WHAT IS CHAPTER 11?

Chapter 11 – Reorganization

As Vince Lombardi said “It’s not whether you get knocked down, it’s whether you get up.”  Chapter 11 allows many small businesses that have been knocked down to get up.  Using Chapter 11 to reorganize, a debtor may restructure its debt, rid itself of unwanted leases, other burdensome contracts or unneeded assets.  The debt restructure can include a reduction of secured or unsecured debt and extension of the payment terms.  The reorganization is normally accomplished through a Plan of Reorganization submitted to the creditors for approval then confirmed by the Bankruptcy Court.  Sometimes a Plan of Reorganization can be confirmed by the Bankruptcy Court even if all classes of creditors do not approve the Plan.  This is called a “cramdown”.

Chapter 11 is normally used for reorganization by businesses; however may be used by non-business debtors, particularity where the debtor’s debt limits exceed the Chapter 13 threshold.

THE IMPORTANCE OF BEING PREPARED AND DILIGENT

One of the keys to a successful Chapter 11 case is preparation, both before and after the case is filed.  In many Chapter 11 cases, the debtor’s management is not knowledgeable about the process and ill-equipped to deal with the process.  While most owners are competent to run their business, the rules change in Chapter 11 and, it seems, not prepared to face what is coming.  This is one of the major reasons Chapter 11 debtors have low survival rates.

Many, if not most, Chapter 11 debtors must file “first day motions” at the inception of the case.  These motions deal with such matters as continuing the debtor’s financing with its primary secured lender (cash collateral motions), employment of professionals, payment of accrued wages, payments to critical vendors, and maintaining utilities without interruption.

Management must spend its time, both before and after the filing, dealing numerous matters including preparation of schedules, producing documents for the U.S. Trustee and/or the court, preparing for and making court appearances, dealing with the US Trustee, preparing the required Monthly Operating Reports.  Then there’s the matter of the Disclosure Statement and Plan of Reorganization due within 120 days of filing (or 180 days for a “Small Business”) unless an extension is granted.

It is imperative that the debtor’s management expects what will take place and be able to respond appropriately.  Debtor’s management must know what duties will be performed by who (e.g. who has responsibility for the Monthly Operating Reports), when task are due and coordinate the tasks, making sure everything is done timely and properly.

THE IMPORTANCE OF SOCIAL INTELLIGENCE

Another key to a successful Chapter 11 case is the debtor management’s ability to negotiate with, cooperate with and just plain get along with its creditors (including specifically its secured creditors), the U.S. Trustee, the Creditors Committee (if there is one), other parties and the court.  This includes treating all parties fairly, with respect, in good faith, and doing whatever is required of the debtor on a timely basis in a satisfactory manner.  As Woody Allen remarked, “eighty percent of success is showing up;” “on time and doing what is required” should be added to make it complete.

The U.S. Trustee has seen hundreds of these cases come and go, and makes fairly quick judgments about whether a Chapter 11 debtor will survive or not.  If the U.S. Trustee believes that a case is going nowhere, generally it does.

Other things being equal, Chapter 11 cases where the debtor spends time in court fighting with its secured creditors and/or the U.S. Trustee have substantially lower success rates than cases where this does not happen.  Reasons for this are varied.  The contested process takes up precious time.  It causes the debtor to incur high administrative cost which it may not be able to afford or which it must take from other valuable activities.  Lack of cooperation with creditors can result in a class of creditors rejecting the debtor’s plan, which then requires the added burden of the debtor having to meet the additional requirements of Cramdown to get a plan confirmed – if it can be confirmed.  And debtors do not always prevail in these contests.  Sometimes the courts allow the secured to retrieve their collateral, often then making reorganization impossible.  As a noted judge observed regarding one of these highly contested cases: “There are no winners, only survivors.”  However, it is true that debtors cannot always avoid the contested process and it must be faced head-on.

 DEBTOR IN POSSESSION

In most Chapter 11 proceedings, a trustee is not appointed. The debtor serves as a Debtor in Possession (“DIP”) who has most of the rights and responsibilities of a trustee – including his fiduciary duties to the estate. The bankruptcy can appoint a trustee “for cause” which would include fraud and/or mismanagement.

