While historically U.S. companies went to great lengths to avoid the stigma of bankruptcy, toward the end of the 20th century and continuing into the 21st, highly publicized cases resulting in the successful reorganization under chapter 11 of the U.S. Bankruptcy Code of several major U.S. corporations, e.g., Delta Airlines, General Motors Co. and Kmart Corporation, led to the recognition of chapter 11 as a respectable planning tool, worthy of consideration by any eligible company that requires financial restructuring to survive and prosper. Indeed, it is common for employees, customers and venders to continue to work for and do business with a company following its commencement of a case under chapter 11 as if nothing had changed, giving the company the opportunity to emerge from its case as a financially strong and healthy enterprise that continues to employ its workforce and provide goods or services to the public for years to come.

Benefits of a Chapter 11 Case, in General

Any individual or company (with a few exceptions, like banks, railroads and insurance companies) that has a domicile, a place of business or property in the United States may commence a case under chapter 11 of the Bankruptcy Code. Even individuals and companies that do not reside or are not chartered in the U.S. are eligible for chapter 11 in the U.S., so long as they have a residence or place of business or property in the U.S.

Continuation of Operations and Management

When a company commences a voluntary case under chapter 11 of the Code, there is a presumption that the company will be, and will continue to be, a "debtor in possession." As long as the company remains a debtor in possession, the company remains in possession and control of, and its management continues to have the authority, duty and responsibility to operate and manage, its properties and business. The company, as a debtor in possession, also has the exclusive right, for a period of 120 days after the commencement of its case (which period may be, and in most cases is, extended for up to 18 months) to file a plan of reorganization.

The Automatic Stay

Upon the filing of a petition commencing a chapter 11 case, a stay is automatically imposed that prohibits the taking or continuation of any action to collect a debt arising pre-petition, any action to enforce any lien securing a debt arising pre-petition, and any action to take possession or control of any property, real or personal, of the debtor's estate or otherwise to deprive the estate of any property. The automatic stay will continue in effect generally with respect to any particular property of the estate until the property is no longer property of the bankruptcy estate or unless and until a party with an interest in the property seeks, and is granted, relief from the stay for good cause, which includes failure of the debtor to adequately protect the party's interest in the property.

Use, Sale and Lease of Property and other Transactions

The debtor's authority to operate its business includes the authority to use, sell or lease property of its estate and to enter into other transactions, without notice to creditors or order of the bankruptcy court, as long as the transaction is in the ordinary course of business and the transaction is not the use, sale or lease of property constituting collateral for a secured creditor's claim. The company may also enter into transactions other than in the ordinary course of business with notice to creditors, if approved by an order of the bankruptcy court. The court will generally approve a company's request to enter into transactions not in the ordinary course of business, unless the court finds that management violated its duties to the company, including its duties of loyalty, prudence and care, in reaching its judgment that the transaction is in the best interests of the company, its creditors and, if applicable, stockholders, or unless the transaction is a use, sale or lease of property that is collateral for a secured creditor's claim.

If a company seeks authority to use, sell or lease collateral for a secured creditor's claim, the company will be entitled to use the collateral, other than "cash collateral" (which includes collateral consisting of cash, checks, promissory notes, stocks, bonds and bank deposit accounts), in the ordinary course of business so long as the secured creditors' interests in the collateral are "adequately protected." "Adequate protection" can be provided, depending on the value of the property and the amount of the debt the property secures, by demonstrating an "equity cushion" – that is, a good amount of value of the collateral in excess of the amount of the debt it secures, by providing to the creditor a senior lien on additional unencumbered collateral or a junior lien on otherwise encumbered collateral, or by making cash payments to the secured creditor in amounts that will compensate the creditor for the decrease in the value of the collateral that will result from its use by the debtor.

Freeing Up Collateral Acquired after the Petition Date

Property acquired by a debtor after the date it filed its petition under chapter 11 generally is not subject to any lien created by any security agreement, mortgage or other instrument the debtor may have entered into before the petition date, except to the extent that the post-petition property constitutes "proceeds, products, offspring, or profits" of the property acquired prepetition.

Use of Cash Collateral and "DIP" Financing

When a company commences a chapter 11 case, it is required in the first instance to segregate and account for any cash collateral in its possession, custody or control, including collections the debtor has received or receives on or after the petition date on any accounts receivable on which a secured creditor has a lien. But when the debtor is relying on cash collateral for operating funds, the company may still use the cash, if the secured creditor consents or, if consent is denied, if the debtor can demonstrate that the secured creditor's interest in the cash is adequately protected. Adequate protection of a secured creditor's interest in, e.g., collections on pre-petition accounts receivable, is most often provided by the debtor creating in favor of the secured creditor, with court permission, a lien on future accounts receivable.

