By the time most owners start reading about Chapter 11, the business is already in trouble. It may be just starting to bleed cash, just short of its debt payments, or seemingly beyond the point of no return. Everyone’s looking for an easier answer: Just reorganize the debt and keep your company running. Sounds simple, right? But the reality is a lot messier - and tougher.
Chapter 11 is a reorganization, not a liquidation. Under Chapter 11, business owners typically retain control over their operations during bankruptcy. The company becomes a “debtor in possession,” and the business can continue to operate while collecting and paying out money. Here’s the reality: The goal of a Chapter 11 isn’t to avoid paying creditors. In fact, the whole point is to pay them: It’s just that you want to arrange that payment over a longer period of time. It might be tempting to imagine a Chapter 11 that simply hides all your problems away, but there’s more to it than that.
Filing a Petition
A bankruptcy case is started by filing a petition with the bankruptcy court where the business is located or where it operates its main office. The bankruptcy petitioner must file the petition with schedules of assets and liabilities, a current income and expense statement, a schedule of executory contracts and unexpired leases, and a statement of financial affairs. Fees are $1,167 for filing plus $571 in administrative fees, both payable to the clerk at the time of filing; failure to pay the fees may result in the dismissal of the case. A company using one of the small business tracks must also file with its petition a current balance sheet, statement of operations, cash-flow statement and federal income tax return - or provide an affidavit explaining their absence. The firm will also have to submit periodic reports to the court and US Trustee’s Office reporting information on the profitability, projected receipts and disbursements, compliance, taxes paid and returns filed. Pretty serious, huh?
Those small business tracks are worth understanding, because they are faster and cheaper than an ordinary case. There are two: the “small business case,” and Subchapter V (the newest, streamlined bankruptcy chapter for small businesses), created in 2019. For either one, a company must be “engaged in commercial or business activities.” It can’t mainly own or run one piece of real estate. Its total secured and unsecured debts must be $3,424,000 or less at filing. At least half of its debts must come from the business.
Once the case is open, the debtor in possession is a fiduciary with a trustee’s duties. This means you are accountable for company property, required to submit monthly operating reports, open new bank accounts, and ensure timely payments for employee withholdings and other taxes. You are also responsible for remitting a quarterly fee to the U.S. trustee ranging from $325 to $30,000 based on disbursements during that period, continuing until your case is converted or dismissed. If you fail to submit reports or follow court orders, the U.S. trustee may seek to have your case converted or dismissed. Chapter 11 also brings the outside world, including creditors, into your business. The U.S. trustee (UST) holds a meeting of creditors, known as the section 341 meeting. Debtors must attend this meeting under oath; the UST and other creditors may question the debtor about their activities, behavior, and assets. In a small business case that is not filed under Subchapter V, the “initial debtor interview” takes place shortly after filing with the UST, who assesses the case’s viability. During this interview, the UST may ask about the debtor’s business plan, explain the reporting requirements, and then monitor the case to determine early whether the plan can be confirmed.
The Automatic Stay
The relief is real, though. The automatic stay is nothing more than a temporary “do not disturb” sign for the business. Its purpose is to give a business time to develop a reorganization plan without interference from creditors. It has the effect of freezing creditors’ actions, temporarily stopping a lawsuit, foreclosure, or repossession, and otherwise keeping the company out of chaos. But the cash in the business comes with rules. The debtor’s estate can spend the money as it’s needed as long as it’s for the ordinary course of business, but if it wants to spend money outside the ordinary course of business, it has to have the approval of the court to do so. What’s more, the company can’t use cash or cash equivalents, including deposits and the proceeds of receivables, without the consent of its secured creditors or an order of the court. And then the cash must be segregated, and the secured creditors can demand “adequate protection”. Payments made up to 90 days before the bankruptcy filing (up to 1 year for insiders) may be clawed back.
The clock is tight. For small business cases, only the debtor may file a plan in the first 180 days of a case. And the court may extend that period only up to 300 days, and only if the debtor shows by a preponderance of the evidence that the plan will be confirmed within a reasonable period. (And if the plan contains adequate information about the issues in the case, the court may dispense with the separate disclosure statement.) In an ordinary Ch. 11 case, the exclusivity period is 120 days, extendable up to 18 months. Subchapter V works differently. Under Subchapter V, a trustee is appointed in every case to monitor the plan and ensure payments. Only the debtor can propose the plan, and there’s no separate disclosure statement unless the court says so. There is no creditors’ committee unless there is cause. A plan may be confirmed if it (1) does not discriminate unfairly, (2) is fair and equitable, and (3) commits all the debtor’s projected disposable income for 3-5 years.
The Plan
Everything leads to the plan, which sorts creditors into classes and spells out how each class will be paid. Creditors who will be impaired under the plan (their claim will be reduced) vote on the plan by ballot. If the holders of 2/3 in amount and more than 1/2 in number of claims of each impaired class vote in favor of the plan, it is accepted. There must be at least one impaired class of claims of non-insiders that accept the plan. The court must also find that the plan is feasible (i.e. will not be followed by liquidation or further reorganization) and has been proposed in good faith. Upon confirmation, most pre-confirmation debts are discharged and the plan terms will replace any old contract terms. In short, if the plan is accepted by enough creditors and approved by the court, the debtor can leave bankruptcy with an adjusted debt structure.
Chapter 11 isn’t all sweetness and light. Cases can be converted to Chapter 7 or dismissed, and the judge can act because of failure to timely file a report, failure to appear at the creditors’ meeting, failure to provide information to the UST, failure to pay post-petition taxes or file returns, failure to maintain insurance, unauthorized use of cash collateral, continuing losses with no reasonable likelihood of rehabilitation and failure to file a plan or confirm a plan timely. How the business is organized matters too. Sole proprietorship case means the owner’s personal assets are in the case, a corporation’s case does not include the shareholders’ personal assets beyond the stock.
So what does all of this mean for an owner deciding whether to file? That the cost and complexity are real. It means that to manage the bankruptcy process, the company will need resources to bring in outside help like lawyers, accountants and consultants. It also means the business must be able to keep up with reports, taxes and fees while it negotiates. But if done right, and on time, a Chapter 11 reorganization can save your business and put you on a path to paying back your debts and staying in business.
