Chapter 11

What it is:

Chapter 11 bankruptcy refers to the section of U.S. bankruptcy law under which companies and individuals can attempt to restructure their debts in order to repay them.

How it works/Example:

Individuals, partnerships, or corporations can file bankruptcy under Chapter 11.

Individuals

To file Chapter 11, the debtor files a petition with the local bankruptcy court. The debtor must provide the court with financial and tax information, as well as a list of creditors and outstanding debts. In many cases, the court also requires proof that the individual has obtained credit counseling. Filing a Chapter 11 petition usually stops most collection actions against the debtor, including lawsuits, garnishments, and phone calls.

In general, Chapter 11 is for businesses, not individuals. This does not mean it's off-limits to individuals, but it does mean that filing Chapter 7 or Chapter 13 is often easier and more favorable for individuals. Most often, individuals who operate sole proprietorships, partnerships, or other businesses that are closely intertwined with their personal assets are the best candidates for Chapter 11. 

Businesses

Let's assume Company XYZ runs out of cash and can no longer service its debt load.  It might choose to file bankruptcy according to Chapter 11. By doing so, Company XYZ is required to submit a plan of reorganization that explains to the bankruptcy court, Company XYZ's lenders, and Company XYZ's shareholders exactly how it will conduct its business in order to repay its debt. Public companies must also file a form 8-K with the SEC to notify shareholders of the bankruptcy proceedings.

The U.S. Trustee (the bankruptcy division of the Justice Department) will appoint one or more committees to represent Company XYZ's creditors and shareholders. The committees negotiate with Company XYZ to try to get as much of their money back as they can, and this process can take months. The creditors, shareholders, and the bankruptcy court must approve the reorganization plan (in some cases, the shareholders vote on the plan), but the court can often overrule everyone and approve the plan anyway. The SEC also reviews the plan to make sure the disclosure is adequate and obeys the law.

Chapter 11 allows Company XYZ's existing management to continue running the business (this is referred to as "debtor in possession" or DIP), but the bankruptcy court must approve major decisions, such as the sale of a division. During bankruptcy, Company XYZ usually will not have to make interest, principal, or dividend payments. 

The seniority of lenders becomes very important in Chapter 11. Lenders whose debt is backed by collateral (secured lenders) are generally repaid first, followed by the unsecured lenders, and finally the shareholders. The reorganization plan may also allow Company XYZ to pay lenders with Company XYZ stock.

Why it Matters:

Chapter 11 is all about rehabilitation. It gives companies the chance to stay in business and control the bankruptcy process at the same time. However, reorganization is complex and expensive. Bondholders and shareholders involved with Chapter 11 bear unusually high risk, and their securities are likely to become worth pennies on the dollar (if that).

In our example, Company XYZ's stock might continue to trade, but exchanges usually delist companies that stay in bankruptcy beyond a certain time. This is not to say that Company XYZ shares won't trade again; the listing may simply be moved to the over-the-counter (OTC) market or the Pink Sheets, where the ticker will end with the letter Q to denote bankruptcy. It is important to note that Company XYZ might also issue a new class of common stock meant to replace the Q stock, and shareholders need to pay attention to which shares they are buying.

As long as the shares trade, Company XYZ will still have to file SEC reports. Furthermore, if Company XYZ is able to emerge from bankruptcy, the lenders often become the new owners of the company and the shares of the existing shareholders are usually canceled or at least substantially diluted. But miracles do happen, and companies do pull themselves out of bankruptcy. In these cases, investors can profit substantially.

If reorganization proves unsuccessful, however, companies can file bankruptcy under Chapter 7 of the code. In this scenario, the company ceases all operations, sells its assets, uses the money to pay off any debt, and shuts the doors for good.

Read on to Learn the Top Causes of Bankruptcy and How to Avoid Them.

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