Not all bankruptcies are designed solely to get rid of debt. A bankruptcy court may oversee the restructuring of a debt load of a company that allows the company to continue operating. This process is called “reorganization” or “rehabilitation.”
Chapters 11 and 13 of the Bankruptcy Code allow businesses and individual debtors to reorganize debts by compromising with creditors. These deals are made using a “plan” that is negotiated and implemented by the debtor and overseen by the bankruptcy trustee and/or court. While the debtors in these cases are technically responsible for running the businesses (or personal finances), the debtor may also need to employ a team of experts and attorneys to navigate the process.
Though Chapter 7 filings are still much more common,[1] Chapter 11 filings have increased in recent years.[2] In fact, Chapter 11 filings increased by over 60 percent between 2017 and 2018.[3] Some 2017 and 2018 Chapter 11 filings of note included Toys R Us, H.H. Gregg, The Limited, Westinghouse Electric Company, RadioShack, Gander Mountain, Remington Arms and Claire’s.[4] Most of those companies remained in business, although some closed their doors.
While a Chapter 7 bankruptcy is a liquidation, Chapter 11 is a reorganization. In a liquidation, all assets of the bankruptcy estate are sold and used to pay whatever debts can be paid in one shot. The rest are discharged. In a reorganization, the debts are paid, but over time, and according to a plan approved by the court while the debtor stays in business. While a liquidation takes a few months, a reorganization can drag on for years.
A successful Chapter 7 liquidates all debts and gives an individual debtor a clean slate or ends the operations of a company. A successful Chapter 11 creates a leaner business, hopefully ready for success.
There also may be circumstances in which a liquidation is the preferred result for the debtor after the Chapter 11 gets started. In these cases, conversion to a Chapter 7 is one option, though a second option is to create a liquidation plan under Chapter 11. This allows the creditors to maintain some control over how they get paid and gives more time to get the debts paid.[5]
Who Can File
Though Chapter 11 can be filed by individuals or businesses, Chapter 11 filings by individuals are rare. Most individuals who file Chapter 11 do so because they cannot qualify their income or debts under Chapters 7 or 13. However, many of the restrictions that apply to individual Chapter 7 filers also apply to individual Chapter 11 filers. The filer must take credit counseling within 180 days of filing the petition and file a debt repayment plan if one was developed in counseling. In addition, an individual debtor must file evidence of payment from employers, if any, received 60 days before filing; and a statement of monthly net income and any anticipated increase in income or expenses after filing.[6] A husband and wife may file a joint petition or individual petitions.[7]
As in the case of a Chapter 7, an individual cannot file under Chapter 11 if, during the preceding 180 days, his bankruptcy petition was dismissed due to the debtor’s willful failure to appear before the court or comply with orders of the court or if it was voluntarily dismissed after creditors sought relief from the bankruptcy court to recover property upon which they hold liens.[8]
Beyond that, individual and business debtors file the same paperwork, which includes schedules of assets and liabilities, current income and expenditures, executory contracts and unexpired leases and a statement of financial affairs.
Chapter 11 contains some other limitations, including:
– Railroad corporations have a specific section of the statute under which they must file.[9]
– Stock and commodities brokers may not file under Chapter 11.[10]
– Single-asset real estate owners (primarily owners of small apartment buildings) have a special code section that allows creditors to avoid the automatic stay to receive at least interest payments while the case is being processed.[11]
Chapter 11 actions can also be brought involuntarily by creditors in rare cases.[12]
Types of Companies and Chapter 11
There are several different kinds of companies, and they can be affected differently in a Chapter 11. In the case of a corporation, the company itself is the debtor. Even though the stockholders technically own the company, the personal property of those stockholders is not at risk, as they are shielded from personal liability. If the stock loses value (which it almost invariably does), of course, stockholders take that hit.
In a sole proprietorship, the owner is the debtor, so a bankruptcy case involving a sole proprietorship can include both the business and personal assets of the owners-debtors and can affect the owner as an individual.
A partnership, like a corporation, is a separate legal entity from the partners. However, in a partnership’s bankruptcy, the partners’ personal assets may be vulnerable to creditors. In some cases, the individual partners may even be forced to file bankruptcy.
