In the U.S., a financially distressed company that wishes to avoid liquidation may file for reorganization under Chapter 11 of the U.S Bankruptcy Code.
The theory of Chapter 11 reorganization is best understood by first considering traditional bankruptcy liquidation, which is found in Chapter 7 of the U.S. Bankruptcy Code. In a liquidation under Chapter 7, a trustee is appointed to marshal (i.e., gather, gain control of) all of the debtor’s assets, sell them in a commercially reasonable manner, and distribute the cash proceeds of those sales in accordance with the list of priorities described in the Bankruptcy Code. For example, claims for “administrative expenses” and wages must be paid before claims of general unsecured creditors (such as suppliers).
Secured creditors also enjoy a priority. If the value of the assets on which they hold a lien exceeds the amount of their claim, they must be paid in full. If the value of the assets on which they hold a lien is less than the amount of their claim, (a) they must be paid 100% of the value of the assets on which they hold a lien; and (b) the portion of their claim that remains unpaid is reclassified as a general unsecured claim and will be treated the same as all other unsecured claims.
The different classes of creditor claims establishes a strict priority: a member of a higher class of claims must be paid in full (unless they agree to accept less than full payment) before members of any lower class can receive any payment at all. In practice, this “absolute priority” rule usually results in little – often nothing – left for general unsecured creditors (such as suppliers) after claims in higher classes are paid in full.
The rationale behind Chapter 11 is that if a debtor can provide (in a reorganization plan) for payments to creditors at or above the level they would receive in a liquidation, then the debtor need not liquidate.
A debtor electing Chapter 11 bankruptcy is allowed to continue operating its business during the bankruptcy case. This is why the debtor is commonly called a “debtor in possession”, or “DIP.” The debtor is allowed to do anything that is “in the ordinary course” of its business while the bankruptcy case is pending without obtaining permission from the bankruptcy court or anyone else.
If the debtor wishes to do anything out of the ordinary course of its business while the case is pending, it applies to the bankruptcy court for permission. All parties who have an interest in the bankruptcy case are notified when the debtor makes such an application and they have an opportunity to object.
A debtor often arranges for a new loan to fund its operations during the bankruptcy case. Since this kind of borrowing is out of the ordinary course of the debtor’s business, court permission is required. In the Toys R Us bankruptcy, for example, a banking consortium has arranged $3.1 billion in new financing for Toys R Us. The bankruptcy court has already granted interim approval for Toys R Us to access up to $2.2 billion of that financing. A hearing is scheduled for October 10th to approve the full amount of the financing.
Once a bankruptcy case commences, creditors are barred from taking any action against the debtor without first obtaining permission from the bankruptcy court. This principle, called the “automatic stay” has two primary purposes. Firstly, it allows the debtor time to formulate a reorganization plan without the distraction of having to defend multiple creditor claims. Secondly, it ensures that claims against the debtor will be paid in accordance with the schedule of priorities set forth in the Bankruptcy Code rather than on a haphazard basis that might unfairly reward aggressive creditors to the disadvantage of other claimants.
There are many other important aspects of Chapter 11. This note merely provides an overview. For further information, please contact any of the Guantao Law Firm lawyers listed below.
Should you any further inquiries, please feel free to contact:
Jennifer Yang (Beijing, yl@guantao.com)
Ying Yin (Shenzhen, yinying@guantao.com)
Frank Huang (Shenzhen, huangfl@guantao.com), and
Shouzhi An (Xiamen, anshouzhi@guantao.com)
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