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If your business is in financial trouble, filing a Chapter 11 bankruptcy may be the appropriate course of action to help reorganize your finances.

Chapter 11 is a totally different animal than consumer bankruptcy cases. Chapter 11 is typically used to reorganize a business, which may be, among other things, a corporation, sole proprietorship, limited liability company, or partnership.

If your small business is having significant financial troubles, you will need the help of an experienced Chapter 11 bankruptcy attorney to help you through this complex process.

Chapter 11 Bankruptcy Definition

Chapter 11 is a chapter of Title 11, the United States Bankruptcy Code, which permits reorganization under the bankruptcy laws of the United States. Chapter 11 bankruptcy is available to every business, whether organized as a corporation, partnership or sole proprietorship, and to individuals, although it is most prominently used by corporate entities.

Should My Business File Chapter 11?

Answering this question requires the management to actually know what caused the financial strain in the first place. One thing that is vital to any successful Chapter 11 Plan of Reorganization is cash flow. Without cash flow, no business can survive, even in bankruptcy.

Here are the things that a Chapter 11 Plan can do for your business:

1. Immediately stop any creditor collection efforts, including any pending litigation against your company, which can either be continued in the bankruptcy court, or resumed at a later date in its original venue.
2. Prevent utility companies from pulling the plug (pun intended).
3. Stop any real property and equipment foreclosure actions.
4. Allow the business to pay back its outstanding debts (including tax debts) over a period of years. Unsecured creditors are often paid pennies on the dollar pursuant to the provisions of a confirmed plan.

Here are the things that a Chapter 11 Plan cannot do for your business:
1. Create a marketable product or service.
2. Increase revenue.
3. Give management the skills and drive necessary to operate a successful business and operate it through the extensive Chapter 11 process.

The Chapter 11 Process

Chapter 11 is in a universe of its own. It is a much more expensive and time consuming endeavor that will not be right for most individuals or businesses. However, I also routinely help businesses and high-net worth individuals file Chapter 11 bankruptcy to protect assets, invoke the protection of the automatic stay, and restructure their debts to preserve going-concern value. Just take a look at the timeline below if you want an idea of how complicated a Chapter 11 case can be.

Day 1 – Meet with your attorney to analyze the pros and cons of filing a Chapter 11 bankruptcy. Filing Chapter 11 is a major decision. Once you file, you can’t just dismiss the case by right. You have to ask the court permission to dismiss the case, and the court will only allow dismissal if it is in the best interest of the business” creditors and the bankruptcy estate. Immediately after filing the case, the debtor is required to close all pre-petition bank accounts and open new “Debtor-in-possession” bank accounts for payroll, taxes, and operating expenses. If you weren’t keeping good books or records prior to filing bankruptcy, you better get up to speed quickly. Your attorney will help with this. Many clients tell me that filing monthly operating reports and maintaining compliance with the bankruptcy code helped immensely with future business endeavors. Most small businesses fail as a result of poor accounting practices.

Within a Few Days – When a Chapter 11 case is filed, there are a number of motions that must be filed on the first day the petition is filed, which is why they are often called the “First Day Motions”. Such motions often request the court to permit the use of cash collateral to continue the operation of the business if a secured creditor has a lien on the business’ accounts receivable. This motion will often involve paying employee salaries, critical vendors, and utilities.

Within 30-40 Days – The U.S. Trustee will hold a meeting of creditors – often referred to as the “341” meeting. There is no Chapter 11 Trustee, as the debtor acts as the “debtor-in-possession” in a typical Chapter 11 case. What this means is that the debtor in a Chapter 11 case will have all the rights and powers of a Trustee in a typical Chapter 7 case, and will continue to operate the business as a going-concern. The debtor has the right to use, sell, or lease property in the ordinary course of business. Prior to the 341 meeting, the U.S. Trustee in the Northern District of Georgia will hold an Initial Debtor Interview. Prepping for this interview requires the production of all insurance declaration pages, 90 days of bank statements, tax returns, and signing various documents to give to the trustee.

