Chapter 6 What Is Chapter 11?

• Jurisdiction: United States

Chapter 6 What Is Chapter 11?

§ 6.1 ~ Introduction

In this chapter, we address the arena where the reader is likely to spend most of her time: chapter 11, the "reorganization" chapter of the Bankruptcy Code. From just reading chapter 11, it is almost impossible to understand what chapter 11 is "about." We think we have a pretty good intuition as to what chapter 11 is "about," and we try to set it forth here. Our exposition is framed by two threshold problems.

First, one problem with chapter 11 is that it is, to some extent, at cross-purposes with itself. The drafters of chapter 11 were faced with the competing goals of:

1. giving the old equity-owners another chance; and
2. maximizing asset values for creditors.

Sometimes these interests coincide, but often they do not. When they do not, the competing goals of chapter 11 seem to run into each other.

Our second threshold observation is that chapter 11 seems to be changing or has changed. Somewhat oversimplified, our view is that the second view is trumping the first. Another way of putting it is to say that chapter 11 used to be about debtors trying to persuade creditors to trim down and stretch out their claims; now, it is increasingly about secured creditors trying to maximize their recovery from the debtor's assets. We do not think this trend was the intention of the drafters of the 1978 Code. Quite the contrary, we think they had a fairly strong (if ambivalent) tilt toward the old equity. But, as we say, the Code seems to admit both views.

In an important article, two experienced chapter 11 lawyers have spoken of "The Creeping Repeal of Chapter 11."¹ We think this title is a good start, but we suspect it both overstates and understates reality. If the authors meant to announce the demise of chapter 11, we think they have gone too far; there is still plenty of support in the statute for the old-equity view. On the other hand, we think it may be that life on the ground has actually outpaced the statute, that the shift toward the asset view has actually gone further in practice than the mere statute might suggest.

We begin by trying to explain the problem — to show what it means to say that the Code is "ambivalent." This section may seem a bit abstract, and you can skip it without loss of continuity. But we think it may be helpful for the beginner to explain some of the seeming contradictions in chapter 11 practice.

Next, we outline one of those items so much beloved in the law: a "hypothetical case." As is permitted with hypotheticals, we do not assert that this hypothetical represents any real case, now or ever. We do suspect that it represents, more or less, what the drafters had in mind when they wrote chapter 11.

Finally, we end with a discussion of strategic points. We also elaborate on this topic in other chapters of this book, chiefly Chapter 10 ("Keeping the Ship Afloat") and Chapter 18 ("Confirmation").

§ 6.2 ~ The One-Minute chapter 11

Chapter 11 is the reorganization chapter of the Code. A chapter 11 case begins like any other bankruptcy case: with a petition, schedules and a statement of financial affairs. Usually, no trustee is appointed, and the debtor remains in possession as a debtor in possession (DIP), with the powers and responsibilities of a trustee. The debtor's business — if there is one — continues to operate. It may even, with court approval, borrow new money. Creditors are stayed from pursuing their claims. Someone — usually management — proposes a plan of reorganization. Creditors whose rights are affected get to vote on the plan. If the plan gets the required votes and satisfies the legal requirements of § 1129, then the court may confirm the plan.²

§ 6.3 ~ Why Chapter 11 is hard to understand

Recall that chapter 11 is hard to understand because of its dual, and sometimes conflicting, purposes. To see why this is so, consider these three cases:³

First case: LittleCo owes debts of $100. If LittleCo were broken up and sold off piecemeal, it would yield $100. With a bit of time and effort, LittleCo can be preserved as a going concern with a value of $120.

This is an easy case for "reorganization." If the debtor liquidates now, creditors get paid, but equity-owners get nothing. If we wait a bit, creditors get paid, and equity gets the $20 residual. The debtor just needs a bit of time. Nobody gets hurt. We preserve the asset value, and we preserve the equity.

Second case: LittleCo owes debts of $100. If LittleCo were broken up and sold off piecemeal, it would yield $80. With a bit of time and effort, LittleCo can be preserved as a going concern with a value of $90.

