There are a lot of variations in what a Chapter 11 can be used for and what it can look like, but Chapter 11 is usually used to reorganize or sell a business or its assets. As I wrote on themain business bankruptcy page, the key question is whether the business can reorganize it’s balance sheet and be viable as a business. Chapter 11 cannot create revenue for the business, but it might be able to free up cash dedicated to debt service and allow for the rejection of certain disadvantageous contracts and leases.  We’ll look at a few scenarios after laying out the basics.

Why does a Business File Chapter 11?

Chapter 11 bankruptcy is usually predicated on a cash crunch. The business may be in work-out mode with creditors or it may see imminent default on the horizon.  The business has a duty to all stakeholders to enter into some sort of plan to stop the company from being torn to pieces by creditors.  When work outs and negotiations fail, that plan usually ends up being bankruptcy. 

Can Owners Keep the Company in Chapter 11?

The answer is, maybe.  There is an important provision of the Bankruptcy Code called the “absolute priority rule.”  The absolute priority rule prohibits business owners from bankrupting a business, shedding its debt, and walking away with the value of the business–contrary to some myths about business bankruptcy.  If you think about the news about big, corporate bankruptcies, it will make sense to you: new stock is always issued after the company emerges from bankruptcy, i.e. the original owners have their equity interests wiped out. 

There are exceptions to this, however, and sometimes the original owners can end up owning the reorganized debtor.  This usually happens in one of three ways:

• All impaired classes of creditors vote to approve the Chapter 11 plan.  An affirmative vote of a class does not require unanimity, but it does require that 2/3 of the dollar amount and one half of the number of claims in the class vote in favor.
• All debts are paid in full in such a way that there are no impaired classes of claims.
• The owners buy the stock of the reorganized debtor under the plan or successfully bid for the business assets at a court-approved sale.

We have experience with the type of Chapter 11 plan that results in the original owners emerging as the new owners of the reorganized entity. 

Why Would Owners Ever File Chapter 11 if They Couldn’t Keep Their Company?

Even if there is no chance of getting creditor acceptance and owners cannot afford or do not want to buy back their business, it often makes sense to file Chapter 11 for a business when faced with the alternatives. There are two main alternatives.

• Continue to attempt to avoid bankruptcy by negotiation.  It is sensible to try this for a time, but sound judgment must be employed in determining when the business must conserve cash and use its available time to seek bankruptcy protection.  Usually this coincides with some actual or threatened litigation.
• File Chapter 7 for the business.  The business assets will be sold by a trustee at a bankruptcy “garage sale.”  Upon filing, the business owners immediately lose control of the company.  This is not always bad. In some situations, the business owners just want to move on quickly. Chapter 7 for a business is also relatively cheap in terms of legal fees, and it requires less time and energy. 

Running a company while engaged in debilitating (and doomed) litigation or participating in endless workout meetings with little leverage is no way to live. It is also not consistent with the company’s duty to its entire creditor body.  First of foremost, Chapter 11 imposes a stay on lawsuits and other collection activities.  It also allows the business owners to stay in charge and draw salaries while exploring the full range options in Chapter 11, which could include a sale, reorganization, liquidation, or a combination of these. Chapter 11 also sometime allows business owners to limit their own personal liability by ensuring that certain debts like wages and taxes are paid.  So even in cases in which the chance that the owners will keep their stock is slim, Chapter 11 is usually the best of several bad alternatives.

What Happens after Chapter 11 Bankruptcy is Filed?

If you do things right, you stay in charge and run the business as a debtor in possession (DIP). If you do things wrong or have been operating the business in a problematic manner, a trustee may be appointed to run the business. In most cases, however, the debtor continues to operate as a DIP and its existing owners stay in charge.

There are many procedural and substantive matters to attend to early in a Chapter 11 case, such as motions to employ estate professionals, motions to use cash collateral and DIP financing, and motions to pay certain pre-petition creditors. DIP bank accounts must also be opened and a procedure set in place to make monthly operating reports to the U.S. Trustee.

A Chapter 11 Plan

There are quite a few options for what you might attempt in a Chapter 11 bankruptcy. They can involve the sale of all or part of the business and/or a restructuring of the business balance sheet by reducing the amounts owed on debts. However, the Chapter 11 plan (and accompanying Disclosure Statement) is an original document drafted by your attorney and submitted to creditors for voting and, later, to the Court for approval. If the plan “impairs” any creditor class, the plan must be approved by at least one of the impaired classes. A class of claims approves a plan if more than a half of the claimants and more than 2/3 of the total dollar amount of the class votes in its favor.

Emerging from Chapter 11 Bankruptcy

Once a Chapter 11 plan is confirmed and a few other loose ends are tied up, a business emerges from bankruptcy (unless it is a liquidating Chapter 11 plan). The “reorganized debtor” is once again free to conduct its own affairs without Court supervision. The duties that the reorganized debtor has taken on under its plan, such as paying pre-bankruptcy creditors a partial dividend on their claims, must be performed, but a reorganized business is often seen as healthy and a good credit risk going forward.

A Brief Word about Personally-Guaranteed Business Debt

Personally-guaranteed debt is a big problem for small business owners when the business goes south.  Although certain debt payments can be reversed as bankruptcy preferencesdepending many factors, including when a business ends up in bankruptcy after the payments, business owners sometimes find it beneficial to pay down personally-guaranteed business debts before a bankruptcy out of business assets.  It really pays to retain an attorney as soon as possible in this situation.   

Next Steps

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