How Bankruptcy Works.
Silverman, Jacob, and Ed Grabianowski. "How Bankruptcy Works" 05 December 2005. HowStuffWorks.com. <http://money.howstuffworks.com/personal-finance/debt-management/bankruptcy.htm> 05 August 2011.
Bankruptcy is one of the most complex areas of law, incorporating elements of contract law, corporate law, tax law and real estate law. In recent years, several high-profile corporations like Enron, WorldCom and Adelphia have filed for bankruptcy. Although businesses only accounted for about 2 percent of all bankruptcy filings in the United States last year, commercial bankruptcies can have a big impact on the economy because there can be a lot of money at stake.
In this article, we'll explain the different types of bankruptcy filings under United States law, figure out who pays what to whom, and describe the process of reorganizing a company and running it under bankruptcy.
All of the different kinds of corporate bankruptcy amount to the same problem -- a company has more debt than it can pay. In this situation, a company files for bankruptcy. This gives it legal protection from its creditors. The company can either get out from under the debt or work out a repayment plan and continue operating. A bankruptcy filing prevents creditors from trying to collect on debts outside the process of the bankruptcy filing itself.
What circumstances lead a company to file for bankruptcy? Sometimes debt grows over time until the business owners realize they have no hope of paying it off. The 2002 bankruptcy of Kmart is an example of this. Competition from other discount store chains led to a steady decline in sales, and the company began missing payments to their suppliers.
Companies sometimes face a sudden loss of revenue that prevents them from paying their suppliers. For example, a printing company might draw 30 percent of its revenue from a single publisher. If that publisher moved its contract to a different company, the printer would lose almost a third of its revenue. However, it would still have to pay employee wages, health care plans, taxes, suppliers and all of its other bills.
A sudden, massive financial loss can result in instant debt without the revenue to pay for it. This is often the result of some wrongdoing on the company's part. A lawsuit or government fines can cost a company millions or billions of dollars. Scandals can also cause stock prices to drop. WorldCom was already struggling in 2002 when an accounting scandal became public. The scandal severely damaged the company and forced them into bankruptcy.
Creditors can also force a company into bankruptcy. They might do this if they discover that the owners are selling off all of the company's assets and preparing to dismantle the company without paying their debts. A creditor might also force a bankruptcy if the company is already making large payments to a different creditor.
Next, we'll take a look at the different terms used in bankruptcy filings and see how bankruptcy filings generally work.
Bankruptcy Basics
Although bankruptcy is complicated and the exact steps can vary from state to state, each chapter of bankruptcy uses the same terminology and follows the same basic process.
Although bankruptcy is complicated and the exact steps can vary from state to state, each chapter of bankruptcy uses the same terminology and follows the same basic process.
Two main parties are involved in bankruptcy filings -- the debtor and the creditor. The debtor is the party who has debt, or owes money, to the creditor. A debtor can be a company or an individual. The creditor is an organization or company that claims the debtor owes property, service, or money. Most bankruptcy cases involve several creditors.
Debtors can have two different types of debt -- secured and unsecured. With secured debts, creditors have the legal right to something of yours if you fail to make the proper payments. Your mortgage, for example, is a secured debt. By loaning you the money to pay for your house, the bank gets a lien on it. If you stop making mortgage payments, the bank can foreclose and take possession of your house.
In business, secured debt can get very complicated. Various business loans may give creditors a lien against intangible aspects of the business, such as patents, trademarks or intellectual property. The creditor can still repossess property that has a lien against it, even if some portion of the debt has been discharged -- secured debt can't ever be fully discharged. The debtor can either make the payments and keep the item, or stop paying on the debt and have the item repossessed. Secured creditors are always paid first in a bankruptcy settlement.
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Related Terms
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Types of Bankruptcy
The four types of bankruptcy are named for their respective chapters in the United States Bankruptcy Code. The type of bankruptcy that you file depends on several factors, including whether or not you are an individual or part of a corporation.
The four types of bankruptcy are named for their respective chapters in the United States Bankruptcy Code. The type of bankruptcy that you file depends on several factors, including whether or not you are an individual or part of a corporation.
Chapter 7 is what most people mean when they say, "I'm filing for bankruptcy." This is a liquidation bankruptcy, which means that the trustee sells off all non-exempt assets held by the debtor so that the debts can be repaid to the fullest extent possible. Individuals, corporations and partnerships are all eligible for Chapter 7 bankruptcies. The portion of the debt that can't be repaid through liquidation is discharged. Businesses generally try to avoid Chapter 7, because it is impossible to conduct business operations. Income generated after the bankruptcy filing is not a part of the bankruptcy -- the debtor can keep it.
Chapter 11 is the most complex bankruptcy filing and the one that most troubled businesses file (although some individuals may file it as well). In a Chapter 11 bankruptcy filing, the debtor continues to function, maintains ownership of all assets, and tries to work out a reorganization plan to pay off creditors.
