Does Filing for Chapter 11 Make You a Business Failure?

In the past year or so, there has been great public debate about whether someone can be considered a successful business person if his or her business has filed for protection under “Chapter 11.” For many people, Chapter 11 is synonymous with bankruptcy, but it is actually only one of several chapters of the Bankruptcy Code that a business can utilize. In turn, “bankruptcy” is, for many people, synonymous with failure. But to professionals who focus on this area of the law, Chapter 11 many times does not mean failure.

Chapter 11 is the portion of the Bankruptcy Code (found in Title 11 of the United States Code) that governs bankruptcy restructurings. The goal of a Chapter 11 case is for the entity to emerge from bankruptcy as an operational business, either through reorganization or through a going-concern sale to new owners. In a “true reorganization,” the entity may restructure its secured debt (typically by extending payment terms or reducing interest rates), improve cash flow by obtaining approval to pay unsecured creditors a percentage of what they may be owed and over an extended period of time, streamline operations by terminating unfavorable contracts, and obtaining new equity financing. Often, creditors will approve these measures because an operating business that pays some portion of its debts is better for everyone than a business that just folds. Hopefully, the combination of bankruptcy strategies utilized by the debtor and creditors in a reorganization case allows the business to continue its operations in a stronger financial position.

The other option is for the business to sell all or substantially all of its assets through the Chapter 11 process. If this is the path the debtor chooses, it will seek court approval for a sale process, which will likely include an auction to be conducted by the bankruptcy court. The goal of this process is to sell the debtor’s business assets for the highest price and then distribute the proceeds of the sale to the debtor’s creditors in order of their priority as determined by the Bankruptcy Code. While this is similar to a liquidation proceeding under Chapter 7 of the Bankruptcy Code, the Chapter 11 sale process more often sells the business assets as a going concern, rather than selling individual assets that would be incorporated into the buyer’s existing business.

For example, say the debtor is a retail store. In Chapter 11 sale, the business assets, including the lease, the inventory, fixtures, and office equipment would be sold together to the highest bidder – essentially a “turn-key” sale. In contrast, in a liquidation sale under Chapter 7 of the Bankruptcy Code, different buyers might purchase each category of assets separately, with one person buying inventory, another buying the office equipment, etc. The biggest difference between the two types of sales is that in a Chapter 11 proceeding, the debtor’s existing management generally stays in control (absent accusations of mismanagement or malfeasance) whereas in a Chapter 7 case, a professional bankruptcy trustee is automatically appointed on a rotation system from a panel of trustees approved by the Department of Justice. Thus, even in a Chapter 11 sale, the end result is an operating business, although it might be under another name.

Successful Chapter 11 cases result in business entities that are financially and operationally stronger, and are primed for long-term success. The most gratifying outcome for those involved in the process is that a successful case preserves jobs by saving an operating business. When viewed that way, it is clear that Chapter 11 should not be synonymous with failure, but should rather be seen as a tool to save a business before its financial distress becomes too severe to overcome.