Chapter 11 Reorganization – An Overview
Reorganization under the Bankruptcy Code is designed to rehabilitate a business, thus preserving its value which might otherwise be lost in a liquidation. Chapter 11 of the Code offers various benefits to the business considering reorganization, which does include certain costs.
First, certain popular misconceptions should be clarified:
- There is no requirement of “insolvency” for filing under a Chapter 11. The only requirement is that the business can’t pay its bills as they come due.
- The Code also provides generally that the business’ existing management continue to operate the business after the filing of the petition for reorganization. The business owner, however, has the responsibility to operate the business according to guidelines in the Code and to protect its assets for the benefit of creditors.
- In order to obtain approval of a plan of reorganization, all claims against the debtor are divided into classes of creditors, e.g., secured, priority, etc. A plan will generally be approved if it is accepted by creditors representing at least two-thirds in amount and one-half of all claims, within each class.
A plan of reorganization can limit the recovery or amount of the claim of either a secured or unsecured creditor. The required approval by the creditors, discussed above, gives them a degree of control over the reorganizing business. A majority of creditors may force a plan upon a recalcitrant creditor or another disapproving creditor. For example, under certain conditions, a secured short term lender may be required against its will to become a long term lender to the reorganized business.
The avoidance of preferential transfers and the rejection of contracts are two of the major powers given a debtor by federal law. The Code governing the preferential treatment of creditors allows the debtor to reacquire any assets transferred to creditors during the 90 days prior to the filing of a petition where the transfer was made in satisfaction of a previously existing debt. A debtor is also able to invalidate any security interest not properly perfected under applicable state law.
The issuance of an automatic injunction which stays all collection efforts, including lawsuits against the debtor, whether filed or unfiled, is one of the strongest protections afforded a debtor. The injunction is automatic upon the filing of the Chapter 11 petition and affects all proceedings against the debtor. The automatic stay provides the debtor a “breathing spell” from creditors’ collection efforts or foreclosure actions. It is designed to permit the debtor a chance to attempt repayment by a reorganization plan, and relief from the financial pressures that caused the business to file bankruptcy.
The automatic stay afforded the business also provides protection for the creditors of the business. Without the stay, creditors would race one another to pursue individual claims against the debtor and its assets, with those proceeding first obtaining recoveries to the detriment of other creditors. The stay, which is the equivalent of a court injunction, is designed to provide the Bankruptcy Court with the opportunity to supervise an orderly procedure under which all creditors are treated fairly. Any action taken in violation of the automatic stay, even by a creditor without knowledge of the filing of a debtor’s bankruptcy petition, is void and exposes the creditor to the risk of being held in contempt of court.
Once the business files a Chapter 11 petition, it becomes subject to the supervision of the Bankruptcy Court. Since creditors of an entity are interested parties, they are entitled to object to certain actions or business decisions proposed by the debtor. For example, a sale of real property by the debtor must be approved by the court and is subject to the objection of any creditor.
Landlords should also beware. The Code prohibits a landlord from interfering in any way with the debtor’s possession of leased premises. The landlord may not recover the premises by instituting any judicial proceeding or by a self-help eviction for pre-bankruptcy rent. Even a telephone call to a debtor threatening to institute a collection or merely demanding payment has been considered a violation of the automatic stay.
Creditors affected by the stay are not without remedies. The court may grant relief from the stay when a creditor can demonstrate that his interest is not being adequately protected by the debtor’s actions.
The advisability of filing a Chapter 11 petition clearly depends on a great number of factors, including the type of business which the entity conducts, the number and composition of creditors, and the various types of assets held by the business or individual.
However, a decision concerning the use of a Chapter 11 reorganization requires careful consideration of the various benefits and the numerous burdens imposed upon the business by the detailed and extensive provisions of the Bankruptcy Code. Whether a business is faced with a decision to use the Chapter 11 reorganization for its own purposes or is confronted by one of its customers who is threatening such action, the decision as to the manner in which to proceed should be carefully considered with experienced counsel.