Chapter 11 Bankruptcy: An Overview
Chapter 11 bankruptcy is designed to allow struggling businesses to restructure their finances and maximize the return to their creditors and owners.
Chapter 11 usually makes it to the news when large corporations fall into financial distress and need bankruptcy relief. Corporations that have filed Chapter 11 include General Motors, United Airlines, Lehman Brothers, and K-Mart. Most Chapter 11 cases, however, never hit the news. In 2010, for example, close to 14,000 Chapter 11 cases were filed in the United States.
Read on to learn about the reorganization process under Chapter 11 of the Bankruptcy Code.
(To learn about other bankruptcy options for businesses, see our Bankruptcy for Small Businesses area.)
How a Chapter 11 Case Begins and Who Can Be a Chapter 11 Debtor
A Chapter 11 case begins with the filing of a petition in bankruptcy court. Generally, Chapter 11 cases are voluntary. In a voluntary Chapter 11 case, it is the debtor who takes the initiative and seeks bankruptcy relief. Occasionally, however, creditors will band together to file an involuntary Chapter 11 petition against a defaulting debtor.
Most debtors file Chapter 11 where their primary place of business is located. Business debtors also can file bankruptcy where they are “domiciled” – i.e., incorporated or otherwise organized. Businesses incorporated in Delaware, for example, sometimes file bankruptcy there instead of their home states.
Chapter 11 cases usually are filed by corporations, partnerships, and limited liability companies. Individuals can file under Chapter 11 if they have too much debt or income to qualify under Chapters 7 and 13. (Learn more about qualifying for Chapter 7 bankruptcy and eligibility for Chapter 13 bankruptcy.)
When possible, however, most individual debtors elect to file bankruptcy under Chapter 7 or 13 to avoid the time, cost, and risk involved in Chapter 11 proceedings. In 2010, close to 1.6 million Americans filed bankruptcy under Chapters 7 and 13 – more than 100 times the number who filed Chapter 11 during the same time period.
What Happens Before a Chapter 11 Plan Is Proposed
There is no absolute limit on the duration of a Chapter 11 case. Some Chapter 11 cases wrap up within a few months. Usually, however, it takes at six months to two years for a Chapter 11 case to come to a close.
Debtor Continues With Business Operations
In most Chapter 11 cases, no trustee is appointed. Instead, the debtor continues to operate its business in the ordinary course as the “debtor in possession” (or “DIP”). The bankruptcy court can appoint a trustee to take over operations from the debtor if it finds sufficient cause. Cause for appointing a trustee includes fraud, dishonesty, incompetence, and gross mismanagement of the debtor’s affairs.
Bankruptcy Court Has Control Over Major Decisions
While the debtor ordinarily continues in business after it files Chapter 11, it loses control over major decisions to the bankruptcy court. Among other things, the bankruptcy court must approve:
- any sale of assets, such as property or real property (except for items such as inventory sold by a retail debtor in the ordinary course of business)
- entering into or breaking a lease of real or personal property
- mortgage or other secured financing arrangements that allow the debtor to borrow money after the case is filed
- shutting down or expanding business operations
- entering into or modifying union, vendor, licensing, and other contracts and agreements, and
- the retention of, and payment of fees and expenses to, attorneys and other professionals.
Role of Creditors
Creditors, shareholders, and other parties in interest may support or oppose actions that require bankruptcy court approval. The bankruptcy court will consider input from creditors and other parties in deciding how to proceed. Formal votes by creditors and equity holders, however, are taken only in connection with proposed Chapter 11 plans.
Unsecured creditors usually participate in the Chapter 11 case through a committee that is appointed to represent their interests. The unsecured creditors’ committee can retain attorneys and other professionals to assist it at the debtor’s expense. In some cases, equity security (i.e., shareholder) and other committees also take an active role.
Chapter 11 Reorganization Plans
Ordinarily, the debtor has the exclusive right for four months after it files Chapter 11 to propose a reorganization plan. Upon a showing of good cause, the court can extend the debtor’s “exclusivity period” to file a Chapter 11 plan to up 18 months after the petition date. The court also can shorten the exclusivity period depending on the circumstances.
Once the “exclusivity period” expires, the creditors’ committee or other parties can propose competing reorganization plans. Competing plans are relatively rare in Chapter 11 cases. More often, creditors or other parties dissatisfied with the debtor’s progress will move to dismiss or convert the case to Chapter 7.
A Chapter 11 plan allows a debtor to reorganize, or in other words, restructure, its financial affairs. A Chapter 11 plan is, in effect, a contract between the debtor and its creditors as to how it will operate and pay its obligations in the future. Most plans provide for at least some downsizing of the debtor’s operations to reduce expenses and free up assets. In some cases, “liquidating plans” are proposed to provide for a total shutdown of the debtor’s operations and the orderly sale of its remaining property.
On rare occasion, a Chapter 11 plan will provide for full and immediate payment of all creditors. Otherwise, creditors are entitled to vote on whether they accept a proposed Chapter 11 plan. At least one class of “impaired” claims must vote in favor of a Chapter plan for it to be approved by the bankruptcy court. An “impaired” claim is an obligation that will not be paid in full upon plan confirmation or when originally due.
Confirmation of the Chapter 11 Plan
Approval of a proposed plan is referred to as “confirmation.” Ultimately, confirmation of a proposed plan rests with the bankruptcy court. To confirm a Chapter 11 plan, the bankruptcy court must find that it meets numerous requirements, including:
Feasibility. The bankruptcy court must find that the proposed plan is feasible, or in other words, likely to succeed. The debtor must prove to the court that it will be able to raise sufficient revenues over the plan term to cover its expenses, including payments to creditors.
Good Faith. The court must find that the plan has been proposed in good faith and not by means forbidden under applicable law.
Best Interests of Creditors. For a proposed plan to be confirmed, it must be in the best interests of its creditors. In Chapter 11, the “best interests” test requires that creditors receive 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 cases, the “best interests” test requires the debtor to pay all of its creditors in full. Most Chapter 11 debtors, however, are financially underwater and can meet the “best interests” test by paying creditors only a fraction of what they owe.
Fair and Equitable. The plan also must be “fair and equitable.” Under the “fair and equitable” test:
- Secured creditors must be paid, over time, at least the value of their collateral. A creditor is considered to be secured if it has a mortgage against real property or lien against personal property (such as inventory or equipment).
- The debtor’s owners may not retain anything on account of their equity interests unless all obligations are paid in full, either immediately upon plan confirmation or over time (and with interest). The bankruptcy court can allow equity holders to retain ownership interests in the debtor in exchange for “new money” contributed to pay reorganization expenses. Otherwise, however, equity holders lose all ownership rights upon plan confirmation.
Some confirmation requirements (such as the fair and equitable test) apply only if the affected creditors vote against the proposed plan.
Does Chapter 11 Really Work?
Reports and studies indicate that about 10 to 15% of Chapter 11 cases result in successful reorganizations. Most cases are dismissed (often by agreement of the parties) or converted to Chapter 7 liquidations. Dismissal or conversion of a Chapter 11 case requires bankruptcy court approval. The bankruptcy court can dismiss or convert a Chapter 11 case for cause, including failure by the debtor to show that it can successfully reorganize.
The bankruptcy laws include special provisions to streamline and expedite Chapter 11 cases involving single-asset real estate and small business debtors. To learn more, see Chapter 11 Bankruptcy for Small Business Owners.