Chapter 11 Bankruptcy

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When a company can no longer pay its debts, it generally creates a relationship between two stakeholders–the debtor and creditors. The debtor seeks relief from the debt it cannot repay, while the creditors seek to recollect their debts, quickly and efficiently. Through the “Chapters” in the Bankruptcy Code, Congress created the rules governing the relationship between creditors and the debtor during bankruptcy in order to systematically, effectively, and efficiently satisfy the often countervailing interests of each side.

Chapter 11 bankruptcy is the formal process that allows debtors and creditors to resolve the problem of the debtor’s financial shortcomings through a reorganization plan. Accordingly, the central goal of chapter 11 is to create a viable economic entity by reorganizing the debtor’s debt structure. Unlike chapter 7, chapter 11 is not a liquidation of the debtor’s assets. Rather, it is a reorganization of existing assets, principally as debt. The confirmed chapter 11 plan becomes a contract between the debtor and creditors, governing their rights and obligations.

The premise behind a chapter 11 reorganization is that a debtor is more valuable as an operating entity than in liquidation (i.e., through a chapter 7 bankruptcy). Hence, chapter 11 bankruptcy is generally chosen when the continuation of a debtor’s business generates more value than a closure and piecemeal sale of its assets. This often occurs when the debtor’s financial troubles are a product of temporary issues, such as low cash flow and diminishing demand. A Bankruptcy Judge will confirm a Chapter 11 plan only when creditors are satisfied that they will receive at least as much as they would under a liquidation.

As such, Chapter 11 is generally intended to provide business debtors, like corporations and limited liability companies, the opportunity to reorganize their debt. Conspicuous examples of chapter 11 bankruptcy include Lehman Brothers in 2008, General Motors in 2009, and Kmart in 2002. However, Section 109 of the Code permits and courts agree that individual debtors not engaged in business may file for relief under Chapter 11. This usually occurs when an individual’s debt exceeds the statutory debt ceiling for Chapter 13 of the Bankruptcy Code.

Procedure

Generally, a debtor initiates their bankruptcy by filing a bankruptcy “petition” with the clerk of the bankruptcy court. Most debtors must also file schedules stating the debtor’s assets and liabilities, current income and expenditures, and business and financial affairs. According to the Bankruptcy Court for the Eastern District of New York, these filings “are carefully designed to elicit certain information necessary to the proper administration and adjudication of the case.” In turn, creditors gain information to make possible a fair and efficient distribution of the debtor’s assets.

When a debtor files for bankruptcy, the court creates a bankruptcy estate, composed of the debtor’s property owned at the commencement of the case. Section 541(a)(1) defines "property of the estate" to include "all legal or equitable interests of the debtor in property as of the commencement of the case." The Supreme Court noted in United States v. Whiting Pools, Inc. (1983), § 541(a)'s legislative history demonstrates that this provision was intended to be broad and include "all kinds of property, including tangible or intangible property, causes of action . . . and all other forms of property currently specified in” the Bankruptcy Act. According to Butner v. United States, a Supreme Court case from 1979, bankruptcy courts look to state law to ascertain the existence and scope of the debtor's "legal or equitable interests" for purposes of § 541(a)(1).

Reorganization Plan

The reorganization plan is the central feature of Chapter 11 bankruptcy. As noted in Tamir v. U.S. Trustee (D. Me. 2016), “the primary goal of Chapter 11…[is] to formulate a comprehensive reorganization plan that will ultimately rehabilitate financially distressed debtors.” Ideally, Chapter 11 should “be...a negotiated process; a system to induce compromise.” Accordingly, the requirements for a proposed reorganization plan reflect the pursuit of order and fairness. A proposed plan must:

●      Designate classes of claims among similarly situated debt- and equity- holders.

●      Identify if the plan will “impair” claims of discrete classes. According to In re Woodbrook Assocs., (7th Cir. 1994), impairment occurs when there is any alteration of a creditor’s rights, “no matter how minor.”

●      Explain how the plan will alter the claims held by the impaired classes.

●      Treat every entity in each class the same as all class members.

●      Provide sufficient measures to implement the plan by, for example, selling debtor’s property, satisfying liens, or waiving a default by the debtor, among other means.

Creditors that are adversely affected by the plan are able to vote for or against it. However, as In re Edgefield Inn, LLC (Bankr. D.S.C. 2014), accurately states, “unimpaired classes...have no vote in the reorganization process.” The statute limits voting power only to impaired classes; indeed, classes not impaired under the plan are “conclusively presumed to have accepted the plan.”

