Law Offices of Nicholas Gebelt

What Exactly Is A Chapter 11 And At Its Core, What Is It Designed To Do?


Chapter 11 is the most complicated chapter in the United States Bankruptcy Code. Originally, it was designed for businesses that were unable to service their debts, but could get back on track with additional time and debt reorganization. Eventually, individuals and married couples became eligible to file under Chapter 11 bankruptcy. Whether it’s a business or a personal Chapter 11, the big-picture goal is to develop a plan of reorganization for which the creditors will vote, and the judge will confirm. The plan terms are based, in part, on the debtor’s assets, debts, income, and expenses.

  1. The Pros of Chapter 11 Bankruptcy
    One of the main pros of Chapter 11 bankruptcy is that it stops everything dead in its tracks: As soon as a debtor files a bankruptcy petition under Chapter 11 (or, indeed, under any chapter), the automatic stay is triggered, which stays all creditor actions against the debtor, the debtor’s assets, and the bankruptcy estate that is created when the debtor files the bankruptcy petition.

    In practical terms, the automatic stay stops the creditors from calling, sending mail to, or suing the debtor, garnishing wages, seizing money from the debtor’s bank account, and foreclosing on the debtor’s property. In essence, it erects a legal brick wall around the debtor to prevent creditor depredations. As long as the stay is in place, the debtor enjoys insulation from the creditors, which makes it a very powerful tool. If a creditor violates the stay after it has received clear notice, the individual debtor can sue that creditor in the Bankruptcy Court. If the debtor is successful, the creditor has to pay damages to the debtor, including the debtor’s court costs and attorney’s fees, which is unusual in American jurisprudence.

    The Bankruptcy Code explicitly provides this relief for an injured individual debtor, but not for a debtor that is a business. Instead, the injured business must appeal to a different portion of the Bankruptcy Code that gives the bankruptcy judge equitable authority to sanction a contumacious creditor.

    The second main pro of Chapter 11 bankruptcy is that it buys time. In fact, the debtor doesn’t even have to file a plan for several months after filing the petition. This provides the debtor with additional time to plan ways to restructure the debt, especially if the debtor had to rush into bankruptcy to stop a foreclosure. Further, the debtor is the only one who can file a plan of reorganization during this exclusivity period.

    A third pro is that the debtor can appeal to the creditor’s self-interests to reduce the size of the debt. One way to do this is to compare what the creditor would get if the case were converted to Chapter 7 with what the plan proposes to pay the creditor. As long as the plan provides more than the payout in a Chapter 7 liquidation, the creditor does better by voting in favor of the Chapter 11 plan.

    An appeal to the creditor’s self-interest is a good application of the key to successful negotiations: Convince the people on the other side of the table that it’s in their best interest to do what is being proposed. Appeals to compassion or mercy will generally fail.

  2. The Cons of Chapter 11 Bankruptcy
    1. Without The Resources To Fund A Plan, The Chapter 11 Is Doomed To Fail
      If the debtor doesn’t have the revenue to support a Chapter 11 plan, then other than the benefit of buying some time, the Chapter 11 is an expensive and pointless exercise. Therefore, one of the first things I discuss with a potential Chapter 11 client is exit strategy: Does the debtor have the resources for a successful Chapter 11 bankruptcy? If so, we’ll proceed with the Chapter 11. If not, we’ll discuss other options.
    2. The Chapter 11 Debtor Comes Under The Close Scrutiny Of The Bankruptcy Court
      This may sound a bit paternalistic, but a judge’s permission is necessary to do anything of a significant financial nature.

      For example, the debtor won’t be allowed to take out a loan without successfully prosecuting a motion for authority to incur debt. Because the motion must have all the loan documents attached as exhibits, the process is a bit more involved than just filing a form. And creditors are permitted to object to the motion, so success is not guaranteed. Finally, we must convince the judge that obtaining the loan is in the best interest of the bankruptcy estate.

