Guide for New York Company Considering Chapter 11 Bankruptcy / Reorganization
A brief introduction to U.S. bankruptcy law for CEO’s
Bankruptcy is a procedure governed by federal law in the United States. It is a federal law and thus operates through Federal District Courts because Article 1 of the Constitution says Congress has the power to make bankruptcy law. The vast majority of cases are for individuals seeking a full discharge of their debts who have no assets to distribute. This is a Chapter 7 bankruptcy.
Corporations who have both assets and debts, who wish to “reorganize” their company can utilize Chapter 11 bankruptcy law. Usually in bankruptcy law a trustee is appointed to control the assets of the individual (debtor) in bankruptcy. In a Chapter 11 case, however, the corporation usually retains control and is called the “Debtor-In-Possession”.
What can Chapter 11 do for a New York company?
The short answer is that Chapter 11 reorganization allows the debtor corporation to preserve the business as a going concern, and thereby maximize value for creditors, shareholders, employees and other stakeholders. This would allow jobs to be preserved and creditors to be paid back, at least in part.
It also offers relief from creditor calls and threats that the company will be sued because as soon as the bankruptcy petition is filed, all the company’s debts are “stayed’ or stopped while the bankruptcy processes. Your bankruptcy lawyer would propose a payment plan over a period of years to pay back creditors. Once accepted, the bankruptcy can end and the company can pay back the usually reduced debts at an agreed rate.
This is not an easy process however and is not without difficulties.
Your corporation may be worth less as a going concern than it would in liquidation. This would make it very difficult for a Chapter 11 repayment plan to be agreed with creditors. Without agreement the Chapter 11 may not complete.
Risk bearing: Interests of owners/equity: Obviously the interests of the business owners and creditors do not always align. If a company is insolvent, the owners always gain from taking risks. Liquidate today and they get nothing, keep the business going and they have a chance of making the business successful.
Risk bearing: Interests of creditors: Creditors are correspondingly risk averse. Liquidate today and they get paid. Take a gamble and the rewards go to owners/equity, while the creditors bear the risk of loss.
This is not to say creditors always favor liquidation. They don’t. It is just that the risk/reward calculation is very different for creditors than it is for equity holders / owners.
The differing risk analysis by creditors and owners is the main difficulty in getting a Chapter 11 case to complete successfully.
Alternatives to Chapter 11
There are a few alternatives to a Chapter 11, although if your company is struggling they may not appear terribly attractive.
An Out of Court Restructuring
The possibility of settling debts out of court may be desirable in some cases. The downside is that creditors may expect these to be paid promptly where agreement is reached or may simply refuse to restructure.
Continuing operations as normal
This is usually not practical as the company’s debts are often piling in too quickly.
Chapter 7 liquidation
This can be expensive as attorney fees will quickly add up and as no discharge is granted it may be best to simply…
Close the doors of the company
This will allow the business owners to simply sell the company assets, pay the proceeds
to creditors, and close the company.
When none of these options sound attractive or plausible, it is time to give Chapter 11 serious consideration.
Filing as a Small businesses New York Chapter 11
If your business has less than $2m in debt (excluding debt to company insiders), it is considered a small business and subject to slightly different rules to other companies in Chapter 11. In practice, these rules are there to fast-track the process. It means there will be no creditors committee, which can be very beneficial, however there are additional financial reporting rules- the debtor company must report more often to the court. The court will also approve the Chapter 11 plan instead of a board of creditors.
Features and rules of Chapter 11 reorganization
The Automatic Stay
The commencement of a bankruptcy case launches an automatic stay which is similar to an injunction whereby creditors cannot request payment for pre-bankruptcy debts. This offers a lot of respite for the company. There are limited exceptions.
Use of property
The debtor company may sell, or lease its property in the ordinary course of business without authorization from the bankruptcy court. However any sale or lease which is not part of the normal course of business requires court approval. Your Bankruptcy attorney can explain what activities will be considered “normal course of business” for your business.
