When a corporation or partnership runs into financial trouble but wants to remain open, it has the option to file for a chapter 11 bankruptcy. This provides protection from creditor actions while the company reorganizes assets and debts to pay things off and keep the business alive. Chapter 11 is a preferable action to a chapter 7 bankruptcy, which requires a complete liquidation and closure of the business.
What Is Chapter 11 Bankruptcy?
A chapter 11 bankruptcy is known as a reorganization bankruptcy because the company will continue to operate while restructuring its debts over a period of time. In some cases, and with the court's approval, a company can borrow new money under a Chapter 11 filing to help with debt reorganization.
In a chapter 11 bankruptcy, the creditors have a say on the company's proposed new plan. In order for the bankruptcy proceeding to continue as a reorganization, it must get the required creditor approvals and meet all legal requirements, which include getting credit counseling from an approved organization.
Many businesses that find themselves in financial distress prefer to file for a chapter 11 reorganization over Chapter 7 bankruptcy because it allows them to stay in business. If the chapter 11 petition is denied for any reason, the company may be forced to file a liquidation of assets and close the business under chapter 7 bankruptcy proceedings.
How Does Chapter 11 Bankruptcy Work?
When filing the petition for Chapter 11 bankruptcy, a corporation will file with the courts a schedule of assets and liabilities, a schedule of current income and expenditures, a schedule of executory contracts and unexpired leases, and a statement of financial affairs.
The corporation will then create a debt reorganization plan and file that with the court as well. In that plan, the corporation will keep possession of assets becoming what is referred to as a "debtor in possession." As a debtor in possession, the business continues to operate and will do so until either the bankruptcy is completed, the bankruptcy is converted to a chapter 7 filing, or a trustee is appointed.
In the process, the court helps to restructure debts and oversees the plan to repay obligations. The process can take two or more years to complete since the company continues operations and is generally not liquidating assets.
Note: Chapter 11 does not wipe out debt -- it restructures it such that the company is able to pay it down. A Chapter 11 bankruptcy also remains on the debtor's account for up to 10 years, affecting their ability to obtain new debt and leases.
Consequences Of Chapter 11 Bankruptcy
The reason that corporations prefer a chapter 11 bankruptcy is that it allows them to stay alive while working through financial difficulties. Company executives continue to make operational decisions for the company but financial decisions must be approved by the bankruptcy court. The company, therefore, could not invest in new assets or businesses without court approval.
Creditors should expect to have their debt negotiated when chapter 11 proceedings occur. The negotiation might attempt to lengthen the time the debt is owed, thereby reducing the monthly payments, or to reduce the debt to a lesser amount. It might also request temporary relief from debt payments while the company raises capital through sale of assets or other means to make the payment.
Companies that have filed for chapter 11 bankruptcy may have a more difficult time obtaining new lines of credit or getting funding. The credit that is obtained must be approved by the bankruptcy court and it is often at a higher interest rate than for those without a bankruptcy on their record.
Examples Of Chapter 11 Bankruptcy
While Chapter 11 bankruptcies may appear to be a lot more successful than Chapter 7 situations, history shows that most companies entering Chapter 11 don't survive either. Less than 10% of Chapter 11 filings have actually been successful.
Notable Chapter 11 success stories include (believe it or not) Apple Computer (AAPL), General Motors (GM), Marvel Entertainment (now owned by Disney (DIS)), and Texaco (now owned by Chevron (CVX)). In most of these successes, the companies had major assistance from other companies or the US government in working through their difficulties.
One notable Chapter 11 situation still in progress is Sears Holdings Corp. (OTC:SHLDQ). The original restructure request by Sears was filed in October of 2018. In October of 2019, 13 vendors pushed for the company to be moved from chapter 11 to chapter 7 proceedings because they would do better in a liquidation than the proposed restructuring but this was denied by the court.
Sears assets were purchased by Eddie Lampert in 2019 with the stock remaining tradable while in chapter 11 proceedings. As of September 2021, Sears still had 19 Sears department stores and 15 Kmart stores open, though more of them are looking at permanent closure in the near future. This is the last of what was once 3,500 stores with more than 250,000 jobs that were cut over a 15-year period. Sears stock is still traded on the pink sheets with a November 23, 2021, price of $0.02 per share.
Tip: While Chapter 11 situations can work out to the benefit of shareholders, the odds are not favorable. Therefore, investors should be cautious with stocks that have filed for bankruptcy, even if using Chapter 11.
Bottom Line
Chapter 11 bankruptcy is a way for a company to restructure its debt obligations while continuing to operate. However, many companies who file initially under Chapter 11 do eventually succumb to a Chapter 7 liquidation in the end. Investors need to fully assess the risks of holding shares in companies with Chapter 11 or Chapter 7 filings.
Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
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