There are circumstances in which a corporation may expose its stockholders to personal liability: a process known as “piercing the corporate veil.” This occurs in “closely-held” corporations with limited numbers of shareholders, many of which may be small family businesses that have incorporated. If the court finds that the corporate entity was set up only to relieve the few stockholders from personal liability, the court may pierce the corporate veil and subject the owners to personal liability.[13]
Fiduciaries and Debtors in Possession
As soon as a Chapter 11 is filed, the debtor assumes the title “debtor in possession.”[14] This means that the debtor continues to run the business while the case is pending. The debtor in possession holds a fiduciary position with the court[15]. A fiduciary is someone who has a duty to act in good faith to take care of the business of the court in a responsible way. There are legal consequences for acting in bad faith from this position.
It is rare that the debtor runs the case alone. In most cases, the fiduciary must hire a bankruptcy attorney and/or other professionals to put a debt repayment plan together and to help implement and supervise it. All members of the team also have fiduciary duties to the court, the debtor and the creditors. Those include accounting for property, examining and objecting to claims and filing tax returns and informational reports as required.[16]
Although the debtor typically remains in possession and control of the operation and assets of the filing company, a bankruptcy trustee may still be assigned to the case. The trustee’s office monitors the debtor’s compliance but is not involved in the case as much as in a Chapter 7 proceeding. The debtor in possession has the power to run the business without interference from the court, unless the court rules otherwise.[17] There are, though, restrictive rules for the debtor’s use of estate cash and assets.[18]
While the trustee takes control of the filer’s assets, a court can order a trustee to control the company for “cause,” through the motion of the Trustee’s office or any party in interest.[19] “Cause” could be, for example, evidence of fraud or falsifying reports.[20] The trustee then steps into the shoes of the debtor and is responsible for filing and administering the plan and managing the estate (potentially including the ongoing business). Alternatively, an “examiner” may be appointed, who has limited powers to evaluate a case and file a report with the judge, though the precise role is up to the judge and can vary from case to case.[21]
In most cases, the debtor will remain a debtor in possession until a plan of reorganization is confirmed and the debtor’s case is dismissed or converted to a Chapter 7.
The Reorganization Plan
After the petition is filed, several forms must be filed with the court that created the parameters of the case.[22]
The filer must file a written disclosure statement with the court.[23] The disclosure statement contains information about the assets, liabilities, and business affairs of the debtor that is sufficient to allow the creditors to make decisions about how to react to debtor plans. Note that small businesses (under about $2 million in non-contingent debt) have their own section of the Bankruptcy Code[24] and the requirement to file a disclosure statement may be waived. Unlike the rest of Chapter 11 cases, a small business case is overseen by the trustee.[25] These cases often finish up in as little as 18 months.
Next, creditor claims must be determined. A “claim” under bankruptcy law is the creditor’s right to payment or to the benefits of a contract.[26] Claims arise automatically when their debts are listed on the filer’s petition or disclosure statement. If a creditor’s claim is not listed, a creditor can file a “proof of claim” with the court.[27] The debtor is then responsible for notifying the other creditors of this filing.[28]
The main feature of a Chapter 11 is the reorganization plan.[29] For 120 days after the order for relief, only the debtor can file a proposed plan, which can be extended to 180 days or otherwise changed by the court for good reason. After 120 days, creditors or the trustee can file competing plans. [30] The plan is subject to an objection by any party in interest.
During the plan negotiations, a creditors’ committee may be formed by appointment of the trustee and ordinarily consists of the creditors who hold the seven largest unsecured claims against the debtor.[31] This committee can be an important factor in a Chapter 11 case.
The plan spells out what is owed, to whom, and how, when and in what amounts each debt will be paid. It includes a classification of claims and interests and must specify how each class of claims will be treated under the plan.[32] Classes of creditors can be as simple as “secured” and “unsecured” or can be far more complex. For example, classes of creditors may include employees owed wages, vendors, independent contractors and similar distinct groups. Most plans cover periods of years, during which time the business continues to operate, or the individual is left with enough money to live on.
Plans often call for the payment of a percentage of a claim across the board-for example, 50 percent of all claims in the class spread out over two years- or it may provide for different treatment of secured and unsecured claims.
Under a plan, debts can be “impaired” or “unimpaired”. An unimpaired claim is one which the plan calls for payment as it was originally engaged. For example, a plan may call for the debtor to continue paying his full mortgage payments as called for by the mortgage agreement. Because their debts are unimpaired, these creditors are not given a say in whether to approve the plan.
