Chapter 11 Bankruptcy: How It Works and What to Know
Key takeaways
- Chapter 11 bankruptcy lets companies and some individuals stay in business while reorganizing their finances to manage their debt.
- You must prove your business can survive its debt repayment in order for the court to approve the reorganization plan.
- Chapter 11 bankruptcy comes with downsides, such as hurting the company’s reputation and financial health.
If your business is behind on its bills or suffering low cash flow, you might not need to throw in the towel. Chapter 11 bankruptcy gives businesses (and some individuals) time to fix their finances through reorganization.
About one in four small businesses don’t make it past their first year, usually due to cash flow problems. But this can sometimes be avoided by getting a fresh start with a Chapter 11 bankruptcy.
What is Chapter 11 bankruptcy?
Chapter 11 bankruptcy lets a business stay up and running while it reorganizes its finances under the supervision of a court in order to deal with its debt.
Some individuals can also file a Chapter 11 if their debt is above the limits for a Chapter 13 bankruptcy.
After filing a voluntary petition for Chapter 11 bankruptcy, the debtor comes up with a reorganization plan that can make changes to the terms of their debt. The impacted creditors can vote on the plan, and after the bankruptcy court confirms it, the debtor must then fulfill all the plan’s requirements.
Small businesses may have two other options that are quicker and don’t automatically involve a committee of creditors, but which also come with extra duties for the debtor.
- A small business case for those with $3,024,725 or less in primarily business debt.
- A subchapter V case is for those with $7,500,000 or less in primarily business debt. It also has relaxed requirements for confirming the reorganization plan.
Chapter 7 vs. Chapter 11 vs. Chapter 13 bankruptcy
Bankruptcy comes in three main types: Chapter 7, Chapter 11 and Chapter 13. Each is handled differently.
| Chapter 7 | Chapter 11 | Chapter 13 | |
|---|---|---|---|
| Who qualifies | Low-income individuals or businesses with primarily business debt | Businesses or individuals with $2,750,000 or more in combined debts | Individuals and sole proprietorships with regular income and combined debts of less than $2,750,000 |
| Primary goal and outcome | Business termination and/or discharge of eligible debts | Reorganization of business or personal debts to stay in business or keep property, or liquidation with more control over the outcome than with Chapter 7 | Reorganization of debt while keeping property and protecting cosigners |
| Process | Liquidation of nonexempt assets by a trustee to pay creditors | Varies depending on the Chapter 11 category, but usually requires the debtor to make a reorganization plan with oversight from a U.S. trustee and creditors | Debtor files a 3-5 year repayment plan with help from a credit counselor. Creditors meet with the debtor, and then the court confirms the plan. A trustee distributes the funds to creditors, and the remaining debts may be discharged |
| Cost and fees | $335 in court fees (waived for some low-income individuals), plus attorney fees | $1,738 in court fees, plus quarterly fees to the U.S. trustee (ranging from $325 to $30,000) and attorney fees | $310 in court fees, plus attorney fees |
Bear in mind that all bankruptcies provide an automatic stay that stops collection attempts and legal action against the business or individual for most debts.
What happens when a company files Chapter 11 bankruptcy?
A business that files Chapter 11 bankruptcy can typically expect the following outcomes:
- Creditors stop trying to collect: Bankruptcy filing provides an automatic stay, so you’ll no longer get calls from creditors or debt collectors. Filing can also stop a lawsuit to recover debt.
- The business may get debt relief: A reorganization plan may help the business get lower payments. Some eligible debts may even be eliminated.
- The company reputation takes a hit: Bankruptcy records are publicly available, so the filing robs your business of some of its privacy and can also result in a loss of public trust or a negative reputation.
- The court oversees operations: During a Chapter 11 bankruptcy, the U.S. trustee monitors the debtor’s business operations, requiring reporting and sometimes other tasks. The oversight can be a hassle for business owners and employees and could even result in delays in service that hurt customer satisfaction.
- Business and/or personal credit score declines: Chapter 11 bankruptcy harms the credit score of a business, and even an individual’s credit score, depending on the business entity and whether the debt was personally guaranteed.
