Chapter 11 Bankruptcy Overview
Most businesses, especially large businesses, that file for bankruptcy file under Chapter 11. Although there are some individuals with very large debts that also file under Chapter 11, because Chapter 11 has no debt limitations for eligibility, Chapter 11 was mainly designed as a means for big businesses to reorganize so that they can operate profitably again, which saves jobs. Furthermore, much of the property held by the business often cannot be efficiently put to other uses. Such was the case of railroads that required a lot of capital to build, and for which there were no alternate uses for the property. Chapter 11 allows the business to continue operating and to use its property for which it was designed.
Reorganization is mainly accomplished by allowing businesses to reject burdensome contracts, to pay secured creditors the value of their collateral instead of the amount of their debt, and to pay unsecured creditors less than what they are owed. Without the option of reorganizing, most businesses would continue losing money until they would be forced to liquidate, thereupon ceasing to exist.
Chapter 11 Administration and Oversight
Chapter 11 was designed to allow the debtor and its creditors the maximum amount of flexibility in reorganizing the business through negotiation, but it also has rules that can force dissenting creditors to accept a plan in what is called a cramdown. The court serves to resolve disputes and to ensure that the bankruptcy is meeting statutory requirements.
Under Chapter 11, unlike other chapters of bankruptcy, no trustee is appointed — the debtor acts as a debtor in possession (DIP), who not only continues to operate the business, but also has the powers usually exercised by trustees, such as being able to avoid liens, or to reverse fraudulent transfers or preference payments. This arrangement is necessary because a trustee does not have the expertise or the time to run the debtor's business. However, a United States Trustee does monitor the DIP and ensures that the bankruptcy moves forward. The U.S. Trustee also forms the creditors' committee to represent creditors and possibly a committee representing equity holders, such as stockholders.
If the U.S. Trustee has reason to believe that the DIP is unreliable or untrustworthy, then a case trustee will be appointed to take the place of the DIP. Usually, the case trustee will hire someone to run the business. However, this usually takes more time and costs more money than if the debtor itself continued running the business, since any new operator would have to learn the details of that particular business and its recent transactions to run it efficiently.
An examiner may be appointed to investigate the DIP and to closely monitor the DIP's progress, reporting to the U.S. Trustee. The examiner may also perform duties the DIP is forbidden to do by the court.
Chapter 11 Petitioner
The Chapter 11 petitioner — the one who files the pleading to initiate the bankruptcy — is usually the debtor, and the debtor may be a corporation, partnership, or individual. In rare cases, the petitioner may be the debtor's creditors who plead an involuntary bankruptcy for the debtor. There are specific provisions that apply only to certain debtors. The most notable of these special debtors is the small business debtor and individual debtor.
Small Business Debtors
The small business debtor is a business entity that has noncontingent, liquidated secured and unsecured debt of less than $2,725,625 (adjusted for inflation; next adjustment: April 1, 2022) and one for which the U.S. Trustee has not formed a creditors' committee. The lack of a creditors' committee greatly simplifies the Chapter 11 process, but it does require that the U.S. Trustee take a more active role in monitoring the small business debtor.
Another simplification is that a standard form can be used for the disclosure statement, and court approval and the distribution of the disclosure statement is simpler.
Chapter 11 has several statutes that apply only to individuals debtors, making it more like Chapter 13, which is only available for individual debtors. Both chapters require evidence of credit counseling from an approved credit counseling agency and the petitioner must submit any budget developed as the result of the counseling in the bankruptcy petition. And if the debtor failed to do so and a creditor objects, the debtor must commit all projected disposable income during the bankruptcy to pay creditors. However, projected disposable income is calculated by subtracting the debtor's necessary living expenses from his income. A debtor with income above the state median is not required to use the means test to determine disposable income.
Unlike for business entities, the debtor does not receive a discharge at confirmation but only after the payment plan is completed and, if applicable, all domestic support obligations have been paid.
Chapter 11 Petition — Voluntary and Involuntary Petitions — Order for Relief
The Chapter 11 petition has much the same information as the petition under any other chapter of bankruptcy, which includes extensive information about the debtor, schedules of its assets and liabilities, income and expenses, executory contracts, including unexpired leases, and a statement of financial affairs, which summarizes the financial status of the debtor.
A Chapter 11 bankruptcy can be voluntary or involuntary. A voluntary bankruptcy is filed by the debtor and the order for relief is automatic with the filing. An involuntary bankruptcy can be filed by the debtor's creditors, if certain requirements are met. The court will then determine, after notice and a hearing, whether to approve the bankruptcy. If it is approved, then the order for relief is granted on the date that the bankruptcy is approved.
Whether the commencement is voluntary or involuntary, the debtor's property becomes the bankruptcy estate and the automatic stay prevents creditors from trying to collect on their debts. Unlike Chapters 12 and 13, postpetition property and income do not become part of the bankruptcy estate, which is necessary for the debtor to continue doing business.
The bankruptcy petition provides information about the DIP's assets and liabilities, income and expenses, executory contracts, a statement of financial affairs, and a list of its creditors, including the amount of their claim. A copy of the petition is sent to each creditor so that they can evaluate the petition. Creditors do not need to file a claim if they are listed in the petition unless they disagree with it, such as the amount of the claim.
Simply to file a Chapter 11 case costs $1,000 plus a $39 administrative fee. However, the administration of the case requires a lot more money, especially for a large business that always employs many professionals specifically for the bankruptcy, such as lawyers and accountants. For instance, the bankruptcy of Lehman's Brothers was reported to cost $1.4 billion dollars, and even for individual debtors, attorney fees can range from $10,000 to $30,000.
