Chapter XI. Bankruptcy

JurisdictionUnited States

XI. Bankruptcy

From a business creditors' perspective, if you first learn about a vendor's financial difficulties as a result of them filing for bankruptcy protection, it is usually too late for you to protect yourself from the negative impact the bankruptcy may have on your claim. However, if you are faced with such an untenable situation, it is critical that you are aware of the ramifications of each section of the Bankruptcy Code, as which chapter is utilized by the debtor will dictate the direction of the bankruptcy case. For instance, if your vendor files for protection under chapter 11 of the Bankruptcy Code, there is the possibility that your claim will be paid, or possibly even paid in full via a pre-negotiated bankruptcy plan. However, if your vendor has filed a bankruptcy petition under chapter 7 of the Bankruptcy Code, it is less likely that there will be any distribution on account of your claim.

What follows is a very general summary of the available chapters of the Bankruptcy Code that are available to a debtor. This a summary review that covers high-end issues if you are faced with a bankruptcy situation. There are many other books published by the American Bankruptcy Institute that analyze different aspects of a bankruptcy case in-depth.

A. Chapter 7

Under chapter 7 of the Bankruptcy Code, concurrent with the bankruptcy filing, complete control over the company and its assets is turned over to an independent chapter 7 trustee. For all intents and purposes, the chapter 7 trustee is the sole officer and director of the company, and the debtor is no longer in the hands of the pre-bankruptcy management and board of directors, all of whom are wholly displaced by the trustee.244With limited exceptions, a chapter 7 bankruptcy filing is meant to cease all operations of the business.

A chapter 7 trustee is automatically appointed randomly from a panel maintained by the Office of the U.S. Trustee (the "UST"), an arm of the U.S. Department of Justice, without being specifically chosen by the court or the company. If there is an abundance of interest from creditors in appointing a chapter 7 trustee, a sufficient amount of creditors can vote to elect their own chapter 7 trustee that would supplant the UST's selection. Given that voting creditors must have allowed claims against the bankruptcy estate that are not contingent, disputed or unliquidated, it is often difficult for creditors to band together and elect a trustee.245 The chapter 7 trustee must be bonded, and oversight of the bankruptcy estate is conducted by the UST. The chapter 7 trustee determines the course of the liquidation of the company, including what assets are sold, liquidated or abandoned, and what causes of action are pursued.246 The chapter 7 trustee also has a statutory option to operate the business pending ultimate disposition, but this option is unique and rarely implemented.

Actions against the company are automatically stayed by the bankruptcy filing.247 However, claims of creditors against nondebtor parties, such as guarantors, are not stayed.

The chapter 7 trustee has the authority to sell assets free and clear of liens (with liens to attach to the proceeds), and can generally provide the buyer with comfort such as protection from successor liability pursuant to a § 363 sale order issued by the bankruptcy court after appropriate notice and a hearing.248

The chapter 7 trustee handles claims against the company, analyzes and negotiates the allowance of the claims of creditors, liquidates the claims through a process before the court if necessary, and ultimately effectuates distributions upon court approval.

Trustees often try to create value by investigating claims against insiders, and by seeking the recovery of preferences (generally, amounts transferred to creditors within 90 days prior to the bankruptcy, one year for insiders) and fraudulent transfers (transfers made with the intent to hinder, delay and defraud creditors, and transfers for less than reasonably equivalent value within up to several years prior to the bankruptcy, depending on which state/federal law is applied). Trustees will also commence and prosecute other actions against insiders or others for other bankruptcy or nonbankruptcy causes of action.

If a chapter 7 bankruptcy is the result of conversion from another section of the Bankruptcy Code, the administrative expenses of the chapter 7 estate will come before the administrative expenses of the pre-conversion bankruptcy estate. Often, conversion to chapter 7 is seen as a less-convenient alternative than a liquidating plan or structured dismissal from a chapter 11 bankruptcy case, the rationale being that the chapter 7 trustee would have to become knowledgeable in the facts and circumstances of the debtor and then hire its own professionals in order to administer the estate. The delay, cost and expense of doing so may outweigh the effort in seeking to have a bankruptcy case dismissed or a plan confirmed. The ultimate decision on whether to convert to chapter 7 or seek another means to wind down a chapter 11 bankruptcy case likely lies in the amount of funds that will be available for distribution to creditors at the end of the day.

