What’s “Bankruptcy” and How Does it Work?

What exactly is a Chapter 11 bankruptcy filing and how does the process work?

A Chapter 11 is a “reorganization” bankruptcy. That is, it is filed with the assumption that the filer will use the protection of the court to reorganize its finances so that it can continue as a going concern.  That doesn’t always happen, but it’s the intention going in.

There are a number of schedules you have to file with the court when the bankruptcy occurs.  These included assets and liabilities, income and costs, a schedule of existing contracts and some others.  Typically, the owner of the business becomes the “debtor in possession” and is responsible for the continued management of the business and control of the associated assets.  He is in a position of fiduciary responsibility with the same powers and obligations as if a Trustee had been appointed to manage the business. He’s required to file the monthly reports, can hire attorneys, accountants, appraisers or other professionals to help with the case, and file tax returns.

Note that a corporation has standing as a separate entity, so an owner’s personal assets are not at risk in a corporate filing, except to the extent of his equity in the business (or if he has given a personal guarantee, though that’s an issue outside of bankruptcy).  A sole proprietor filling a chapter 11, on the other hand, will find his personal assets are part of the bankruptcy.  Something to think about.

All You Need Is Cash- and a Bankruptcy Attorney

With the filing of the bankruptcy petition, all collection efforts by creditors are required to cease.  In fact, the company is not permitted to pay any unsecured debts incurred prior to the date of the bankruptcy filing.
Actually, it’s worse than that. The debtor in possession has the right and maybe the obligation to recover certain payments or transfers of property made prior to the bankruptcy filing so they can be equally divided among creditors. You can understand how the bankruptcy judge and creditors might insist on that if the owner used corporate assets to buy a Caribbean island a week prior to the filing when he wasn’t paying his creditors. Giving stuff to relatives or other insiders in anticipation of the filing is also a no-no.

Generally, this does not apply to payments made in the ordinary course of doing business, so one thing you make sure you do is pay your employees everything you owe them up to the day of the filing.  Remember you’re trying to restructure the business and it can be kind of hard if the employees have been stiffed right along with the other unsecured creditors.

You’re also going to need cash for a retainer for your friendly bankruptcy attorney, who knows he won’t get paid for 120 days or so after the filing and wants some money to bill against.  The phone company and other utilities will probably want a deposit to continue providing service, and some of your suppliers you haven’t paid and now can’t pay by law may be reluctant to ship you more merchandise on credit (though their chances of getting paid on new shipments may actually have improved).

It takes some cash to file a successful chapter 11.  Any company thinking about it should be hoarding some in advance.

Cash Collateral

If there’s a bank or other financing source involved, chances are they have security in the company’s assets.  If you don’t pay them, they have the right to the inventory, receivables, trade name, furniture and fixtures, patents, copy machine, and your lunch in the office refrigerator.  But of course, if they take all that and try to liquidate it to get themselves paid, there’s no business.

The debtor in possession can’t use that cash collateral, as it’s called, without permission of the secured creditor or authorization of the court. The court is required to make sure the collateral belonging to the secured party is adequately protected on a continuing basis. So typically there will be a cash collateral hearing where the secured creditors, the judge, and the debtor in possession, along with appropriate attorneys, will figure this all out.

The secured creditors’ interest is in ultimately collecting their money.  They know things were going to hell before the filing.  They also know that if they had to sell the debtor’s inventory and collect his receivables themselves, it might not go too well.  So, if they believe they can continue to be adequately secured and that the debtor in possession has a fighting chance to turn the business around, they will often not oppose the debtor’s use of cash collateral.  And even if they do the bankruptcy judge, who has quite a bit of discretion in the whole bankruptcy process, can require them to allow it as long as they have “adequate protection.”

The debtor needs use of the cash collateral to continue to operate the business, but there’s a chance he also needs some additional financing.  There is a class of lender who provide “debtor in possession” financing.  Remember that as a result of the filing, all the unsecured creditors have made an involuntary and hopefully temporary contribution to the debtor’s capital, immediately strengthening the balance sheet.  A lender supplying debtor in possession financing often has priority over existing unsecured debt, so their risk is reduced.