Within 120 Days – The Debtor has the exclusive right to file a plan within 120 days after filing bankruptcy and, if a plan is filed by the debtor within that time period, the debtor has the exclusive right to obtain acceptances of the plan within 180 days after the Chapter 11 petition is filed.

At Least 28 Days After Disclosure Statement Filed – The court will hold a hearing to approve the Disclosure Statement. The Disclosure Statement is the document that discloses information regarding the Plan of Reorganization proposed by the Debtor to repay its debts. The Disclosure Statement must contain adequate information for a hypothetical investor typical of holders of claims or interests of each class to make an informed decision about whether to vote to accept or reject the plan.

At Least 28 Days After Approval of Disclosure Statement – The court will hold a hearing on confirmation of the Chapter 11 Plan. This requires the debtor’s attorney to mail out a packet with the Disclosure Statement, Plan, and Voting Ballots to solicit votes for the Plan.

Discharge – In an individual case, the debtor will receive a discharge after completing all plan payments. In a corporate case, the debtor will receive a discharge upon the substantial confirmation of the Chapter 11 Plan.

Chapter 11 is not just for small businesses and large corporations suffering insurmountable debt problems. Pursuant to Section 109(d) of the bankruptcy code, a person that may be a debtor under Chapter 7 (which is any individual) may also take advantage of the generous provisions in Chapter 11 to overcome their debt problems. Many high-income debtors will file a Chapter 11 if they fall outside the debt limits for Chapter 13. The current Chapter 13 debt limits are $1,081,400 for secured debt, and $360,475 for unsecured debt. If you owe more than this in either category, you will have to file Chapter 11 to propose a payment plan to repay your creditors over time. While many individuals with primarily business debts will be able to file a Chapter 7, regardless of income, Atlanta, Georgia Judge Wendy Hagenau recently ruled that an individual with primarily business debts who files a Chapter 7 and has a very high level of disposable income may be forced into a Chapter 11. Regardless of which Chapter you file, it is imperative that you consult with an experienced bankruptcy attorney prior to filing.

The Benefits of Filing an Individual Chapter 11

Historically, individuals filed Chapter 11 bankruptcy when they exceeded the debt limits of Chapter 13. For instance, many celebrities and professional athletes are required to file a Chapter 11 rather than a Chapter 13 because they have far too much secured and unsecured debt. However, there are also a number of benefits in filing a Chapter 11 for people who would otherwise qualify for a Chapter 13.

1. Pre-petition Mortgage Arrears Are Too High: If a you want to keep your primary residence in bankruptcy and are behind on your mortgage payments, you cannot file a Chapter 7 to prevent the loss of your home. Chapter 13 is the typical solution; however, one of the limitations of Chapter 13 is that all your mortgage arrears must be paid within a 5 year period in equal monthly payments. If your haven’t made a mortgage payment in over a year, it can be very difficult to maintain your regular monthly payment in addition to an amount each month that will pay off your arrears in five years. With a Chapter 11 bankruptcy, you are not bound by this 5 year limit and can stretch out the cure period for a significantly longer time period.

2. Cram-Down of Your Recently Financed Car: In bankruptcy, a creditor’s lien can be reduced to the fair market value of the property securing it. So, if you owe $100,000 on a rental property that is worth only $50,000, your balance will be reduced to $50,000. However, there are certain limitations on the debtor’s ability to do this, and one such limitation is governed by the “hanging paragraph” in Chapter 13. The “hanging paragraph” represents a paragraph in Chapter 13 of the bankruptcy code that provides that any car loan obtained within 910 days of your bankruptcy case cannot be crammed down to the value of the vehicle. This limitation does not exist in Chapter 11. So if Dan the Contractor finances a $45,000 truck in 2010, owes $35,000 by 2012, and files a Chapter 13 that same year, he will have to pay the entire $35,000 balance over the life of the plan. If he files a Chapter 11 and can prove that the truck is only worth $20,000, he will only have to pay back $20,000 through the Chapter 11 Plan. This results in a savings of over $15,000 over five years – a significant amount of money for Dan.