In the past, a business had an almost unlimited amount of time to come up with their reorganization and payment plan. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 imposes a 120-day time limit. If the debtor has not submitted a plan within that period, creditors can submit their own plans.
Chapter 12 is specifically for farm owners. The debtor still owns and controls his assets and works out a repayment plan with the creditors. Chapter 13 is like Chapter 11, but for individuals. The debtor retains control and ownership of assets. He also works out a three to five-year repayment plan. Some portion of the debt may be discharged, depending on the income of the debtor. There are also limits on the amount of debt involved.
Chapter 11 - Business Bankruptcy
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State Laws
In addition to the federal bankruptcy laws, each state has its own provisions for handling bankruptcies within that state. For the most part, the differences have to do with income and debt limits that debtors must meet to be eligible for filing under each chapter. There are also differences in the time limits given for reorganization plans, income subject to liquidation, exempt assets and other details. In the past, these differences led debtors (particularly corporations) to "shop around" for the state with the best possible terms. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 requires anyone filing for bankruptcy in a state to have lived in that state for two years prior to the filing.
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Companies choose to file Chapter 11 because its long-term revenues will be higher than the liquidation value of the assets. This way, creditors can get more money back if they allow the debtor business to reorganize and work out a payment plan. The business becomes a debtor in possession, maintaining control and ownership of their assets and continuing their regular operations. At this point, there is usually no trustee.
A company that declares Chapter 11 must disclose all of its assets and make a list of all the debts that it is seeking protection from. This is the creditors' right to question the debtor, a fundamental part of bankruptcy law. In cases involving millions or billions of dollars, this step alone can be incredibly complex. The creditors also meet with the debtor.
If the bankruptcy court finds that there has been fraud or gross mismanagement on the part of the debtor, they can appoint a trustee, who will take over the operations of the debtor for the duration of the proceeding. The business continues to operate as normal, but the original owner is no longer in control. The trustee appointed to a specific bankruptcy may be different from the "U.S. Trustee." While federal bankruptcy courts are in charge of the proceedings, the Department of Justice also assigns a U.S. Trustee to each district. The U.S. Trustee serves as a watchdog over bankruptcy cases and may act as the trustee in a proceeding.
While under Chapter 11, a company can only make the usual sales and purchases that are part of its standard business operations. For example, it can't buy out another company, sell off a division of the company, or sell a major piece of equipment or property without approval from the court. It can't undergo a major expansion, either.
In all Chapter 11 proceedings, a creditors' committee represents the majority of the unsecured creditors, and negotiates the best possible payment options for them. Large-scale cases may have multiple creditors' committees, each representing different groups and factions of the creditors. Stockholders can also form a committee.
At this point, the debtor formulates a plan to reorganize its debts. This plan can be a simple as a payment plan. With larger bankruptcies, companies may take many steps to reorganize their debt. They might offer stock to some creditors. A retail business might have to close stores, lay off employees, or renegotiate union contracts. One of the major provisions of Chapter 11 allows a company to void many of its contracts, including union contracts, contracts with suppliers, and real estate leases.
Although some large companies have filed for bankruptcy in recent years, the overall number of corporate bankruptcies has declined.
The debtor can also "avoid" certain payments or purchases that happened in the period prior to the bankruptcy. The usual period is 90 days, but payments or gifts made to friends, family or company insiders have a one-year limit (or longer, depending on the state where the bankruptcy is filed). Some payments can be returned to the debtor and become subject to the terms of the reorganization plan. This keeps debtors from manipulating their assets and giving preference to certain creditors.
Once the debtor submits a reorganization plan, the creditors and the company's stockholders vote on it. Stockholders are generally very low in terms of priority, and even if they vote down the plan, the court can go ahead with it if the creditors approve. Once the court approves the plan, the Chapter 11 bankruptcy is certified and confirmed. Now the debtor must comply with the plan and make the proper payments to the creditors (or to the trustee, if one has been appointed).
It is important to note that during the period of reorganization, the company's stocks will be virtually worthless. If the company gets out of Chapter 11 and begins operating normally, those stocks can increase in value, but at first they will probably be worth much less than the initial purchase price. Bondholders can sometimes get a fraction of the bonds' face value as part of the reorganization.
If a debtor violates the terms of the plan, there are several potential consequences. A trustee may be appointed. If it appears that the company will not be able to operate profitably and follow through with repayment plans, the Chapter 11 will be converted into Chapter 7. This is a death sentence for the company.
No one ever goes to jail for being in debt. This is easy to overlook when many high profile corporate bankruptcies follow financial crimes committed by executives or accountants. Financial fraud can lead a company to bankruptcy, and the executives may be prosecuted, but bankruptcy itself is not a crime.
