Business Bankruptcy: A Last Resort
January 2010

The current form of Chapter 11 bankruptcy has been law in the United States since 1978. From a large business like a manufacturing company to a small business like a restaurant, Chapter 11 bankruptcy can provide effective tools for all stakeholders to fare better than they would have in state court or foreclosure. Sometimes the benefits outweigh the unavoidable cost, delay and uncertainty of the bankruptcy process.

Consider a legal environment without Chapter 11 bankruptcy. Many businesses in the American economy will, over their history, find their cash flow is less than expenses, including debt service, or their assets are worth less than their debts, or both. This can occur due to an underinsured accident, or a change in the market, unanticipated expense of doing business or simply as a result of a general economic recession. Without bankruptcy, the secured creditor conducts a foreclosure sale. Without bankruptcy, the unsecured creditor gets a judgment and executes on assets. Without bankruptcy, every creditor is entitled to demand all that the law allows regardless of the impact on the business, other creditors or owners. Any of these scenarios can move into state law liquidation through receivership, supervised by a court.

A Chapter 11 bankruptcy petition gives the creditors and owners a choice over immediate foreclosure or liquidation. The business, called a debtor, upon filing the bankruptcy petition is the “debtor in possession” or DIP. The DIP can operate the business in the ordinary course of business. The automatic stay prevents foreclosure, stops receivership, and halts prosecution of lawsuits, among other things. The DIP has an exclusive period of 120 days to propose a plan of reorganization. Secured creditors can authorize use of cash collateral on terms including budgeting, reporting and interim payments. Gross mismanagement or fraud can be addressed through the appointment of a bankruptcy trustee, who must be disinterested. Serious allegations can be investigated and reported on by a disinterested examiner. A creditor’s committee may be appointed to investigate the DIP and take positions in bankruptcy court. Expensive, money-losing contracts can be breached, or rejected, while profitable contracts can be assumed even if the contract is terminable upon bankruptcy or insolvency. These are some of the tools Chapter 11 bankruptcy offers a troubled business.

In addition to preservation of assets, the Bankruptcy Code addresses creditors’ claims.  Secured claims are recognized if valid under state law to the extent of the value of the collateral.  Secured debt in excess of the value of the collateral is treated as unsecured debt.  Unsecured claims of injured persons have no more or less priority then unsecured claims of banks or suppliers.  Certain claims have priority as determined by Congress, such as recently incurred employee wages and benefits, child or spousal support, and taxes.  The recovery for all creditors is reduced by the expenses of administration of the bankruptcy, including the DIP’s attorneys’ fees, but each creditor generally bears her own attorneys’ fees incurred, creating incentives to reach agreement rather than reward lawyers for conflict.  

Often the best thing for a troubled business is “sale as a going concern” to a new financially responsible owner. “Sale as a going concern” means the business continues to provide employment, buy goods and materials, sell products and services, pay rent, utilities and taxes. Even a secured creditor interested in foreclosure may prefer a bankruptcy sale to maintain the business as an operating entity, rather than allowing the uncertainty of real estate and personal property foreclosures to shut down the business. From examples such as Chrysler to a franchised restaurant location, a bankruptcy sale can often maximize the return for creditors.

Chapter 11 is also about negotiation, some times leading to reorganization. When a service company can pay $6 million of debt service, but owes $16 million in debt, reorganization may be possible. Existing owners often are willing to invest new capital in return for a business whose debt service burden is manageable. A bank holding a secured loan worth less than the debt may prefer a new, financially reorganized borrower, rather than foreclosure on a business that owns leased furniture without employees, products or hopes of repayment. Such businesses have been successfully reorganized and bankruptcy lawyers will continue to do so when it is in the claimants’ best interest.

It is too simple to say that bankruptcy too often results in a small, if any, distribution to creditors, while paying bankruptcy professionals their fees and expenses. It is more accurate to say that without bankruptcy, financial reorganization is very unlikely, while liquidation and loss of going concern businesses, jobs, services, products and tax revenues is assured.


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