Editor’s Note: Benjamin E. F. B. Waller is a member of the Financial Institutions and Creditors’ Rights Practice Groups of Ward and Smith, P.A.
What do Polaroid Corporation; Winn-Dixie Stores, Inc.; Chrysler, LLC; and General Motors have in common? All have filed for bankruptcy. Bankruptcy is intended to make the best of a bad situation by maximizing the benefits to both the debtors and the creditors involved. It is designed to provide debtors time and room to get their financial affairs in order while simultaneously assuring comparable treatment for similarly-situated creditors. Whether your business is considering filing bankruptcy or is a potential creditor in a bankruptcy proceeding, a general understanding of business bankruptcy concepts is extremely useful in today’s economic climate.
The Bankruptcy Code
The Bankruptcy Code ("Code") is set forth in Title 11 of the United States Code. There are numerous Chapters in the Code, but the two most important Chapters for businesses are Chapter 7 and Chapter 11. The types of bankruptcy allowed by these Chapters are commonly known by their Chapter numbers: "Chapter 7" and "Chapter 11."
In a Chapter 7 bankruptcy, also known as a "liquidation bankruptcy," a trustee is appointed to oversee the orderly and efficient shutting down of the debtor’s business and liquidation of its assets. The Chapter 7 trustee is an independent third party chosen by the bankruptcy court to investigate the debtor’s financial condition and to collect and liquidate the debtor’s assets in a manner that will maximize their value to creditors under the circumstances.
In contrast, a Chapter 11 bankruptcy may be either a liquidation or a reorganization bankruptcy, depending on the debtor’s intentions and financial viability. Chapter 11 debtors, with the assistance of their bankruptcy counsel, typically remain in possession and control of their assets throughout and after the bankruptcy case and are given the same powers to deal with their assets and debts as an independent trustee would have, but subject to the same duties and obligations as the trustee would have. Further, any fraud, mismanagement, or incompetence on the part of a Chapter 11 debtor-in-possession may result in the appointment of an independent trustee by the bankruptcy court to replace the debtor in order to shepherd the business through the bankruptcy.
The Bankruptcy Estate
The filing of a bankruptcy petition, whether under Chapter 7 or Chapter 11, creates an estate of the debtor comprised of all of the debtor’s property interests that exist as of the date the petition is filed. With the commencement of the bankruptcy case, the debtor surrenders the right to freely control or dispose of the estate property. In a Chapter 7 case, the trustee assumes exclusive authority over the property of the bankruptcy estate. In a Chapter 11 case, the debtor-in-possession retains control over the estate property, but such control is subject to the duties and obligations that otherwise would be imposed on a bankruptcy trustee as stated above.
The Automatic Stay
Upon the filing of a bankruptcy petition, the debtor enjoys the protection of an "automatic stay." Subject to certain limited exceptions, the automatic stay prohibits any attempt by creditors to collect pre-petition debts from the debtor, including the commencement or continuation of any action to recover a debt or to enforce a claim against the debtor. The automatic stay also bars creditors from attempting to enforce and collect on any judgments against the debtor entered prior to the filing of the petition. The stay is intended to benefit all creditors by bringing all of the debtor’s assets and creditors into one forum where the creditors’ rights can be balanced instead of having one or more creditors take action that could give them more than their "fair share" of the debtor’s assets.
Under certain circumstances, creditors with secured claims may be allowed relief from the automatic stay in order to pursue their rights against their collateral. Whether relief from the automatic stay is appropriate is determined on a case-by-case basis by the bankruptcy court. Obtaining relief from the automatic stay generally requires filing a motion as well as providing notice to all interested parties and an opportunity for them to object.
Chapter 7 vs. Chapter 11 – More Distinctions
As noted above, in a Chapter 7 bankruptcy, the business debtor’s assets (to the extent there is any equity in such assets) are liquidated. Businesses may choose to file Chapter 7 when there is no prospect of rehabilitating the company. Secured creditors either receive their collateral by the debtor’s "surrender" of such collateral, or are paid from the proceeds of the trustee’s liquidation (i.e., sale) of the collateral. Any proceeds remaining after the liquidation of assets and payment to secured creditors generally are distributed to unsecured creditors on a pro rata basis. However, in most Chapter 7 cases, there are no assets available for liquidation and distribution to unsecured creditors. In the event the Chapter 7 trustee identifies assets that may provide some payment to unsecured creditors, all interested parties are notified to file claims asserting their entitlement to payment. The amount paid to each unsecured creditor will depend on the number and the amount of unsecured claims filed.
Business debtors typically file Chapter 11 when they anticipate being able to reorganize their business activities, restructure their debts with the help of the bankruptcy court, and continue operating. Notable recent examples of companies seeking to reorganize using Chapter 11 are General Motors and Chrysler, LLC, the nation’s largest and third-largest automakers. A Chapter 11 debtor may decide to keep some assets and liquidate others (subject to bankruptcy court approval).
When a Chapter 11 petition is filed by a debtor, the debtor’s creditors are notified to file with the bankruptcy court their claims against the debtor’s estate, together with documentation supporting the claims. Creditors with valid claims receive treatment according to a reorganization plan. The debtor must submit its proposed reorganization plan to its creditors for consideration together with a "disclosure statement" containing sufficient information concerning the operation of the debtor’s business to permit the creditors to evaluate the plan properly. In the proposed plan, each creditor’s claim will be addressed and either be impaired (i.e., the creditor’s rights are altered) or be unimpaired. The creditors are given an opportunity to either accept or reject the proposed plan.
After creditors have submitted their ballots accepting or rejecting the proposed plan, the bankruptcy court holds a hearing to determine if the proposed plan should be confirmed. The bankruptcy court may confirm the reorganization plan, even over the objections of some creditors, as long as there is at least one class of impaired creditors that votes to accept the proposed plan. Alternatively, the bankruptcy court may deny confirmation of the proposed plan, in which case the debtor may be permitted additional time to propose an amended reorganization plan or, in some instances, the bankruptcy case may be dismissed. A third alternative is that the case may be converted to a liquidation case under Chapter 7.
Conclusion
With big-name business bankruptcy filings grabbing headlines, businesses should be cognizant of general bankruptcy concepts when making decisions about if and how to move forward in this tough economic climate. Struggling businesses need to understand the options available to them, and all businesses, regardless of their financial health, must consider the possibility that they may end up a creditor in a bankruptcy proceeding. As with all legal proceedings, bankruptcy cases involve deadlines and rules that must be strictly obeyed and followed. Failure to abide by those deadlines and rules may result in a waiver of rights by a creditor. Businesses considering filing bankruptcy, as well as those involved as creditors, should seek appropriate guidance as to their rights and obligations.
© 2009, Ward and Smith, P.A.
Ward and Smith, P.A. provides a multi-specialty approach to the representation of technology companies and their officers, directors, employees, and investors. Benjamin E. F. B. Waller practices in the Financial Institutions and Creditors’ Rights Practice Groups, where he concentrates his practice in the representation of businesses and individuals in debt collection and bankruptcy disputes and litigation. Comments or questions may be sent to bew@wardandsmith.com.
This article is not intended to give, and should not be relied upon for, legal advice in any particular circumstance or fact situation. No action should be taken in reliance upon the information contained in this article without obtaining the advice of an attorney.
