What happens after Chapter 11 bankruptcy? Bankruptcy is a high-stakes game for both creditors and debtors, making it crucial for all parties involved to grasp the intricacies of Chapter 11 restructuring to safeguard their interests.
During challenging economic times, a thorough understanding of bankruptcy becomes even more vital. In distressed companies, directors and officers may be hesitant to broach the topic of bankruptcy due to its negative connotations. Concerns about tarnishing their reputation, credit rating, or self-image may lead them to overestimate their ability to effectively communicate with customers, suppliers, lenders, and employees, resulting in a reluctance to address the possibility of bankruptcy.
However, opting for reorganization bankruptcy in Chapter 11 often proves more advantageous than liquidation under Chapter 7 when cash reserves are dwindling, short-term maturities loom, and covenant breaches are a possibility.
Chapter 11 reorganization offers a range of benefits to troubled businesses, including relief from overwhelming levels of debt, the opportunity to shed burdensome contracts, and breathing room to develop a strategic plan. A debtor’s creditors and the company collaborate to formulate a reorganization plan that enables the business to start anew, aligning its balance sheet with current operational realities.
Whether you find yourself in a management group, a supplier grappling with unpaid invoices from a company in bankruptcy, or an investor seeking opportunities, understanding the evolving motivations of creditors and debtors becomes paramount in the event of bankruptcy.
What Is Chapter 11 Bankruptcy?
Chapter 11 bankruptcy’s definition is quite specific. There are two parties involved in bankruptcy: the debtor and its creditors. In bankruptcy, these parties are divided into two groups: the debtor and its creditors. Each debtor’s creditors are treated separately.
The bankruptcy process begins when a debtor files a petition with a Bankruptcy Court. This court is a federal court that handles a large number of bankruptcy cases both for consumers and businesses. A company can file for bankruptcy if it has followed the formal procedures outlined in its bylaws to take this extraordinary action. Filing for bankruptcy involves filling out a simple form and paying a small fee. It is important to note that insolvency is not a requirement for filing. This means that the total liabilities are greater than the total assets or, more generally, not paying debts when they are due.
The petition date is crucial in Chapter 11 bankruptcy proceedings. The focus is on creditors who are owed debts, have claims, or have other liabilities that arose before the petition was filed. In most cases, debtors are not allowed to pay prepetition creditors outside the bankruptcy process. However, post-petition creditors receive special protections to encourage customers and vendors to continue doing business with the bankruptcy debtor.
In the United States, creditors are treated more favorably compared to other countries where laws prioritize liquidation over reorganization. The Bankruptcy Code is based on the principle that reorganization provides greater advantages than liquidation. This is because reorganization safeguards businesses that generate employment, provide valuable goods and services, and contribute to tax payments. By undergoing Chapter 11 reorganization, debtors are given a second opportunity, while creditors receive a higher recovery compared to what they would obtain in a liquidation process.
The main goals of Chapter 11 reorganization are:
- Give debtors a fresh start and release them from their prepetition obligations.
- Ensure that all creditors receive an equitable and fair distribution.
- Provide a breathing space for the development of a reorganization plan.
- Consolidate all disputes concerning the debtor into a single forum.
- Empower debtors to uncover and address unethical business arrangements.
- In the case of liquidation, prioritize giving creditors more than they would receive through the liquidation process.
Protecting the Estate of a Debtor
All assets belonging to the debtor are included in the estate at the time of filing the petition. Assets can be located anywhere, even in the possession of creditors. The Bankruptcy Code has multiple provisions that preserve the value of the debtor’s property.
Timeline for Petition
As the name implies, an automatic stay is triggered automatically on the date of the petition. The automatic stay protects the debtor against creditors’ collection efforts in the period following the petition. This is a primary reason why people file for bankruptcy. The automatic stay prevents debtors from paying creditors for claims, debts, or liabilities that were incurred before the bankruptcy petition. This helps to avoid favoritism and ensures a fair settlement of disputes. In many cases, pre-petition debts and liabilities are not paid until after the bankruptcy.
Bankruptcy Courts take willful violations of the automatic stay very seriously. Willful doesn’t mean that the creditor was aware that their action violated the automatic stay. It means that they knowingly took the action. Creditors should avoid setoffs, which are the act of comparing amounts due to a customer against debts owed to them. This will prevent inadvertently breaking the automatic stay. It is generally better to request permission from the Bankruptcy Court rather than seek forgiveness later.