      If the debtor fails to comply with the rules and orders of the Court, the Court can dismiss the case, or convert it to Chapter 7. On top of that, the Office of the United States Trustee exercises considerable oversight of the case. The debtor must keep the U.S. Trustee informed by submitting monthly operating reports. If it looks like things are amiss, the U.S. Trustee may seek dismissal or conversion. The debtor must also pay quarterly fees to the U.S. Trustee based on the amount of money disbursed over the prior quarter. Failure to do so can lead to dismissal or conversion.

      As with so many things in life, the choices are not necessarily between good and bad options, but between different sets of trade-offs. The debtor must compare Chapter 11 bankruptcy with the alternatives. Even with the cons, Chapter 11 may be the best option because not filing for Chapter 11 bankruptcy could mean the loss of the business or home.

  3. Chapter 11 Bankruptcy: The Process
    As soon as a debtor files for Chapter 11 bankruptcy, the automatic stay is triggered, and several things must be done right away.

    1. The Seven-Day Package
      First, the debtor must submit the seven-day package to the Office of the U.S. Trustee within seven days of the petition date. In the Central District of California, this package is voluminous. It contains — inter alia — documentation regarding the debtor’s assets, liabilities, income, and expenses; lays out the history that led the debtor to file for Chapter 11 protection; and states the proposed exit strategy.
    2. Three Important Hearings
      Next, the debtor must attend three hearings.

      1. The Initial Debtor Interview
        The first hearing is called the initial debtor interview (IDI). At the IDI, the individual debtor (or in the case of a business, the person who is most knowledgeable about the business) and a representative of the Office of the United States Trustee discuss the past, present, and future of the case, and the exit strategy. Creditors are permitted to attend, and in most cases, one or two of the big-ticket creditors are present to find out where the case is heading.
      1. The Meeting Of Creditors
        The second hearing is the meeting of creditors under section 341(a) of the Bankruptcy Code. A representative of the U.S. Trustee presides at the hearing. The hearing is designed to give creditors and the U.S. Trustee an opportunity to examine the debtor. Unlike 341(a) meetings in Chapter 7 and Chapter 13 cases, creditors frequently do attend. These hearings can get quite heated because creditors are permitted to ask the debtor questions, many of which are very probing, and are designed to determine whether the debtor has acted in bad faith, and to see if there is a way to challenge the discharge.
      1. The First Status Conference
        The third hearing is a status conference before the judge. Prior to the status conference, the debtor must file an initial status report. In essence, the purpose of the status report is to explain the debtor’s prebankruptcy history to the judge, state why the debtor needs a Chapter 11 bankruptcy, and provide a roadmap for the case — the exit strategy. The judge will consider this information and then set a timetable. The judge will also set a claims bar date by which creditors must file proofs of claim. If a claim is submitted after the bar date, the debtor can object to it as untimely.

        However, unlike Chapter 7 and Chapter 13 cases, creditors in a Chapter 11 case are not required to file proofs of claim. If a creditor is happy with the way the debtor scheduled its claim in the petition, it does not have to file a proof of claim. If the creditor disagrees with the way its debt was scheduled, then it must file a proof of claim. Otherwise, the treatment of its claim will be based on the way it was scheduled in the petition.

        The judge may also set a date by which the disclosure statement and plan have to be filed, as well as a date for the hearing on the adequacy of the disclosure statement. Some judges will bundle the plan and disclosure statement together. In fact, one of our judges has his own form that combines the disclosure statement and plan into a single document. However, all judges have separate hearings on the adequacy of the disclosure statement and on confirmation of the plan because the confirmation hearing cannot take place until the creditors have received the approved disclosure statement and plan, and have voted on the plan.

    3. First-Day Motions
      The debtor must also prosecute first-day motions. Despite the name, they don’t have to be filed on the first day of the case, but they do have to be filed pretty quickly.

      1. Employment Application
        One that is near and dear to every bankruptcy attorney’s heart is the employment application. Unlike in a Chapter 7 or Chapter 13 bankruptcy — the Chapter 11 attorney is not employed until the judge grants the employment application. For this reason, the employment application needs to be filed right away, and the hearing scheduled as quickly as possible. Otherwise, the attorney won’t get paid.
      1. Utilities Motion
        Another type of first-day motion is called the utilities motion. Its purpose is to obtain the Court’s permission to pay the utilities adequate protection so that they will continue providing the necessary utility services such as electricity and water.
      1. Cash Collateral Motion
        Yet another first-day motion is the cash collateral motion. What is cash collateral?

