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Reuniting With a Persistent Chapter 11
Those who do not deal with bankruptcy matters may encounter Chapter 11
Jonathan Goldsmith
Western Massachusetts Law Tribune
April 9, 2002
Enron, Bethlehem Steel, K-Mart, Malden Mills -- lately it seems as if every day we hear of another company that has filed for protection from its creditors under Chapter 11. Whether the filing is precipitated by the downturn in the economy, competitive pressures, the effects of Sept.11 or otherwise, Chapter 11 is (again) becoming commonplace. For example, Chapter 11 filings in the Western Division of the U.S. Bankruptcy Court for the District of Massachusetts in 2001 increased 76.5 percent over the prior year. Although the actual number of filings is not at all at an alarmingly high level, the trend is clear, at least for the foreseeable future. As such, it is likely that even lawyers who do not generally deal with bankruptcy matters in their practices will encounter a client who is somehow drawn into a Chapter 11 case. This can be as a vendor, landlord, employee or even an investor.
Below are some of the more salient aspects of Chapter 11 to assist those practitioners who may not have dealt with a Chapter 11 case either at all or in quite some time.
The U.S. Constitution, in particular Article I, Section 8, provides that Congress has the power to establish "uniform laws on the subject of bankruptcies throughout the United States." The principal source of modern bankruptcy law is the Bankruptcy Reform Act of 1978, which is referred to as the Bankruptcy Code ("Code"). Congress has amended the Code several times since its creation, including significant amendments made by the Bankruptcy Reform Act of 1994. The Code is codified as Title 11 of the United States Code and it governs all bankruptcy cases filed in the United States. Procedural aspects of Chapter 11 are addressed in both the Federal Bankruptcy Rules as well as the local bankruptcy rules promulgated by each specific district of the bankruptcy court.
Chapter 11 is one of five basic types of bankruptcy cases provided for under the Code. Congress created Chapter 11 to provide a single unified forum and procedure for reorganizing most business enterprises. Chapter 11 has two major objectives: to rehabilitate a troubled debtor and to maximize return to creditors. Chapter 11 also has the added benefit of maintaining jobs and preserving other economic benefits to its community.
A Chapter 11 case is initiated when a bankruptcy petition is filed with the bankruptcy court. A petition may be either voluntary (filed by the debtor) or involuntary (filed by creditor(s) that meet certain requirements under § 303 of the Code). In a voluntary petition the filing operates as an "order for relief;" no formal adjudication is necessary. In an involuntary case, however, the petition itself does not entitle the creditors to relief. Rather, an order for relief against the debtor results only if the debtor fails to answer the creditors' petition or a ground for bankruptcy is found to exist.
Typically, Chapter 11 is filed by a corporation, an individual operating as a proprietorship or a partnership. It should also be noted that an individual, even if not engaged in business, is permitted to seek protection under Chapter 11.
One of the most important and immediate consequences of a bankruptcy filing is the imposition of the automatic stay that prevents creditors from enforcing their pre-petition claims or from seeking recourse against the debtor's assets. Essentially, the automatic stay stops most collection actions. Under certain situations a bankruptcy court may grant a creditor relief from the stay. The grounds for granting relief from stay are set forth in § 362(d) of the Code. There are, however, certain types of actions that are not stayed and these are delineated in § 362(b) of the Code.
The ultimate objective of a Chapter 11 debtor is to obtain confirmation of a reorganization plan that provides, among other things, the amount to be repaid to creditors and how payments will be made. The reorganization plan constitutes a contract between the debtor and its creditors and states all relevant terms of the proposed repayment of creditors, the parameters for the disposition of assets and the conditions under which the debtor will operate its business.
For the first 120 days after filing a Chapter 11 case, the debtor has the exclusive right to file a plan. The court may lengthen or shorten this time for cause. Entitled to vote to accept or reject a plan are all impaired classes of creditors -- that is, those whose legal or contractual rights are altered. The plan divides creditors into classes, putting like with like, and must treat each class separately, fairly and without discrimination. The plan traditionally classifies each secured creditor in its own class but usually places general unsecured creditors in one class. The Code entitles some defined classes of claims to preferred -- or priority -- treatment. In general, no lower-priority class or equity security holders may be paid until higher-priority creditor classes are paid in full or agree to accept less. Class vote determines acceptance or rejection of the plan, not the vote of individual creditors. A class of creditors is deemed to have accepted the plan if a majority in number, and two-thirds in dollar amount of those voting assent. The court then confirms the plan if all impaired classes of creditors vote to accept it and it meets all the legal criteria for confirmation set forth in § 1129 of the Code.
Sometimes the court can confirm the plan even if all impaired classes do not vote to accept it. In some circumstances, if at least one impaired class accepts the plan, the court can confirm it through a statutory process called "cramdown."
In a Chapter 11 case, the court establishes the amount of creditors' claims in one of two ways. In the first way, the debtor files schedules of liabilities that identify all creditors; identify the amount believed owed to each and designate whether any creditor's claim is disputed, contingent or unliquidated. If a creditor disagrees with the claim amount -- or if the claim is listed as disputed, contingent or unliquidated -- the creditor must timely file a proof of claim with the court.
If the debtor or other parties-in-interest object to the claim, the court conducts a hearing to determine the claim amount. Each creditor's distribution will be based on the allowed amount.
The Code provides that the debtor in possession or the trustee, as the case may be, and in some instances the creditors committee, may avoid certain prepetition transactions. The most common of these actions is the preference avoidance. The source of the preference law is § 547 of the Code.
The preference must be a transfer that is: (1) "to or for the benefit of a creditor;" (2) "for or on account of an antecedent debt owed by the debtor before such transfer was made;" (3) "made while the debtor was insolvent;" (4) "made -- (a) on or before 90 days before the date of the filing of the petition; (b) between 90 days and one year before the date of the filing of the petition, if such creditor at the time of such transfer was an insider;" and (5) "and that enables such creditor to receive more than such creditor would receive if: (a) the case was a case under Chapter 7 of this title; (b) the transfer had not been made; and (c) such creditor received payment of such debt to the extent provided by the provisions of this title."
All five elements must be proved in order for the plaintiff to succeed in avoiding the transfer. The preference actions are most commonly brought to avoid and return to the bankruptcy estate payments made by a debtor to a creditor within the applicable look back period.
Jonathan Goldsmith is a bankruptcy attorney practicing in Springfield, Mass.
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