What is Chapter 11 Bankruptcy: Merits & Demerits of Filing

 

• A Chapter 11 bankruptcy allows a company to stay in business and restructure its finances and operations.
• If a company filing for Chapter 11 opts to propose a reorganization plan, it must be in the best interest of the creditors.
• If the debtor does not put forth a plan, the creditors may propose one instead.
• Many major corporations, including General Motors and United Airlines, have used Chapter 11 bankruptcies as an opportunity to restructure their debts while continuing to do business.

                        How Chapter 11 Bankruptcy Works

Chapter 11 is named after a section of the U.S. Bankruptcy Code. Companies that file Chapter 11 do so in order to obtain time to reorganize and make a fresh start.1

During a Chapter 11 proceeding, the court will help a business restructure its debts and assets. In most cases, the company can continue to operate. Many large U.S. companies have filed for Chapter 11 bankruptcy at one time or another to stay afloat. They include such well-known names as General Motors, United Airlines, and Texaco, as well as thousands of other companies of all sizes.

Corporations and partnerships are the most common filers of Chapter 11, but in rare cases, individuals with a lot of debt who do not qualify for Chapter 7 or 13 may be eligible for Chapter 11.23 However, the process is not a speedy one.

As mentioned, the debtor, called a "debtor in possession," can generally run the business more or less as usual. However, in cases involving dishonesty, fraud, or gross incompetence, a court-appointed trustee will step in to run the company throughout the bankruptcy proceeding.

The business is not allowed to make certain decisions without the permission of the courts. These include the sale of assets, other than inventory, starting or terminating a rental agreement, and stopping or expanding business operations. The court also has control over decisions related to retaining and paying attorneys and entering contracts with vendors and unions. Finally, the debtor cannot arrange a loan that will commence after the bankruptcy is complete.

In Chapter 11, the business or individual filing for bankruptcy has the first chance to propose a reorganization plan. These plans may include downsizing business operations to reduce expenses, as well as renegotiating debts. In some cases, plans will involve liquidating all assets to repay creditors. If the suggested path is deemed feasible and fair, the court will accept it, and the process will move forward.1

Chapter 11 and Small Business

The Small Business Reorganization Act of 2019, which went into effect on Feb. 19, 2020, added a new Subchapter V to Chapter 11 designed to make bankruptcy easier for small businesses. The act defined eligible businesses as "entities with less than about $2.7 million in debts that also meet other criteria."45

The CARES Act of 2020 temporarily increased to the debt limit to $7.5 million for bankruptcy cases filed on or after March 27, 2020. Then, in 2022, the Bankruptcy Threshold Adjustment and Technical Corrections Act (BTATCA) extended the temporary limit for cases filed on or after March 27, 2022 for another two years, or until March 27, 2024.67

Subchapter V "imposes shorter deadlines for completing the bankruptcy process, allows for greater flexibility in negotiating restructuring plans with creditors, and provides for a private trustee who will work with the small business debtor and its creditors to facilitate the development of a consensual plan of reorganization," the Justice Department says.

Chapter 11 Example

In January 2019 Gymboree Group Inc., a popular children's clothing chain, announced that it had filed for Chapter 11 and was closing all of its Gymboree, Gymboree Outlet, and Crazy 8 stores in Canada and the United States.

According to a press release from Gymboree, the company had received a commitment for a debtor- in-possession financing ($30 million in new loans) provided by SSIG and Goldman Sachs Specialty Lending Holdings and a "roll-up" of all of Gymboree's obligations under a "prepetition Term Loan Credit Agreement."9

It added that it was "continuing to pursue a going-concern sale of its Janie and Jack business and a sale of the intellectual property and online platform for Gymboree."9 Gap Inc. announced in March 2019 that it had purchased Janie and Jack.10 In early 2020, Gymboree made its return as a "shop-in-a-shop" in Children's Place locations and with a new online store.11

This was the second time in two years that the Gymboree Group Inc. had filed for bankruptcy under Chapter 11. The first occurred in 2017, when the company was able to successfully reorganize and significantly lower its debts.12

Frequently Asked Questions (FAQs)

What Are All the Chapters of the U.S. Bankruptcy Code?

There are currently six chapters in the U.S. Bankruptcy Code. They are: Chapter 7 (liquidation for individuals or businesses), Chapter 9 (for municipalities), Chapter 11 (reorganization, usually for businesses), Chapter 12 (for family farmers and fishermen), Chapter 13 (reorganization for individuals), and Chapter 15 (international bankruptcies). Of these, Chapter 7, Chapter 11, and Chapter 13 are the most common.13

What Is the Difference Between Chapter 7 and Chapter 11?

Chapter 7, also referred to as liquidation bankruptcy, is when the court appoints a trustee to oversee the sale of as many of debtor's assets as are needed to pay their creditors. Unsecured debt, such as credit card debt, is usually erased. However, Chapter 7 does not forgive any tax obligations, alimony or child support, or student loans. Filers are allowed to keep certain "exempt" property.

By contrast, Chapter 11 is a form of bankruptcy that involves a reorganization of a debtor's financial affairs. It is most often used by companies, though it is available to some individuals, as well. The main difference is that the entity filing for bankruptcy remains in control of more of their assets as long as they comply with the agreed-upon plan.

Are There Advantages to Filing Chapter 11?

The biggest advantage is that the entity, usually a business, can continue operations while going through the reorganization process. This allows it to generate cash flow that can aid in the repayment process. The court also issues an order that keeps creditors at bay. Most creditors are receptive to Chapter 11 as they stand to recoup more, if not all, of their money over the course of the repayment plan than if the company simply went out of business.

What Are the Disadvantages of Filing Chapter 11?

Chapter 11 bankruptcy is the most complex of all bankruptcy types. It is also usually the most expensive. For a company that is struggling to the point where it is considering filing for bankruptcy, the legal costs alone might be onerous. Plus, the reorganization plan has to be approved by the bankruptcy court and must be manageable enough that the business can reasonably pay off the debt over time.

The Bottom Line

Chapter 11 can allow a business that is experiencing serious financial difficulties to regroup and get back on track. However, it is complex, costly, and time-consuming. For these reasons, a company should consider Chapter 11 reorganization only after exploring other possible alternatives.