Chapter 11 of the Bankruptcy Code governs the process of reorganization. At the end of a Chapter 11 process, the debtor emerges from bankruptcy as an operating entity.
Like all bankruptcy cases, a Chapter 11 case begins with the filing of Schedules and Statements of Financial Affairs, which are filed under oath. These documents provide a detailed picture of the debtor’s income, assets, and obligations. Shortly after the filing of the bankruptcy petition, a “341 Meeting” or “First Meeting of Creditors” will be conducted by the United States Trustee. The United States Trustee is an independent office organized under the Department of Justice that monitors bankruptcy cases for compliance with the Bankruptcy Code and its fundamental purposes. At the 341 Meeting, the United States Trustee will ask the debtor questions (under oath) about the Schedules, Statement of Financial Affairs, and how the debtor believes it will exit bankruptcy. Creditors may also ask questions of the debtor at this meeting.
The debtor stays “in possession” of its company and assets during the pending of the case unless a party in interest moves for the appointment of a Chapter 11 Trustee. A Chapter 11 Trustee can be appointed on various grounds, but typically, the moving party alleges that the pre-bankruptcy management grossly mismanaged the business either before or after filing the bankruptcy petition (sometimes both). Pre-petition mismanagement may include allegations that the individuals in charge mismanaged funds or used corporate funds for personal expenses. Post-petition mismanagement may include allegations that the individuals in charge are not complying with their reporting obligations, are not complying with court orders, or that they’re not considering serious or reasonable offers that would allow the company to exit bankruptcy. Alternatively, a debtor in possession can employ a Chief Restructuring Officer to manage the bankruptcy process and provide a more neutral perspective. Chief Restructuring Officers are typically independent consultants who have experience with distressed or insolvent companies and often have experience in the debtor’s industry.
To maintain operations during the pendency of a bankruptcy case, the debtor may receive a special type of short-term financing called a “Debtor-in-Possession Loan” or “DIP Loan”. These short-term loans are often critical to sustaining operations while the debtor implements its exit strategy.
Whether the pre-petition management remains at the helm or a Chapter 11 Trustee takes over, the debtor must find a source of funds to aid its emergence from bankruptcy. Sometimes the debtor conducts a sale of all or substantially all of its assets under section 363 of the Bankruptcy Code. In that type of sale, the debtor is sold as a going concern and creditors are paid from sale proceeds in the order of their priority (roughly, administrative claims – expenses incurred to get the debtor through bankruptcy – and the taxing authorities first, secured lenders next, general unsecured creditors – including trade creditors – next, and equity owners last). The distribution of the sale proceeds will be set forth in a plan of reorganization that is filed with the Bankruptcy Court and voted on by eligible creditors.
Alternatively, the debtor could obtain long-term financing (sometimes called “exit financing”) that has easier terms than its pre-petition financing and the debtor will continue operations under the pre-petition ownership. In those cases of “true restructuring” the debtor’s debts are restructured – perhaps the terms are lengthened or interest rates are lowered – so that the debtor will have sufficient liquidity to service its debt and sustain operations going forward. Often in those cases, the administrative claims such as the DIP Loan and the secured debt will be paid off with exit financing. Unsecured creditors are frequently paid a pro rata share of their claims from future profits. The portion that an unsecured creditor will be paid can vary widely from case to case; it is not unusual for general unsecured creditors to be paid as little as 5% of their claim. The sources of financing and how creditors will be paid is described in a plan of reorganization that is filed with the Bankruptcy Court and voted on by eligible creditors.
Whether the debtor is sold as a going concern or is reorganized, the creditors are limited to collecting based on the terms of the confirmed plan of reorganization. For example, if an unsecured creditor is going to be paid only 20% of its claim under the plan of reorganization, it cannot undertake separate collection actions to recoup the other 80%.
Successfully exiting from a Chapter 11 bankruptcy case provides the debtor organization with a “fresh start” and the goal is for it continue operating and growing from a stronger financial foundation.