Bankruptcy can be a valuable tool for businesses looking to reorganize assets and liabilities, allowing a company to continue operating while reducing financial burdens; or, to liquidate assets and wind down a company in an efficient manner. Bankruptcy can allow an otherwise profitable company struggling with debt to shed or reduce financial strains. Bankruptcy can also put an end to ongoing litigation and debt collection activities and allow a business owner to wrap up the company’s affairs through a more orderly process. Corporations, as well as any other businesses with a separate identity from individual owners, must be represented by counsel in court proceedings. However, not every attorney has experience with bankruptcy filings, in order to maximize the success and efficiency of your business’s bankruptcy, the services of experienced and capable bankruptcy counsel is essential.
The Bankruptcy Code is divided into several different chapters of which two are most common for businesses – Chapter 7 and Chapter 11. Chapter 15 may be necessary and useful if your company operates or does business outside of the United States.
Filing Chapter 7
Chapter 7 results in the liquidation of a debtor’s business, the proceeds of which are used to pay the business’s creditors. The Chapter 7 estate, or the assets to be liquidated, includes those assets owned by the debtor at the time of filing and the proceeds of any litigation claims the debtor may have.
Unlike with other chapters, a Chapter 7 debtor does not remain in control of the estate, instead a Chapter 7 trustee is appointed to collect and liquidate the debtor’s assets. The trustee is able to investigate and recover assets of the debtor not turned over to the trustee (e.g., assets held by a court appointed receiver or on consignment by a third party).
Once a trustee recovers and then liquidates the Chapter 7 estate, he or she will assess the validity of the claims filed by creditors and exemptions filed by the debtor, and distribute the proceeds in order of priority. Creditors will generally not recover in full and a business debtor is not eligible for discharge, except in special circumstances. However, a Chapter 7 debtor ceases to be an operating entity after liquidation so generally a discharge is unnecessary.
Filing Chapter 11
In Chapter 11, a debtor generally remains in control of its own estate. A trustee may be appointed for cause (i.e., fraud, dishonesty, incompetence or gross mismanagement), or if such appointment is in the best interest of the creditors; but this type of relief is relatively rare.
A Chapter 11 debtor’s intentions regarding its reorganization are laid out in its plan of reorganization. A plan of reorganization reflects the tools for rearranging its financial affairs the debtor intends to employ. For example, a plan may allow a debtor to sell assets free and clear of all liens, reject certain contracts or leases with a cap on damages, refinance existing loans while extending their maturity dates or decreasing interest rates.
The plan of reorganization is voted on by creditors and must either be approved or meet the criteria required for the debtor to cram down the plan on creditors. If a debtor is unable to confirm a plan of reorganization, the case may be converted to Chapter 7 or dismissed. After the confirmation of a plan, the business’s bankruptcy is essentially over, however, the bankruptcy court generally retains jurisdiction over the case at least until the last plan payment is made.
In general, filing for bankruptcy grants a debtor an automatic stay from the enforcement actions of creditors. This precludes creditors from continuing or bringing lawsuits, filing liens against property, or foreclosing on property. Under the bankruptcy automatic stay, creditors who wish to take action to enforce their claims must first seek relief from the bankruptcy court.
When a business files for bankruptcy, a creditor cannot receive payment until either the assets are liquidated and the Chapter 7 trustee distributes funds, or the debtor’s plan is confirmed and payments are made pursuant to the plan.
Pre-bankruptcy creditors are generally divided into three categories: secured creditors, priority unsecured creditors or general unsecured creditors. Secured creditors are generally paid first if the assets securing their claims are sold, or they are entitled to interest if their claims are refinanced and paid over time. Priority unsecured claims (e.g., taxes, wages, deposits) are second in priority and recover below secured claims. General unsecured creditors are lowest in priority. Where the value of a debtor’s estate is insufficient to pay all creditors in full, secured creditors will recover first until paid in full, then priority unsecured creditors and finally unsecured creditors. If there are not enough assets to pay a certain class of creditors in full, the creditors in that class will receive a percentage of their total claims. Finally, absolute priority requires classes entitled to greater priority to recover above junior creditors. As applied, this means that an unsecured creditor cannot recover a penny if priority unsecured creditors do not recover in full. Similarly, creditors in the same class must be treated equally.
Holders of the equity of a business (e.g., shareholders, members, partners) are lowest in priority and pursuant to the absolute priority rule, are only entitled to retain their equity interests if creditors have recovered in full. Limited exceptions to this exist where equity holders contribute new value to a Chapter 11 debtor’s business. The new value must be necessary for the plan of reorganization and equivalent to the value the equity holders seek to retain.
Filing a business bankruptcy is a complex process that will require the help of an experienced legal professional. If you are a business owner and are considering bankruptcy, it is imperative that you consult a bankruptcy attorney, as each filing is specific to the financial circumstances of the business.