan? How about unsecured
claims? What's a pre-packaged or pre-negotiated Chapter 11?
Chapter 11 allows a company to
remain in business while it addresses its financial problems.
Chapter 11 is based upon the economic premise that a business,
even though not currently able to meet its obligations, can often
be restructured so that creditors and stockholders would receive
more from future profits (or a sale of the restructured company)
than from a forced liquidation of assets by a bankruptcy trustee
under Chapter 7 of the Bankruptcy Code. Chapter 11 can also maintain
employment and other economic benefits for the community where
the debtor company operates. An ailing company will typically
consider Chapter 11 if its business, or some portion of it, is
likely to be worth substantially more as a going concern than
on the auction block. Chapter 11 can also be used as an orderly
way to liquidate a company's assets and wind up its affairs.
Commencement of Chapter 11 Reorganization
A Chapter 11 reorganization begins
when a company files a petition and various related documents
with the United States Bankruptcy Court. The immediate result
of the Chapter 11 petition is to impose the "automatic stay."
The automatic stay is the equivalent of a court order freezing
all debts of the company and preventing creditors from demanding
payment, bringing lawsuits, seizing assets or engaging in any
other kind of collection activity. The purpose of the automatic
stay is to preserve the status quo while the company and its
creditors negotiate the terms upon which pre-Chapter 11 debts
will be settled. The proposed terms of settlement will be set
forth in a document known as the "plan of reorganization,"
or, more simply, the "plan." A successful Chapter 11
reorganization culminates in the "confirmation" (i.e.,
approval) of the plan by the bankruptcy court.
Parties that play a significant role in a Chapter 11 case include
the debtor, secured creditors, the creditors' committee appointed
to represent the interests of general unsecured creditors, the
United States Trustee (who appoints the creditors' committee
and monitors the reorganization process for compliance with the
administrative requirements of the Bankruptcy Code) and the bankruptcy
judge, who by determining legal issues, establishing procedures,
and signaling to the debtor and other parties the court's view
of whether proposed courses of action are desirable or disfavored
- can greatly influence the tenor and outcome of a Chapter 11
case.
Creditors' Committee
Soon after the filing of the
Chapter 11 petition, a creditors' committee is formed if there
is sufficient interest among unsecured creditors in having one.
The committee ordinarily consists of representatives of seven
largest unsecured creditors who are willing to serve. (For information
about what to expect if you serve on a creditors' committee,
click here.) The committee is charged
with representing the interests of all unsecured creditors. The
committee almost always engages counsel and will often hire an
accountant and/or financial advisor as well. These professional
persons are paid from assets of the Chapter 11 company. The committee's
most important function is to negotiate, on behalf of all unsecured
creditors, the treatment of their claims under the plan. To this
end, the committee will often monitor quite closely the business
operations of the Chapter 11 company, and is entitled to be heard
on all matters that come before the bankruptcy court.
Operation of the Business
During Chapter 11, the company's
existing management continues to operate the company as a "debtor-in-possession."
However, the company must obtain court approval for any transaction
out of the ordinary course of its business (such as sale of a
major asset), after notice to the creditors' committee and other
interested parties. This process shields managers and directors
from liability for decisions that are "pre-cleared"
by the bankruptcy court after full disclosure.
Creditors may ask the court to oust the company's management
if there has been fraud, dishonesty, incompetence or gross mismanagement,
or if it would be in the best interest of creditors, for example,
where the owners are deadlocked or have a conflict of interest
with the company. If such a request were granted by the bankruptcy
court, a trustee would take over operation of the business. Appointment
of a Chapter 11 trustee is fairly unusual.
If creditors lose confidence in the company's ability to reorganize
successfully, they may move to have the Chapter 11 case converted
to a liquidation under Chapter 7 of the Bankruptcy Code. The
bankruptcy court seldom grants this type of motion unless the
company is continuing to incur substantial operating losses and
is not making progress toward confirmation of a reorganization
plan.
Funding Operations During Chapter 11
A company that has filed a Chapter
11 petition will often face an immediate cash crunch. Suppliers
are typically reluctant to ship on credit, even though the bankruptcy
law provides for payment of obligations incurred by a debtor-in-possession
ahead of pre-bankruptcy unsecured claims. Where will the money
come from to pay C.O.D.? Accounts receivable and inventory have
typically been assigned to a bank creditor as collateral, with
proceeds to be used to repay loans upon default.
The bankruptcy law allows the Chapter 11 company to obtain emergency
relief from the court. The bankruptcy court may permit the company
to use proceeds from cash sales or collection of accounts receivable
for continuation of the business if the company can provide "adequate
protection" to the secured creditor against any deterioration
in its economic position. Typically, "adequate protection"
can be provided by putting up substitute collateral, such as
new accounts receivable or newly purchased inventory. Knowing
this, secured lenders will often agree, in advance, to finance
the Chapter 11 company on at least a provisional basis.