        Perhaps the simplest example that illustrates cash collateral is in the case of a debtor who has a mortgage on a rental property, and is renting the property to tenants. Typically, the mortgage contract will have an assignment of rents clause, which states that the rent being paid by the tenants belongs to the mortgage company. In other words, the mortgage company has a claim against the rent being paid to the debtor. Of course, if the debtor is making the monthly mortgage payments on time, then the mortgage company won’t take any action. However, if the debtor is not making the mortgage payments, then the creditor has a lien on the rent payments and can recover them. The rent payments are called cash collateral because they serve as partial collateral for the mortgage.

        With a cash collateral motion the debtor seeks to obtain the Court’s permission to use the cash collateral on necessary expenses such as mortgage payments, utility payments, and employee wages.

        There are other first day motions that may be filed, depending on the nature of the case and whether an individual or business is filing.

    4. Duties To The U.S. Trustee
      As previously mentioned, every month the debtor must submit a monthly operating report to the U.S. Trustee. If the debtor fails to submit the operating report, the U.S. Trustee may file a motion to dismiss the case or convert it to a Chapter 7 bankruptcy, whichever option is in the best interest of the creditors.

      Every quarter, the debtor must pay the U.S. Trustee a quarterly fee, the size of which depends on the amount disbursed during the previous quarter.

    5. The Disclosure Statement And Plan
      The debtor must eventually file the disclosure statement and plan.

      The disclosure statement provides a history of why the debtor has ended up in bankruptcy, and includes a general picture of the plan moving forward. It must contain adequate information for creditors to intelligently evaluate the plan and decide whether to vote for or against it. The plan states how the claims will be treated, and the sources of plan funding.

      There is a lot of overlap between the content of the disclosure statement and the content of the plan. In essence, the plan describes what and how the creditors will be paid, and how the plan will be funded: Whether that’s through asset liquidation, loans, or other means. While the plan doesn’t have to be filed right away, it does have to be filed within the exclusivity period; failure to do so allows the creditors to file their own plans, which could be very problematic for the debtor. For this reason, it’s certainly not something that should be put on the back burner.

    6. After Plan Confirmation
      If the debtor is a business, then when the Court confirms the plan the debtor receives a discharge. However, if the debtor is an individual, it does not receive a discharge until plan completion.

      Once the judge confirms the plan, the debtor commences making the payments due under the plan. The debtor must still pay the quarterly fees to the U.S. Trustee, but instead of filing monthly operating reports, the debtor files quarterly reports. As long as the debtor does those three things, the Court and the U.S. Trustee no longer have much of a role in the case until the debtor completes the plan. I’ll discuss this further in Chapter 4 below.

    7. Subchapter V
      Although not explicitly stated, the discussion thus far has focused on what might be called the standard Chapter 11. There is another version of Chapter 11, based on Subchapter V of Chapter 11, to which we now turn.

      The Small Business Reorganization Act (“SBRA”) is Subchapter V of Chapter 11 of the Bankruptcy Code. It was enacted to provide a streamlined Chapter 11 process for small businesses.

      You might wonder what the differences between a standard Chapter 11 and a Subchapter V Chapter 11, especially because there are many similarities. Here are some of the most important differences:

      1. Voting

      In both a standard Chapter 11 and a Subchapter V Chapter 11, the creditors get to vote on the plan. However, Subchapter V has some benefits unavailable in a standard Chapter 11.

      1. The Standard Chapter 11
        As previously stated, a crucial step in the standard Chapter 11 case is propounding a disclosure statement and plan. The disclosure statement is designed to give the creditors sufficient information so they can intelligently vote on the plan. The plan provides for the treatment of all interests and claims. If the judge rules that the disclosure statement provides adequate information to the creditors, then we send the disclosure statement, plan, and ballots to all the creditors.

