No one sets out in business to fail, but despite our best efforts, this sometimes occurs. The reasons are multiple and varied: Sometimes there is a change in the industry and the business has not been able to evolve to meet the changing marketplace. Sometimes it is the pressure of increased competition and reduced prices. Other times it could be that a significant customer fails to pay, causing a negative chain reaction or an adverse judgement.

For the countless businesses struggling to cope with obstacles—reduced demand, increased competition, scarcity of capital, changing business models, etc.—reshaping strategy is critical to surviving and prospering in today’s economy. Indeed, unforeseen events out of the business owners’ control inevitably occur, but how business owners react to and plan for such events can significantly impact their ability to survive and thrive. If, however, bankruptcy is determined to be the only option, below is a description of the basics of a chapter 11 reorganization. In later blog posts, I will discuss different turnaround options apart from formal bankruptcy proceedings.

Chapter 11

Chapter 11 is very flexible. It allows a company to liquidate under the control of the Debtor in Possession (DIP), sell the assets, or reorganize. More often than not, management (often with professional assistance) is in a better position than a trustee to maximize the return on the asset liquidation or reorganization. The chapter 11 process does, however, require that existing management is available and that the company has sufficient funding to hire appropriate expert personnel to assist management of the company through the chapter 11.

Reasons for Chapter 11

Chapter 11 allows a financially distressed business a breathing spell and an opportunity to modify its financial structure. The reasons for filing a chapter 11 are many. Among the most common are:

the company cannot pay its debts;
lawsuits are filed by creditors against the business (Chapter 11 provides a broadly interpreted stay of litigation against the company that pauses any potential action against the company prior to the bankruptcy filing. With limited exceptions, it stays all proceedings, giving the business a breather);
a secured creditor seeks to foreclose. (The automatic stay also applies. Say, for example, that the business lender has filed a lawsuit and is preparing to seize the company’s bank account to satisfy a part of the debt. Or, for example, that the company has real estate, and the real estate lender is proceeding with a foreclosure;
a company is involved in multiple product-liability lawsuits and needs a way to coordinate litigation;
a company needs to terminate a lease agreement. (For example, when several retail locations are not prospering and the company wants to walk away from leases, the landlords will likely sue the business. Such damages could put the company out of business. However, if the company files bankruptcy, there is the ability to reject a lease agreement, in which case, the landlord’s damages become part of the creditors’ unsecured claims in the bankruptcy case.)

The Basics of Chapter 11

A separate estate, referred to as the bankruptcy estate, is created upon filing a petition in court for chapter 11 bankruptcy. The business’s books and records must clearly separate the prepetition assets and liabilities from the post-petition assets and liabilities.

In most chapter 11 cases, a creditors’ committee is appointed—unless the business is able to qualify under Subchapter V of Chapter 11, which limits the aggregate non-contingent, liquidated secured and unsecured debts to $3,204,000. (There is no creditors’ committee in a Subchapter V.) The committee usually consists of three to seven of the most substantial unsecured creditors of the company. Its role is to monitor the operations of the chapter 11 company and to have a meaningful say in the ultimate restructuring of the company. The company’s management is expected to keep the committee closely involved in the decisions that the company makes. On occasion, when the company and the committee disagree, such matters are resolved by the court.

If the chapter 11 company has a pre-existing secured loan, then bankruptcy law requires that the lender either consents to or the court approves of the use of “cash collateral.” By definition, cash collateral is the proceeds generated from the security held by the lender. For example, rents created by real estate security held by a lender are cash collateral. Or receivables generated from inventory security held by a lender are cash collateral.

In addition to the use of cash collateral, in preparation for a chapter 11 the attorney and turnaround consultant will typically evaluate the need for and availability of chapter 11 financing, called DIP, or debtor in possession, financing, which requires court approval.

As many businesses need additional financing to make it through the chapter 11, the company’s existing lender may provide this DIP financing, but only if the lender is satisfied that it will resolve the company’s problems and hasten its exit from chapter 11. The turnaround consultant and the attorney are usually integrally involved in helping the company make its case to the lender.

A bankruptcy filing under chapter 11 creates an automatic stay, precluding creditors from pursuing the company’s assets. However, not all creditors are “stayed” indefinitely. For example, secured creditors can seek relief from stay by asking the court to allow them “for cause” to pursue their pre-bankruptcy remedies. The court will evaluate the cause on a case-by-case basis by balancing the needs of the company that has filed bankruptcy with the stay’s impact on the creditor.

A typical chapter 11 filing for an entrepreneur-operated company can take as little as four months, if the company has done a good job in talking to stakeholders before the filing to get them on board, or as long as two years, if, for example, there is ongoing litigation or other unresolved issues. At any rate, during the bankruptcy case, the business must start showing progress in the reorganization and turnaround. Even though a chapter 11 can provide a “legal cocoon” around the business to allow time to reorganize, ultimately the company must develop a fiscally viable means to restructure.

Plan of Reorganization

The primary objective of chapter 11 is to reorganize, either through a plan of reorganization or by selling the assets. If the court approves the plan of reorganization, it essentially becomes a binding contract for both the bankrupt company and all of its creditors, and it will supersede the prior relationship between the company and its creditors to the extent provided for in the plan. Reorganization plans always divide creditors into various classes, which follow an order of priority. Secured creditors are first, followed by priority creditors, unsecured creditors, and, at the bottom, equity. All creditors within a class must receive the same treatment.

Commonly, secured creditors are entitled to get paid in full, up to the value of their collateral, or to recover their collateral, while unsecured creditors get partial payments, with all treated the same way. For example, if the plan calls for the unsecured creditors to get 50 cents on the dollar in monthly payments over a two-year period, they must all be given the same terms, unless the company can offer a good reason to the bankruptcy court for different treatment. The payment calculation to unsecured creditors is often the result of negotiation with the creditors’ committee, which takes into account how much the company can reasonably be expected to set aside in the future to pay creditors after paying expenses for operations.

Equity owners can continue to own the business after the chapter 11 plan of reorganization is approved by the court. However, unless the company qualifies under Subchapter V the “absolute priority rule” will apply. The absolute priority provides that unsecured creditors must be paid in full before equity holders can participate and retain their ownership of the company. This rule does not apply in a Subchapter V, but the plan must be “fair and equitable” to creditors. Subchapter V plans require payment over 3 to 5 years.

Conclusion

Chapter 11 can be a very effective reorganization for a business. It however does not come without its stress or financial cost. However, when the business is on the precipice of failure, chapter 11 can provide the answer.

Brian L. Davidoff

ACG LA - Beers with Peers

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