Under 11 U.S.C. Section 1125, a proponent of the plan is generally required to submit a disclosure statement. Such disclosure allows potentially affected parties to make an informed judgement on whether to vote for the plan. § 1126(c) states that a class of creditors accepts the plan if “creditors … that hold at least two-thirds in amount and more than one-half in number of the allowed claims of such a class” vote to accept the plan. Section 1126(c), (e) authorizes the court to disregard the vote of any creditor whose acceptance or rejection of the plan was not in good faith.

Subsequently, the court will hold a hearing to “confirm” the plan. For the plan to be confirmed, a court must find that creditor classes either accept the plan or are not impaired and that the plan satisfies additional criteria listed in Section 1129 of the Bankruptcy Code. A Chapter 11 reorganization plan may not be confirmed unless it satisfies a number of statutory requirements, principally the following three:

(1)  Best Interests of Creditors. Under Section 1129(a)(7)(A), a reorganization plan must satisfy the "best interests of creditors" test. According to the Supreme Court in United States v. Reorganized CF&I Fabricators of Utah, Inc. (1996), this test requires that each holder of an impaired claim or interest either accept the plan or receive under it at least as much as they would receive in a chapter 7 liquidation. Unless a creditor consents to otherwise, this requirement means that a creditor must receive property that has a present value equal to what that participant would have received in a chapter 7 distribution, had the debtor been liquidated on the plan’s effective date.

(2)  Feasibility. The "feasibility requirement" requires the court to find that a plan is workable, but success need not be guaranteed. A plan is workable under the statute if the court finds that the debtor is unlikely to liquidate or need further financial reorganization. The debtor bears the burden of establishing the feasibility of the plan by showing that the plan has a reasonable probability of success. The court in In re Apex Oil Co. (Bankr. E.D. Mo. 1990) notes that to determine whether the plan has a reasonable probability of success, the court may compare the debtor's future income and expenses to actual performance, considering the capability of management, the adequacy of capital resources, and reasonably anticipated liquidity.

(3)  Cram-down. Under certain circumstances, the Code permits a court to confirm a plan over a creditor's dissent. This non-consensual confirmation is called a "cram-down" and the Code requires the debtor to show that the plan “does not discriminate unfairly, and is fair and equitable, with respect to each class of claims or interests that is impaired under, and has not accepted, the plan.”According to In re Hoffinger Indus., Inc. (Bankr. E.D. Ark. 2005), the plan may only treat similar claims differently when the debtor has a reasonable basis for the disparate treatment. There is generally a reasonable basis for treating secured claims differently from each other since secured claims are usually secured by different collateral, therefore warranting disparate treatment.

When a plan is confirmed, it becomes a binding contract on the debtor, the creditors, and other parties. The effect of a confirmation vests all of the property of the estate in the debtor, “except as otherwise provided in the plan or the order confirming the plan.” In turn, “confirmation generally discharges the debtor from its pre-confirmation debt,”substituting the obligations of  the plan for the debtor's prior indebtedness. The Bankruptcy Court retains jurisdiction to “interpret, enforce,  or aid” the management of the reorganization plan.

Debtor-In-Possession

Under a chapter 11 bankruptcy, the debtor generally holds possession of its assets throughout the proceeding and administers them for the benefit of the creditor class. This feature, termed “debtor-in-possession,” reflects a key distinction between the bankruptcy rules under chapter 7 and chapter 11.

Under chapter 7, a trustee administers the debtor’s assets to satisfy creditors’ claims. By contrast, chapter 11 reflects Congress’ view that “current management is generally best suited to orchestrate the process of rehabilitation” to benefit creditors and other interests of the estate. In turn, the debtor generally retains its control over its assets and business operations, acting as a “debtor-in-possession.” Such status explains why managers of the debtor prefer chapter 11 over chapter 7: chapter 7 displaces the managers’ control over the firm vis-a-vis the appointed trustee, while chapter 11 does not require such an appointment.

In practice, chapter 11 permits the debtor-in-possession to use property and transact in the ordinary course of business, without preapproval from the court. For acts taken outside the ordinary course of business, notice, hearing and court approval is generally required in advance. According to the District of Utah Bankruptcy Court, an action “outside the ordinary course of business” encompasses any transaction “that might be considered unusual, controversial, or questionable for the debtor to undertake during its chapter 11 case.” The same court in another proceeding found a sale of “substantially all the debtor’s assets” to satisfy that standard. As such, this standard balances the efficiency of permitting the debtor-in-possession to perform ordinary business functions without onerous oversight of creditors and the court with the need to protect creditors from unordinary transactions.  

[Last updated in May of 2020 by the Wex Definitions Team]