Chapter 11 Bankruptcy

Chapter 11 bankruptcy is a case under chapter 11 of title 11 of the United States Code, the chapter that lets a debtor, almost always a business, reorganize its affairs and continue operating under court supervision rather than be liquidated. The SEC's investor bulletin on public-company bankruptcy puts it in one sentence: under Chapter 11 "the company seeks to reorganize its business and, in particular, restructure its debt obligations." Management often continues to run day-to-day operations, "but all significant business decisions must be approved by the bankruptcy court," and a company that succeeds "will emerge from bankruptcy with more manageable debt obligations."

The general bankruptcy page covers what every chapter shares, including the automatic stay that stops collection on the day of filing, and the Chapter 7 and Chapter 13 pages cover the two chapters individuals use. This page covers Chapter 11 from the outside, as the holder of a company's stock or bonds meets it: who runs the company during the case, how a plan is proposed and voted on, the priority rule that decides who gets paid, and what the SEC says about trading the securities of a company in the middle of it.

The company stays in charge of itself. In most Chapter 11 cases no trustee is appointed. Section 1101 defines the "debtor in possession" as the debtor itself, and section 1107 gives a debtor in possession "all the rights ... and powers" of a trustee and requires it to perform a trustee's duties other than the investigative ones. The federal judiciary's own guide describes this as placing the debtor "in the position of a fiduciary." The U.S. Trustee monitors the case and appoints a committee of the largest unsecured creditors, which negotiates with the company on the creditors' behalf. A trustee or examiner can be appointed for cause, but that is the exception, which is why a company in Chapter 11 keeps announcing results and running stores while its debts are restructured around it.

The plan, the vote, and who gets a say. Section 1121 gives the debtor the exclusive right to file a plan for the first 120 days after the case begins, extendable by the court but never beyond 18 months, after which any party in interest may propose one. Before votes can be solicited, section 1125 requires a court-approved disclosure statement containing "adequate information" about the debtor and the plan. Claims and interests are sorted into classes, and each impaired class votes. Under section 1126 a class of creditors accepts when holders of "at least two-thirds in amount and more than one-half in number" of the claims actually voted accept, and a class of equity interests accepts on two-thirds in amount alone. A class that receives nothing under the plan is deemed to have rejected it. The SEC's bulletin translates this for a securities holder: "you may be asked to vote on the plan of reorganization," and before you do you should receive the plan or a summary, the court-approved disclosure statement, a ballot, and notice of the confirmation hearing and objection deadline.

Confirmation, and the rule that erases old equity. Section 1129(a) lists the requirements for confirming a plan, one of which, at (a)(8), is that every impaired class has accepted it. When a class rejects, section 1129(b) lets the court confirm anyway, at the plan proponent's request, if the plan "does not discriminate unfairly, and is fair and equitable" as to each rejecting class. For a rejecting class of unsecured claims, "fair and equitable" includes the condition that "the holder of any claim or interest that is junior to the claims of such class will not receive or retain under the plan on account of such junior claim or interest any property." Common stock is junior to every creditor, so this clause, known as the absolute priority rule, means a dissenting creditor class cannot be forced to accept a plan that lets shareholders keep anything. The parallel clause for a rejecting class of interests protects preferred holders against common holders in the same way. Under section 1141, confirmation discharges the company from its pre-confirmation debts unless the plan says otherwise, and the legislative history records that the discharge "also terminates all rights and interests of equity security holders" as the plan provides.

