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Chapter 7

What is it?

Chapter 7 is the liquidation of a debtor’s estate and distribution of cash proceeds to creditors according to a pre-arranged scheme or set of priorities. To accomplish this goal the Court must appoint an independent 3rd party (the Trustee) to take control of the debtor’s possessions and move in the direction of their sale. This third party is usually an Attorney but can also be an Accountant. Although the United States Trustee makes the initial appointment of the Chapter 7 Trustee, the creditors may insist on an election at which they can install anyone of their choosing, so long as he or she is “disinterested” (more on this later).

Who Can be a Debtor?

Chapter 7 is available to any person or entity except railroads (and as otherwise noted above). Cases which start under other Chapters can be converted to Chapter 7 at almost any time. Typically, this happens when the Debtor’s business cannot be salvaged, and continued operation will only result in increased losses.

How are Assets Disposed of?

While the Court may authorize the Trustee to operate the Debtor’s business for a short time if doing so would increase the creditors’ recovery on the Debtor’s assets, Chapter 7 frequently involves selling the Debtor’s assets on a piecemeal basis, rather than as a going concern. For example, trustees routinely operate a business to complete work-in-progress if there is a reasonable likelihood that the resulting inventory can be sold (rather than selling the work-in-progress for scrap value). Sales are conducted via public auction or a negotiated private sale.

What Factors go Into a Successful Asset Sale?

The degree to which such the sale of a debtor’s assets succeeds depends on factors such as a Trustee’s contacts among likely buyers, the advertising budget, and the Trustee’s willingness to engage in aggressive marketing. The more successful a sale, the more creditors receive and the higher the Trustee’s commission –- note however that the debtor sees no difference regardless of the price at which assets are sold. The benefit to the debtor is merely release from debt – or so the theory goes.

Chapter 11 What is it?

Chapter 11 is primarily a tool for reorganizing an ongoing business enterprise. Chapter 11 may also be used by individuals, but was not designed for them and generally does not provide a good fit. A company entering Chapter 11 remains in possession of its assets and in control of its affairs. Management remains the same, and the business remains in the control of the board of directors.

A Chapter 11 debtor is provided with a certain amount of time (180 days, subject to extension) in which to analyze its situation, negotiate with its creditors, and develop a plan for reorganizing itself. Chapter 11 provides for the appointment of a group of unsecured creditors (usually between three and seven) to an official committee. This Committee has an important role in the bankruptcy case. The Debtor generally conducts its plan negotiations with the Committee (acting on behalf of the unsecured creditors). The Committee, with bankruptcy court approval, is permitted to hire professionals (for example, attorneys and financial advisors) at the Debtor’s expense. The expenses of the Committee members are also paid for by the Debtor. The Committee has a persuasive voice with the bankruptcy court. Chapter 11 is geared toward the negotiation and consummation of a plan of reorganization, which will generally expunge the Debtor’s old debts and repay them with new debt or equity instruments. Where the Debtor’s creditors depend on future recoveries in this manner, they become, in essence, “business partners” with the Reorganized Debtor, and often their percentage of recovery is tied to the success of the reorganized entity.

There is no prohibition in the Bankruptcy Code, however, against liquidating a company under Chapter 11. A liquidating Chapter 11 case essentially means that the Debtor (rather than a Chapter 7 Trustee) sells its own assets (presumably as a going concern) and files a plan of liquidation which does little more than distribute the proceeds of the Debtor’s assets under Chapter 11.

Who Can be a Debtor?

Chapter 11 is available to any person or entity (including railroads), except stockbrokers and commodity brokers. Brokers can only file for bankruptcy under certain special provisions of Chapter 7. Chapter 11 therefore is available to individuals and family farmers even though there are special Chapters for them. Chapter 11 is not geared towards individuals (and would not be efficient for individuals); therefore, unless ineligible, individuals should generally file under Chapter 7, 12, or 13. There is no requirement that a Debtor be “insolvent” to file a petition under Chapter 11. There have been many entities (i.e., Johns-Manville and Dow Corning) which have filed Chapter 11 cases for legitimate business reasons rather than as a result of liquidity crises. Indeed, perhaps because of the difficulty in reorganizing when management is spending its time just trying to keep their company alive, some of the most successful Chapter 11 cases have been those which were filed before the Debtor’s business problems became extreme.

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