Chapter 11 bankruptcy does for businesses what Chapter 13 does for individuals in terms of buying time to reorganize in hopes the business can turn things around and pay off creditors over time.
Chapter 11 is a re-set button, not a going-out-of-business sign and a lot of company’s use it.
It’s difficult to name an airline – United (2002), Delta (2005) and American (2011) — that hasn’t gone through it. Two of Detroit’s Big Three automakers — General Motors and Chrysler — filed in 2009.
Casinos do it. Drug companies do it. And after a tsunami of red ink washing away assets and swamping stores, even venerable Sears sought relief through Chapter 11 in October 2018.
During the coronavirus pandemic, an onslaught of prominent retailers filed for Chapter 11 protection. Epiq AACER said Chapter 11 bankruptcy filings in May of 2020 were up 48% over the previous year and included businesses like:
- J. Crew
- Neiman Marcus
- Stage Stores
- J.C. Penney
- Tuesday Morning
- Advantage Rent A Car
During the peak of the Great Recession and the early years of the recovery (2008-2012), nearly 250,000 businesses filed for bankruptcy (not all of them Chapter 11). Since then, business bankruptcies have dipped dramatically, as have all forms of bankruptcy, averaging a bit less than 24,000 annually, although analysts have noted, with worry, about the uptick in Chapter 11 filings that began in December 2017.
It’s a virtual guarantee we’ve all heard of Chapter 11 bankruptcy, then. But what is it? How does it work? Who can qualify? What are its advantages?
Let’s check it out.
What Is Chapter 11 Bankruptcy?
Chapter 11 allows a troubled business — any sort of business, including big corporations but also partnerships, LLCs, and sole proprietorships — to restructure its debts and other obligations.
To build confidence among creditors, under Chapter 11 the debtor corporation submits a reorganization plan that includes a disclosure statement to creditors, a key phase in the process.
A Chapter 11 corporation will attempt to regain profitability through the application of assorted tools, including a total discharge of some debt, repayment of others, liquidation of certain assets, downsizing its workforce, and termination of leases and long-term contracts.
To reiterate, the debtor company (or, in rare cases, individual with an enormous amount of debt) filing Chapter 11 has first shot at proposing a reorganization plan. If the debtor does not lay out a plan, creditors may propose one instead.
“Chapter 11s,” says bankruptcy attorney James G. Aaron, chairman of New Jersey-New York-based Ansell Grimm & Aaron, “look to reorganize past-due debt, stop the payment of the past-due debt, and say to a court that you can reorganize by paying your creditors more than they would receive in a Chapter 7 liquidation of the assets.”
Who Can File Chapter 11 Bankruptcy?
Chapter 11 is considered a business, or commercial, bankruptcy for a reason: It tends to be more flexible, and therefore more complicated and expensive to execute, than Chapters 7 and 13 bankruptcies, which favor individual (or spouse-and-spouse) filers. It also has no limitations on the amount of debt to be addressed; for this reason alone, Chapter 11 is the typical choice for large businesses seeking to restructure their debt in hopes of survival.
Among the complications: A creditors committee usually is appointed by the U.S. Trustee from among the 20 creditors with the largest unsecured stakes (excluding insiders). The committee, representing all the creditors, provides oversight for the debtor’s ongoing operations. The debtor, while maintaining possession of its assets — becoming, officially, a debtor in possession — can negotiate a plan of reorganization with the committee.
If approved, the debtor organization gets on with its plan. In cases of suspected fraud or gross mismanagement, however, the court may appoint a trustee, who will oversee operations of the debtor throughout the process. The business operates as planned, but the original owner is no longer in control.
None of this means individuals or small businesses can’t, or shouldn’t, file under Chapter 11. But when it comes to reorganizing under the protection of bankruptcy, Chapter 13 is usually a better bet, offering a streamlined process at a discounted price while allowing the debtor to maintain possession of his assets, get square on secured debt, and, at the end of the plan, discharge unsecured debt.
What Is the Process?
