How business bankruptcy works

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More than 20,000 companies file for bankruptcy each year.

While businesses follow many different paths to bankruptcy, each encounters a carefully designed process to balance the rights of debtors and creditors.

As I have learned from studying and practicing bankruptcy law, the system is not perfect and the results sometimes seem unfair. But bankruptcy is certainly not a way out of jail for heavily indebted companies.

Make the most of a gloomy situation

For most people, bankruptcy has a negative image. And for good reason: a deposit almost always means that there is not enough money for everyone.

But the system makes the most of a gloomy situation by forcing an orderly and open process that preserves value and encourages negotiation. Bankruptcy reorganizations of well-known brands like Delta and General Motors show they can bring the parties together and resuscitate struggling businesses.

At the most basic level, the Bankruptcy Code creates an estate to bring all the assets together in one place, identify and rank the claims against the debtor in terms of priority, and then allocate the assets accordingly.

How exactly this plays out depends largely on the type of bankruptcy that the debtor files.

Delta went public after coming out of bankruptcy in 2007.
AP Photo / Mark Lennihan

Chapter 7 vs. Chapter 11

Large business debtors have two options for bankruptcy: liquidation or reorganization.

Chapter 7 cases are designed to liquidate the company, meaning it will no longer exist, and any remaining value is divided and distributed to creditors.

In contrast, a Chapter 11 reorganization allows a debtor to sell some or all of its assets or come up with a reorganization plan that aims to resolve and satisfy enough creditors to re-emerge as a going concern.

For example, airlines United, Delta, and American all filed for Chapter 11 protection in the mid-2000s and managed to offload enough debt to stay aloft. The most recent reorganization requests include those of Sears, Pacific Gas and Electric Company and Toys R Us.

Once a Chapter 11 reorganization plan is finalized and approved, a debtor comes out of bankruptcy and continues to operate, usually in a stronger position than before.

Benefits of bankruptcy for debtors

Bankruptcy offers at least two valuable benefits to all debtors: time and space.

The moment a debtor files their petition, an automatic stay is imposed on creditors, which functions as a pause button on any collection effort, litigation, or similar action. Creditors can ask the court to lift the stay in certain circumstances, but the standard for doing so is often difficult to meet.

The bankruptcy court has broad authority to review all matters relating to the debtor’s estate, including claims that are distantly related to the main bankruptcy case. The debtor can ask the court to stay other lawsuits apart from the bankruptcy case if they affect the estate. By bringing together all those who have an interest in the assets of the business in one place, a debtor can more efficiently deal with all claims against him.

Debtors then assess their problems and make the changes necessary to be successful after the reorganization. This includes deciding which contracts they wish to postpone and which to abandon.

To avoid a contested process, savvy debtors seek a comprehensive settlement with as many stakeholders as possible and come up with “softeners” to convince undecided creditors to back their plan.

Benefits for creditors

Obviously, bankruptcy gives debtors significant power to reorganize their affairs.

What many people misunderstand, however, is that this power is balanced by strong protections against creditors. before taking many actions outside the ordinary course of business.

The code provides for additional checks on the debtor, including the Unsecured Creditors Committee and the US Trustee. Creditors who are concerned about the debtor’s ability to preserve the value of the estate may ask the court to appoint an examiner or trustee to take possession of the estate, and creditors may even decide to drop the case if they think the debtor is abusing the bankruptcy process.

These and other characteristics add a certain degree of fairness to an inherently unfair situation. The debtor may be seated in the driver’s seat, but there are many other stakeholders who have the power to ensure that the company obeys the rules of the road.

This is an abridged version of an article originally published on August 29, 2019.

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