UNITED STATES TRUSTEE

The Office of the U.S .Trustee is a part of the United States Department of Justice.  It is charged with monitoring activities of bankruptcy cases.  In Chapter 11 cases, it normally takes an active role.  For instance, the US Trustee will monitor the DIP to make sure that it maintains proper insurance on its assets and activities.  The DIP must file Monthly Operating Reports with the Court.  The U.S. Trustee will review these reports and take appropriate action if they are not timely filed or if a review discloses the business is not being conducted as it should.  If the US Trustee believes that fraud or mismanagement exist, he may seek the appointment of a trustee, the dismissal of the Chapter 11 case, or a conversion of the case to a Chapter 7 case.

If the U.S. Trustee believes that a proposed Disclosure Statement does not contain adequate information, he may object to the approval of the Disclosure Statement – which action may delay or stop further reorganization proceedings and add additional administrative cost to the DIP.  If the US Trustee believes that a proposed Plan of Reorganization does not comply with the requirements of the Bankruptcy Code, he may object to the proposed Plan of Reorganization, again delaying or stopping the reorganization process and adding cost of administration to the DIP.

It is normally in the DIP’s best interest to cooperate fully with the U.S. Trustee by filing timely reports, providing requested information and keeping the U.S. Trustee informed of its activities.

BUSINESS OPERATIONS DURING THE CHAPTER 11

After the Chapter 11 is filed, the DIP may operate the business in the ordinary course of business. However, for the debtor to use “cash collateral”, it must obtain approval of the creditor having a security interest in it or of the bankruptcy Court.

For most businesses, cash collateral is the cash or proceeds of other assets, such as receivables or inventory, which is subject to the security interest of a creditor. This would typically apply where a creditor bank has a security interest in the inventory and accounts and their proceeds of the debtor. In such case, the DIP cannot use the cash collateral unless 1) the secured creditor approves of its use or 2) the secured creditor approves of its use. Often, the DIP and secured creditor will attempt to reach some agreement how this collateral will be protected in the bankruptcy and this tentative agreement may including giving the secured creditor a replacement lien on inventory and accounts and their proceeds acquired by the debtor subsequent to filing the bankruptcy. The DIP and secured creditor will request that the bankruptcy court approve of this tentative agreement.

CREDITORS’ COMMITTEE

The U.S. Trustee may appoint a unsecured creditors’ committee. If the appointment is made, the creditors’ committee is normally comprised of the seven largest unsecured creditors, excluding insiders and tax creditors. The creditors’ committee may, with court approval, employ its own counsel and other professionals. In most small cases, the US Trustee usually declines to appoint a creditors committee.

DISCLOSURE STATEMENT AND PLAN OF REORGANIZATION

For the debtor to have its debts reduced, the Plan proponent (normally the debtor) must have its Plan approved by the bankruptcy court. Before the Plan can be submitted to creditors, the bankruptcy court must approve the adequacy of the Disclosure Statement submitted by the Plan proponent. The Disclosure Statement is a document which provides the creditors with sufficient information about the debtor’s business to have an informed opinion of the Plan.

In the proposed Plan, the creditors will be classified by similar types. Typically, unsecured creditors will be put into a class, tax creditors into a class, etc. Secured creditors may be put into a class or may be put into separate classes.

Once the adequacy of the Disclosure Statement is approved by the court, the Disclosure Statement and Plan will be submitted to the creditors for voting. For the Plan to be approved, either i) over one-half in number and two-thirds in dollar amount of each class (counting only those voting) must approve the Plan or ii) the court must cramdown the Plan for it to be confirmed. Cramdown is a procedure whereby, if certain conditions exist, the court can confirm a Plan even if it does not receive the requisite votes of all classes of creditors.

DISCHARGE

An individual receives a discharge in a Chapter 11 when he completes his Plan. A corporation does not get a discharge in a Chapter 11 if it is liquidating its assets. Otherwise, a corporation gets a discharge effective upon confirmation of the Plan.

CHAPTER 11 USED FOR LIQUIDATION

Sometimes a Chapter 11 is used to liquidate the assets of a business. An example would be where a debtor wants to liquidate its business for its going concern value, which exceeds its liquidation value. In such an instance where the sale proceeds will not satisfy the unsecured debt of debtor, the buyer may require that the transaction receive the approval of the bankruptcy court – and Chapter 11 is used for that purpose.