In certain circumstances, creditors can request in writing that the Bankruptcy Court “lift” the automatic stay on specific assets to allow them to take action. The Bankruptcy Code, for example, allows the automatic stay to be lifted when the assets are not essential to the debtor’s reorganization.
A voidable preference is another way the Bankruptcy Code can protect the estate of the debtor. The automatic stay protects the assets of the estate after the bankruptcy, but a voidable preference targets pre-petition transfers. A Bankruptcy Court can void a transfer of property made to a creditor before the petition based on a debt incurred while the debtor was insolvent. This allows the creditor to receive more money than they would have in a bankruptcy case. A presumption is made that the debtor was insolvent 90 days before the petition date (one year for insiders). All transactions that occurred within 90 days of the petition date will be scrutinized to ensure that certain creditors were not treated preferentially or with favor.
During a Chapter 11 restructuring, the debtor can continue to conduct business as usual, with the exception that activities outside the normal course of business require Bankruptcy Court approval. Such activities include selling the company or raising financing after filing a bankruptcy petition.
Debtors utilize this period to restructure their balance sheets, improve operations, and strive to regain solvency. Throughout the bankruptcy process, the debtor is granted an exclusive timeframe to propose a reorganization plan, which is then subject to a vote by the creditors. The proposed plan is subsequently presented to the Bankruptcy Court for confirmation. The court assesses the plan’s compliance with the Bankruptcy Code and other applicable laws before confirming it. However, the court does not have the authority to impose or dictate the content of the plan. It can only refuse confirmation if the majority of creditors reject the plan. In case of plan rejection or court refusal, the debtor will have to start over.
Under the Bankruptcy Code, the Bankruptcy Courts can extend the exclusive period for the debtor to propose a plan and gather votes. However, the amendments made to the Bankruptcy Code in 2005 established a maximum time limit of 18 months (including the solicitation period of 20 months). Once the debtor’s exclusive period expires, any creditor is eligible to submit a plan. This may result in multiple plans being put forward for voting, leading to confusion and delays in the bankruptcy process. Therefore, it is encouraged for debtors and creditors to reach an agreement before the debtor loses its exclusive period.
Numerous motions, objections, and notices can be filed in a bankruptcy proceeding. However, the following provides a general outline of how Chapter 11 transforms a financially troubled business into a reorganized entity:
- Retaining lawyers and advisors to represent the debtor.
2. Declaring bankruptcy, finalizing the board resolution, or shareholder vote.
3. The debtor can file a bankruptcy petition.
4. The Bankruptcy Court opens a bankruptcy case.
5. The debtor files a motion on the first day, and the Bankruptcy Court holds a hearing on the first day.
6. Appointment of the Official Committee of Unsecured Creditors (OCCUC) by the US Trustee.
7. Retaining lawyers and advisors for the Official Committee of unsecured creditors.
8. The debtor may assume or reject executory contracts, unexpired leasing agreements, and other leases.
9. Creditors submit proofs of claims before the claim bar date.
10. Filing of the disclosure statement.
11. Filing of the reorganization plan.
12. Creditors voting on the reorganization plan:
a. The votes are tallied by classes.
b. Receiving full recovery is deemed acceptable while receiving no recovery is deemed rejection.
c. The plan must have 2/3 of the amount and 1/2 of the number in a class to pass.
d. The voting is repeated until an agreement is reached.
13. Confirmation of a plan of reorganization from the Bankruptcy Court.
14. Reorganized business exiting Chapter 11.
15. The debtor can file voidable claims for preference.
16. Resolution of voidable preferences and fraudulent transfers, prepetition litigation, and rejection damages.
17. Distribution of bankruptcy estate assets according to the plan for reorganization.
18. The Bankruptcy Court closes the bankruptcy case.
Priority of Claim Is Related to Rate of Recovery
The Bankruptcy Code is designed to accomplish the objective of fairly and equitably distributing debts to creditors and ensuring that all creditors are treated with fairness and equality. To achieve this, the Code assigns priority to specific classes of creditors. Even if a distressed business never files for bankruptcy, the expectations of its creditors can still impact its behavior. Out-of-court settlements are frequently negotiated with the backdrop of potential bankruptcy proceedings.