Why the SEC says the stock is likely to be worthless, and why it keeps trading anyway. The bulletin's reasoning follows directly from the priority scheme: "the common stock (that is, 'equity') is the last in line to receive what's available," creditors including bondholders, suppliers and employees "all come before holders of the company's common stock," and "even if a company successfully reorganizes, its plan of reorganization often cancels the existing shares of common stock." The new shares of the reorganized company typically go to creditors "as settlement," and holders of the old stock "generally do not receive any of these shares." What confuses investors is that the old shares often trade throughout a case that "may take months, if not years." The SEC notes that "there is no federal law that prohibits trading of securities of a company solely because it is in bankruptcy," that a bankrupt company is "generally unable to meet the listing standards" of the exchanges and so is typically delisted, and that its shares "may continue to trade on over-the-counter securities markets." The bulletin adds that a "Q" may be added to the stock symbol to indicate bankrupt status, and that if the reorganized company issues new stock, the new shares trade without the "Q" while any still-traded old shares keep it. A bondholder is in a different position from a stockholder: bonds are claims, they vote in their class, and they are frequently the securities that receive the reorganized company's new equity.

Three variants worth naming. A Chapter 11 case can end in liquidation rather than reorganization: section 1112 lets the debtor convert to Chapter 7, and lets the court convert or dismiss the case for cause, and the SEC notes a securities holder may receive notice of a hearing if the company converts. A plan can also be negotiated and voted on before the petition is filed, a "prepackaged" case that section 1126 contemplates by counting pre-petition acceptances solicited with adequate disclosure. And since 2020, small businesses below a statutory debt ceiling may elect subchapter V, a streamlined track in which only the debtor may file a plan, a trustee is appointed to oversee it, and relaxed confirmation rules apply. The debt ceiling for subchapter V has been changed by Congress more than once and is not stated here; the federal judiciary's Bankruptcy Basics page carries the current figure.

A company files a petition, becomes a debtor in possession, and keeps operating under the automatic stay while the U.S. Trustee appoints a creditors' committee. Within its exclusivity period the company proposes a plan and a disclosure statement; once the court approves the disclosure statement, the impaired classes vote. If every impaired class accepts and the other requirements of section 1129(a) are met, the court confirms the plan; if a class rejects, the court can confirm only if the plan is fair and equitable to that class, which for creditors means nobody junior to them keeps anything. On the effective date the plan's distributions are made and the old securities are treated as the plan provides.

A hypothetical example of how the priority rule allocates value. Harbor Tool Company files under Chapter 11 owing $400 million to secured lenders and $300 million to unsecured bondholders, and its common shareholders hold 50 million shares. The plan values the reorganized company at $450 million. The secured lenders' claims are paid in full: $400 million, in the form of new secured debt. That leaves $50 million of value, against $300 million of unsecured claims, so the bondholders receive all of the new company's stock, worth about 17 cents on the dollar ($50 million divided by $300 million). The old common shares receive nothing and are canceled. If the plan had instead proposed to give the old shareholders 5 percent of the new stock, the bondholders could reject it, and under section 1129(b)(2)(B)(ii) the court could not confirm it over their objection, because a junior class would be retaining property while a senior class went unpaid. Had Harbor's old shares still been trading at $2 during the case, a buyer of 1,000 shares would have paid $2,000 for a security the confirmed plan valued at zero.

Pros

• The business keeps operating, which preserves jobs, contracts and the value of the enterprise as a going concern; a liquidation usually recovers less for everyone.
• Creditors get a vote, a court-approved disclosure statement and a statutory priority scheme, so a plan cannot simply be imposed on them.
• Bondholders often end up owning the reorganized company, which means a creditor's recovery can include the upside of a business that has shed its old debt.
• The disclosure statement, the plan and the company's Form 8-K filings are public, so an investor can read exactly what each class is proposed to receive before deciding anything.

Cons

• Common stock is last in line, and a confirmed plan usually cancels it; the SEC's guidance is that the old shares are "likely to be worthless."
• The old shares can keep trading at prices that bear no relation to what the plan will give them, so a buyer in mid-case is paying for a claim the plan may value at zero.
• Cases run for months or years, the professionals' fees are administrative expenses paid ahead of unsecured creditors, and a case can convert to a Chapter 7 liquidation partway through.
• A company in Chapter 11 is typically delisted from its exchange, so even holders who mean to sell face a thinner over-the-counter market.