An impaired claim is one which is modified under the plan. This may mean that the payments will be less than or over a longer period than initially called for under the agreements or it could mean that the creditor will lose a security interest or that its secured property may be used to satisfy another claim, or any other change to the agreement.[33]
Approving the Plan
After the original plan is filed, it is sent to all impaired creditors, along with a ballot[34] asking whether that creditor accepts or rejects the plan. The creditors then vote on whether to accept it by returning their ballots to the party who initiated the plan. Unimpaired classes do not vote on the plan and are deemed to have accepted the plan.[35]
The votes are counted by class of creditors and are confirmed or rejected by class.[36] If the plan is accepted by more than half the creditors in a class who hold at least two-thirds in total debt, that class is deemed to have accepted the plan.[37]
If all classes that include impaired creditors approve the plan, the plan is approved. If at least one class of impaired creditors approves the plan, but others do not, the judge may “cram down,” or force, the plan onto the impaired creditors over their objections.[38] Section 1129(b) allows a cramdown if the judge determines that the plan is fair and equitable to all classes. This usually means that the claims held by senior classes of creditors are paid in full before junior classes of creditors are paid, a principle known as the “absolute priority rule.”[39]
If the judge declines to do so or if no classes of impaired creditors approve the plan, the plan is rejected but can be altered and re-submitted. There also may be competing plans submitted to the creditors, so each plan and modified plan must be dated and signed and may be voted upon.[40] In addition, any party in interest—not just listed creditors—can file an objection to the plan.
Motions, Proceedings and Final Decrees
While the debtor is running the business in Chapter 11, creditors can bring any number of motions to contest the debtor’s actions. These motions are usually based on accusations of bad faith management of the business or the plan by the debtor. Motions can seek relief from the automatic stay, enjoining the debtor’s use of cash or credit, appointment of a trustee conversion to a Chapter 7 liquidation proceeding or even dismissal of the case.
A debtor in possession or trustee can also bring lawsuits on behalf of the bankruptcy estate, called “adversary proceedings.”[41] Adversary proceedings can be brought to void contracts, avoid liens, recover money or property for the estate, avoid fraudulent transfers or recover property.
The debtor in possession or trustee also has what are known as “avoiding powers.” The debtor in possession can “avoid” (which means to cancel or undo) transfers of property made within certain time limits before the case was filed, often 90 days.[42] The money or property can then be reacquired by the bankruptcy estate and can be distributed to the creditors. This is often done when payments were made to select creditors (at the expense of other creditors) before the petition was filed (sometimes known as a “preference”). Creditors and creditors’ committees can also file adversary proceedings for similar reasons, against the estate or officers of the company in Chapter 11.[43]
Confirmation and Final Decree
There are several steps involved in ending a Chapter 11: the discharge, post-confirmation actions, and the final decree.
Once all the objections are settled, the claims are in, and the hearings are held, the plan can finally go into effect. The court’s acceptance of the plan is called a “confirmation.”[44] Once the plan is confirmed, it is administered as is until it is modified, or until the case is concluded by dismissal, conversion to a Chapter 7, or discharge.
The confirmation of the plan discharges the business debtor from all dischargeable debts that arose before the date of the confirmation[45] and creates new contractual relationships that replace those debts. For individual debtors, a discharge only takes place after all the obligations of the plan are completed.[46] In a liquidation case, the confirmation acts as a discharge for an individual but not for a business.
A plan can be modified after it is confirmed if the court determines that circumstances warrant such a change.[47] This adjustment could be to the entire plan or for only some of the claims.
After confirmation, there may be further objections to the plan or other adversary proceedings, which the court will administer. The court will be able to make any necessary decisions and orders under these circumstances.[48] The court can also revoke a confirmation order if it finds that order was obtained by fraud.[49]
After the bankruptcy estate has been “fully administered”, the court must enter a final decree.[50] This closes the case. The timing of a final decree is up to the court.
In our next module, we’ll turn to the primary method of re-organization of debts available to individual debtors: bankruptcy under Chapter 13 of the Code.
[1] http://www.uscourts.gov/statistics-reports/us-bankruptcy-courts-judicial-business-2014
[2] Wolf Richter, “Chapter 11 Bankruptcies are up 63% from a Year Ago,” Business Insider, (April 10, 2018), https://www.businessinsider.com/chapter-11-bankruptcies-are-up-63-from-a-year-ago-2018-4.
[3] Id.
[4] See, e.g., “Here’s a List of 40 Bankruptcies in the Retail Apocalypse and Why They Failed,” CBInsights, (Mar. 19, 2018), https://www.cbinsights.com/research/retail-apocalypse-timeline-infographic/.
[5] “Chapter 11 – Bankruptcy Basics,” U.S. Courts,http://www.uscourts.gov/services-forms/bankruptcy/bankruptcy-basics/chapter-11-bankruptcy-basics (last visited Sept. 21, 2018).