Some companies will have enough cash to carry on operating without new cash infusions during Chapter 11. Even these companies however, will often rely on using cash which is subject to a lenders security interest. To use this, the debtor will need either an agreement from the lender, or the court’s approval. If the lender does not agree to the use of the cash collateral, a debtor must provide what is called “adequate assurance” to the lender. Essentially this means the debtor must show that the collateral will not decrease in value.
Most companies do need a new line of credit. The bankruptcy code makes this possible by offering priorities and protections to induce lenders to make these loans, which are referred to as “Debtor-In-Possession Loans”.
Without such inducements of priority payment, interest rates would be higher or loans rejected altogether. Lenders find that this is a very safe form of protection, in part because of high fees paid to them.
Executory contracts and leases
An executory contract is one in which there are still obligations to be performed by either party. An unexpired lease or utility contracts are both examples. The bankruptcy code allows companies a lot of flexibility with these. Most contracts and leases, commercial or otherwise can be assumed or rejected in bankruptcy. Unilateral modifications of contracts is not possible, but negotiating behind the backdrop of rejection can be useful.
The “middle” of the case
After a few weeks, activity usually slows down in the Chapter 11 case. Business operations normalize and the debtor can continue “business as usual”. In addition, the debtor must continue to comply with the bankruptcy obligations- reporting regularly to the bankruptcy court (usually monthly). Early in the case, the management and bankruptcy lawyers must meet with the United States trustee for the “341 hearing” where questions will be asked under oath. Quarterly fees must be paid to the United States Trustee also . The middle of the case allows management to consider business strategy, and lawyers to consider legal strategy and continue negotiation with creditors.
The “rest” of the case
This part is where the company can resolve serious problems with its business and complete the Chapter 11. A company may have to revise its marketing tactics, collection methods, or lay of non-essential employees. Whatever the cause of your company’s financial troubles, a business solution must be created that will improve net profits.
Benefits of entering bankruptcy
Some aspects of bankruptcy are unique:
Some creditors may be forced to agree with your plan
Because of the automatic stay, creditors are not permitted to try to collect their debts
Agreement between the parties is final and agreed by a federal judge, not subject to attack
Some powers in bankruptcy are not available anywhere else
What is the “plan”?
The bankruptcy lawyers for the debtor company must decide what the company may be able to negotiate from the bankruptcy, and what their strategy is to get this. This may involve coming up with a “plan” of how to pay creditors and over what period. The period may be as long as 20 years, but is usually shorter.
Creditors will also be paid according to their priority. This means that creditors like the IRS and those with claims secured on the corporations assets will be paid more, and before those creditors who are unsecured.
When the plan is put forward, it will be approved by the creditors (or the court in a small business case) or rejected. Creditors may also put forward their own plans in response. The plan must be agreed and confirmed by the court, for a Chapter 11 case to complete. Failure to do this may result in the case being dismissed or converted to a Chapter 7 bankruptcy.
The confirmation of the plan is a major goal of the Chapter 11 bankruptcy, and once confirmed suggests that the bulk of the work is over. At this point, the hard part is over, leaving legal to tie up any loose ends before the case ends.
ABOUT THE AUTHOR: David Scott Hamilton of Dwyer & Associates LLC, A Boutique NYC law firm
David S. Hamilton is a bankruptcy associate at the firm. David was admitted to the bar of the state of New York in 2007. He focuses on bankruptcies and landlord tenant law.
David graduated from the University of Ulster School of Law in 2006 and later graduated with a masters in law from Duke University School of Law in North Carolina in 2008. David studied bankruptcy, restructuring and the law of corporate finance while at Duke University School of Law.
David is a member of the New York State bar association, the Irish Bar Association of New York and the New York City Bar Association. He is licensed to practice Bankruptcy in the Eastern and Southern Districts of New York (Metro NYC area).
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Disclaimer: While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer. For specific technical or legal advice on the information provided and related topics, please contact the author.