3. Recent Discharge in Chapter 7 or Chapter 13 Case: If you have received a discharge in a Chapter 7 case within 4 years of the petition date or a discharge in Chapter 13 within 2 years of the petition date, you cannot receive another discharge in Chapter 13. But even if you just received a discharge under either Chapter, you can still file a Chapter 11 bankruptcy and receive a discharge once you complete all payments under the Plan.

4. Nondischargeable Debts (Payroll Taxes, Domestic Support, Etc): Chapter 11 can give an individual the time needed to properly reorganize their affairs for liabilities considered nondischargeable under the bankruptcy code. Nondischargeable means the debt will not be wiped out in bankruptcy. Among the debts that will survive bankruptcy are payroll taxes. Payroll taxes are serious business, and if your business fails to pay these taxes, you can be held personally liable. Fortunately, filing Chapter 11 will stop any penalties and fees from accruing on these unpaid taxes, and your attorney can work with the IRS to structure a repayment plan or settlement offer that you can afford.

The Chapter 11 Plan

The goal of any Chapter 11 bankruptcy is to propose a viable plan of reorganization that is fair to both the debtor and its creditors. The Plan essentially allows small businesses to repay their debts overtime, including both secured and unsecured debts. Unsecured debts (trade creditors, lines of credit, etc.) are often paid back pennies on the dollar, and secured creditors’ claims can often be “crammed-down” to the value of the collateral, resulting in significantly lowered payments.

For instance, if you were in the business of providing roll-off container services to various businesses in the Atlanta area, you would likely have financed the purchase of the roll-off containers through a local bank. If the loan balance had increased to $600,000 from the accumulation of fees and unpaid interest, but the roll-off containers were currently worth only $300,000, I would put a provision in the Chapter 11 Plan to lower the balance to $300,000, extend the maturity date a few years, and lower the interest rate to acceptable levels. This would result in a monthly payment less than half your original amount and give your business the breathing room it needs to thrive and remain profitable.

The Chapter 11 process to seek plan confirmation is much more rigorous than in a Chapter 13. The requirements to confirm a plan are set out in Section 1129 of the Bankruptcy Code. The biggest difference between Chapter 11 and Chapter 13 confirmation is the requirement of Chapter 11 debtors to obtain creditor approval of their plan. Don’t worry. This doesn’t mean the debtor is at the mercy of its creditors. To meet confirmation requirements under Section 1129(a)(10), the debtor only needs one (1) class of impaired claims to vote in favor of the plan.

How Do Classes of Claims Work?

Creditors in a Chapter 11 Plan are broken into different classes based on the types of claims they hold. Typically creditors with similar claims and rights will be lumped into one class together. For instance, a manufacturing business may have a first and second mortgage on its factory location and commercial loans on its delivery trucks. Since this business is going through a short-term liquidity problem, it will also have a few hundred thousand dollars of unsecured trade debt built up that it has trouble servicing. The mortgage lenders will each be put in their own classes.

Mortgage Lender #1 could be put it, for example, Class 1, and the second mortgage holder could be put in Class 2. If the value of the real property is less than what is owed to the first mortgage company, we could use the plan to strip-off – or cancel – the second mortgage and convert their claim to an unsecured claim. The second mortgage holder will now have a deficiency claim that will be paid the same as other unsecured creditors. The commercial truck lender could be designated as Class 3. The unsecured creditors, including all trade creditors, business credit cards, and deficiency claims, could be Class 4. Class 5 would typically be the equity security holders of the reorganized business. Each class will have unique language that explains how they will be paid back under the Plan.

If a Class Has More Than One Creditor, How Are Votes Counted?

As we discussed earlier, one of the most important milestones to achieve in a Chapter 11 case is to get one impaired class to vote for your plan. For a class to be impaired, its rights under the Plan must be modified from the original contractual terms in a way that results in less benefit to the creditor. For instance, the hypothetical manufacturer from our previous scenario could not offer the commercial truck lender of Class 3 a better deal than it bargained for outside of bankruptcy to garner a vote in favor of the plan. Classes of creditors that are not impaired are automatically considered to consent to plan approval.

