Bankruptcy: Chapter 11

AFRAID OF THE “B” WORD? CHAPTER 11 IS THE DEBTOR’S CHOICE

Despite historic acceptance of debt cancellation, dating back even to Roman times, there still exists some negative connotations to filing bankruptcy under any chapter of our federal bankruptcy statutes. Bankruptcy in America today, however, is not so much for the “deadbeat,” but for the business or individual seeking financial restructuring, rehabilitation, extension and some elimination of debt-essentially a “fresh start” or an opportunity to start over.

Why has Congress adopted what some consider a lenient policy toward the discharge of debts? It may be the influence of an American entrepreneurial spirit that has influenced our law makers to reject old fashioned remedies such as “debtor’s prison” or “stocks”, and has caused Congress to appreciate that individual who takes a financial risk, then loses and works to start over. We have learned that this individual is more likely to “come back” and contribute to commerce than the same individual who is shackled with debt he can never repay. Many successful Americans fit this category. Howard Johnson, for example, is reputed to have gone broke six times before he started over selling ice cream on Nantasket Beach. Numerous similar stories exist in all areas of American business.

From the creditor’s side, the seller or “extender of credit” will make more money by selling or loaning to the new customer or even the discharged bankrupt than by chasing the debt-ridden individual. In essence, our laws give an entity a chance to start over by eliminating, extending or restructuring debt. We have learned that these laws are also good for business.

Chapter 11 is one of three chapters under the bankruptcy code offering relief to the financially distressed individual or business. Chapter 7, available to all businesses and consumers, is referred to as a “straight” bankruptcy and provides for a court appointed trustee to liquidate all nonexempt property. Chapter 7 usually results in a discharge of all debt with the exception of some taxes, some fraudulently incurred obligations and certain domestic claims. Chapter 13 frequently referred to as the “Wage Earner Plan”, is for individuals only, requires a monthly payment for 36 to 60 months and is available only up to certain debt limits.

Chapter 11 is the choice now for virtually all business cases. It is available in all sizes, from United Airlines to the neighborhood grocery. Chapter 11 permits a restructuring, extension of debt, reorganization and even a partial or complete sale of assets. It has no debt limits and is available to both individuals and all business entities. Chapter 11 can best be explained by defining in simple terms some phrases used routinely in business reorganizations. Consider the following:

Debtor – the individual or entity that files the petition under Chapter 7, 11 or 13.

Debtor in possession – the individual or business who files Chapter 11 and stays in control of the business without the appointment of a trustee. The debtor stays in possession if he and his counsel follow the basic court rules. The theory is that the individuals, who are running the business, can generally operate, liquidate or reorganize the business better than an outsider or trustee if they follow the court’s rules.

Creditor – this is the bank, insurance company, loan company, taxing authority, other individual or any entity that is trying to collect money from the debtor.

Automatic Stay – this is an immediate “stop” to all suits, foreclosures and other creditor action. The practical effect is that the debtor or the business owner can apply his mental energy to productive efforts instead of fighting the collection efforts of creditors. The stay lasts until the case is concluded or until it is “lifted” by the court “for cause” or for other reasons.

Liquidation Test – allows the debtor in Chapter 11 to “pay for what he keeps.” In essence, a debt may not be paid in full, but only in an amount that the creditor would otherwise receive if the debtor’s property were liquidated in a Chapter 7.

A sale free and clear of liens – allows the bankruptcy court to order a public or negotiated sale of property, free and clear of liens, even if there are mortgages, tax liens or judgments against the property. The purchaser gets a clear title, and the court sorts out later how the money is distributed.

Confirmed plan – the goal of the Chapter 11 debtor. The bankruptcy court will enter an order confirming the plan of reorganization, and the treatment of all debts are described in that order. All creditors are bound by the order confirming the plan.

Why is Chapter 11 favored by businesses and individuals with high debt limit? First, Congress has established a national policy that the rehabilitation or reorganization of a troubled business, with the owner in control, is generally preferred to liquidation of assets by a trustee, a foreclosure or a forced sale of business assets. Second, Chapter 11 enables the debtor to remain in possession and control of its assets and operations without the appointment of the trustee. Third, Chapter 11 has no limits and is available to all individuals and every form of business entity. The Bankruptcy Code even has a special provision for “small businesses” that contemplates a faster track or expedited process for the small businesses that qualify.

Bankruptcy practitioners and those who deal with workouts and debtor-creditor issues are committed to Chapter 11 as an effective tool for financial rehabilitation and for treating all creditors in a single forum. Factors usually affiliated with a successful reorganization are the following:

1. A desire to stay in business and continue business practices that have been successful in the past;

2. A good accounting system and a willingness to follow the rules of the bankruptcy court and the bankruptcy administrator;

3. A need to downsize, sell unnecessary property or sell property that is subject to numerous liens, while keeping the assets needed to effectively reorganize;

4. The existence of numerous disputed creditors that need to be addressed in one forum, without the expense of separate lawsuits; and

5. A business which is subject to an industry problem, a seasonal problem or a cash flow problem that is not typical of the ordinary operation of the business.

Those businesses which are not as successful in Chapter 11 are those which are operated by inexperienced individuals, by those who do not really want to continue in business, do not want to keep accurate records or who are not willing to follow the rules of the court and advice of counsel.

Like all legislation, the Bankruptcy Code and its related statutes are subject to abuse. For those who are willing to work within the system, however, Chapter 11 is an effective way to take advantage of a statutory philosophy which favors reorganization and rehabilitation and allows the debtor to enjoy a “fresh start” instead of liquidation and financial failure.

Bankruptcy: Chapter 11 (pdf)