The bankruptcy law makes available an extraordinary level of
protection to postpetition lenders. A lien on all assets can
be provided at the stroke of the bankruptcy judge's pen, without
the need to file at the registry of deeds, the Secretary of State,
the Patent and Trademark Office, or anywhere else. A lender can
be provided with priority over pre-bankruptcy claims (including,
in some instances, secured claims) and also the right to be repaid
in full immediately on the effective date of any Chapter 11 plan
or at any prior date. The lender can even be granted "super-priority,"
which means priority over even postpetition claims. Because
of these protections, a worried lender will sometimes require
the company to file a Chapter 11 petition as a condition to further
extension of credit.
Secured Creditors
A secured creditor may seek relief from the automatic stay.
The two principal grounds on which such relief is granted are:
(1) if the creditor's collateral is declining in value, and the
company is not able to provide "adequate protection"
in the form of cash, a replacement lien or the like, or (2) if
the company has no equity in the collateral, and either has no
reasonable prospect of obtaining confirmation of a plan within
a reasonable time or has no genuine need for the collateral in
the reorganization effort.
Contracts and Other Assets
Firms having contracts with a
Chapter 11 debtor often wish to cancel them because of concern
that the debtor might shut down. This, of course, could become
a self-fulfilling fear. Therefore, the bankruptcy law generally
forbids cancellation by the non-debtor party just because of
the Chapter 11 petition or because of payment defaults occurring
before the petition. However, the Chapter 11 company is generally
required to pay rent and meet other kinds of contractual obligations
relating to the post-petition period.
If the terms of a particular contract (especially a real estate
lease) are advantageous, the Chapter 11 company will often have
the right, despite anything to the contrary contained in the
agreement, to assign the contract to a third party in exchange
for a cash payment. In the converse situation, where the company
wants to cancel a disadvantageous contract or lease, it may do
so with court approval. The non-debtor party can claim damages
for breach of contract, but usually this will be just one more
unsecured claim to be paid at a discount under the Chapter 11
plan. The ability to reject unfavorable contracts and leases,
and to perform or assign favorable ones despite contractual provisions
to the contrary, can be one of the most important benefits of
Chapter 11.
Another important benefit of Chapter 11 is the ability to sell
assets, with the bankruptcy court's permission, free and clear
of creditors' liens. Outside bankruptcy, in order to sell an
asset that is subject to a lien, a company will usually need
either to obtain the lienholder's approval or to pay off the
lien in full. In bankruptcy, however, the court may permit the
company to sell the asset free of the lien, with the lien to
attach to the proceeds instead. This procedure allows the Chapter
11 company and other parties, without jeopardizing an advantageous
sale, to challenge the amount claimed by the lienholder or to
argue that the lien holder has enough other collateral so that
the company should be permitted to use the sale proceeds.
Plan of Reorganization
Once the process of stabilizing
the company's operations and disposing of surplus assets is under
way, attention turns to negotiation of the Chapter 11 plan. Unless
otherwise ordered by the bankruptcy court (which would be highly
unusual), the Chapter 11 company has the exclusive right to propose
a plan during the first 120 days of the reorganization. The purpose
of this provision is to allow the company's management a fair
chance to propose a settlement with creditors. The "exclusive
period" for proposing a plan can be extended by the bankruptcy
court at the company's request. If the exclusive period expires,
then any creditor, committee or other interested party may propose
a plan.
The company will usually negotiate the terms of the plan with
the creditors' committee, representatives of the principal bank
lenders and lessors, and anyone else who will be particularly
important to the success of the reorganization (for example,
union officials). Two factors will generally determine the terms
of the settlement with creditors. One is the ability of the company
to generate cash over and above its operating expenses. The other
factor is the set of minimum standards for the treatment of each
type of claim contained in the bankruptcy law. These standards,
essentially a "bill of rights" for creditors, can be
summarized as follows:
1. Secured creditors are entitled to receive the full value of
their collateral. If a secured creditor's claim is greater than
the value of the collateral, the unsecured balance is usually
treated as a general unsecured claim (discussed below). The secured
portion of the claim need not be paid at once. However, if it
is paid over a period of time, the secured creditor has a right
to receive interest at a fair market rate and to keep its lien
on the collateral or to receive equivalent assurance of payment.
2. Unsecured claims are divided into two categories: "priority
claims" and "general unsecured claims." The principal
types of priority claims are obligations incurred since the filing
of the Chapter 11 petition, pre-bankruptcy wages and employee
benefits, and taxes. In general, priority claims must be paid
in full when the plan takes effect. The most important exception
is pre-bankruptcy taxes, which can be extended for as long as
six years if interest is paid.
3. There is almost limitless flexibility in dealing with general
unsecured claims. The company may propose one or any combination
of the following: immediate cash, a fixed payment schedule, a
payment schedule tied to profits or cash flow, or the issuance
of stock, warrants, bonds, notes or any other instrument. Creditors
protect their interests primarily through the exercise of two
rights.
