Chapter 11 Primer
Courts consider the reorganization of a business preferable to its liquidation if doing so preserves jobs, keeps assets productive, and enhances the local economy.
Chapter 11 permits restructuring of an individual’s or business’ finances as it operates, so that it can retain employees, create new jobs, pay trade creditors, produce returns for stockholders, and repay pre-filing creditors from future operating profits.
The Code presumes that the persons best equipped to operate the business throughout reorganization are its existing managers. So with few exceptions, the managers in place at the outset of a Chapter 11 case will continue to operate the business until its conclusion.Who Can be a Debtor in Chapter 11?
While an individual may seek Chapter 11 relief, the provisions of this section of the Code are generally too complex, and compliance too expensive, to suit the needs of consumers.
Nonetheless, consumer Chapter 11 is appropriate where Debtor(s) have liabilities that exceed the limits prescribed by the Code for Chapter 13 reorganization.Is Reorganization Feasible?
The threshold question in Chapter 11 is whether the Debtor is worth more as a going concern than it would be if it were liquidated. This inquiry is often expressed as an equation:
But even if the numbers support reorganization, the central question is whether the managers of the business are prepared to reduce operating costs in order to return the enterprise to financial health? And if so, can they do it within the Plan period?How Chapter 11 Works The Petition
The Chapter 11 Petition notifies creditors, customers, and employees the Debtor has filed Bankruptcy. Petitions may be filed voluntarily by the Debtor or involuntarily against the Debtor, by creditors that meet certain requirements.
A Voluntary Chapter 11 Petition must include:
- Business name of Debtor and all subsidiaries
- SSN of directors, officers, and shareholders
- The EIN of the business Debtor
- The Location of the primary office
- Residence address of directors, officers, shldrs
- Location of the principal assets of the Debtor
- Whether Debtor qualifies as a “small business”
- Whether Debtor elects to be a “small business”
An Involuntary Chapter 11 Petition will not include many of the above items of information because such Petitions are generally not created by insiders with this knowledge but rather by creditors or other 3rd parties who must rely on the Court to demand that the information be provided by the current slate of managers.The Automatic Stay
The Automatic Stay provided for by §362 of the Code ushers in a “quiet period” in which all of the judgments, collection activities, foreclosures, repossessions, litigation, citations, liens, and other attempts to collect from the Debtor are suspended until the Plan of Reorganization is approved by the Bankruptcy Court.
Eventually however the Debtor must propose a means to come current with secured creditors. If the Debtor is unable to do so, secured creditors may obtain relief from the Stay, repossess or foreclose on property of the Debtor, sell it, and apply the proceeds to their debt.
It should be noted that, although creditors are stayed from action against the Debtor unless relief is granted by the Court, the Code permits applications for fees to be made by certain professionals during the case. Thus, a trustee, a Debtor's attorney or any professional person may apply to the Court at intervals of 120 days for interim compensation and reimbursement payments. In very large cases with extensive legal work, the Court may permit more frequent applications. Although professional fees may be paid pursuant to authorization by the Court, the Debtor cannot make payments to creditors on pre-petition obligations, (e.g. obligations that arose before the filing of the Petition). The ordinary expenses of the ongoing business, however, continue to be paid.The Debtor in Possession
Upon filing the Petition the Debtor automatically assumes an additional identity as the Debtor in Possession (DIP). Until the confirmation of a Plan, the Debtor keeps possession and control of its assets while undergoing the reorganization. The appointment or election of a trustee occurs only in a small number of cases. Generally, the Debtor in Possession continues to operate the business and performs many of the functions that a trustee performs in cases under other Chapters.
The DIP is a fiduciary with the rights and powers of a trustee, and must perform all but the investigative functions and duties of a trustee. These duties are set forth in the Bankruptcy Code and Federal Rules of Bankruptcy Procedure. Such powers and duties include:
- Accounting for property
- Examining and objecting to claims
- Filing reports (e.g. Monthly Operating Reports) as required by the Court and U.S. Trustee
The Debtor in possession also has many of the other powers and duties of a trustee including the right, with the Court's approval, to employ:
- Other professionals
Other responsibilities include filing tax returns and filing such reports as are necessary or as the Court orders after confirmation, such as a final accounting. The U.S. Trustee is responsible for monitoring the compliance of the Debtor in Possession with the reporting requirements.DIP Avoidance Powers
The DIP, or the Trustee in cases where one is appointed, has so-called Avoidance Powers to undo a transfer made within a certain period before the filing of the Petition. By avoiding a particular transfer the DIP can cancel it and force the “disgorgement” of the payments or property; which is then distributed to all creditors rather than benefiting just the creditor to which it had been transferred (i.e. the recipient of the preferential or fraudulent transfer).
