What Is Chapter 11 Bankruptcy? Who May File A Bankruptcy Under Chapter 11?

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Bankruptcy cases are filed under the United States Bankruptcy Code, which is a federal statute that is divided into chapters. The most complicated chapter is Chapter 11. The goal in a Chapter 11 is to reorganize the debtor and restructure the debts through a plan of reorganization that must be confirmed by the court, and that makes the debts manageable. The reorganization can be spread out over a long period of time.

Pretty much anybody can file a Chapter 11 petition. However, in order to understand what’s at work, it helps to think of Chapter 11 as three different kinds of Chapter 11s.

1. The Classic Business Chapter 11

The first type of Chapter 11 is the classic business case. At one time that was the only type of Chapter 11 case. The original Chapter 11 was designed to help businesses reorganize their debts. Although there is a great deal of variation among Chapter 11 cases, under a common scenario some of the debts get wiped out, some get converted to stock, some get paid in part or in full, and some assets may be sold to pay debts. As part of the plan, the creditors are put into different classes, with all of the creditors in a single class receiving the same treatment.

2. The Personal Chapter 11

The second type of Chapter 11 is the personal Chapter 11 case. Congress amended the Bankruptcy Code to make it possible for individuals and married couples to file for Chapter 11. Since Chapter 11 is the most complicated chapter — and is concomitantly the most expensive — it is natural to ask why an individual debtor would choose to file under Chapter 11. After all, unlike a business, the individual debtor can reorganize under the much simpler Chapter 13. Or the individual can discharge debts without reorganizing using Chapter 7. While Chapter 13 has no income ceiling, it has two debt ceilings — one for secured debts, the other for unsecured debts. If the debtor exceeds either debt ceiling, Chapter 13 is unavailable. In mirror image, while Chapter 7 has no debt ceilings, it has income ceilings. Thus, if the petitioner’s income is too high (in a way that can be made precise) Chapter 7 is unavailable. It is in that setting that Chapter 11 makes sense for the individual debtor.

3. The Subchapter V Chapter 11

The third type of Chapter 11 is very new to the Bankruptcy Code. In February 2020, Congress added a new section to Chapter 11, called Subchapter V. Subchapter V of Chapter 11 is known as the Small Business Reorganization Act. A case filed under Subchapter V has a much more streamlined process than the classic Chapter 11. Among its many benefits is that the plan can be confirmed over the objections of all the creditors. One of the big hurdles in a classical Chapter 11 is to get the creditors on board. The creditors get to vote on the plan of reorganization, and if the debtor can get the creditors to vote in favor of it (in a way that can be made precise), then the judge will confirm the plan. But, if the debtor can’t, then the judge can’t confirm the plan. However, in a Subchapter V case the court can confirm the plan, even if none of the creditors vote to confirm it.

To summarize, there are three basic types of Chapter 11: The classic business case, the individual or married couple Chapter 11, and the Subchapter V Chapter 11. By the way, if an individual or married couple has a business, then with the right facts they can file a personal Chapter 11 case under Subchapter V.

What Is The Office Of The United States Trustee? What Does It Do In A Chapter 11 Bankruptcy Case?

The office of the United States Trustee is a subdivision of the United States Department of Justice. There are offices in every district. Although there is a person called the U.S. Trustee, the office has a staff. For simplicity we’ll use the term “U.S. Trustee” to refer collectively to the entire office.

The U.S. Trustee has a few big goals. One is to police the integrity of the system. They make sure that the debtor who files under a particular chapter really is eligible for that kind of relief. For example, if somebody seeks Chapter 7 protection and has income that’s way off the charts, the U.S. Trustee will step in and either seek to dismiss the case, or give the debtor an opportunity to convert to a different chapter. Another thing that the trustee does is monitor for fraud and dishonesty in bankruptcy cases. If there is fraud, the U.S. Trustee will refer the case to the United States Attorney’s Office for prosecution. Because the U.S. Trustee is a subdivision of the U. S. Department of Justice, one of the investigative tools it has is the FBI. They do investigate cases, and I always make sure that my clients understand that it’s very important to tell the truth in the bankruptcy papers. It’s very important to tell the truth at every hearing as well. If you don’t tell the truth, you could end up in a federal penitentiary.

The U.S. Trustee is more involved in a Chapter 11 case than in a case under one of the other chapters. The U.S. Trustee will conduct an initial debtor interview shortly after the case is filed to get some sense of what’s going on with the case. The U.S. Trustee’s office will also preside at a meeting of creditors under section 362 of the Bankruptcy Code because there isn’t a Chapter 11 trustee, unless it’s a Subchapter V case, or something’s gone terribly wrong.