[6] 11 U.S.C. § 521; see also Chapter 11 – Bankruptcy Basics,” U.S. Courts, http://www.uscourts.gov/services-forms/bankruptcy/bankruptcy-basics/chapter-11-bankruptcy-basics (last visited Sept. 21, 2018).
[7] 11 U.S.C.§ 302(a).
[8] 11 U.S.C.§§ 109(g), 362(d)-(e); see also Chapter 11 – Bankruptcy Basics,” U.S. Courts, http://www.uscourts.gov/services-forms/bankruptcy/bankruptcy-basics/chapter-11-bankruptcy-basics (last visited Sept. 21, 2018).
[9] See Chapter 11 – Bankruptcy Basics,” U.S. Courts, http://www.uscourts.gov/services-forms/bankruptcy/bankruptcy-basics/chapter-11-bankruptcy-basics (last visited Sept. 21, 2018).
[10] 11 U.S.C.§ 109(d).
[11] 11 U.S.C.§ 362(d).
[12] 11 U.S.C. §§ 303.
[13] Lauren Gross, “The Relationship Between Declaring Bankruptcy and Piercing the Corporate Veil,” American Bankruptcy Institute Law Review, https://www.abi.org/member-resources/blog/the-relationship-between-declaring-bankruptcy-and-piercing-the-corporate-veil.
[14] 11 U.S.C. § 1101.
[15] 11 U.S.C.§ 1107(a).
[16] 11 U.S.C.§§ 1106, 1107; Fed. R. Bankr. P. 2015(a).
[17] 11 U.S.C.§ 363(c).
[18] 11 U.S.C. § 363 (various subsections).
[19] 11 U.S.C.§ 1104(a).
[20] 11 U.S.C. § 1104(a); Fed. R. Bankr. P. 2007.1.
[21] 11 U.S.C. § 1106(b).
[22] We will discuss these forms in the last module of this course.
[23] 11 U.S.C. §1125.
[24] 11 U.S.C. § 101(51C); see Chapter 11 – Bankruptcy Basics,” U.S. Courts, http://www.uscourts.gov/services-forms/bankruptcy/bankruptcy-basics/chapter-11-bankruptcy-basics (last visited Sept. 21, 2018).
[25] 28 U.S.C.§ 586(a)(7).
[26] 11 U.S.C.§ 101(5).
[27] Fed. R. Bankr. P. 3003(c)(2).
[28] Fed. R. Bankr. P. 1009(a).
[29] See Chapter 11 – Bankruptcy Basics,” U.S. Courts, http://www.uscourts.gov/services-forms/bankruptcy/bankruptcy-basics/chapter-11-bankruptcy-basics(last visited Sept. 21, 2018).
[30] 11 U.S.C. § 1121.
[31] 11 U.S.C. § 1102.
[32] 11 U.S.C. § 1123.
[33] 11 U.S.C. § 1124; 11 U.S.C. § 1126.
[34] See Chapter 11 – Bankruptcy Basics,” U.S. Courts, http://www.uscourts.gov/services-forms/bankruptcy/bankruptcy-basics/chapter-11-bankruptcy-basics (last visited Sept. 21, 2018).
[35] 11 USC Sec. 1126(f).
[36] See 11 U.S.C. § 1126(c). An example of a bankruptcy court ballot rule is attached (N.D. Indiana).
[37] 11 U.S.C. § 1126(c).
[38] 11 U.S.C. § 1129(b).
[39] “Absolute Priority,” Investopedia, https://www.investopedia.com/terms/a/absolutepriority.asp (last visited Sept. 21, 2018).
[40] Fed. R. Bankr. P.3016(a).
[41] Adversary proceedings are governed by Part VII of the Federal Rules of Bankruptcy Procedure.
[42] 11 U.S.C.§§ 101(54), 547(b), 548.
[43] 11 U.S.C. § 101(16), (17), § 1111. Fed. R. Bankr. P. 3003(c)(2); See Chapter 11 – Bankruptcy Basics,” U.S. Courts, http://www.uscourts.gov/services-forms/bankruptcy/bankruptcy-basics/chapter-11-bankruptcy-basics (last visited Sept. 21, 2018).
[44] 11 U.S.C. § 1129.
[45] 11 U.S.C.§ 1141(d)(1) generally.
[46] 11 U.S.C. § 1141(d)(5).
[47] 11 U.S.C.§ 1127(b).
[48] Fed. R. Bankr. P. 3020(d).
[49] 11 U.S.C. § 1144.
[50] Fed. R. Bankr. P.3022.