Chapter 11 is sometimes called reorganization bankruptcy. Unlike liquidation, the business usually continues to operate and you remain in charge of day-to-day operations, but you must repay creditors over time under a written plan that’s approved by a sufficient number of creditors and then confirmed by the bankruptcy judge. Chapter 11 is the most complex and costly type of bankruptcy. And filing does not make the debt disappear. Instead, the debt is frozen in time, divided into categories, voted on, restructured, and much of it is eventually discharged.
When a bankruptcy petition is filed, a “stay” goes into effect that stops every creditor from pursuing a lawsuit or other means of collection. That does not end the debt, though - it just puts a stay order on its collection until it is resolved in the bankruptcy process. This means all collection activity stops: no more calls, no foreclosures, no civil lawsuits against your business. You don’t need to make any payments on existing debts. The case can last anywhere from a few months to a few years, and not having to pay old debts during that time means better cash flow. Only a limited number of proceedings survive the stay: criminal proceedings, divorce proceedings, and actions by government agencies enforcing their police powers.
In Chapter 11, a business can walk away from bad deals, like a commercial lease that no longer works, if that’s the best business decision it can make. The other party still gets a claim in the bankruptcy. Filing might also make it easier to get the money you need to stay open, called debtor in possession (DIP) financing. This money can keep you running and bring you closer to paying back your debts.
If the creditor wants a piece of the action, it has to have a claim against you. If your schedules are accurate and the debt is listed there and is not contingent, disputed or unliquidated, the creditor doesn’t have to do anything else. If it’s not clear, the creditor needs to file a proof of claim to demonstrate how much it was owed at the time you filed and whether it’s entitled to priority. Claims are paid in an order of priority depending on whether the claim is fully secured, undersecured or unsecured.
Fully secured creditors get paid first. Their collateral has a value equal to or greater than their claim — for example, the bank that has a lien on your equipment or building. They have to be paid in full and with cash, and if their payments are spread out over time they also get interest. An undersecured creditor has collateral worth less than their claim. If the creditor is owed $400,000, but the collateral is only worth $250,000, then $250,000 of the claim is secured, and the remaining $150,000 is unsecured. They generally do not receive interest on delayed payments.
Priority unsecured claims are debts without any security, but they get first dibs among unsecured claims because it’s in society’s interest to pay them. They include things like employee wage claims, consumer deposits, taxes, and the expenses of running a Chapter 11 case. Unsecured priority debts cannot be wiped out in bankruptcy; the debtor has to pay them. Non-tax priority claims must be paid in cash at the time the plan is confirmed (unless the creditor consents to another treatment). Priority tax claims may be paid in cash installments with interest for up to five years from the date the bankruptcy was filed.
Everything else is called “general, nonpriority, unsecured debt.” That includes credit cards, judgments obtained through lawsuits, and trade credit (in other words, unpaid bills to suppliers and vendors). The creditors get paid last, after all the priority debts. The plan doesn’t have to pay them in full, but each must receive at least as much as it would in a Chapter 7 liquidation. Payment can be in cash, assets, or securities in the business or a successor.
Submit a Plan
A Chapter 11 plan describes which creditors will be paid and when, and also how the business will continue operating. The business has four months from the filing date to submit a plan; the bankruptcy court can extend that deadline up to 18 months. If the business doesn’t submit a plan, the creditors sometimes come up with one. There is no set time limit, but for most small businesses the plan typically lasts three to five years. Often businesses use the plan to downsize, trimming costs and setting aside assets to pay the creditors.
The creditors vote. Before the vote, the court must approve a disclosure statement that explains the business’s assets, liabilities and overall situation, and then creditors receive a ballot for the plan. Claims are sorted into classes. If a class is paid in full, it is deemed to have voted yes; if it receives nothing, it is deemed to have voted no (it does not actually vote either way). A class votes yes when creditors holding half the claims and two-thirds of the dollar value cast a yes vote. If some impaired classes vote no but at least one class votes yes, the judge can still confirm the plan by cramming it down, provided it is fair and equitable and does not treat the rejecting classes unfairly. Once the judge confirms it, the business and all of its creditors are bound by the plan.
So, what do you get in exchange for going through bankruptcy? Discharge. In other words, as soon as the plan is confirmed, any debts your business incurred before confirmation are wiped out. Unless the plan itself says otherwise, the business is no longer responsible. Any debts incurred after filing are not wiped out. If the business files a plan to sell all of its assets and then stops operating, it does not get a discharge. And if the business stops making payments under the plan, that also doesn’t automatically invalidate the discharge. Technically the court can revoke it, but it almost never does.
If the plan cannot be confirmed by the court, the business is generally allowed to make changes and present a revised plan at a second hearing. If the court cannot confirm any plan, it dismisses the case or converts it to a Chapter 7 proceeding, where the business’s assets are liquidated and the proceeds are used to pay as many creditors as possible. Likewise, if the business defaults on a confirmed plan and the court refuses an amendment, the case will be dismissed or converted to Chapter 7. After a dismissal, the creditors will resume pursuing claims through lawsuits and foreclosure.
Chapter 11 is expensive. There is the court filing fee, then $250 to $10,000 (depending on the quarterly disbursements of the debtor) in quarterly U.S. Trustee fees, plus attorneys and financial advisors. If a business is an LLC, corporation or partnership it is required to have a lawyer.
Subchapter V is a streamlined form of Chapter 11 tailored to small businesses. The Small Business Reorganization Act of 2019 amended the Bankruptcy Code to provide this streamlined chapter. It’s meant for businesses whose noncontingent, liquidated debts are below a certain amount and whose principal business isn’t owning real estate. It has no U.S. Trustee quarterly fees, no creditors’ committee, a 90-day deadline to file a plan, and a plan may be confirmed even if no class of creditors voted for it. Only the debtor can propose or modify a plan. In exchange, a trustee is appointed to assist the debtor in developing the plan and making the distributions, but the trustee generally does not operate the business. Extensions are difficult to obtain, and the debtor is required to commit all projected disposable income for three years to pay creditors.
You shouldn’t file for bankruptcy unless the cost is justifiable compared to the outcome. Take time to think through every step of the process and explore all of your options before you make the decision to file.