The U.S. Trustee will monitor the financial affairs of the debtor after filing a Chapter 11. This includes ensuring that the debtor closes all prepetition bank accounts and opens new bank accounts called debtor in possession accounts. Every single month, the debtor has to file a monthly operating report that gives a breakdown of the financial activity of that debtor for that month. The U.S. Trustee will monitor that to make sure that what’s going on in the debtor’s financial life matches what the debtor put in the bankruptcy papers and any other pleadings in the case. The U.S. Trustee gets paid for its efforts, and collects the fees every quarter. If a debtor does not pay the quarterly fees, the U.S. Trustee may ask the Court to dismiss the case or convert it to Chapter 7. However, as long as you’re keeping the U.S. Trustee happy, you won’t hear a lot from them. Therefore, it is important to file the monthly operating reports, and to submit proof of insurance because the debtor is required to have insurance on all motor vehicles or real property. The U.S. Trustee is not the enemy in the case of a debtor who abides by the requirements of the Bankruptcy Code, the Federal Rules of Bankruptcy Procedure, and the Local Bankruptcy Rules.

In the Central District of California, there is another way in which the U.S. Trustee is involved early in the case. Within seven days of filing the Chapter 11 petition, we are required to submit a seven-day package. The seven-day package contains great volumes of documentation that establish what’s going on with the debtor. The U.S. Trustee’s office goes over that package very carefully to make sure that the case is on track.

Are There Advantages Of Being Treated As A Small Business Debtor In A Subchapter V Chapter 11 Bankruptcy?

1. The Subchapter V Debt Ceiling

There are advantages of being treated as a small business debtor in a Subchapter V Chapter 11 bankruptcy. However, Subchapter V has a debt ceiling eligibility requirement. A small business Subchapter V debtor’s total debt must be less than $2,725,625. However, due to the COVID-19 pandemic, Congress recently enacted the CARES Act, which temporarily increased that dollar amount to $7 million until March 23, 2021.

There are some very real benefits to being a small business debtor under Subchapter V. Here are a few of them.

2. A Subchapter V Plan Can Be Nonconsensual

In a classic Chapter 11, the debtor must have at least one consenting class of creditors — a class that votes in favor of plan confirmation —to get the plan confirmed. In contrast, in a Subchapter V, even though creditors get to vote, the debtor can still get the plan confirmed even if none of the creditors vote in favor of the plan.

3. The Absolute Priority Rule

In a classic Chapter 11, the debtor can get the plan confirmed even if some classes vote against confirmation, as long as at least one class votes in favor of confirmation. However, if there is a nonconsenting class, something called the absolute priority rule is triggered. Subchapter V has no absolute priority rule.

What is the absolute priority rule? Let’s set the stage for the answer with a definition.

1. The Bankruptcy Estate

The act of filing a Chapter 11 petition creates a bankruptcy estate. The contents of the estate consist of all the debtor’s assets. (However, if the debtor is an individual, the debtor can remove assets from the estate using an exemption table.)

2. The Creditor Classes

As part of the crafting of a Chapter 11 plan, the creditors are put into classes. All creditors in a particular class must be treated the same in the plan, so their claims must be of the same type. The classes establish a sort of hierarchy. Some classes have priority over others in the order of plan payout because the Bankruptcy Code treats some kinds of claims more favorably than others. The highest priority class must be paid in full before the next class in priority gets a penny. That next class must be paid in full before the next class after it gets and penny, and so on. The lowest priority class is the debtor, which in the case of a corporation is the owner.

3. The Absolute Priority Rule

If all of the classes vote in favor of confirmation, the plan is consensual, and the Court will confirm it. In a consensual plan the debtor retains all the assets in the estate.

If there is a nonconsenting class, the Court can still confirm the plan if there is at least one consenting class. However, if there is a nonconsenting class, then unless all of the creditors are paid in full through the plan, the debtor loses all ownership in the estate. The only way to get any of those assets back is by adding new value to the estate by buying back the assets from the estate. That, in a nutshell is the absolute priority rule.

In contrast, there is no absolute priority rule in a Subchapter V case. Even if there are nonconsenting classes, the Court can confirm the plan, the debtor retains all estate assets.

4. Trustee Fees

In the classic Chapter 11, the debtor has to pay a quarterly fee to the office of the United States Trustee. The amount that’s paid is based on the amount that the debtor disbursed over that quarter. In Subchapter V, there are no quarterly fees to the U.S. Trustee.

However, in a normal Chapter 11 there is usually no Chapter 11 trustee. The U.S. Trustee has some oversight in the case, but there’s no chapter trustee. In a Subchapter V case, there is a Subchapter V Trustee. The Subchapter V Trustee’s main task is to get the plan confirmed, and that person can be very helpful. I had a very good experience recently in a Subchapter V case with one of the panel Subchapter V Trustees in our district. The wrinkle is that trustee must be paid. So what the right hand giveth, the left hand taketh away. In sum, there are benefits to Subchapter V, but there are costs as well.

A final note on the Subchapter V Trustee: If the plan is confirmed as a consensual plan, the Subchapter V Trustee is terminated — but not in the Arnold Schwarzenegger sense — thus ending the obligation to pay that Trustee. However, if the plan is nonconsensual, then the Subchapter V Trustee stays on as disbursing agent for the plan, and continues to get paid.

For more information on Chapter 11 bankruptcy, or a Subchapter V Chapter 11 bankruptcy, call (562) 777-9159 for a free 20 minute phone strategy session today.