Priority of Claims
The Bankruptcy Code requires that the debtor-in-possession (DIP), a type of special post-petition funding, be paid first. This financing enjoys super-priority over other claims. DIP loans are typically funded by first lien secured creditors who aim to retain control of the bankruptcy process. However, in some cases, a new investor may step in. DIP lenders with super-priority must be fully paid before any first lien creditors can receive any recovery. Afterward, secured pre-petition claims are paid, followed by unsecured claims and equity interests.
Generally, lower-ranking creditors cannot be paid until their predecessors are fully paid, a principle known as the absolute prioritization rule. The different levels of priority may be divided into tranches of unsecured or preferred debt, first lien and secured debts, and so on. This payment priority is sometimes referred to as a “waterfall,” where the distributable funds fill the highest-priority bucket first until all creditors have received 100% of their recoveries. Then, the next bucket is filled, and so forth until the distributable funds run out.
An important concept to understand is security. This class of claims is most likely to be converted into equity ownership during restructuring. Creditors who receive full recovery are considered to accept a reorganization plan, while those receiving no recovery are deemed to reject it. Fulcrum securities, which are the claims that receive partial recoveries, often play a decisive role in approving a plan. The fulcrum security is partially in-the-money and partially out of the money, so creditors’ recoveries are likely to be in the form of equity in a reorganized business emerging from bankruptcy. The fulcrum may change over time, especially in cyclical industries and those affected by volatile commodities.
What to Do if Your Customer Declares Bankruptcy
Different Types of Unsecured Creditors
Vendors make up only a small portion of the unsecured creditors in general. In large bankruptcy cases, thousands or even tens of thousands of unsecured creditors can be included in the same category. Vendors can benefit from monitoring the developments that affect other unsecured creditors since. In general, all unsecured claimants must receive the same recovery rate. The trading price of unsecured bonds may be indicative of the recovery rate among all unsecured creditors, including vendors.
There are several types of unsecured creditors, including:
- Unbilled prepetition services are provided by utilities to the debtor.
- Vendors waiting for payment after providing goods or services to the debtor during the prepetition phase.
- Landlords who entered into leases before the petition period that were rejected by the debtor during the post-petition phase and suffered damages as a result of such breach.
- Plaintiffs with meritorious claims against the debtor.
- Bondholders, holders of subordinated notes and bonds, as well as other investors who hold unsecured securities.
- Counterparties who have swaps, futures, or other trades in the money with the debtor as of the petitioning date.
- Prepetition taxes, governments owing unpaid and nonpriority tax.
- Unpaid wages and benefits for employees who have not yet started their employment.
- Pensioners owe unfunded amounts.
Best Practices for Vendors
If creditors harass customers to pay prepetition amounts during the post-petition phase, they may be held liable for violating the automatic stay. The Bankruptcy Court has the authority to impose penalties on creditors who engage in “self-help” by violating the automatic stay.
If a client goes bankrupt, suppliers have the option to sell their bankruptcy claims to a claims broker. While this approach only ensures a partial recovery, it provides suppliers with quicker access to funds and allows them to avoid the time and expenses associated with the bankruptcy process.
Additionally, vendors should adhere to the following best practices when their customers file for bankruptcy:
- Verify your contact information on the notice List.
- The First Day Declaration provides background information about bankruptcy cases.
- Monitor public information for bankruptcy cases using Pacer.
- File proof before the claim bar date.
- Check for accuracy in the debtor’s schedules about your claim.
Vendors should also review the debtor’s disclosure statement. This document is designed to provide all creditors with the necessary information to comprehend the company’s performance both before and following the bankruptcy petition. It enables creditors to make informed decisions regarding the debtor’s proposed reorganization plan.
When customers file for bankruptcy, it is crucial to seek guidance from qualified bankruptcy professionals. Turnaround professionals can assist you in comprehending your specific situation and navigating the bankruptcy process effectively.