Plan Formulation — Creditors' Committees
A reorganization plan must be formulated that will allow the DIP to run the business profitably. The DIP has an initial exclusive right for 120 days to file the plan, but the creditors get to vote on whether to accept or reject the plan. Hence, much of the initial stages of the bankruptcy require formulating a plan, negotiating with creditors to secure their votes, then getting the plan confirmed by the court. Sometimes, in what is called a prepackaged bankruptcy, the debtor will negotiate with its creditors before filing so that the debtor will already have an acceptable plan, allowing it to emerge from bankruptcy sooner. Once the plan is confirmed, then all parties in interest, including those who voted against the plan, are bound by it.
To facilitate the negotiation with creditors, a creditors' committee is formed by the United States Trustee that is composed of representatives of the business debtor's 7 largest creditors. The debtor must negotiate with the creditors' committee to arrive at a reorganization plan that will allow the debtor to survive at the least possible cost to the creditors. The plan will detail what assets to sell, which executory contracts will be rejected, and how creditors are classified and how much each class will be paid as a percentage of their claim.
The debtor is given 120 days to file a plan and 180 days to confirm it. If the debtor fails to either provide a plan or get a plan confirmed, then the creditors may submit a plan. The time limit motivates the DIP to formulate a desirable plan that will be acceptable to its creditors, because if it doesn't, the creditors will be allowed to submit a plan that may be less desirable for the DIP.
Creditors' committees are not usually formed for most small businesses and individual debtors filing under Chapter 11, since there is usually a lack of interest from creditors in participating in a committee. In these cases, the U.S. Trustee takes a more active role in shaping the plan.
The DIP must negotiate with the creditors' committee for an acceptable plan. Since the creditors vote on whether to accept the plan or not, the DIP must send the creditors a disclosure statement that is approved by the court, after notice and a hearing, which contains adequate information so that creditors can evaluate it and make an informed decision. For a big business, the disclosure statement is much like a prospectus for an investment, since the same types of information must be disclosed. Generally, the disclosure statement will provide a history of the business and its transactions, the details of its plan to emerge from bankruptcy, possible alternatives to the plan, and the financial information that creditors need to evaluate the probable success of the plan.
Solicitation and Voting
When the court approves of the disclosure statement, it also sets a time to collect all votes. Creditors receive ballots in which they choose to either accept or reject the plan. The ballots must be returned by the prescribed time, or their vote is not counted.
The Chapter 11 Code has specific rules about who can vote and how the votes are counted. Creditors and equity holders are placed in classes, according to the type of collateral or the priority of their claims. For instance, secured and unsecured creditors would be in separate classes, as would be preferred and common stockholders. Often, all unsecured claims of little value are also placed in a class separate from other unsecured creditors to reduce administration expenses.
Since creditors and equity holders vote as a class, how they are classified will affect their voting rights. Although the DIP classifies the creditors and equity holders, to prevent classification schemes designed to manipulate votes, the classification must have a reasonable basis and the court must approve of the classification.
The plan must describe how the creditors will be classified, particularly which classes will be impaired, since they will be the only ones voting on the plan. An impaired class is one whose rights are being altered under the plan from nonbankruptcy law, usually meaning they are getting less than the full amount of their claim.
Unimpaired classes are deemed to accept the plan, since their nonbankruptcy rights are not altered, except that the debtor has the right to cure defaults and to decelerate loans by compensating the class for the delay in payment. An impaired class who is getting nothing under the plan is deemed to reject the plan. Hence, only impaired classes who are getting something get to vote on the plan.
Although each member of an impaired class gets to vote, only the class vote matters. Under §1126(c) of the Bankruptcy Code, an entire class of claims is deemed to accept a plan if the plan is accepted by creditors that hold at least 2/3 in amount and more than ½ in number of the allowed claims in the class. Those creditors who rejected the plan are at least entitled to receive the present value of what they would have received under a Chapter 7 liquidation.
For those holding interests in the debtor, such as shareholders, a class of interests is deemed to have accepted the plan if at least 2/3 of the class voted in favor of the plan.
Section 1129(a) of the Bankruptcy Code lists the requirements for confirmation, including:
- the plan must be lawful and proposed in good faith;
- impaired claims and interests who have rejected the plan must receive at least as much as they would have gotten under a Chapter 7 liquidation;
- all impaired classes must have accepted the plan;
- all priority claims must be paid in full;
- and the plan must have a good chance of success.
When the reorganization plan is confirmed, the business debtor receives a discharge of most of its debts. It then must effectuate the plan to completion, after which, the court will issue a final decree.
Under §1129(a)(10), if there are impaired classes of claims, the court cannot confirm a plan unless it has been accepted by at least one class of non-insiders who hold impaired claims. Even if this is satisfied, however, if there are any impaired classes who rejected the plan, then the plan can only be confirmed by cramdown under §1129 (b), which requires that:
- all the requirements listed in §1129(a) must be met except for subsection (8), which requires the approval of all impaired classes;
- the plan does not discriminate unfairly and is fair and equitable against impaired classes who have rejected the plan.
Discharge and the Final Decree
When the plan is confirmed the business debtor receives a discharge at the time of confirmation and the property of the bankruptcy estate vests with the debtor. However, an individual debtor must complete the plan before receiving a discharge.
The debtor must continue reporting to the U.S. Trustee until the plan is completed, after which, the court issues a final decree and the case is closed.