So now that we know what an impaired class is, next we need to know how to count votes of a class with dozens of creditors, such as the Class of general unsecured creditors. To get an approval of a class of impaired claims, the debtor must have more than one half in number and two-thirds in amount of claims vote in favor of the plan. In simple terms, 51% (not half, but MORE THAN half) of that class must vote for the plan. In the case of 10 voting creditors, 6 must vote in favor of the plan. If these 10 creditors hold $1,000,000 in claims, 6 creditors with claims totaling ~$666,666.67 (rounding up) must vote in favor of the plan. This prevents a large number of small creditors from taking over a plan. Fortunately, the debtor only counts the creditors that actually cast a vote. Creditors who do not vote are not tallied one way or another UNLESS they are the only creditor in that class. For instance, if a secured creditor in its own class does not vote for the plan, many districts, including the Northern District of Georgia, do not count silence as acquiescence.

Cramming Down Creditors and What Happens When a Class Rejects the Plan

Cram-down is a bankruptcy term that usually refers to a secured creditor’s claim being reduced or “crammed down” to the value of the collateral its claim secures. For example, if a debtor owns real property worth $1.2 million with a $2 million mortgage and can prove that the property is only worth $1.2 million, the debtor can reduce the principal balance of the bank’s claim to $1.2 million. The bank will then be left with a $1.2 million mortgage and an $800,000 deficiency claim (the bank can now vote in the unsecured creditors’ class as well).

The debtor can also adjust the interest rate and extend the life of the loan out many years beyond the original maturity date.
Cramming down unsecured creditors simply means paying them less than the full value of their claims. If all classes of claims do not vote for the Plan, you must proceed under Section 1129(b) of the Bankruptcy Code – often colloquially referred to as the “Cram-Down” Section. In order to confirm the plan under this section, the debtor must prove that the plan is fair, equitable, and does not discriminate against a class of creditors.

For instance, if there are two or more creditors of the same class and one of those creditors receives a significantly lower recovery than the others of the same class, that could be considered discriminatory treatment. Similarly, if two classes are so similar that the court thinks they should receive the same recovery, it could block confirmation until the plan is amended to treat those two classes the same.

Cram-Down of Secured Creditors

To be treated fairly and equitably, a secured creditor must retain the liens securing their claims to the same extent and priority as existed prior to the petition date to the extent of the value of their claim and must receive deferred cash payments equal to the value of their collateral. In plain English, this means that the secured creditor remains a secured creditor and must receive regular payments that will equal the present value of its collateral. So in the case of our hypothetical mortgage holder and manufacturing debtor, if the real property is worth $1.2 million, it would be fair and equitable to treat that mortgage as a $1.2 million mortgage with a market rate of interest amortized over a reasonable period of time taking into consideration the risks the creditor originally bargained for. It would not be fair and equitable to extend an interest-only variable note with a 5-year maturity date to a 30-year fixed note. A debtor could, if the court approved, extend a 10-year commercial mortgage to 20 years at a slightly lower interest rate.

Cram-Down of Unsecured Creditors

If a class of unsecured creditors does not vote in favor of the Plan, the Plan must pay them 100% of the value of their claims or the owners of the debtor business cannot retain an interest in the reorganized debtor under the plan unless they contribute ‘new value’ to the plan. New value can take many forms and is a topic for another day. Just take note that getting the approval of a debtor’s unsecured creditors is always top priority in seeking plan confirmation. This is called the absolute priority rule, and many cases have been fought over this issue.

Other Confirmation Issues

For a Chapter 11 Plan to be confirmed, it must past the “best-interest of creditors test.” This simply means that creditors under the plan must receive as much as they would if the business were liquidated in a Chapter 7. The plan must also be “feasible,” and the court can take up the issue of feasibility on its own to ensure the debtor does not fail shortly after confirming a plan. Courts will look at the debtor’s monthly operating reports to determine if the business is making enough money to service the reorganized debts under the plan.

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