Alternatively, a secured creditor may agree to provide post-petition financing (debtor in possession, or "DIP," financing), because the debtor may, with court approval, grant favorable terms to a person providing DIP financing, which may include providing to the creditor, in addition to a lien on all property of the estate, a claim for the indebtedness incurred under the DIP financing facility that has priority over any or all administrative claims and that is secured by any or all property of the estate.

Rejection of Executory Contracts and Unexpired Leases

A debtor in a chapter 11 case is entitled, with the approval of the court and within specified time periods, to assume or reject any executory contract or unexpired lease. An "executory contract" is a "contract under which the obligation of both the bankrupt and the other party to the contract are so far unperformed that the failure of either to complete performance would constitute a material breach excusing performance of the other."

While the other party to the contract or lease is entitled to a claim for breach in the event that its contract or lease is rejected, its claim is typically an unsecured claim, not entitled to priority, and the debtor is relieved from further performance under the contract or lease. In the case of real property leases and employment contracts, the other parties' damage claims (as well as the indemnity claims of guarantors) are limited, in the case of real property leases, to the accrued and unpaid rent that is due plus the present value of future rent for no more than three years, and in the case of employment contracts, to the accrued and unpaid compensation that is due plus future compensation for no more than one year.

Recovery of Preferences and Fraudulent Transfers

The Bankruptcy Code permits a debtor to avoid and recover as preferences certain payments and other transfers (e.g., transfers of collateral) made to its creditors during the 90 days preceding a bankruptcy filing (the period is extended to one year for payments made to related parties) if the transfer was for or on account of an antecedent debt and made while the debtor was insolvent. Creditors may assert several defenses to preference claims, including that the payment was made in the ordinary course of business, and, although the company will be presumed to have been insolvent during the 90 days preceding the petition date, the presumption is rebuttable.

The Code further permits a debtor to avoid and recover as fraudulent transfers payments and other transfers of its property and obligations incurred within two years before the petition date, if the debtor made the transfer or incurred the obligation with actual intent to hinder, delay or defraud its creditors, if the debtor received less than a reasonably equivalent value in exchange for the transfer or obligation and was insolvent at the time the transfer was made or the obligation was incurred, or if the debtor made the transfer or incurred the obligation under other specified conditions that in general had the effect of prejudicing its creditors.

The Chapter 11 Plan

Although a company may propose a plan that provides for the liquidation of all of its assets, chapter 11 may be used constructively as a tool to reorganize a company's financial affairs so that it can continue in business as a viable concern. In formulating its plan, the debtor will need to keep in mind both the features the Bankruptcy Code requires the debtor to include, and the features the Code gives the debtor the opportunity to include, in the plan.

Classification of Claims

The plan must divide the equity interests in and claims (except for certain priority claims) against its estate into designated classes. The plan may place a claim or interest in a class only if the claim or interest is substantially similar to the other claims or interests in the class, except that the plan may designate a separate class of all unsecured claims that are less than, or have been reduced to, a relatively small amount that has been approved by the court as reasonable and necessary for administrative convenience.

The "Best Interests of Creditors" Test

Any individual general unsecured creditor in any class who is entitled to vote on the plan but has not voted to accept the plan may block confirmation of the plan if it can demonstrate that it would not receive or retain under the plan on account of its claim property of a value that is more than it would have received if the debtor were liquidated under chapter 7 of the Bankruptcy Code. This requirement is referred to as the "best interests of creditors" test, and it requires that a debtor, to be prepared to meet a challenge by any single general unsecured creditor, understand and be prepared to show how the proceeds of its property would be distributed to its creditors and equity interest holders if its property were liquidated in a chapter 7 case.

Priority of Distributions to Creditors

In a chapter 7 case assets that are subject to liens created in favor of secured creditors are liquidated, and the proceeds of the liquidation (net of the reasonable fees, costs or charges of disposing of the property) are distributed first to the secured creditors, up to the amount of their secured claims. If the net proceeds of the liquidation of a secured creditor's collateral are insufficient to satisfy his allowed claim in full, the amount of his deficiency is considered an unsecured claim, which is then treated the same way that other similar unsecured claims are treated in the case. If the net proceeds of the liquidation of a secured creditor's collateral exceed the allowed amount of his claim, the surplus becomes available for distribution to unsecured creditors.

The surplus, if any, resulting from the liquidation of the property subject to liens and the net proceeds of the liquidation of all unencumbered property of the debtor's estate are distributed to satisfy unsecured claims in the order of priority expressly set out specifically in the Bankruptcy Code.