Begin with the disclosure statement, describing the debtor’s structure and how it conducts its business. It’s here the business seeking relief attempts to convince the court reorganization will help it survive and recover to the point of profitability.
Confirmation follows, in which creditors vote on the reorganization plan. Creditors are parceled into classes, and their votes weighed, based on the type and amount of debt they hold. Generally, the judge and creditors must approve the plan, although there is an exception in which the debtor company gets its way through what’s known as “cram down.”
Next comes the post-confirmation period, in which the company attempts to make good on its restructuring, making promised payments, through a third party, to creditors.
If successful, the final phase arrives: The company’s restructuring has prevailed, the creditors are substantially repaid, and the bankruptcy is discharged.
Going through Chapter 11 isn’t cheap. There’s a $1,167 filing fee, administrative costs for the U.S. Trustee, and, most likely, an experienced bankruptcy attorney banking endless billable hours.
What Debts Can Be Included in Chapter 11?
Most debts incurred prior to declaring bankruptcy can be discharged. These include, but are not limited to, business debts, back rent, and credit card bills.
It’s easier to note what can’t be done away with in Chapter 11 filings, beginning with this: A debtor who commits misconduct during the course of a bankruptcy proceeding will be denied discharge.
Otherwise, debts that cannot be discharged include certain tax claims (income, property, payroll, sales) and mortgages. These can be restructured, however, as part of a realistic repayment scheme that allows the business to endure.
Restructuring plans must survive a “fair and equitable” test, a key consideration of which is whether secured creditors will receive at least the value of their collateral.
How Does Chapter 11 Differ from Other Forms of Bankruptcy?
There are three types of bankruptcies that we’ll detail below. Briefly, here’s how each works:
Chapter 11: Called a “reorganization bankruptcy,” it allows businesses to keep operating while restructuring their finances. Creditors are temporarily prohibited from taking action against the company.
Chapter 7: Assets are liquidated and creditors get little or nothing. It gives creditors incentive to instead approve Chapter 11 bankruptcy.
Chapter 13: Sometimes called the Wage Earner’s Bankruptcy, this form of bankruptcy allows those with enough income to replay all or part of their debts as an alternative to liquidation. It allows filers to keep their home as long as the mortgage is paid under a settlement plan.
Chapter 11 vs Chapter 7
Of the two, Chapter 11 bankruptcy is usually preferable for companies and creditors because it allows a business to continue operating.
Any business or individual can file for Chapter 11 bankruptcy protection. It can be anything from a sole proprietorship to a small business or a national corporation
The bankruptcy court must approve major decisions under Chapter 11, but at least the company can still do business.
As a “reorganization bankruptcy,” Chapter 11 gives businesses time to restructure their finances so they can pay their bills. Creditors are temporarily prohibited from taking any action.
The business or individual has four months to come up with a reorganization plan, which can be extended to 18 months. After that, creditors can propose reorganization plans.
The plan defines how the business will operate and pay its financial obligations. Most plans include some downsizing to reduce expenses and free up assets.
Creditors vote whether to accept a Chapter 11 plan. If they don’t accept it, then the next step could be filing for Chapter 7 bankruptcy.
A Chapter 7 bankruptcy has no reorganization plan or restructuring of debt to continue operations. Assets are liquidated and creditors could get little or nothing.
Chapter 11 vs Chapter 13
Both allow businesses to continue operating under reorganization plans. Both also have safeguards against repossession or foreclosure and typically request forgiveness of other debts.
Most businesses choose Chapter 13 because it’s simpler and less expensive than Chapter 11.
A trustee is always appointed in a Chapter 13 case. He or she collects payments and distributes them to creditors.
One of Chapter 13’s most attractive features is filers get a chance to keep their home as long as they pay the mortgage under a settlement plan. Filing for Chapter 13 suspends any current foreclosure proceedings and payment of any other debts owed.
Chapter 13 bankruptcy allows three to five years for people to repay their debts. Their disposable income is used to reduce their debts. They can also eliminate unsecured debts while catching up on missed mortgage payments.
Can Chapter 11 Save My Small Business?
