Five Common Misconceptions About the Chapter 11 Bankruptcy Process
It has been years since businesses have filed for Chapter 11 bankruptcy protection at the pace they are doing so today. According to data from Epiq Systems, commercial Chapter 11 filings were up 48% in May as compared to May 2019, with a total of 724 new petitions. The surge in filings comes as little surprise, as many sectors of the economy, particularly retail and hospitality, are being hit hard by the COVID-19 pandemic.
Chapter 11 bankruptcy was a household term a decade ago, as businesses sought refuge from the fallout of the financial crisis, and it’s creeping back into our collective consciousness. Despite its ubiquity in the headlines of the financial press, there are common misconceptions about what Chapter 11 means and what the process entails. As a result, some perceive Chapter 11 as a fix-all “silver bullet” for troubled companies even though it’s not. Others avoid Chapter 11 at all costs, often to their detriment, for fear of being tagged by a “scarlet letter.” The truth lies somewhere in the middle.
Here are five of the most common misconceptions about Chapter 11 bankruptcy:
1. Bankruptcy Means Going Out of Business
Just because a business files for bankruptcy does not mean it is going out of business. While a Chapter 7 business bankruptcy filing involves the liquidation of a company, Chapter 11 allows a business to restructure its debts and remain in operation. A business going through Chapter 11 often downsizes as part of the process, but the objective is reorganization not liquidation. Some companies don’t survive the Chapter 11 process, but many others, including household names such as Marvel Entertainment and General Motors, successfully emerge and thrive.
Fundamentally, the result of most Chapter 11 cases is merely that there is a change in ownership in the newly reorganized entity from equity holders to creditors and bondholders, since creditors and bondholders are entitled to a higher priority on assets than shareholders.
The stores remain operational, the assembly line keeps moving, and the planes keep flying. In other words, the assets remain productive—just under a different ownership and debt structure.
2. Chapter 11 Requires a One-Size-Fits-All Approach
A financially distressed company can seek Chapter 11 protection to halt litigation and collection efforts, negotiate with its creditors, and propose and confirm a plan of reorganization that allows the company to emerge from bankruptcy with a fresh start. While that may be the traditional use of the process, Chapter 11 can be used as a strategic tool to effectuate different outcomes, including the sale of all or substantially all of the company’s assets. Indeed, many companies who enter Chapter 11 have no intention of reorganizing as a going concern. The primary purpose of many cases is to quickly conduct a sale (called a “363 sale”) in which a buyer acquires the debtor’s assets, and the proceeds are used to pay creditor claims.
The threat of bankruptcy, itself, can also be used as a strategic tool, allowing a company to reorganize outside of court, such as by negotiating more favorable real property lease terms which could otherwise be rejected in a bankruptcy proceeding.
3. Chapter 11 is a Long, Drawn-Out Process
There have been companies that have languished in Chapter 11 for years, but a bankruptcy case does not need to drag on endlessly. In fact, Chapter 11 cases can wrap up in as little as 24 hours or less. In 2019, Sungard Availability Services emerged from bankruptcy a mere 19 hours after its case was filed.
A lightning-fast bankruptcy is known as a prepackaged case, or “prepack,” which involves the negotiation with creditors and voting on a Chapter 11 plan before the bankruptcy case has even been filed. Pre-negotiated cases are ones where a Chapter 11 plan is developed before the filing with the company’s principal creditors, and the bankruptcy filing is premised on a plan to pursue that plan. Prepackaged and pre-negotiated cases, which take significantly less time than a traditional, “free fall” case, account for the majority of all large Chapter 11 filings, according to the American Bankruptcy Institute.
4. A Bankrupt Company Has Plenty of Money Because it Doesn’t Have to Pay its Creditors
Most Chapter 11 debtors enter bankruptcy with millions of dollars in pre-petition debts—that is, debts they accrued before the filing by withholding payments to lenders, landlords, and other creditors. Accordingly, one might assume that having enough cash to operate the business in bankruptcy would not be a concern. However, in addition to needing cash to operate the business, a bankrupt debtor must pay the costs associated with being in bankruptcy, including the fees of lawyers and other professionals. Such costs can total in the tens, and sometimes hundreds, of millions of dollars in large cases.
As a result, most debtors cannot rely on cash flow alone to get through Chapter 11, even if a company is aggressively cutting operational costs during the process. In almost all cases of any size, debtors must seek debtor-in-possession (or “DIP”) financing to help them get to the other side.
5. Customers and Vendors will Flee
Commencing a Chapter 11 case involves filing a petition and paying a filing fee. Most customers of a bankrupt company will likely never know it is in Chapter 11 unless they’re skimming through the pages of The Wall Street Journal. People are still buying shoes at Neiman Marcus, and renting cars from Hertz. For all intents and purposes, it’s business as usual while the reorganization process unfolds in bankruptcy court.
Most vendors and suppliers, on the other hand, become aware when a customer files for bankruptcy. Those who are creditors of the bankrupt company will receive various notices throughout the case. However, unless a debtor chooses to terminate a relationship, most vendors and suppliers opt to stick around—even when they’re owed a pre-petition debt.
In some instances, such as when there is an existing contract in place obligating them to perform, vendors and suppliers have no choice but to continue the relationship. In other instances, they choose to because they’re entitled to be paid for goods and services they provide as an “administrative expense” of the bankruptcy—a high priority in the claim priority scheme established by the Bankruptcy Code. As long as the debtor has sufficient cash flow and/or DIP financing to operate, the risk of not being paid while the debtor is in Chapter 11 tends to be low.
Dispel the Misconceptions to Make Informed Decisions
We are bound to see more bankruptcies in the months ahead. The wave is just building. Accordingly, it’s important, as a troubled company, or as the customer or supplier of one, to understand the process. The failure to do so can lead to poor decisions and missed opportunities.