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Chapter 11 Summary

A primary difference between a Chapter 7 liquidation and a Chapter 11 reorganization is that the Chapter 11 estate is generally managed by the debtor (called a “debtor in possession” — “DIP”) instead of a trustee.  A second primary difference is that the DIP is given a chance to reorganize his, her or its affairs.

A chapter 11 bankruptcy is an extremely potent tool in the hands of the debtor. The filing of the chapter 11 case imposes the automatic stay under 11 U.S.C. §362(a). This completely stops all actions on the part of any creditor to attempt to collect on existing debts or to even improve the creditor’s position or security of their debt.

After the filing of the chapter 11 case, the DIP remains in exclusive control of all of the properties and their other assets and generally has the power to operate an ongoing business under § 1108 of the Code. Once a chapter 11 case is filed, there is a period of between three and six months  during which no party, except the debtors, can effectively take any action whatsoever, and the DIP is given the exclusive right to propose a plan of reorganization.  11 USC § 1121.

The debtor in possession also has a number of other “super-powers” in a Chapter 11 case, including the right to reject unfulfilled leases and other contracts (called “executory contracts”) under 11 USC § 365, or assume them and assign them to other entities if that would be more beneficial to the debtor’s efforts to reorganize.  The DIP can also take other actions to modify existing contracts, partially or completely strip liens that secure the debtor’s property(ies) and in some cases avoid liens that otherwise would bind a debtor outside of bankruptcy. 

The public policy behind the bankruptcy law strongly favors debtors and is designed to allow debtors to reorganize. During this period of time, the debtors will take a variety of actions to minimize their exposure to the parties in litigation and to maintain control of the properties to the extent they may be able to profit from doing so. To the extent parties hold secured debt, through the bankruptcy process, some of that debt may be determined to be unsecured, and “peeled off” of the property. Thus, in bankruptcy, debt of lenders/sellers that may be secured under California law may be deemed unsecured claims. Judgment creditors who have secured their claims may have the secured status stripped off. To the extent a claim is determined to be unsecured, the claim would only require payment in the amount that the claim would be paid in a chapter 7 case.

Similarly, to the extent debtors can demonstrate that any property is reasonably necessary for the effective reorganization , the debtor may be able to retain control over that property for as long as two years after the case is filed, without payment to a lender. To the extent the debtor will incorporate a property into the debtor’s reorganization, the debtor can “impair” the claim of a creditor whose debt is secured by the property. As one example, the debtor may be able to have the court greatly reduce the interest rate, as necessary for the reorganization of the debtor.

The bankruptcy prevents lenders from taking action against the debtor during this time. However, it does not prevent the debtor taking action against creditors.

The ultimate goal in a Chapter 11 is to emerge from bankruptcy without debts, judgments, security interests or ongoing contractual obligations (such as leases or employee agreements) that may have placed the debtor into bankruptcy in the first place. Aside from reducing the status of various claims as described above, the debtor must come up with and get approved a plan of reorganization.

Requirements of a Plan

In order to confirm a Chapter 11 plan, there are a number of requirements. Among them are:

  1. Similar claims must be treated similarly and putting one creditor in another class separate from other similarly situated creditors may be prohibited where the primary purpose is to get a confirmable plan (In re Barakat [9th Cir. 1996] 99 F.3d 1520, 1525). But, some claims can be subordinated under certain circumstances, which can  make the subordinated claim different from general unsecured claims. In re US Financial Inc. 648 F.2d 515, 523 (9th Cir. 1980).
  2. The plan must be in good faith and feasible, meaning among other things able to be carried out in a reasonable period of time, and must have “adequate means” for implementation (e.g., based in reality on projected sales prices, income, etc.) 11 USC § 1123(a)(5).
  3. Unsecured claims have to be paid within five years in an individual case. 11 USC § 1129(a)(15).
  4. Unsecured creditors must get at least as much in plan payments as they would in a Chapter 7 liquidation.
  5. Individual debtors must devote their monthly disposable income (as measured by a Chapter 13 means test) unless they are to be paid in full by other methods such as by sale of assets. 11 USC § 1129(a)(15).
  6. The plan can be formed other than just from disposable income, such as a liquidating plan in which payments are funded by the sale of assets.
  7. If a plan is to pay any class of creditors less than the full amount, the class is “impaired” and at least one “impaired class” must approve the plan.
  8. Administrative claimants must have their fees approved, and must be paid at the commencement of the plan unless lesser treatment is agreed to by the claimants. 11 USC § 1129(a)(9).
  9. The debtor must continue to file taxes, report to the OUST, and pay US Trustee fees for the life of the plan or until the case is converted or dismissed. 28 USC § 1930; 11 USC § 1106.

While these hurdles can appear daunting, the Chapter 11 debtor’s ability to have the court modify contracts, subordinate claims or strip liens, and other powers can assist in creating an environment where creditors become more willing to negotiate in a bankruptcy case than they would have been outside a bankruptcy.