The going-concern value is higher than the liquidation value, so creditors are impelled to preserve the higher value. The difference from case one is that in this case, there is nothing for old equity-owners either way. The creditors may need the assistance of the court to preserve the going-concern value, but the equity-owners have no dog in the fight.⁴

Third case: LittleCo owes debts of $100. If LittleCo were broken up and sold off piecemeal, it would yield $80. LittleCo has the opportunity to invest all $80 in a new venture. The new venture is promising but risky, with a 50/50 chance of success. If it succeeds, the assets will be worth $240. If it fails, they will be worth nothing. The Las Vegas expected value of the project is, therefore, $120.⁵

This is the case that exposes the tension in chapter 11. Taking the risk gives equity another chance, but it achieves its end at the expense of creditors. In effect, it is "gambling with other people's money."⁶ In short, our two first principles are at war with each other; creditors want to "preserve the assets" (liquidate today), and equity wants to "preserve the equity" (take the risk). You cannot always do both at once.

From this, we can draw two essential initial principles:

1. The debtor gains from more time. More precisely, if the equity owners would lose everything in liquidation today, then any delay is to their advantage because something might turn up.⁷
2. Risk helps equity and hurts debt.

Of course, these statements are oversimplifications, and there are exceptions, but they are nonetheless important principles that pursue us all the way through chapter 11.

If this stuff still seems too abstract, you need to know that it is old stuff in business school. Every M.B.A. student learns it in his first semester finance class and builds it into his mindset on investing.⁸

§ 6.4 ~ A Hypothetical

We turn now to our hypothetical case. We do not mean to suggest that this is a typical case (in fact, we think it is not), but we think it is probably the kind of case the drafters had in mind when they wrote the statute.

We proceed as follows. We tell you a little about LittleCo's business and about how it got into this mess. We suggest how it might go about trying to solve its problems — by appealing not to the generosity of its creditors, but to their self-interest. We suggest reasons why a negotiated deal may be difficult or impossible. Then we show you what chapter 11 has to offer.

LittleCo Balance Sheet

Assets (in millions)		Liabilities & Net Worth
Cash	$2	BigBank	$4
Inventory	$3	FinCo	$5
Accounts Receivable	$3.5	Trade Creditors	$6
Plant	$5	Total L	$15
		Net Worth	($1.5)
Total Assets	$13.5	Total L&NW	$13.5

LittleCo is a small manufacturer and distributor of widgets. It owns some inventory, some accounts receivable, a factory building and a little cash. It owes $4 million to BigBank. It owes $5 million to FinCo. It owes $6 million to some 150 vendors and other unsecured creditors with claims ranging from a few hundred thousands down to just nickels and dimes. Lester Little is president and a 60 percent shareholder. The other shareholders are his brothers and sisters.

On a day-to-day basis, LittleCo is a functioning, healthy company — meaning that it can pay its ordinary expenses as they come due from ordinary income. But last year, a series of unexpected misfortunes caused LittleCo to fall behind on many of its obligations. During these unhappy times, LittleCo's trade debt more than doubled and has remained at a high level ever since.

LittleCo has adopted a variety of tactics to fend off its creditors. Most importantly, the company has slowed down its payments to its vendors. It used to pay in 30 days; now, the lag time is more like 45. More passive creditors have had to wait even longer while more aggressive or threatening creditors got paid on time. Lester and other family members have had to skip some of their own personal paychecks. Recently, Lester was even tempted to dip into the sacrosanct "trust fund account," where he keeps money withheld from employee paychecks that the company is supposed to turn over to the tax collector.⁹

Among the creditors, BigBank has proven most malleable. The reason is easy enough to understand: Big-Bank's $4 million claim is secured by LittleCo's plant, which is worth perhaps $5 million. BigBank sent out an appraiser to assure itself that the plant was really worth as much as the books showed, but after they got a favorable appraisal, BigBank quit pushing for monthly payments. Lester sometimes suspects that BigBank would actually like to foreclose on the plant so it could sell it at a higher price.

FinCo, with its claim of $5 million, holds a security interest in inventory and receivables. The books show the inventory value at $3 million and receivables at $3.5 million (a total of $6.5 million), so on the face of things, FinCo has no cause for concern. But LittleCo and FinCo both know these numbers are probably soft (unreliable). The $3 million inventory number is a signal that inventory simply hasn't been selling and is piling up in the warehouse. The receivables, too, have been creeping up as customers pick up rumors that LittleCo may be in trouble. After all, the main reason for paying a supplier like...