How does Chapter 11 reorganization restructure my business’s secured, unsecured and tax debts?

Chapter 11 bankruptcy is commonly called a corporate reorganization, but it’s named for the chapter in the law that covers it. The Bankruptcy Code is Title 11 of the United States Code, and so Chapter 11 literally is “Title 11, Chapter 11.” A chapter 11 case is formally commenced when the petition is filed. In most cases the petition is accompanied by a bunch of other forms and paperwork, but legally it’s the petition itself that brings the case into existence and sets it in motion. Once it is filed, an automatic stay takes effect immediately. This in turn means that practically all the debts and liabilities and obligations of the debtor will be barred from enforcement. In addition, the automatic stay will strip most courts of jurisdiction to hear cases that even concern the debtor. In practical terms, a chapter 11 filing means everything having to do with the debtor stops, a kind of legal paralysis. This is generally the most important and dramatic effect that a chapter 11 filing has. The bankruptcy court gets priority over all matters regarding the company after a bankruptcy filing. Any lawsuits that are pending will be put on hold, for example. No new lawsuits can be started against the bankrupt company. The forms filed with the petition include schedules. The schedules need to itemize and describe all the assets, liabilities, income, and expenses of the company. Other schedules give some financial history as well. Not only corporations can file for Chapter 11 but partnerships, LLCs, and individuals. Big debts, especially personal guarantees of business loans, drive some Chapter 11 filings. What’s in a reorganization plan? A common plan reworks three kinds of debt, secured loans, unsecured debts and taxes.

Take Williams Brothers Trucking Corporation. Williams Brothers owes money on six secured loans, and also to a long list of unsecured creditors. Let’s look at each group in turn, starting with the secured lenders.

Cram Down Secured Debt

Under certain conditions a court can cram down secured debt to the collateral’s value. The company owes $429,000 on six items of collateral worth $314,000. The total contract payments come to $8,415 a month. Here’s a proposal to do just that. The plan states Commercial Bank would be assigned a new monthly payment of $1,370; the first Bank of America loan gets $1,470, the first Wells Fargo loan gets $1,605, and First Savings Bank receives $685. The second Bank of America loan pays $590 a month, and the second Wells Fargo loan comes to $431. The new total, of the lot of them combined, would be a meager $6,151 a month. The principal owed gets knocked off by $115,000 and monthly payments by $2,264, each about 27%. That leaves $2,264 in the business each month to pay other creditors. Something like that is all but impossible to force on lenders without filing. Why does that work in bankruptcy court? Because you get to cram it down if it passes muster with the court. Outside bankruptcy the lenders hold the contracts. They do not have to settle for anything less than what the contracts say they can get.

Unsecured Debts

Unsecured debts are those with no collateral, things like credit cards or signature loans. Williams Brothers has $375,000 worth. The trucking company owes $6,250 a month to unsecured creditors under its contracts. The monthly budget surplus, after paying off overhead, is an average $9,000 a month, so with $6,151 going to secured lenders, there is still some money for unsecured creditors at $2,849 a month. If approved, the plan pays off $170,400 of the $375,000 owed unsecured creditors at $2,849 a month. That’s $204,600 off, or 55%, of the money owed those creditors. The main support in justifying the unsecured creditor cutback is the surplus income figure. After the two sets of expenses, only $2,849 is left, so the unsecured creditors cannot get paid the $6,250 the contracts call for, even disregarding interest. There’s no more money to squeeze out of the rock. Another major plank in the foundation for this type of cutback are the dropped interest charges.

So far the plan leaves out taxes, but the company owes back taxes too. The business owes the federal tax agency $60,000 and the state $15,000. The IRS and the State of South Carolina get a pass over general unsecured creditors because they have priority. The plan pays the tax authorities the $75,000 owed plus interest set at a reasonable rate. This comes to $1,350 a month: the IRS $1,080 and the State $270. The tax payment is subtracted from the $2,849 designated for all unsecured creditors. That leaves unsecured creditors the remaining $1,499 a month. At that rate, over five years they will get $89,940 of the $375,000. That’s about 24%, no interest.

Discharged and Permanently Forgiven

In theory, plans can run longer than five years, but this one pays secured creditors, the tax authorities, and unsecured creditors in 60 months. Unpaid balances then get discharged and permanently forgiven. Creditors can no longer collect anything of a debt wiped out in bankruptcy. So long as the business follows the plan, they must drop all demand for the rest. The plan’s set-in-stone provisions bind the debtor and its creditors when it’s approved. It becomes a new contract, an arrangement replacing the old debt. To you, one major purpose of the filing is protection. The case gives that for as long as you keep going by the plan. What the plan calls for is not the old debt the contracts demanded but the payment set out in the proposal, the agreed amount.