Claims entitled to priority over general unsecured claims include claims for domestic support obligations, for the administration of the chapter 11 case (including post-petition wages, salaries and commissions, post-petition taxes, compensation of attorneys, accountants and other professionals employed, with the approval of the court, by the debtor or employed by an official committee of unsecured creditors and certain expenses incurred by members of the committee), fees payable to the U.S. trustee, wages, salaries and commissions, including vacation, severance and sick leave pay earned by employees and contractors, not to exceed $13,650 per creditor within 180 days before the petition date, contributions to employee benefit plans arising from services rendered within 180 days before the petition date (subject to specified limitations), deposits made by consumers, before the petition date, of money in connection with the purchase, lease or rental of property or the purchase of services, certain income taxes or gross receipts taxes, employment taxes, excise taxes and property taxes, and damages for death or personal injury resulting from the operation of a motor vehicle or vessel if the operation was unlawful because the debtor was intoxicated from using alcohol, a drug or another substance.

Acceptance of the Plan

How a plan may treat the creditors in a class of creditors or the equity interest holders in a class of interests, and whether the court may confirm a plan, may be dependent on whether the class has accepted the plan. A class of creditors accepts a plan if creditors that hold at least two-thirds in amount and more than one-half in number of allowed claims in the class vote to accept the plan. A class of interests accepts the plan if holders of interests that hold at least two-thirds in amount of interests in the class accepts the plan.

Treatment of Claims under the Plan

While the Bankruptcy Code requires that a plan provide in general for priority claims to be paid in full, the Code does not in all cases mandate that they be paid in full in cash on the effective date of the plan. In the case of administrative claims, the Code does require that the plan provide for the payment of each claim in full on the effective date, unless the holder of the claim agrees to different treatment. But in the case of priority tax claims, the Code permits a plan to provide for the payment of such claims in deferred payments over a period ending up to five years after the petition date, so long as the deferred payments have a present value equal to the allowed amount of the claims.

In the case of any class of priority domestic support claims, compensation, wage and commission claims, pension plan contribution claims, and consumer deposit claims, the Code requires that the plan provide for the payment of all claims in in the class in full in cash on the effective date of the plan, except for any claim held by a creditor who agrees to different treatment. But if the class accepts the plan, the Code permits the plan to provide for the payment of all claims in the class in deferred payments over any period of time so long as the deferred payments have a present value equal to the allowed amount of the claims.

If there is a class of creditors holding priority wrongful death or personal injury claims, the debtor may treat the class the same way it treats any class of nonpriority unsecured claims, but taking into account the "best interests of creditors" test.

A plan may provide for the holders of nonpriority unsecured claims in any class and any class of equity interests, without the class accepting the plan, to retain unaltered all of the rights to which their claims entitle them or, if their claims would entitle them to accelerate payment of their claims, may provide for the reinstatement of the original maturity of their claims, as long as all defaults (other than defaults consisting of insolvency or bankruptcy or the like) are cured. If the plan provides for treatment of a class to receive treatment as described above, the class is considered to be "unimpaired" and is not entitled to vote on the plan.

If any class of nonpriority unsecured claims or any class of equity interests is impaired under the plan, the plan may provide for the holders of claims or interests in the class to receive any treatment that the debtor can persuade, in the case of a class of claims, a sufficient number of creditors in the class holding a sufficient amount of debt, or if a class of interests, the holders of a sufficient amount of interests, to accept, so long as the debtor can demonstrate, if challenged by any individual creditor in the class of claims, that the plan meets the "best interests of creditors" test, i.e., that the objecting creditor will receive more under the plan than it would have received in a liquidation case. But if one or more impaired classes of claims or interests does not accept a plan, the plan may be confirmed only if the plan meets the "cram-down" requirements discussed below.

Cram-Down

A plan of reorganization can be confirmed without the acceptance of an impaired class of creditors or interest holders (commonly referred to as a "cram-down"), so long as, if a class of claims is impaired, at least one impaired class accepts the plan, and so long as (1) the plan must "not discriminate unfairly," and (2) the plan is "fair and equitable."

A plan does not "discriminate unfairly" with respect to a class if, among other things, the class is treated substantially the same as other similar classes, if any, and if a class is discriminated against, the discrimination is supported by a reasonable basis.