Generally, Avoidance Powers are effective against transfers made within 90 days before the filing of the Petition. However, transfers to insiders (e.g. relatives, general partners and directors or officers of the Debtor) made up to 2 years before filing can be avoided or undone. In addition, the Trustee has authority to avoid transfers under applicable State law, which in Illinois means that the Trustee or DIP can look back up to 5 years.The Plan of Reorganization
In order to reorganize under Chapter 11, the Debtor in Possession must propose a Plan by which it can realistically continue to operate while repaying its debts. The Plan must include a classification of claims and specify how each class of claims will be treated (e.g. how they will be repaid). The Plan must be voted upon by all creditors whose claims are “impaired” by the terms of the Plan (e.g. those whose contractual rights are to be modified or who will be paid less than the full value of their claims – usually these are all unsecured creditors).The Disclosure Statement
In addition to the Plan, a written Disclosure Statement must be filed with the Court. The Disclosure Statement should contain enough information concerning assets, liabilities, and affairs of the Debtor to enable a creditor to make an informed judgment about the Plan.The Confirmation Hearing
After the Disclosure Statement is approved, and the ballots are collected and tallied, there must be a Confirmation Hearing at which the Court determines whether to confirm the Plan.The “Exclusive” Period
There is no specific statutory time limit set for the filing of a Plan. However, during the first 120 days after filing its Petition, only the Debtor may propose a Plan (unless a Small Business Debtor as defined herein). This Exclusivity Period may be extended or reduced by the Court. After the Exclusivity Period has expired, a Creditor or the case trustee may file a competing Plan. The U.S. Trustee may not file a plan, however. A Chapter 11 case may continue for many years unless the Court, the U.S. Trustee, the Creditors’ Committee or another party in interest acts to ensure its timely resolution. Thus, the Creditors’ right to file a competing Plan provides incentive for the Debtor to file its own Plan within the Exclusivity Period and avoid delay.Creditors' Committees
Creditors’ Committees can play a major role in Chapter 11 cases. The U.S. Trustee appoints the Committee, usually consisting of the persons holding the 7 largest unsecured claims against the Debtor. The Committee may consult with the Debtor in Possession on the administration of the case, investigate the conduct of the Debtor and the operation of the business, and participate in the formulation of a Plan. A Creditors’ Committee can be an important safeguard to the proper management of the business by the Debtor in Possession.Recurring Issues: Cash Collateral, Adequate Protection, and Operating Capital
Unless the Court orders otherwise, the Debtor in Possession may use, sell or lease property of the Debtor in the ordinary course of business without prior approval. If that sale or use is outside the ordinary course of business, permission from the Court is required. However, a Debtor in Possession may not use Cash Collateral (e.g. collections from accounts subject to security interests, or proceeds from the sale of pledged inventory or equipment) without the consent of the secured party or authorization of the Court after an examination of whether the interest of the secured party is adequately protected. The Code defines Cash Collateral as:
cash, negotiable instruments, documents of title, securities, deposit accounts, or other cash equivalents, whenever acquired, in which the estate and an entity other than the estate have an interest, including the proceeds, products, offspring, rents or profits of property and the fees, charges, accounts or payments for the use or occupancy of rooms and other public facilities in hotels, motels, or other lodging properties subject to a creditor's security interest
When Cash Collateral is used the secured creditors receive additional protection under the Code. The Debtor in Possession must file a motion requesting an order from the Court authorizing the use of the Cash Collateral. Pending consent of the secured creditor or Court authorization, the Debtor in Possession must segregate and account for that Cash Collateral. A party with an interest in property being used by the Debtor may request that the Court prohibit or condition this use to the extent necessary to provide them with “adequate protection.”Equity Security Holders
An Equity Security Holder owns an equity security of the Debtor (e.g. stock, limited partnership interest, option, etc.). An Equity Security Holder may vote on the Plan and file a proof of interest for any interest that appears in the Debtor's schedules, unless it is scheduled as disputed, contingent, or unliquidated. An equity security holder whose interest is not scheduled or scheduled as disputed, contingent or unliquidated must file a proof of interest to be treated as a creditor for purposes of voting on the Plan.Conversion or Dismissal
A Debtor in a case under Chapter 11 may be able to convert the Chapter 11 case to a case under Chapter 7 unless: (1) the Debtor is not a Debtor in Possession; (2) the case originally was commenced as an involuntary case under Chapter 11; or (3) the case was converted to a case under Chapter 11 other than at the Debtor's request. A Debtor in a Chapter 11 case does not have an absolute right to have the case dismissed upon request.