        The creditors vote as members of their priority classes. A class is deemed to have voted in favor of the plan if at least two-thirds of the total dollar amount of the class’s claims, and more than 50% of the allowed claims vote in favor of confirmation. In that case it is called a consenting class. Otherwise it is a nonconsenting class. If all the classes consent, the Court can confirm the plan.

        But suppose there is a nonconsenting class. Then if there is at least one consenting class, you can get the plan confirmed. Otherwise it cannot be confirmed.

      2. The Subchapter V Chapter 11
        In a Subchapter V case, there is no disclosure statement requirement. However, you’ll undoubtedly have to include the requisite disclosures in the plan itself. Otherwise, the judge will not let you send out the plan and ballots.

        The creditors still get to vote in a Subchapter V case, but you can get a nonconsensual plan confirmed. You don’t need even one consenting class. Then what is the point of having the creditors vote?

        Unlike a standard Chapter 11 in which there is no Chapter 11 Trustee — unless something has gone terribly wrong with the case — a Subchapter V case has a Subchapter V Trustee. That Trustee’s main role is to get a plan confirmed. If each class is a consenting class, then the Trustee’s role ends upon plan confirmation. Otherwise, the Trustee continues with the case, primarily as the disbursing agent of plan payments. And the Trustee must be paid for those services.

      1. The Absolute Priority Rule
        1. The Standard Chapter 11
          Although you can get the plan confirmed without class unanimity — though you must have at least one consenting class — if you don’t have unanimity, confirmation triggers something called the absolute priority rule. What is this rule? A visual analogy may help to put things into perspective.

          You’ve undoubtedly seen a fountain that consists of a stack of bowls, with a water source at the top bowl. The top bowl must be filled before the second bowl gets any water. The second bowl must be filled before the third bowl gets any water, and so forth. The bottom bowl gets no water unless all of the higher bowls have been filled. By analogy, if we think of the bowls as priority classes, no class gets any money unless all the classes that are higher in priority are paid in full. Thus, there is an absolute priority of payment order.

          In the analogy, the business owners are the bottom bowl.

          Suppose all the classes vote in favor of the plan. Then the terms of the plan control, and the owners retain their interest in the business.

          If there are nonconsenting classes, but everybody gets paid in full, then there is also no problem because no one is prejudiced by the owners retaining their interest in the business.

          However, suppose there is a nonconsenting class, and there is a class that doesn’t get paid in full. Then the bottom class gets nothing, meaning that the owner’s interest in the business is turned to ashes. It’s gone. The owner no longer has any ownership interest in the business. The only way that the (now former) owner can get any ownership interest in the business is by adding new value to the business. Generally, that is understood to be adding money. In other words, the owner has to buy an interest in the business.

        2. The Subchapter V Chapter 11
          There is no absolute priority rule in a Subchapter V case. The business owner gets to keep the business, even if there are no consenting classes. However, to prevent bad debtor behavior, the Court can confirm a nonconsensual plan only if the plan does not unfairly discriminate against any creditors, and it is fair and equitable. Providing the meanings of these terms would require a lot more time than we have here, so I’ll not discuss them further.
      1. Who Can File A Plan
        1. The Standard Chapter 11
          In standard Chapter 11, the debtor is the only one who gets to file a reorganization plan during the 120-day post-petition period called the exclusivity period. (This period can be extended with Court approval.) If the debtor has not filed a plan by the end of the exclusivity period, then anybody can file a plan. Even if the debtor has filed a plan, if the Court has not confirmed the plan within 180 days of the petition date, than anyone who wants to can file a competing plan.
        2. The Subchapter V Chapter 11
          In Subchapter V, only the debtor gets to file a plan. However, the debtor must file the plan within 90 days of the petition date. This deadline can be extended with Court approval.

          Based on this discussion of the benefits of Subchapter V, you might ask why any business would file a standard Chapter 11. The reason is simple: Not everyone qualifies for Subchapter V protection. Subchapter V has a total debt ceiling of $2,725,625 (with a little bit of qualifying language), which has been temporarily increased to $7.5 million. Therefore, if the total debt exceeds the ceiling, then Subchapter V is unavailable.