A plan is "fair and equitable" with respect to a class of secured claims generally if the plan provides (a) that each secured creditor in the class retains under the plan the liens securing his claim and receives payments in installments in a total amount that is at least the allowed amount of his secured claim, and which have a present value, as of the effective date of the plan, of at least the value of his collateral; (b) for the sale of the property that is subject to the liens, free and clear of the liens, with the liens to attach to the proceeds of sale, and for the treatment of the liens on such proceeds as described in (a) above or (c) below; or (c) for the realization by the holders of such claims of the "indubitable equivalent" of such claims.

A plan is "fair and equitable" with respect to a class of unsecured claims generally if the plan provides for payment in full of the claims or if the plan follows the "rule of absolute priority," i.e., that under the plan no holder of any claim or interest that is junior to the claims of the class will retain any property on account of such junior claim or interest. In other words, without the affirmative vote of each class of unsecured creditors or payment in full of each class of unsecured creditors, a company's plan cannot provide for the current stockholders of the company to retain their stock or any other interest in the company, at least not on account of their current stockholdings. It is possible, however, that the current stockholders could obtain stock in the surviving reorganized debtor by virtue of the so-called "new value corollary" to the "rule of absolute priority," i.e., by contributing cash or property to the reorganized company, but only if existing stockholders are not given the exclusive right to invest in the new company and others are given the opportunity to bid on the stock of the reorganized company.

A plan is "fair and equitable" with respect to a class of interests only if the plan provides that each holder of an interest in the class receives or retains on account of such interest property of a value equal to the greatest of the allowed amount of any fixed liquidation preference to which such holder is entitled, any fixed redemption price to which such holder is entitled, or the value of such interest, or the plan follows the "rule of absolute priority," i.e., the plan provides that the holder of any interest that is junior to the interests of the class will not receive or retain any property on account of such junior interest.

Drawbacks to a Chapter 11 Case

Studies indicate that not more than 10 to 15% of chapter 11 cases result in successful reorganizations. The other cases are dismissed or converted to liquidation cases under chapter 7 of the Code. Clearly, there is no assurance that a chapter 11 case will solve any particular company's financial troubles.

Also, a company must recognize that its freedom while in chapter 11 is constrained by the limitation that without obtaining an order of the bankruptcy court, it may engage only in transactions "in the ordinary course of business." To engage in any activity outside the ordinary course of business, the debtor must obtain a court order, and there may be adverse consequences to taking actions outside the ordinary course of business without court approval or making a determination as to what constitutes ordinary course of business that is successfully challenged.

Furthermore, in a chapter 11 case the U.S. trustee is required to appoint an official committee of unsecured creditors. The committee has the authority, among other things, to "investigate the acts, conduct, assets, liabilities, and financial condition of the debtor, the operation of the debtor's business and the desirability of the continuance of such business, and any other matter relevant to the case or to the formulation of a plan." 11 U.S.C. § 1103(c). Any active committee can be expected to weigh in on any motions the debtor may make seeking any authority or relief requiring court approval. While a committee's support for the debtor's motions can be helpful, contending with a committee that is unsupportive can require time, effort and expense on the part of the debtor and its professionals. Of particular importance is the fact that a committee is authorized, with the approval of the court, to select and employ attorneys and other professionals to represent the committee, and the court customarily will award to its professionals reasonable compensation, which constitutes a priority administrative expense chargeable to the debtor's estate.

Finally, the bankruptcy court may deprive a company of the status of "debtor in possession" and order the appointment of a trustee, at the request of a creditor, the U.S. trustee or another interested party, upon a showing of persuasive evidence of fraud, dishonesty, gross mismanagement or the like on the part of the company, whether the objectionable conduct occurred before or after the commencement of the case, or that the appointment of a trustee is otherwise in the best interests of creditors, stockholders or other equity holders. A trustee, if appointed, will have the authority and duty to operate the business of the debtor, to "investigate the acts, conduct, assets, liabilities, and financial condition of the debtor, the operation of the debtor's business and the desirability of the continuance of such business," and to file a plan of reorganization. In the exercise of his or her rights, the trustee may, and customarily will, replace management of the company.

Conclusion

Before filing a petition under chapter 11 of the Bankruptcy Code, a company should diligently consider, in consultation with its legal and financial advisors, its financial condition and prospects, the reasons for its difficulties, the feasibility of overcoming those difficulties and developing a plan with a reasonable likelihood of success, and the likelihood of achieving the support of its employees, creditors and customers, and, in general, the costs (both monetary and intangible) and potential benefits of a chapter 11 case. In the case of any financially troubled company, the costs of a chapter 11 case can be substantial and the likelihood of success uncertain. But a chapter 11 case not only may be highly beneficial to a distressed company, it may constitute the only reasonably viable tool available to preserve the business of the company for the benefit of its employees, customers, vendors and, in a proper case, equity owners.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.