Bankruptcy Basics

Bankruptcy Basics: Know the Drill
Published: March 23, 2001
By Andrew Apfelberg, Christopher Celentino, Contributing Authors

What's that sound of papers shuffling? It's another dot-com filing for bankruptcy. But what exactly does bankruptcy involve?

A business, be it corporation, partnership or sole proprietorship, can file a bankruptcy case in one of two ways. One way is to liquidate. The other is to reorganize.

These two approaches are commonly known by their respective chapters of the bankruptcy section of the U.S. Code. Chapter 7 of the Code covers liquidation; Chapter 11 addresses reorganization. The public policy behind the Code is to discharge debts and give an honest debtor a fresh start.

The management of a company in Chapter 7 will be replaced by a trustee. This trustee's job is to marshal as many assets as possible, sell them and return the greatest possible yield to creditors.

Chapter 11 frees a company from the threat of creditors' legal action while the company reorganizes. The plan of reorganization must be accepted by a majority of the company's creditors. Unless a court rules otherwise, the debtor remains in control of the business and its assets.

In all cases under the bankruptcy code, a stay of creditor actions against the debtor automatically goes into effect when the bankruptcy petition is filed. These actions include wage garnishments, telephone calls demanding payments, and initiation or continuation of lawsuits.

Chapter 7
Sometimes referred to as "straight bankruptcy," a Chapter 7 bankruptcy liquidates a failing business through an appointed trustee who gathers and sells the debtor's nonexempt assets. Creditors receive income distributions in accordance with the priority scheme set forth in the Bankruptcy Code.

Chapter 7 relief is available regardless of the amount of debt or whether the debtor is solvent or insolvent. The debtor's personal liability for debt is dissolved. Individuals, partnerships and corporations qualify to file a Chapter 7 case.

An estate is created, which becomes the temporary legal owner of all the debtor's property. The estate consists of all legal or equitable interest of debtor and property, including property owned or held by another person if the debtor has an interest in the property. Generally speaking, the debtor's creditors are paid from nonexempt property of this estate.

A trustee is appointed by the Office of the U.S. Trustee and is confirmed by the bankruptcy court to administer the case and liquidate the debtor's nonexempt assets. If, as is often the case, all the debtor's assets are exempt or subject to valid liens -- claims on property as security for debt payment -- there will be no distribution to unsecured creditors.

If, however, the case involves nonexempt assets, unsecured creditors with claims against the debtor will be asked to file proofs of their claims with the clerk of the bankruptcy court within 90 days after the first meeting of creditors. Secured creditors aren't required to file proofs of claim to preserve their security interests or liens.

The Chapter 7 trustee's primary role is to liquidate the debtor's nonexempt assets so as to maximize the return to unsecured creditors. First, the trustee liquidates the debtor's nonexempt property -- both property the debtor owns free and clear of liens, and property with market value above the amount of any security interest, lien or exemption.

Then the trustee pursues lawsuits belonging to the debtor to recover money or property under the trustee's "avoiding powers." These powers include the right to set aside preferential transfers made to creditors within a certain number of days before the filing of the bankruptcy, and the power to pursue nonbankruptcy claims available under state law.

The court might also authorize the trustee to operate the debtor's business for a limited time if it will benefit creditors and enhance liquidation.

A meeting of creditors, conducted by the trustee, is held 20 to 40 days after bankruptcy is filed. The debtor must attend this meeting, at which creditors can appear and ask questions regarding the debtor's financial affairs and property. The trustee will also question the debtor on these matters.

The distribution of the estate's property is governed by the bankruptcy code, which sets forth an order of claims payment. The debtor is not involved in the disposition of assets, except concerning payments for debts not discharged by the bankruptcy.

Chapter 11

A Chapter 11 bankruptcy case allows the debtor to continue business operations by reorganizing the company's finances and operations, which must meet criteria specified in the bankruptcy code.

The primary argument for reorganization is that the value of an ongoing business is greater than the value of its assets that would be sold in a liquidation. A common scenario: A business owner develops financial difficulties -- typically, not being able to pay creditors due to irregular cash flow -- and files for Chapter 11.

If the business can extend or reduce its debts, or drastically lower its operating costs, it often can be returned to a viable state. Generally, it's more socially advantageous to reorganize than to liquidate because doing so preserves jobs and assets. It is more difficult to accomplish, though, because a successful reorganization requires full cooperation from all interested parties.

Filing Chapter 11 can be voluntary, that is, filed by the debtor, or involuntary, that is, filed by a certain number of creditors that meet certain requirements.

On filing, the debtor assumes an additional identity as "debtor-in-possession." This term specifies a debtor still in possession and control of assets while the business is undergoing reorganization, without the appointment of a trustee and prior to confirmation of the plan of reorganization. A trustee is rarely appointed in Chapter 11 cases.

The debtor-in-possession continues to operate the business, as well as perform many of the trustee's functions as described under a Chapter 7 case.

A disclosure statement and a plan of reorganization must be filed with the court. The disclosure statement contains information concerning the debtor's assets, liabilities and affairs sufficient to enable a creditor to make an informed judgment about the plan.

The plan of reorganization includes a classification of claims and a specification of how each class of claims will be treated. The plan must be voted on by those creditors whose claims are impaired, that is, those who will be paid less than the full value of the claims unless their contractual rights are modified. After the disclosure statement is approved and the ballots are collected and tallied, the court holds a hearing for the plan's confirmation.

The bankruptcy code places the debtor-in-possession in the position of a fiduciary, with the rights and powers of a Chapter 11 trustee, and requires the performance of all of the investigative functions and duties of a Chapter 7 trustee.

The authors thank the Clerk of the U.S. Bankruptcy Court for the Central District of California, Los Angeles Division, for providing extensive source materials. This article is for informational purposes only and is not intended to provide legal advice. This article does not express the views of Luce, Forward, Hamilton & Scripps LLP.

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