Bankruptcy is the process by which a business that is insolvent may eliminate or modify its existing obligations. Corporate bankruptcy means any bankruptcy entered into by an entity organized as a corporation, a limited liability company, partnership, limited liability partnership or any other form of business entity. The term corporate bankruptcy is also frequently misused to refer to any bankruptcy other than an individual bankruptcy. The corporate bankruptcy process is governed by the Federal Bankruptcy Code, codified in Title 11 of the United States Code.
Corporate bankruptcies are divided into two distinct types.
- Chapter 7 “liquidations”. In Chapter 7 liquidation, the business is dissolved and its assets are sold. The proceeds from the sale are then used to pay the business’ creditors.
- Chapter 11 “reorganizations.” In Chapter 11 reorganization, the goal is to provide a viable business a “fresh start” by eliminating debt, allowing it to terminate existing agreements, discharging liabilities, and potentially eliminating entire areas of the business. Unlike Chapter 7 bankruptcy, a Chapter 11 bankruptcy does not dissolve the existing company.
Both Chapter 7 and Chapter 11 bankruptcies can be filed voluntarily or involuntarily. In a voluntary bankruptcy, the debtor asks the federal bankruptcy court to initiate legal proceedings for the purpose of discharging the debtor’s debts and obligations. In an involuntary bankruptcy, the creditors of the debtor petition the federal bankruptcy court to initiate legal proceedings in an effort to collect on their interests.
Chapter 7 Basics
After a company files for Chapter 7 bankruptcy, a bankruptcy trustee is appointed by the court to oversee the bankruptcy and to wind down the business. The trustee is charged with selling off the business’ assets by whatever method will create the most value for the bankruptcy estate. The only significant limit on the trustee’s power to sell off assets is the rule that secured creditors are entitled to enforce their security rights. The secured creditors are permitted to take the collateral which is pledged for repayment of the debtor’s obligations to the secured creditors.
Once the trustee has collected the company’s assets, the trustee uses them to discharge the company’s existing debts. Creditors are paid based on their “priority.” Their priority is determined in accordance with 11 U.S.C. Section 507. Under Section 507, the priority of creditors is as follows: (1) secured creditors to the extent of their security interest, (2) certain unsecured creditors who provide necessary supplies and services to the corporation (such as employees, utilities, and suppliers of raw materials), (3) all other unsecured creditors, including tort claimants, (4) the debtor company and/or its partners or shareholders. No creditor can receive any payout unless all creditors with superior priority have had their claim paid in full. For example, no tort claimant can collect until all secured creditors and special unsecured creditors have been paid IN FULL. If there are not sufficient assets to pay all creditors of a given priority, each creditor receives a pro rata payment based on the amount of its claim.
Once all assets are collect and the proceeds from these assets are distributed, the Chapter 7 case is closed. Once the case is closed, the corporation is considered “dissolved.”
Chapter 11 Basics
The goal of Chapter 11 reorganization, is to reorganize a company to provide it the opportunity to become a profitable business. In a typical Chapter 11 case, the debtor (incumbent management) serves as the trustee, a status known as “debtor in possession”. The debtor in possession is charged with operating the company during the bankruptcy and is given the first opportunity to submit a reorganization plan. A reorganization plan describes how the existing creditors will be paid and how the debtor company will be organized and capitalized. The reorganization plan is the key document in a Chapter 11 bankruptcy. It establishes how the company will dispose of its assets, the rights of the creditors, and the capitalization of the company when it emerges from bankruptcy. The requirements of a Chapter 11 reorganization plan are discussed in greater detail in the article in this series entitled Bankruptcy Reorganization Plan.
As in Chapter 7, creditors must be paid in accordance with their priority under 11 U.S.C. Section 507. If the company’s debts exceed its assets, the rights of the existing shareholders will be completely eliminated. If the company’s debts do not exceed its assets, the shareholders receive the company’s remaining value on a pro rata basis. Because a company in Chapter 11 will emerge as a going concern, one of the assets that can be used to satisfy the existing creditors is stock in the new corporation. For example, a company that is valued at $1 Million after bankruptcy with current assets of $500,000 and $1.5 million in debt can use the current assets to satisfy $500,000 and the stock in the future company to satisfy the remaining debt.
Unlike a Chapter 7 trustee, Chapter 11 trustees can receive additional financing and loans. To incentivize new lending, a Chapter 11 trustee can secure loans by giving the new lender priority over existing creditors. This type of financing is known as “debtor in possession financing” or “DIP financing.” The debtor is also allowed to terminate existing contracts as long as the other party has not already performed.
At the completion of a Chapter 11 case, the company emerges from the reorganization free from any liabilities for acts that occurred prior to the bankruptcy and free of any debts not explicitly assumed as part of the reorganization process. An unsuccessful Chapter 11 bankruptcy can be converted to a Chapter 7 bankruptcy.
Key Differences Between Chapter 7 and Chapter 11 Bankruptcies
- Post Bankruptcy: In a Chapter 7, the company is dissolved. In a Chapter 11, the company emerges from bankruptcy as an ongoing entity.
- Controlling Party: After a company files for Chapter 7, a bankruptcy trustee is appointed by the court to run the company and oversee the sale of assets and paying of creditors. In Chapter 11, the debtor usually retains possession and continues to run the company;, though the court may appoint a third party trustee.
- Permissible Actions: In Chapter 7, the trustee is generally limited to collecting and distributing the company’s assets. In Chapter 11, the trustee can also obtain additional loans, incur additional debts, and void existing contracts.
- Liabilities: After a Chapter 7, the company’s liabilities are not “extinguished.” They continue to exist; there are just insufficient funds to satisfy them. Conversely, in a Chapter 11 case, liabilities are extinguished when the company emerges from bankruptcy.
- Speed: Chapter 7 cases are generally faster than Chapter 11 cases.
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