  4. Business as Usual?
    If a business is in a Chapter 11 bankruptcy, then the business’s intention is to stay in existence. During the bankruptcy process, the business can operate as usual. That said, in order for the business to incur new debt, it must successfully prosecute a motion for authority to do so. The debtor is not given carte blanche to do anything it wants to do. Any significant financial decisions have to be approved by the Bankruptcy Court. For example, if the debtor wants to buy equipment or borrow money, it must get the bankruptcy judge’s permission first.

    The way to borrow money is to file a motion for authority to incur debt. There is a provision in section 364 of the Bankruptcy Code that provides a stair-step approach. For example, the debtor can begin by trying to obtain an unsecured loan. If that is not possible, then the debtor can try to get a secured loan. If there are debts that are already secured by a particular asset that is to be used as collateral for the new debt, then the process of obtaining the loan must include specifying the priority of the claims secured by the asset.

    Some vocabulary: The petition day is the day the bankruptcy petition is filed; prior to that is prepetition, and after that is post-petition. The plan is designed to deal with prepetition debts. Obligations that the debtor incurs post-petition, the debtor can pay as they come due. However, the debtor is not allowed to pay prepetition obligations without the judge’s permission.

    An example of a prepetition debt that the Court may allow the debtor to pay is to a critical vendor. A critical vendor is a creditor that provides the debtor with goods or services that are critical to the debtor’s ability to continue operating.

    Another example of a prepetition debt that the Court may allow the debtor to pay is employee wages. Otherwise, the employees will leave, and the business will cease operations.

    Creditors and the U.S. trustee can object to such motions. However, if the debtor shows a clear benefit to the bankruptcy estate, and thus to the creditors, then there probably won’t be pushback from anyone.

    In sum, the judge and the U.S. Trustee exercise a great deal of oversight: They keep the debtor on a fairly tight leash. This isn’t because they’re megalomaniacal and want control, but because they want the Chapter 11 case to succeed. They do not want the business to make a last-ditch effort, only for everything to fall apart.

  5. Length Of A Chapter 11 Bankruptcy
    There isn’t necessarily a typical time frame for a Chapter 11 bankruptcy because it is dependent on the individual facts of a case. For instance, I had a case that took almost five years from the petition date to the date the Court confirmed the plan because there was a creditor who fought tooth and nail, filed many frivolous pleadings, and embodied the concept of vexatious litigant. In other cases, it might only take six months from the petition date to the day the plan is confirmed.

    After the Court confirms the plan, the terms of the plan control its length.

    Unsecured debts are typically paid over five years, though I had a plan confirmed that included a seven-year period for paying unsecured debts because the creditors all voted in favor of confirmation.

    If a secured creditor doesn’t object, secured debt payments can be pushed out indefinitely. In fact, if a secured debt is being paid through the plan, then it’s essentially a mortgage, the repayment of which could take 20 to 30 years

    There is an important exception. Unless the taxing authority agrees to different treatment, a priority tax debt must be paid in full within 60 months of the petition date rather than 60 months from the confirmation date. Therefore, the longer it takes to get the plan confirmed, the shorter the time window to pay the tax debt.

    While there have been Chapter 11 plans that have lasted for a couple of decades, personal cases rarely last longer than five years. Indeed, suppose the debtor is 60 years old. Then unsecured creditors may insist on a plan that lasts a shorter time due to the high actuarial likelihood of the debtor’s death within that shorter period.

    I recently helped a debtor receive a discharge after a case that was pending for only a couple of years. That particular case involved the debtor taking out a loan and paying the debts in full (the loan was secured by certain real properties owned by the debtor).

    Finally, a plan under the SBRA lasts between three and five years, during which the debtor devotes all disposable monthly income to the plan. While there is a technical definition of disposable income, the gist is simple: Subtract taxes and reasonable expenses from gross income to calculate disposable income.

    Ultimately, the time for bankruptcy cases varies widely depending on the facts. Therefore, stating a plan length must be done on a case-by-case basis.

For more information on Chapter 11 Bankruptcy In The State Of California, a free 20 minute phone strategy session is your next best step. Get the information and legal answers you are seeking by calling (562) 777-9159 today.

Attorney Nicholas Gebelt

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