The 6 Features That Define Chapter 11 Bankruptcy as a Reorganization

Chapter 11 is a bankruptcy filing under the federal bankruptcy code that allows businesses, and sometimes individuals, to reorganize their finances while continuing to operate. Chapter 11 bankruptcy does not have to mean the loss of a business and the destruction of the owner’s finances. On the contrary, it can be a way to save a business and build a new future, using the protection of a chapter 11 bankruptcy. It just depends on the particular business and its financial situation.

A chapter 11 case features an automatic stay, which prevents most collection actions, a debtor-in-possession who runs the business, the ability to cancel or re-negotiate contracts and leases, the re-valuation of collateral and treatment of collateral for less than the secured debt, a bankruptcy court-approved plan voted by creditors, and finally, the ability to cramdown plans on dissenting creditors. This is in contrast to a Chapter 7 filing, which shuts down the business, sells assets and pays creditors what it can from the sale proceeds, and where there is no plan at all.

Benefits of Filing Bankruptcy

Upon filing, a debtor-in-possession takes over. This is usually the same person who was in charge of the business when the petition was filed. The debtor-in-possession runs the day to day operations of the business while the bankruptcy court supervises the bankruptcy case. The court does not take over your business, and, at least initially, neither does a trustee. The goal of the process is to try to give a failing business a fresh start. This works to benefit both the business and its creditors, by keeping the business alive and functioning.

One of the most powerful benefits of filing bankruptcy is what the law calls the automatic stay. An automatic stay, which occurs the moment a Chapter 11 petition is filed, is a court order that forbids creditors from continuing to try to collect what they are owed. What this means is that most collection actions, including lawsuits, repossessions, and foreclosures, stop the instant you file for bankruptcy. The point of the automatic stay is to give the debtor room to breathe and get their financial affairs back in order.

A Chapter 11 debtor has an opportunity to reject or keep contracts and leases, with court approval. Commercial real estate leases are a special case: the debtor has up to 120 days after filing to assume or reject the lease and the court can extend the period for up to 90 days. After that, the leases are rejected if the debtor has not yet decided. A rejected lease means that the debtor is off the hook for the future payments under the lease, but the landlord can file an unsecured claim. The ability to reject a lease puts the debtor in a strong position to negotiate lower rent, get more favorable terms, or simply move on from a costly or problem lease. Because a landlord could end up with an unsecured claim rather than current rent if the lease is rejected, the landlord is incentivized to make sure the debtor assumes the lease.

If collateral values have decreased, a debtor in a Chapter 11 can use section 506 of the Bankruptcy Code to re-value collateral used to secure a debt. Only the first part of the debt, up to the current value of the collateral, stays secured. The second part becomes unsecured, just like other unsecured debts such as credit cards and loans without collateral, and can be paid at a discount. This is part of reorganizing finances and shedding debt.

The Final Plan

The plan is the blueprint for the debtor to reorganize and get back on their feet. Not all creditors are the same: The absolute priority rule dictates that certain creditors with more senior claims must be paid first. Junior creditors and owners come afterwards. In other words, the senior creditors eat first and the owners eat last. The Bankruptcy Code gives the debtor a break by preventing creditors from filing their own competing plans for the first 120 days. Once a plan is proposed, certain creditors will vote on it, and in the end the bankruptcy court must approve the final plan.

Votes on the plan are cast by class. Only impaired creditors, which means those whose claims are modified, can vote. A class accepts the plan if at least two-thirds of the dollar amount of claims in a class, and more than half of the creditors in the class, vote for the plan. The bankruptcy court must check to make sure the plan is feasible and the debtor will not just go bankrupt again. Next, the court must check to see if the plan was proposed in good faith.

If one class is not approving, the court may consider forcing the plan through anyway, an ability called “cramdown.” Cramdown takes its name from the ability of the court to “cram” the plan down on one or more dissenting classes. The plan must not “discriminate unfairly” against the dissenting class. It must also be “fair and equitable” as to that class of creditors.

Filing a Chapter 11 is complicated, expensive, and can take several years, and you must decide whether the cost and time is worth it. You have to pay fees for the lawyers, financial advisors, accountants, and other expenses that mount up. Additionally, there may be a creditors’ committee that disagrees with management and tries to fight your plan. It is a little easier for small businesses, where there are special “sub-chapter V” rules designed to expedite the process and reduce costs.

Subchapter V may also ease requirements. To qualify for Subchapter V, a business’s debts must be no more than $3,424,000 and at least 50% of the debts must be from the business.

In Subchapter V, only the debtor is allowed to propose a plan. It must be filed within 90 days of the petition date. There is no absolute priority rule. This means that you may be able to keep your equity and ownership. In return, you must commit all of your projected disposable income into the plan.

Finally, if your plan is confirmed by the bankruptcy court, your prepetition debts are generally discharged when the plan is confirmed, giving you a fresh start. That’s the goal of a Chapter 11 reorganization: to fix what is not working, get a restructured business, and give it a path to prosper and avoid bankruptcy in the future. But you can’t just assume that a plan will be approved without being thoroughly prepared. An experienced bankruptcy attorney will be key in dealing with other creditors and the court, and for making sure that a proposed plan gets through the bankruptcy process as quickly as possible. The goal is to get out from underneath the bankruptcy case and the court and back in control of your own future.