As the economy has plummeted deeper and deeper over the last two years, bankruptcy filings of all types were markedly increased. This included companies who filed for reorganization under Chapter 11 of the United States Bankruptcy Code, which have nearly doubled in the past several years. Among the filers were some very large corporations: Lehman Brothers, Washington Mutual, General Motors, Chrysler, and CIT Group.
Chapter 11 Bankruptcy
Chapter 11 bankruptcy permits all businesses, whether corporations or sole proprietorships, even individuals to file for protection from their creditors while they reorganize their affairs. It is almost exclusively utilized by corporations as a stop-gap measure to remain in business even in dire circumstances.
General Info
When a business gets to a point where it cannot pay its creditors, the business can file with a federal bankruptcy court for assistance and protection, under either Chapter or Chapter 11. If filed as a Chapter 7 bankruptcy, the business ceases to exist and the trustee sells off the assets and distributes what remains to the creditors. If there is any extra amount, it is returned to the owners. Chapter 11, by contrast, is filed for protection while the business remains in charge. What this means is that the company continues to run, but with the bankruptcy court’s oversight.
Chapter 11 bankruptcy has many of the same features of all bankruptcy proceedings, and it also gives debtors some additional tools to use. The biggest point is that it gives the trustee the power to operate the business, and then the management serves as trustee of the business. Effectively, the business is operated as before, but with the court’s oversight. The debtor in possession has many tools to restructure the business. They can seek and acquire new financing or loans on favorable terms because they can give new lenders priority on earnings. The court can also allow the debtor to reject or cancel current contracts. The automatic stay protects the business from further litigation during the term of the bankruptcy.
If the business has debts exceeding the company assets, the restructuring ends the owner’s rights and interests to the company and the company’s creditors become the owners of the restructured company. All of the company’s creditors have a right to their say in court. The bankruptcy court is charged with determining if the plan of reorganization complies with bankruptcy code.
The Chapter 11 Plan
Chapter 11 bankruptcy is a restructuring instead of liquidation, and the company can emerge from a Chapter 11 in just a couple of months or several years, depending on the size and how complex the issues are. The plan can be proposed by any interested party, and interested creditors vote for the most favorable plan. Once confirmed, it is binding and spells out everything for the plan’s duration.
Automatic stay
Like all other types of bankruptcy, an automatic stay provision is enacted, and creditors must cease any collection attempts, and also cannot attempt debt collection after the bankruptcy is completed. Some companies may liquidate under Chapter 11, during which management might be able to achieve higher financial gains than if a Chapter 7 liquidates assets.
Existing Contracts
Some contracts can be rejected if canceling them makes financial sense for the company and its creditors. Examples are labor union contracts, supply contracts, operating contracts, and real estate contracts. Upon cancellation, the parties to the contract become unsecured creditors. Priority is given to secured creditors first, then suppliers of products and employees before unsecured creditors.
Publicly Traded Companies
In the vast majority of bankruptcy cases, the Chapter 11 plan terminates the shares of the company, and they no longer have any value. Publicly traded companies are generally delisted from its stock exchange position.
Why?
When Congress enacted Chapter 11 bankruptcy, they felt it was sometimes better to reorganize a company than liquidate it. By keeping the company’s running, jobs can be saved, and the company’s creditors almost always realize more of their money than they would if liquidated under Chapter 7.
Critics claim that Chapter 11 is extremely lenient for businesses and gives them an “out” in case of mismanagement and failure of the company. They believe it damages the economy as a whole and also allows shoddy managers to continue in their positions. It is not typical that the current management is fired, because it’s assumed they know more about the company than new managers would. European bankruptcy law is much stricter on failing companies.
Another criticism is that the protection of the Chapter 11 bankruptcy gives the company an unfair advantage against its competition—since they are able to stop making payments, they have more free cash to expand or lower prices to beat out competitors, with the court’s approval.
Finally, by stalling the creditors from enforcing their rights, the value of the collateral is decreasing, which inevitably will raise the costs of secured lending.
Recently, a number of large corporations have come out of bankruptcy leaner and stronger, but one forgets that there are also a number of creditors involved that may not have fared so well with the bankruptcy proceeding. Stockholders and suppliers can lose all interest that they have in the company; rendering any investment, and the paperwork they have totally useless.
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