Chapter 11 bankruptcy: A little breathing room while a company restructures

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Can this business be saved?

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Businesses, as well as sole proprietors or individuals, sometimes find themselves buried in a mountain of debt that can be blamed on everything from poor financial management to a shift in consumer spending or an economic downturn.

Sometimes a sales slowdown, poor cash flow, and over-leveraging can leave little or no light at the end of a long financial tunnel. Chapter 11 bankruptcy protection gives companies a chance to restructure their debt—and the entire enterprise—for a fresh start while staving off creditors. But the process is complicated. It’s not for those who are short on patience, and it can be quite costly.

The U.S. Bankruptcy Code refers to a chapter 11 filing as a “reorganization” bankruptcy because companies retain possession of their business. Under chapter 11, businesses typically continue to operate as they restructure and look for outside funding.

Called a “debtor in possession,” a company in chapter 11 bankruptcy continues to operate without a bankruptcy trustee calling the shots. However, a trustee does monitor chapter 11 proceedings. They may require debtors to file operating reports and stay abreast of compensation and reimbursement to employees and outside parties.

In the process, which could take years, a plan is crafted that typically includes a downsizing—potentially of property, operations, and/or employees—aimed at cutting expenses and freeing up assets.

Unlike other types of bankruptcies, chapter 11 includes creditors’ committees made up of the top several creditors for unsecured debt (that is, debt not backed by collateral such as a building or property). These committees make sure the bankruptcy is handled in a fair way.

If claimants (including creditors, vendors, and anyone else holding debt) don’t get full payback, they’re considered “impaired,” and they get to vote on whether they accept the reorganization plan. The court will either confirm the decision or ignore the creditors’ objections. If the creditors’ objections are ignored, it’s called a “cramdown.” This usually happens when a judge considers the plan fair and equitable despite creditor dissent.

Chapter 11 bankruptcy filings aim to rearrange knotty finances to help companies get a fresh start. Although sole proprietors and individuals are also allowed to file chapter 11, this level of protection is mostly geared toward larger companies with heavy debt loads. The high cost of a chapter 11 filing—plus the long time periods typically involved—would be major headwinds for smaller companies and individuals considering this bankruptcy route versus a chapter 13 or chapter 7 path.

The bankruptcy courts require debtors in possession to pay a $1,167 case filing fee and $571 as a miscellaneous administrative fee, and that’s just the start. There’s a quarterly bill for trustees, which may range from $325 to $30,000, depending on the total of quarterly disbursements. There will be costs anytime the business needs to make a copy of a document, retrieve something from the court, make a change to the agreement, and so on. And don’t forget the costs of putting together that reorganization plan and all the attorney fees involved.

Like other bankruptcy filings, the chapter 11 case begins with a petition in court. Chapter 11 bankruptcies may be voluntary (i.e., the company makes the first move) or involuntary, meaning creditors force it upon them (after meeting certain requirements).

Typically, debtors-in-possession must disclose a full rundown of their financial situations, including:

Individuals opting for chapter 11 must also file a credit counseling certificate and a copy of the debt repayment plan, similar to individual chapter 13 and 7 filing requirements.

As with chapter 13 and 7 bankruptcy filings, chapter 11 stops the collection process through an “automatic stay,” which prohibits creditors from beginning or continuing any kind of collection process, eviction, or foreclosure.

However, in what the code calls “specific circumstances,” a secured creditor can bypass an automatic stay. For example, if a debtor has no equity in a property and that property isn’t needed to continue its operations, the court might lift the stay to allow the creditor to foreclose on the property, sell it, and apply the proceeds to the outstanding debt.

Certain parties, such as a debtor’s attorney, a trustee, or another professional appointed by the bankruptcy court, may seek compensation from the company every three months. “In very large cases with extensive legal work, the court may permit more frequent applications,” according to the Bankruptcy Code. This happens frequently in bigger bankruptcies that take extraordinary amounts of time to complete.

In addition to the disclosure filings listed above, the company must file a reorganization plan. In other words, the company must have already put pencil to paper on how it hopes to get out of its financial pickle before it even files.

The plan could include everything from a list of properties to be sold and cutbacks to be made, to a funding source and even potential buyers. It also must include a classification of the claims and how each class will be addressed under the reorganization plan. This could come through payment plans, modified interest rates, and sometimes debt that is purged entirely.

For example, a plan might classify claim holders in order of seniority:

After the disclosure statement is approved by the court and the impaired claimants’ votes are tallied, the court’s confirmation hearing will determine the yes-or-no outcome. In some cases, the discharge is a cramdown. Once the case is discharged, the business has to continue to repay its debts.

As noted, big-buck bankruptcies are not an in-and-out process. They can take months or even years of back-and-forth between debtors-in-possession and creditors, who typically form long lines when large multinational companies have filed.

The hope is that the debtor in possession can get out from underneath expensive leases or agreements that have bogged down earnings and profitability. Chapter 11 filings also offer struggling companies an opportunity to find more attractive funding sources (although that usually comes with strings attached) and the ability to sell off assets to prime the money pumps.

But creditors aren’t likely to go away quietly. They want their money back and will fight for as much of it as possible. Remember, the courts are looking for a pact that’s in the best interest of the debtor in possession as well as its creditors. All this takes time as agreements are hashed out.

Chapter 11 bankruptcy petitions may involve liquidation of part or all of the business if necessary. In this case, creditors are allowed to take “a more active role” in how assets are sold and proceeds are dispersed than they would be allowed under a chapter 7 liquidation.

At its best, a chapter 11 bankruptcy can salvage a sinking ship before it has sunk. It has saved many U.S. companies, ranging from General Motors (GM) to American Airlines to J.C. Penney and others. But it’s a complicated, drawn-out process with a constant ring at the cash register.

The success rate of a chapter 11 bankruptcy resulting in a fully reorganized, effective business is “probably” no higher than 10% to 15%, according to Debt.org, and the lingering effects can have a material impact on the business by damaging customer goodwill, brand value, and business relationships.