- Shareholders will be impacted: Company stockholders vote on the debtor’s reorganization plan. Some businesses offer shareholders compensation to encourage plan approval, but it’s not always needed. Existing shares are often canceled and replaced by new ones once the reorganization plan is confirmed.
- Executive and officer salaries may be capped: The court may limit compensation for certain key stakeholders in the company while the reorganization plan is in effect.
- The business might end up in Chapter 7: Not all reorganization plans are successful, and many businesses that file Chapter 11 end up shutting down entirely.
How to file Chapter 11: The process explained
The exact process for a Chapter 11 bankruptcy depends on different factors, but debtors can generally expect to take the following steps, as outlined in the bankruptcy code:
1. Filing of the petition and other documents
A debtor files a voluntary petition (as outlined in Form B 101) with the local bankruptcy court. The debtor must also file documents showing assets and liabilities, income and expenditures, active contracts and leases and a statement of financial affairs. Individual filers must submit additional documents.
2. Payment of fees
Debtors must pay $1,738 to the court clerk when filing, unless the court approves an installment plan for an individual filer.
3. Identification of “debtor in possession”
When filing a voluntary petition, the debtor includes a request for relief, which automatically designates them as the “debtor in possession.” This person typically operates the business and performs most of the duties that a bankruptcy trustee would perform under other chapters.
4. Filing of reorganization plan
The debtor must include a reorganization plan or an intent to file a plan with the petition. After filing the petition, the debtor must propose the plan within a certain timeframe (usually 120 days, unless the debtor is filing under a small business subchapter or the court offers an extension).
If the debtor doesn’t meet the deadline, a creditor may file a competing plan. The plan should include:
- All debts owed
- Which debts will be repaid and how
- Guidelines for business operations during repayment
- Who will oversee the plan
5. Approval of disclosure statement
In most cases, the court needs to approve a disclosure statement that outlines the company’s financial affairs before voting can take place. Small business cases may be exempt.
6. Voting
Creditors impacted by the plan, such as those not receiving full payment, and shareholders (if any) have the opportunity to vote on the plan of reorganization.
7. Plan approval, conversion or dismissal
The court may approve the plan, or it may convert or dismiss the case with cause. Generally, the plan must prove that the business has a reasonable chance of staying afloat. Plans may also be dismissed or converted to Chapter 7 for various other reasons.
8. Ongoing plan administration
The debtor in possession usually implements the plan and reports to the U.S. trustee every quarter, through UST Form 11-PCR. The process is different for small business cases, but ongoing reporting is still required.
9. Closure of case
If the debtor needs more time for repayment, the case may be closed temporarily, or the court may issue a final decree if the plan is mostly complete.
Alternatives to Chapter 11 bankruptcy
Chapter 11 bankruptcy gives businesses a second chance to succeed. But there are many pros and cons to filing for bankruptcy, and it may not be best for every business. Before filing, consider the alternatives below.
Debt consolidation
Businesses with less than $5 million in debt may consider a business debt consolidation loan. Debt consolidation involves taking out a new loan with a lower interest rate or easier repayment terms and using the money to pay off existing business debts.
Business owners can also apply for a personal loan to consolidate debt if the business doesn’t qualify.
Assignment for the benefit of the creditors (ABC)
In some states, insolvent debtors can have a third party liquidate the company’s assets to pay off its creditors. The process happens outside of court and may limit reputational damage and liabilities for business owners and managers.
Section 363 sale
A 363 sale is a legal process under Chapter 11 of the bankruptcy code that allows for the quick sale of a business without the buyer taking on liens or liabilities.
It’s an alternative to a reorganization plan or liquidation plan, and the debtors may get higher returns from this process, thanks to competitive bidding.
Debt management plan
A debt management plan is a type of debt consolidation tool offered by nonprofit credit counseling agencies. Your business makes a monthly payment to the agency, which negotiates better interest rates, lower fees or different terms with your creditors and distributes the funds on your behalf.
However, not all business debts, including secured loans, may be eligible for inclusion in these plans.