Chapter 11 Reorganization – A Business Planning Tool

Michael McGrath, Frederick J. Petersen

Reorganization under the Bankruptcy Code is designed to rehabilitate a business, thus preserving its value which might otherwise be lost in a liquidation.

Why Consider Chapter 11?

One or more of the following may prompt the filing of a Chapter 11.

Inability to pay debts and make required payments.
When filed, a bankruptcy petition stops creditors from taking legal action and releases the business from payment obligations on pre-petition claims. It defers debts until a plan of reorganization is implemented or the assets are distributed in a liquidation. A reorganization is often initiated when a business's line of credit is depleted or frozen or when wages or other operational expenses cannot be paid.
Stopping litigation.
The reorganization petition also serves as an injunction which blocks litigation against the debtor's business and property. Sometimes this allows a business to lessen litigation costs and vulnerability. It also brings most of the litigation into one forum - the Bankruptcy Court - to establish a more streamlined resolution.
Rejection or renegotiation of burdensome executory contracts.
The Code allows a business to reject contracts that require continuing payment or other performance obligations. Often, this power allows the debtor business to renegotiate contracts that are not commercially reasonable. A reorganization may be especially attractive to a business that has financially burdensome long-term contracts.
Rejection or renegotiation of labor contracts.
The Bankruptcy Code creates standards that limit a business's ability to modify or reject a labor contract. However, the debtor can still file for reorganization in order to renegotiate the terms of existing collective bargaining agreements.
Changing pension plans and obligations.
Pension plans and associated deferred obligations are another motivation behind Chapter 11 filings, particularly when the pension plans require substantial continued payments or are seriously under-funded.
Recovery of preferences and fraudulent conveyances.
The Code allows a business to avoid certain pre-petition payments or transfers. These include preferences (payments on debts incurred within 90 days prior to filing the bankruptcy petition - one year in the case of insiders) and fraudulent transfers (transfers intended to "hinder, delay or defraud" other creditors or which are not for a reasonably equivalent value).
Rearrangement of indebtedness.
One of the basic purposes of reorganization is to allow a business to reschedule certain indebtedness - for example, stretching out secured debt and converting debt to equity. Reorganization plans will vary greatly and are usually resolved in negotiations between individual or business debtors and their creditors.

Caveats

Possible loss of business control.
The entity which filed a reorganization petition will become subject to the supervision of the Bankruptcy Court. Since creditors are interested parties, they are entitled to object to actions proposed by the debtor. For example, the sale of real property by the debtor must be approved by the Court; and any creditors may object if the terms are not advantageous to the creditor(s).
Limits on out-of-the-ordinary business decisions.
A company in Chapter 11 needs Court approval to engage in activities that may be outside the ordinary course of business. These could include new business ventures, capital spending or the sale of assets. Creditors may require that a committee be appointed by the Court to have a stronger voice in the operations and business decisions of the debtor.
Immediate cash flow problems.
Usually one of the fundamental reasons to file for reorganization is to free up cash of post-petition operations. This often requires negotiation and adjustment with lenders. Banks that have secured lending relationships with businesses that have filed reorganization petitions usually take security interest in cash, receivables and proceeds of inventory. This cash may be designated as "cash collateral." Debtors may use this cash only with the lenders' consent or when the Court finds that lenders would have adequate protection from loss. If the debtors find themselves in need of more cash than is available, they may have to negotiate a financing agreement with existing lenders or find new ones.
Possible acceleration of damage claims.
While being able to reject executory contracts can be a positive use of the Code, it will result in damage claims for breach of contract made against the debtor. These claims must be included and paid according to the plan.
Liability of guarantors.
Persons who have guaranteed the corporate debt may be particularly concerned when the corporation files for reorganization. A Chapter 11 may accelerate collection of outstanding guarantees. In addition, a filing could strain relations with lenders, trade creditors and, in some cases, shareholders.
Uncertainties of reorganization.
A business that files for reorganization will find itself incurring substantial legal and professional fees. It cannot guarantee that the creation and negotiation of a plan for reorganization will bring a favorable result. The filing of a Chapter 11 petition may provide the breathing time necessary to regroup and formulate a working plan for handling outstanding obligations. However, any decision concerning the use of a Chapter 11 reorganization requires serious consideration of both benefits and burdens.

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