- Within 90 days from the date of the petition, gather evidence to defend yourself against a potential voidable preference lawsuit for payments made by insolvent customers
- Assessment of reclamation claims for certain products sold on credit within 20 days from the date of the petition
- Requesting approval for the set-off of mutual claims and debts
- Advocating for critical vendor status
- Selling your claim to a claims trader
- How to evaluate your claim
- How to vote on the plan of reorganization
Priority Vendors: Jump in Line Before Others
Often, a company relies on suppliers that are crucial to its operations. Vendors who provide goods or services to a struggling company may become aware of the company’s financial difficulties when payment patterns start to change. Suspicious suppliers may respond by limiting supplies or services until the company settles its outstanding payments. In severe cases, suppliers may completely cut off the company, leading to significant distress. In such situations, a company may attempt to switch to a different vendor that offers more favorable payment terms, but sometimes there is no viable alternative. A supplier who is indispensable and cannot be replaced during bankruptcy proceedings is known as a critical vendor.
A critical vendor, being vital to the business, holds a strong negotiating position in recovering its prepetition claims since it can refuse to supply essential services and goods necessary for the company’s operations. However, meeting the heavy burden of proof is necessary. The vendor must demonstrate that they are an essential supplier to the debtor and that no other suppliers are acceptable.
Seeking critical vendor status can be highly advantageous for an unsecured creditor, as the Bankruptcy Court can approve payment for their prepetition claim separately from the overall reorganization plan. Instead of waiting for partial recovery at the end, a critical supplier can receive full payment at the beginning of the bankruptcy case. The automatic stay prevents the debtor from paying critical vendors without the approval of the Bankruptcy Court.
Official Committee of Unsecured Creditors
Vendors should also consider whether it would be advantageous for them to participate in an Official Committee of Unsecured Creditors (UCC). The UCC plays a pivotal role in determining the outcome of a bankruptcy case and is often referred to as the “watchdog” of the process. It represents various types of unsecured creditors and significantly influences the success and trajectory of the case. The U.S. Trustee selects volunteers from the top 20 creditors of the debtor to serve on the UCC.
The UCC is supported by its lawyers and advisors, whose fees are covered by the debtor. While unsecured creditors have the right to be heard by the Bankruptcy Court, they are responsible for covering their legal expenses. The Bankruptcy Code recognizes the establishment of the UCC because it would be impractical and costly for hundreds or even thousands of unsecured creditors to individually file objections, appear before the court for hearings, and negotiate a reorganization plan.
Instead, the UCC acts as the representative of unsecured creditors and engages in negotiations with secured lenders and the debtor to develop a reorganization plan that allows for an exit from Chapter 11. The UCC may propose that unsecured creditors vote on whether to accept or reject the debtor’s proposed plan, but each unsecured creditor retains the freedom to make their own decision.
Benefits and Disadvantages for Vendors to Voluntary UCC Service
|It is better to express opinions in groups than individually||Committing significant time to a project|
|Influencing the decisions of the Bankruptcy Court and debtor||Fiduciary duty to all unsecured creditors|
|Reimbursement of costs by the debtor||Confidentiality of information|
|Staying informed about case developments and accessing confidential information||Restriction on claims trading|
|Networking with other creditors in the same industry||Distractions from the day-to-day business|
|Possibility of strengthening the relationship after reorganization||Relationships with debtors after reorganization could be damaged|
Collaboration Is the Key to Value
Working together, the parties can increase the overall value of a reorganization. This will give the debtor a fresh start while providing creditors with a greater recovery compared to liquidation. The bankruptcy process is intended to be collaborative and consensus-building. However, it can be challenging to rebuild trust and credibility to reach an agreement on an exit strategy. In the midst of uncertainty and volatility, parties who perceive bankruptcy as a zero-sum game can hinder progress and undermine value.
Experts in restructuring offer clarity during turbulent times. They play a crucial role in helping multi-party negotiations achieve a positive outcome by considering bankruptcy from various perspectives. Reorganizing specialists serve as a reliable bridge between financial, legal, and operational matters. They can address inefficiencies, enhance financial reporting, strengthen internal controls, overcome liquidity challenges, and provide guidance throughout the turnaround process.
Drawing from their experience in previous cases, restructuring experts can anticipate potential issues, predict outcomes, and help avoid common mistakes. Ultimately, they contribute to increasing value for both creditors and debtors by developing innovative strategies and resolving conflicts.
Can a Business Survive Chapter 11 Bankruptcy?
Reorganization under Chapter 11 is not always fatal for an enterprise. This can be a way to get out of unsustainable debt, remove burdensome contracts, and create breathing space to formulate a plan. When debtors and creditors agree, a business can start fresh with a brand-new balance sheet.
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