The shortest possible answer is this: Yes. In some cases. But don’t get your hopes up.
Only about 10% of Chapter 11 filings result in success; far more often, they end up in Chapter 7 straight bankruptcy, in which the company closes and its assets are sold to pay back secured creditors.
“Any business entity of any form is eligible for a Chapter 11,” says attorney Aaron. “The philosophy is the same.” Indeed, under the right circumstances, Chapter 11 could help a small business survive.
Take a start-up company that has taken on substantial debt in development costs. Just as the business finally begins to generate significant income, the bills come due, there’s not sufficient cash to meet them, and there’s no place to raise needed capital.
“Chapter 11 would make sense,” Aaron says, “because the Chapter 11 stops the creditors from seeking payment [and] gives the debtor 120 days from the date of filing to file a plan of reorganization.”
In some cases, Aaron says, courts weigh what creditors might recover from a straight liquidation vs. what they could reasonably expect over a period of time and extend the duration allowed for the company to pay its debts — up to five years.
If the court is convinced, this Chapter 11 grace period allows the business to get on its feet, when otherwise, Aaron notes, creditors would shut down the company “without allowing [it] the opportunity to capitalize on all the hard work it has put in up to the date of filing.”
Moreover, sole proprietors or general partners of a small business are personally liable for the business’ debts. Your personal assets are your business’ assets, which means business creditors can seize your stuff to settle your debt.
A Chapter 11 filing could protect your business and personal assets.
You may qualify if you’re pursuing commercial or business activities that in sum do not exceed $2 million. Qualifying small business debtors go on a “fast track,” getting different treatment from a customary Chapter 11 case. A creditors committee may not be appointed, and the court may decide a separate hearing to approve a disclosure statement is not necessary.
Small business cases move faster because the stakes and number of creditors tend to be smaller/fewer. The court may approve a disclosure statement conditionally, awaiting final approval after notice and a hearing, and a creditors’ vote to accept or reject the reorganization plan.
But, again, the odds are stacked against surviving Chapter 11. Target has, but for every Target, there are nine Toys “R” Us businesses that didn’t.
Can I Keep My Property During Chapter 11 Bankruptcy?
Yes, you’ll likely get to keep your home during a Chapter 11 bankruptcy. But only up to a certain amount.
A Chapter 11 personal bankruptcy allows up to $1,184,200 in secured debt — mortgage and car payments. It also allows $394,725 in unsecured debt such as credit cards.
Assets such as property can also be written down. For example, if you own a property worth $98,000 but owe $150,000 on the loan, the principal balance of the mortgage can be reduced to the value of the property. The new mortgage would be $98,000.
Chapter 11 also allows the interest rate on the loan to be reduced and repayment terms can be extended. That could drop your monthly mortgage payments.
How Long Does Chapter 11 Take?
Because it is complicated, what with disclosures and committees and hearings and special accounts and audits and votes and, sometimes, refinancing and oversight by the U.S. Trustee’s Office, Chapter 11 is not only labor-intensive, it can be extremely time consuming.
“In theory,” Aaron says, “a company could be in and out of bankruptcy in 30-45 days.” Others, he says, “drag on for years,” weighed down by pre-existing litigation and other potential complications, such as whether the company is a single-asset entity — say a real estate partnership with a lone shopping center that’s hit a tough patch.
However, there is no limit on completing the repayment plan under Chapter 11. Most take from six months to two years to complete.
Just coming up with a reorganization plan can take time. The business or individual is allowed four months to come up with a plan, and it can be extended to 18 months.
Ideally, the business navigating Chapter 11 continues to operate through the reorganization until it emerges ready for success on a freshly poured foundation.
This continued functioning is a key ingredient of Chapter 11 proceedings, but, because customers, clients, vendors, partners, and even employees tend to hear “bankruptcy” — and translate it into “going out of business” — much louder and more readily than “reorganization for success,” these stakeholders must be reassured about the path ahead.
If you qualify for Chapter 11 bankruptcy, consider discussing your financial situation with a credit counselor.