I don’t know what the debtor in possession financing market is like right now given current economic conditions.  It will be interesting to find out.

Now What?

Well, the immediate pressure is off the debtor in possession, and he can try and restructure his business.  He’s no longer spending all his day shucking and jiving with creditors and figuring out how to make payroll.  He has an exclusive period of 120 days in which to file a plan of reorganization. Nobody else can do it during that time. The 120 day can be extended, but not past 18 months.  Knowing that somebody else (like the creditors’ committee) might be allowed to file one can motivate the debtor to get it done.

There’s probably been a creditors’ committee formed which typically consists of the 7 largest unsecured creditors. They can be more or less active, but typically consult with the debtor in possession on running the business and developing the plan.  It can be useful to have the committee looking over the debtor’s shoulder.

There may be various legal proceedings going on where, for example, certain creditors try to get relief from the stay that keeps them from trying to collect their money.

The debtor has the right to reject contracts and leases he does not believe are in his interest.  He’ll be busily using that leverage to restructure his business.

He’ll also be working to convince customers, suppliers (who have not been paid but can be paid for new work in bankruptcy), and employees that the business is viable and that they should continue to deal with him.  What fun.

The Plan

At the core of the plan eventually filed with the courts is the issue of who gets paid how much. As the business and its assets are the source of that repayment, how the business is going to operate and how much cash it flows off are critical.  It would be typical for the plan to classify those who are owed money as secured creditors, unsecured creditors, and equity security holders, though there can be others. The further down the list you are, the lower your priority.  The tax authorities and the lawyers and other professionals who worked with the firm during the bankruptcy are at the top of the list.

Typically, there’s not going to be enough to give everybody 100 cents on the dollar, so there’s some negotiations involved in getting the plan approved. If I remember this right, a whole class of claims is said to accept the plan if the creditors in that class who do accept it represent at least two-thirds in amount and more than one half of the numbers of claims in the class. One of the things that’s sometimes done to simplify the approval process is to agree to pay all the smallest claims 100% of their claim when the plan is approved. That tends to get them on your side.

I’ve described in about 1,500 words a process and set of circumstances on which many books have been written. There can be a lot of permutations and combinations, but I hope this gives you the general picture.  The process of getting a company through a bankruptcy is interesting and challenging – though not so much if you’re the debtor or a creditor.
Read more at http://business.transworld.net/features/market-watch-chapter-11-bankruptcy-what-does-that-mean-exactly/#0zv6LhGGjHbcbx60.99


7 replies
  1. Mark Cole
    Mark Cole says:

    Can’t tell you how much I’ve learned from your posts over the years. This one was particularly informing. Hopefully I’ll be able to thank you in person one of these days!

    • jeff
      jeff says:

      Thanks Mark. That’s actually an old article I wrote years ago. Thought it might be timely to post it again, and apparently it was.

  2. bobby
    bobby says:

    Hey Jeff, I have a ton of respect for your website and your intuitive, non-objective writing on this industry – However, It is a bit misleading for to reference Active Ride Shop (again) – believe they filed bankruptcy over 5 years ago. You might want to reiterate that..

    • jeff
      jeff says:

      Hi Bobby,
      The thing is, I wrote that article over 5 years ago. I’m just reposting it as informational about bankruptcy due to the Quik filing.
      Thanks. I’ll see what I can do.

    • jeff
      jeff says:

      I went back and took out the reference to Active Ride. That should do it. Thanks for reminding me.

  3. Justin
    Justin says:

    Hey Jeff,
    Thanks for the article! What would be the reason for a company to let go a large group of employees a few days before they filed for chapter 11?

    • jeff
      jeff says:

      Hi Justin,
      Hope you weren’t one of the ones they let go? The answer is that I don’t know, but I’ll speculate a little here. First, given Quik’s circumstances, it could have been that those layoffs were coming anyway. But it may also be that it was part of the negotiation with the secured creditors who are sort of in the driver’s seat in this deal.
      Thanks for the comment,


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