In the past, only large corporations could afford the costs associated with Chapter 11 bankruptcy. Fortunately, Chapter 11 has evolved, and large and small businesses can use it to stay open. Individuals who don’t qualify for Chapters 7 and 13 can file, too. In this article, you’ll learn:
Businesses turn to Chapter 11 bankruptcy when pinched financially—often due to a temporary downturn. It can help a viable business keep the doors open long enough to regroup and reimagine a future-forward strategy. It doesn’t matter whether the company is avoiding paying vendors, having a tough time meeting payroll or rent, or struggling with some other obligation that’s come due— the debt relief afforded by Chapter 11 gets businesses back on track. Here’s how it works.
All bankruptcy chapters work by stopping the collection process. Once filed, the “automatic stay” prohibits most creditors from pursuing you, giving you, your creditors, and the court the breathing room needed to address finances in an organized fashion. For instance, the stay will temporarily stop:
Unlike other bankruptcy chapters, a bankruptcy trustee isn’t put in charge of the business and other bankruptcy property. The filer continues to run the everyday functions of the business as a “debtor in possession” during the Chapter 11 bankruptcy.
The goal of Chapter 11 is to create a financial plan that the filer, creditors, and the court agree will enable the company to remain open and prosper. The plan can include modifying interest, payment due dates, and other terms—it can even discharge (erase) debt entirely. 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” shutdown the debtor’s operations and provide for the orderly sale of its remaining property (although a debtor can accomplish this in a Chapter 7 business bankruptcy.)
If all necessary creditors approve of the plan, it becomes a new contract, and the filer receives the debt discharge immediately. If the court approves the plan without creditor consent, such as in Chapter 11, Subchapter V, the filer must make all required payments before receiving the debt discharge.
When possible, most debtors elect to file for bankruptcy under Chapter 7 or 13 to avoid the time, cost, and risk involved in Chapter 11 proceedings. So your first step should be to learn about personal bankruptcy, as well as bankruptcy options for small businesses.
You’ll find an overview of the Chapter 11 process below. Chapter 11 bankruptcy, Subchapter V involves simpler procedures, and we’ve highlighted some of the significant differences.
A Chapter 11 case begins with the filing of a petition in bankruptcy court. Generally, Chapter 11 cases are voluntary and it is the debtor who takes the initiative and seeks bankruptcy relief. Occasionally, however, creditors will band together to file an involuntary bankruptcy petition against a defaulting debtor.
Most debtors file where the business is located, but business debtors can file bankruptcy where they are “domiciled” (incorporated or otherwise organized). For instance, businesses incorporated in Delaware sometimes choose Delaware instead of their home states.
There is no absolute limit on the duration of a Chapter 11 case. Some Chapter 11 cases wrap up within a few months, but it’s more usual for it to take six months to two years for a Chapter 11 case to come to a close.
While the debtor ordinarily continues running the business as a debtor in possession, the bankruptcy court must approve:
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 when deciding how to proceed. Formal votes by creditors and equity holders, however, are taken only in connection with proposed Chapter 11 plans.
Unsecured creditors participate in the Chapter 11 case through a committee 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, Subchapter V cases don’t include creditor committees.)
The filer must fully disclose background information so that a creditor can make an informed decision about the feasibility of the proposed plan. The fact that creditors can object to the disclosure statement and the actual plan creates two rounds of costly litigation. (Chapter 11, Subchapter V filers don’t submit a disclosure statement). The court sets dates for plan objections and creditor voting after approving the disclosure statement.
Ordinarily, the debtor has the exclusive right to propose a reorganization plan for the first four months; however, the court can extend the debtor’s “exclusivity period” for to up 18 months after the petition date. This provision is one of the reasons why Chapter 11 is so costly. (By contrast, Chapter 11, Subchapter V filers are rarely granted extensions).
Once the exclusivity period expires, the creditors’ committee or other parties can propose alternate reorganization plans. But more often, creditors or other parties dissatisfied with the debtor’s progress will move to dismiss or convert the case to Chapter 7.
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. An impaired claim is an obligation that will not be paid in full upon plan confirmation or when originally due.
In reality, the debtor and creditors can agree to any plan that they choose. If a creditor objects to the plan, however, the court will consider factors, including:
Feasibility. The bankruptcy court must find that the proposed plan is feasible or likely to succeed. The debtor must prove the ability to raise sufficient revenues to cover expenses and creditor payments.
Good Faith. The plan must be proposed in good faith and not seek to further an agenda forbidden under the law.
Best Interests of Creditors. 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 (wherein the debtor’s property would be sold and distributed to creditors). 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:
Counsel must represent all businesses that file for Chapter 11. A bankruptcy attorney will be in the best position to explain your options and the specific procedures you can expect in your case.