First, almost any creditor has the right to object to confirmation
of a plan that leaves the creditor worse off than if the company
were liquidated under Chapter 7 of the Bankruptcy Code. Thus,
whatever the company offers its creditors under the plan must
have a present value at least equal to the liquidation value
of the company's assets (usually, but not always, auction value),
less the cost of liquidation and the amount owed to secured and
priority creditors.
Second, before the plan can be
confirmed by the bankruptcy court, creditors receive a "disclosure
statement" prepared by the company and approved by the court,
containing information concerning the company and the plan. Then
the creditors may vote to accept or reject the plan. If a majority
in number and two-thirds in amount of the general unsecured claims
have voted in favor of the plan, it will be deemed to have been
approved by that class of creditors and will be confirmed so
long as all other statutory requirements are met. If not approved
by the general unsecured class, the plan will be confirmed only
if the court finds the plan to be "fair and equitable."
In general, this means that if the plan does not provide for
creditors to be paid in full, then all junior interests (such
as stock or subordinated debt) must be canceled. Some bankruptcy
courts in limited circumstances recognize a "new value corollary"
to this rule, and will permit the existing owners to continue
to own the business (or, more accurately, to buy back ownership
of the business) by making a new investment in the company under
the plan, even though unsecured creditors will not be paid in
full and have voted against the plan. Confirming a plan over
the objection of a class of creditors is known as "cramdown."
The company's management usually has a prominent place at the
negotiating table because management will often be the best (and
will sometimes be the only) party in a position to deliver more
to the creditors than they would receive in a liquidation of
the company. Because the consequences of failure to agree are
typically so unpleasant for both sides, the company and its creditors
can usually reach agreement on the terms of the Chapter 11 plan.
The Prepackaged Bankruptcy Case
The bankruptcy law permits a company
to file its Chapter 11 petition after already having proposed
a plan, distributed a disclosure statement and obtained the necessary
votes of creditors. This is colloquially known as a "prepackaged"
bankruptcy case. In this situation, all that remains to be done
during the Chapter 11 case is to confirm the plan, which can
be accomplished in as little as 30-45 days. This contrasts with
the six months to two years that a Chapter 11 case would typically
take.
A prepackaged Chapter 11 case has two great advantages for the
troubled company. First, by going into Chapter 11 only after
locking up the creditors' acceptance of the plan, company management
minimizes the risk that it will lose control of the Chapter 11
case to a creditors' committee or potential acquirer. Second,
the short duration of the Chapter 11 case tends to keep down
its cost (primarily professional fees), although savings during
the Chapter 11 case are partially offset by fees that are front-loaded
to the pre-bankruptcy period.
While a prepackaged Chapter 11 can be advantageous, in many situations
it is not feasible. Sometimes, a troubled company may require
months or even years in Chapter 11, protected from collection
activity of creditors, while the company resolves litigation,
restructures operations and negotiates with key constituencies.
Moreover, prepackaging only works if the company is able to stay
out of bankruptcy until the prepackaged plan is negotiated, prepared,
circulated for vote, and accepted. In addition, a prebankruptcy
disclosure statement must comply with any applicable securities
laws presenting risks, costs and a potential for delay that can
be avoided by distributing the disclosure statement during the
bankruptcy case. Finally, the bankruptcy court will not rubber
stamp confirmation of a prepackaged plan. The disclosure statement,
not having been approved by the court prior to distribution,
will be subject to scrutiny as part of the confirmation process.
Any perceived defect can serve as grounds to deny confirmation
of a plan without ever reaching its merits. This would mean starting
over with the disclosure and confirmation process.
Despite potential pitfalls, a prepackaged Chapter 11 can be the
best approach in the right situation. Among the issues that must
be weighed for each company contemplating a prepackaged plan
are (i) what are the chances of success, and (ii) how serious
are the consequences of not succeeding for example, if
pressure from creditors requires filing a Chapter 11 petition
before the votes are in, or if the first month of the Chapter
11 case turns out to have been wasted because the court denies
confirmation of the prepackaged plan.
The Pre-Negotiated Bankruptcy Case
Even when a prepackaged Chapter 11 does not make sense, the
duration and expense of the Chapter 11 case can sometimes be
minimized through a "pre-negotiated" Chapter 11. In
a pre-negotiated Chapter 11, the debtor reaches agreement with
major creditors before filing for bankruptcy, but does not solicit
the votes of creditors generally. The plan and disclosure statement
are prepared prepetition and filed with the bankruptcy petition
or shortly thereafter. In as little as 30-60 days, the disclosure
statement might receive court approval, thus permitting the process
of vote solicitation to begin, with plan confirmation obtained
30 to 45 days later. Back
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This article provides general
information concerning its topic. It is not intended to provide
legal advice or to create an attorney-client relationship.
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