A person, corporation, or government entity may file bankruptcy when they are in a dire financial situation and unable to repay outstanding debts to creditors. Usually, it is initiated by the debtor and overseen by a bankruptcy court.
A corporation may need to file bankruptcy due to several reasons, including:
A significant decline in business operations negatively impacting revenues, costs, income, and cash flows. This decline in operations may be due to external factors (for example, COVID-19) or internal factors like poor business judgment.
Taking on too many debt obligations, resulting in the inability to repay creditors.
In the United States, there are several different ways to file for bankruptcy. For corporations, this typically means either filing a Chapter 7 bankruptcy or a Chapter 11 bankruptcy.
A Chapter 7 bankruptcy is considered a liquidating bankruptcy. This means that a company filing for Chapter 7 does not expect to continue to operate much longer and will officially go out of business.
A Chapter 11 bankruptcy is considered a reorganization of debts. Chapter 11 allows the business to continue operations and propose ways to satisfy its secured and unsecured debts.
Different Types of Bankruptcy
According to United States federal law, there are different several different ways to file for bankruptcy according to the federal bankruptcy code. For the purposes of this article, we will focus on two different bankruptcies that corporations may file: a Chapter 7 bankruptcy and a Chapter 11 bankruptcy.
While both types are overseen by a bankruptcy court, they can be quite different in process and outcome, which can also impact creditor returns.
The Chapter 7 Bankruptcy Process
A Chapter 7 bankruptcy is often considered a liquidating bankruptcy. This means that a company filing for Chapter 7 does not expect to continue to operate much longer and will officially go out of business. This makes it different from a Chapter 11 bankruptcy, which is discussed below.
Filing a bankruptcy petition under Chapter 7 “automatically stays” (stops) most creditor collection actions against the debtor. However, the stay is only available for a limited time. But as long as the stay is in effect, creditors generally must cease collecting on debts.
When a company files a Chapter 7 bankruptcy, it does not prepare a plan of reorganization. Under Chapter 7, a bankruptcy court trustee sells the debtor’s assets and uses the sales proceeds to pay back creditors.
The debtor’s property may be subject to liens that pledge certain property to creditors (known as secured debt). If this is the case, these creditors can generally seize the assets for use, or more commonly, for sale.
The Chapter 7 trustee will then liquidate the remaining debtor assets to maximize, as much as possible, the return to the debtor’s unsecured creditors. While there are various intricacies along the way, this broadly follows the priority of payments in that secured creditors are paid first, before any unsecured creditors are paid.
The debtor will need to cooperate with the bankruptcy trustee and provide any requested financial and legal records to the trustee.
The Chapter 11 Bankruptcy Process
A Chapter 11 bankruptcy is a legal process that involves the reorganization of a debtor’s debts and assets. It is available to individuals, sole proprietorships, partnerships, and corporations but is most commonly used by corporations.
The reorganization allows the business to continue operations but under supervision of the court, subject to the debtor’s fulfillment of some of its obligations.
A Chapter 11 bankruptcy is much more complicated and costly, compared to a Chapter 7 bankruptcy. Due to this, a business should perform a careful analysis of all other bankruptcy alternatives before settling for Chapter 11.
Once a business has filed a Chapter 11 bankruptcy, it is allowed to continue operating under the current management team. During the Chapter 11 proceedings, the company is referred to as the debtor in possession.
The bankruptcy petition may be voluntary or involuntary. A voluntary petition is submitted by the debtor, while an involuntary petition is filed by creditors.
The debtor in possession will account for its property and examine creditor claims. The debtor will typically hire restructuring lawyers and finance professionals that specialize in bankruptcy.
Like a Chapter 7 filing, a Chapter 11 filing creates an automatic stay preventing creditors from collecting debts. After filing the petition, the debtor must submit a disclosure statement and a plan of reorganization (POR).
The disclosure statement has details about the debtor’s assets, liabilities, and financial affairs. The disclosure statement is required so that the interested parties can make informed decisions on the plan of reorganization.
The Plan of Reorganization
The bankruptcy court requires the debtor to propose the plan of reorganization within 120 days from the date of filing the bankruptcy petition. If the debtor proposes a reorganization plan within the stated period, the court grants another 180 days to allow the debtor to obtain confirmation of the plan from the creditors.
The plan of reorganization contains a classification of claims and the treatment of each claim. Creditors whose claims are impaired (meaning the POR plans on paying these creditors less than their claims) will vote on the plan of the reorganization through balloting. Creditors who are unimpaired (they will be paid in full) are deemed to accept the POR and do not vote. After the court has allowed the disclosure statement and tallied the votes, it holds a hearing on whether to confirm the plan of reorganization.
Chapter 11 dictates that an entire class of creditors is deemed to have accepted the reorganization plan if the plan is accepted by creditors with at least two-thirds in amount and at least one-half of the number of allowed claims in the class. Also, the plan must be approved by at least one class of creditors who are considered impaired.
If at least one class of creditors vote to object, the plan can still be confirmed as long as certain requirements are met. The basis of this confirmation is that the plan must be fair and equitable and should not discriminate against the objecting class of creditors.
The court must also find that the plan is feasible, is proposed in good faith, and that the plan and its components have complied with Chapter 11. The plan then becomes binding and identifies how debts will be treated by the plan.
If the reorganization plan is not accepted, the court can either convert the case to a Chapter 7 bankruptcy or dismiss it in its entirety. Rejecting the plan returns things to the status quo before the original Chapter 11 filing.
Chapter 7 vs Chapter 11
A corporation must weigh the relative advantages and disadvantages of Chapter 7 vs Chapter 11 when considering filing for bankruptcy. Below are some advantages and disadvantages of both filings.
Advantages of Chapter 7
A Chapter 7 filing is typically much cheaper compared to a Chapter 11 filing, as the company will liquidate and wind down operations. The bankruptcy court trustee will be heavily involved in winding down the company.
Disadvantages of Chapter 7
Of course, winding down a company is usually bad for most creditors as the proceeds from liquidating asset sales will almost always lead to lower recoveries versus a Chapter 11 bankruptcy.
Advantages of Chapter 11
A Chapter 11 filing allows the company some breathing room and to come up with a plan that satisfies creditors while continuing to operate.
A Chapter 11 bankruptcy usually results in higher recoveries for creditors when compared to Chapter 7, as the company will continue operating and generating cash flows that can aid in repayments.
Disadvantages of Chapter 11
This bankruptcy filing is the most expensive since the company will need to hire bankruptcy advisors to help prepare a plan for reorganization.
Chapter 11 is probably the most complex bankruptcy process. The company will continue operating, and hopefully emerge from bankruptcy as a viable company. However, it will need to deal with multiple creditors, often with competing interests.
The proposed plan of reorganization must be viable, as judged by the court, or it will not be approved.
CFI offers the Commercial Banking & Credit Analyst (CBCA)™ certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant resources below:
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