Chapter 11 is a business bankruptcy. It is filed in the Federal Bankruptcy Court generally where the principal assets of the business are located. Entities and individuals may file chapter 11 as long as they are engaged in a for profit endeavor of some kind. In a chapter 11 case the Debtor implements a plan to restructure its debts or otherwise fund a payment to creditors by selling its assets. Chapter 11 is generally filed to defend against a creditor taking action with respect to the Debtor’s assets, and it immediately stops any such effort by a creditor. Creditors affected by a chapter 11 case include the business’ lenders, taxing authorities and third party vendors or those with other claims against the Debtor, such as parties with litigation claims.
All creditor claims in a chapter 11 case are paid as a function of the value of the collateral that secures such claims. A lender with a lien on any of the assets of a business is entitled to be paid the value of those assets, not the amount of the claim, under the cram down provisions of the Bankruptcy Code. Priority creditors include taxing authorities and holders of certain other defined claims, and they get paid before general unsecured creditors. Unsecured creditors must receive more under a Chapter 11 Plan than they would get if the business were liquidated, and that is generally accomplished by paying a share of profits from the business after confirmation of a Plan and a contribution of new value from existing stakeholders who keep their interests.
When a case is filed all actions by creditors are immediately stopped. The Debtor must obtain authority from the Court to use its bank accounts and cash so a hearing is usually scheduled very quickly after filing to consider that and other immediately pressing issues in the case. During the case the Debtor makes a monthly report of its operations available to the Court and all parties. Once the basic operation of the business is stabilized and any preliminary issues are resolved, the Debtor proposes a Plan in the case and seeks confirmation of the Plan after notice to all creditors. When a Plan is confirmed by the Court the case can end, and the terms of the Plan become a new contract between the Debtor and its creditors.
If you feel that you can pay the debts of your business but just need more time or a structured mechanism to do so, Chapter 11 may work. It is important to consider a few limiting features of a chapter 11 case. For one, the case generally does not affect the legal obligations of a guarantor of a company’s debt. If that debt gets paid in full, it is possible that there will be no significant impact on a guarantor. But if the lender’s claim is reduced to the value of its collateral in a chapter 11 case, the difference between that amount and the total owed to the lender is a deficiency claim the lender may collect from the guarantor. It is likely that a guarantor will need representation from a separate lawyer as the guarantee liability presents a conflict of interest for counsel to a chapter 11 debtor.
Another important feature to consider before filing a chapter 11 case is what is called the absolute priority rule. In order to wind down a business entity, it generally must pay creditors before owners. In chapter 11, this rule means any Plan in a case must either pay all creditors in full, or those creditors must agree to accept less than a full payment, in order for the existing owner to retain their interest. In many jurisdictions, there is an exception to this rule if the owner puts new value into the Debtor to retain the interest even if creditors are not paid in full. In addition, recent changes to the law have created a new form of small business bankruptcy that allows the Debtor to confirm a plan without observing the absolute priority rule.