B. Chapter 11

1. Business Reorganization

Chapter 11 of Title 11 of the U.S. Code (the Bankruptcy Code) provides a mechanism that enables a company (a "debtor") to seek protection from creditors, and restructure its debts, eliminate or negotiate burdensome or unprofitable contracts or leases, and effectuate a financial reorganization while management stays in control and operations continue in the ordinary course of business. However, such ordinary-course operations are conducted under strict scrutiny from the bankruptcy court and other constituencies in order to ensure that the interests of all creditors are considered in the business decisions of the debtor.

Most entities are eligible to file for chapter 11 protection. A company does not need to be insolvent to file a chapter 11 bankruptcy petition. If a challenge is made by creditors that bankruptcy protection is not necessary, the company must be able to show in good faith that it has the need to restructure its business affairs and that without such reorganization, the company would likely fail. For instance, despite being cash-flow positive, a business may desire to use the benefits of the Bankruptcy Code as leverage to re-negotiate its contracts, leases or union contracts, or sell certain of its assets free and clear of liens, claims and encumbrances.

Upon the commencement of the chapter 11 case:

• Existing officers and directors of the company remain in place, as does the preexisting management team of the debtor;
• The debtor continues to operate its business as a "debtor in possession" in the ordinary course of business and generally without interference by the bankruptcy court while the company attempts to reorganize, except that all actions taken by the company that are outside of the ordinary course of business must be approved by the bankruptcy court;
• If there is sufficient interest among the creditor body, an official committee of unsecured creditors may be appointed whose duties include oversight of the debtor's activities, investigation into potential claims and causes of action against the debtor, and participation in the formulation of a plan;
• All creditors are prohibited from collection activity against the debtor by way of the automatic stay, unless creditors appear and receive permission from the bankruptcy court upon notice to the debtor to obtain relief from the stay;
• The debtor can continue to obtain ordinary-course unsecured or certain forms of secured financing for operations without court approval (e.g., trade credit, unsecured third-party credit, PMSI);
• The debtor must obtain court approval for secured or unsecured financing outside of the ordinary course of business (e.g., debtor-in-possession — or DIP — financing or use of cash collateral with favorable terms or replacement liens);
• The debtor can seek court authorization to reject unfavorable or unprofitable contracts (equipment leases, real estate leases, nonunion employment contracts, supply contracts, etc.); the debtor can attempt to modify collective bargaining agreements and retiree benefits if it can meet the stringent procedural and substantive requirements set forth in the Bankruptcy Code;
• The debtor can attempt to negotiate a financial restructuring of its existing debts and obligations to reduce the amount or improve the terms of what creditors will ultimately receive for their claims upon confirmation of a plan of reorganization at the conclusion of the chapter 11; and
• If negotiations with its key creditors fail, the debtor may seek to confirm a plan over the objections of creditors and cram that plan down on creditors if certain requirements are met, focused on equal treatment of on-par creditors and on the "absolute priority rule," where senior creditors must be paid in full before junior creditors or equity-holders may receive or retain anything, and claims may be valued and treated, all in accordance with strict statutory authority.

The Bankruptcy Code gives the debtor the ability to evaluate all of its existing executory contracts (while not defined in the Bankruptcy Code, generally meaning any contract with obligations remaining to be performed both parties) and unexpired leases of nonresidential real property. Typically, the debtor has three options with respect to contracts and leases: (1) reject; (2) assume; and (3) assume and assign.

The general legal standard applied to the debtor's decision with respect to its treatment of contracts and leases is whether the decision is a reasonable exercise of the debtor's business judgment. This is a very low standard. Collective bargaining agreements and retiree benefits are treated separately from other executory contracts in a chapter 11 case, requiring the debtor to meet...

To continue reading

Request your trial

VLEX uses login cookies to provide you with a better browsing experience. If you click on 'Accept' or continue browsing this site we consider that you accept our cookie policy. ACCEPT