Generally, upon the request of a party in interest in the case or the U.S. Trustee, after notice and hearing and “for cause,” the Court may convert a Chapter 11 case to a case under Chapter 7 or dismiss the case, whichever is in the best interest of creditors and the Estate. The Court may convert or dismiss a case “for cause” when there is a continuing loss to the Estate, an inability to effectuate a Plan, unreasonable delay that is prejudicial to creditors, denial or revocation of confirmation, or inability to consummate a confirmed Plan.Discharge
A separate order of Discharge is usually not entered in a Chapter 11 case where the Debtor is a corporate entity; however, for an individual debtor, the discharge comes at the end of the plan, similar to a chapter 13. For a company, the confirmation of a Plan discharges the Debtor from all debts that arose before the date of confirmation. After the Plan is confirmed, the Debtor is required to make Plan payments and is bound by the provisions of the Plan. The confirmed Plan creates new contractual rights, replacing or superseding pre-bankruptcy contracts.Effect of Reorganization
Chapter 11 is typically used to reorganize a business, which may be a corporation, sole proprietorship, or partnership. However, there are special types of Chapter 11 Debtors: individuals, small business, and single asset real estate.Corporation
A corporation exists separate and apart from its owners, the stockholders. The Chapter 11 bankruptcy case of a corporation does not put the personal assets of the stockholders at risk, although they may lose the value of their investment in the company's stock.Sole Proprietorship
A sole proprietorship does not have an identity separate and distinct from its owner(s); accordingly, a bankruptcy case involving a sole proprietorship includes both the business and personal estates of the owners-Debtors.Partnership
Like a corporation, a partnership exists separate and apart from its partners; however, the partners' personal assets may, in some cases, be used to pay creditors in the bankruptcy case or the partners may, themselves, be forced to file for bankruptcy protection.
It should be noted that railroad reorganizations have specific requirements under subsection IV of Chapter 11 which will not be addressed here and that stock and commodity brokers are prohibited from filing under Chapter 11 and are restricted to Chapter 7. 11 U.S.C. 109(d).Special Types of Debtors
Small Business Debtor
Certain types of Debtors are defined in the Code and have special provisions that apply only to them. One such case is the Small Business Debtor, defined as a person or entity:
[E]ngaged in commercial or business activities (not including one that primarily owns or operates real property) that has aggregate non-contingent liquidated secured and unsecured debts that do not exceed $2,000,000
If a Debtor qualifies and elects to be considered a Small Business under 11 U.S.C. 1121(e), the case is put on a fast track and treated differently than a regular Chapter 11 case under the Code. For example, the appointment of a Creditors’ Committee and a separate hearing to approve the Disclosure Statement are not mandatory. On request of a party in interest, and for cause, the Court may order that a Creditors’ Committee not be appointed. The Court may conditionally approve a Disclosure Statement, subject to final approval after notice and a hearing. Solicitation of votes for acceptance or rejection of the Plan may proceed based on the conditional approval of the Disclosure Statement. Thereafter, the Disclosure Statement hearing may be combined with the Confirmation Hearing. In addition, the Debtor has a shortened period of time (100 days from the date of the order for relief) within which only the Debtor may file a Plan. After the 100-day period expires, any party in interest may propose and file a competing Plan; however, all plans must be filed within 160 days from the date of the “order for relief” (filing a voluntary bankruptcy petition constitutes an “order for relief”).Single Asset Real Estate Debtor
Another type of Debtor that has special provisions under the Bankruptcy Code is the Single Asset Real Estate Debtor. The term “single asset real estate” is defined as:
a single property or project, other than residential real property with fewer than 4 residential units, which generates substantially all of the gross income of a Debtor, on which no substantial business is being conducted by the Debtor other than operating the real property, which has aggregate non-contingent liquidated secured debts of no more than $4,000,000 The Code provides circumstances under which creditors of a Single Asset Real Estate Debtor may obtain relief from the Automatic Stay. For example, on request of a creditor with a claim secured by the real estate and after notice and a hearing, the Court will grant relief from the Automatic Stay within 90 days from the date of the order for relief, unless the Debtor files a feasible Plan or begins making payments to that creditor be equal to the current fair market interest rate on the creditor’s interest in the real estate.Individuals
An individual debtor is one of the most common types of debtors in a Chapter 11. However, Chapter 11 is also the most confusing for individuals. This is because unlike Single Asset Real Estate or Small Business, individuals do not have a special section of the Chapter 11 code.
The individual classification is more informal. Generally there are not creditor committees. However it is not uncommon for there to be a fight over the use of cash collateral. Like in a Chapter 13, the Debtor must file a plan, but unlike a 13, there must also be a disclosure statement.Conclusion
MHA has the experience and knowledge to help all kinds of Debtors navigate the complex Chapter 11 process. Contact MHA today to see how we can help you get the relief you need.