What is Chapter 11 Bankruptcy?
What is Chapter 11 Bankruptcy?
Definition: Chapter 11 Bankruptcy is a process created by the United States Bankruptcy Code to preserve the going concern value of operating businesses and to allow for a decision to be made by company’s creditors and equity holders or the Bankruptcy Court (if agreement cannot be reached) as to how such going concern value will be shared, distributed or reallocated.
As a matter of public policy, Chapter 11 Bankruptcy is utilized by a business entity (or its creditors) when the businesses’ component parts are worth more operating as a going concern than their liquidation value. In other words, when the business is worth more alive than dead. The entire process is designed to protect this going concern value and, if such value does not really exist due to management overoptimism, to facilitate the transition of the case to a liquidation of the assets for the benefit of creditors.
Typically, a Chapter 11 bankruptcy is filed because of a given trigger event — such as an imminent foreclosure, eviction or entry of judgment resulting from the company’s inability to meet its contractual obligations — that cannot be “undone” with one of the bankruptcy tools. The automatic stay (a federal injunction) immediately stops the undoable event from happening without any necessity (at least initially) of a hearing. Congress, as a matter of public policy, created the automatic stay to preserve the going concern value of the company. The automatic stay applies to almost all collection activities of creditors for the time being.
Then, again typically, management or an appointed trustee identifies (if it has not already done so) the primary problem causing the company to be unable to meet its obligations as they come due. In general, the problem is always the same — cash inflow is insufficient to cover cash outflow. This can be caused by unexpected drops in revenues or increases in expenses or other uses of cash. The point of a chapter 11 is to bring the company’s cash flow (EBITDA) back into the black (positive). Typically, revenue cannot be increased by the bankruptcy process and attention immediately turns to the expense (or cash outflow) side of the income statement.
An initial litmus test of the financial prospects of the company are whether its operating income is sufficient to cover its operating expenses In other words, can it operate profitably even if it had no debt service? If the answer is no, then absent drastic and immediate change, the company will likely be guided towards a closure and liquidation.
If the company can operating in the black prior to debt service, then the process turns to reaching agreement with the creditors (both secured and unsecured (e.g., trade vendors)) as to how the existing debt and claims will be paid from the cash flow of the business. Typically, this is done with an agreement whereby the term of repayment is increased, the interest rates are lowered, or even some debt released or removed.
If debt is released or removed, then typically equity does not get to keep its ownership absent agreement of the creditors. This is known as the “absolute priority rule.” Often, this agreement may come in the form of the equity holders agreeing to infuse new investment in order to retain their equity (or maybe more accurately, to repurchase their equity) interest.
These agreements among the debtor, its creditors and equity holders are placed in what you have heard of as the plan of reorganization (which is really just one large agreement between all of the parties). If enough of the parties agree to it, then it is approved (“Confirmed”) by the Bankruptcy Court.
The company then receives a “Final Decree” and exits the bankruptcy process.