Chapter 11: Three Reasons Why Reorganizations Fail

Chapter 11 is a powerful tool to help businesses and high income individuals restructure their debt. The ability to modify secured claims, reject burdensome leases and negotiate steep creditor discounts create unparalleled opportunities to give new life to struggling debtors. However, the right to reorganize is not absolute: debtors need to be able to prove that they can identify sufficient profits to make some meaningful distribution to their creditors. Most Chapter 11 cases fail, for one of the following reasons:

Losing Money. Turning distressed companies profitable is the primary goal of Chapter 11. The central reorganizing philosophy is that if a business has breathing room from creditors and can focus on its core business lines, it has the best chance to make more money than it spends. Once a company shows a track record of profitability in Chapter 11 it can propose a plan of reorganization detailing its proposed repayment of creditors.

Unfortunately, many companies never achieve profitability. Instead, high operating expenses, low margins and cash flow crises result in prolonged losses. Debtors need to report these losses in monthly operating reports filed with the Bankruptcy Court. Once these losses are spotted by a bank, a creditors committee or the Office of the United States Trustee (a division of the US Department of Justice charged with overseeing the entire bankruptcy system) the debtor should expect to soon face a motion to convert the Chapter 11 case to Chapter 7. If a debtor has significant assets, continuing losses will erode that asset base and reduce the recovery available to creditors if those assets need to be sold. Of course, a debtor’s management wants to remain in control with its assets intact; otherwise, the business must close. Therefore the debtor is more than willing to sustain losses in the hope that the business will turn itself around. However, keeping the doors of a business open while liabilities continue to mount means that the company is gambling with creditors’ money. Neither creditors nor the Court will permit a reorganization to go on for very long when business losses threaten to obliterate the debtor’s asset base.

Fraud or Mismanagement. Chapter 11 and the bankruptcy system as a whole are based largely on the honor system. A debtor sets out its assets, liabilities, and statement of financial affairs under penalty of perjury. The bankruptcy world tends to take most of these representations on faith because it would be prohibitively expensive to verify each and every financial statement a debtor makes in the bankruptcy case. In Chapter 11 specifically, debtor’s management remains in place once the bankruptcy case is filed. Management assumes the role of “debtor in possession” with all the powers of a trustee. As a fiduciary, the debtor’s management owes the highest duty of care and honesty to its creditors.

At the same time, debtors face constant anxiety that their shaky finances will collapse and they will lose the protections from creditors. Moreover, debtors frequently want to retain as many assets as possible while paying as little as they can to creditors. This imbalance of goals and allegiances frequently cause debtors to compromise their integrity. However, once the trust is gone the debtor’s control over its assets will quickly follow. If a creditor can prove that the debtor has mislead creditors or the court a bankruptcy judge will not hesitate to convert the reorganization case to a Chapter 7 liquidation (although sometimes, if the debtor retains significant valuable assets, creditors will request that the debtor be liquidated under the supervision of a trustee in Chapter 11 instead of Chapter 7).

A Powerful Enemy. In Chapter 11, creditors have the right to vote to accept or reject their treatment under a plan of reorganization. Although the debtor may force some of its rejecting creditors to accept proposed treatment, frequently the configuration of creditors and claims will vest in a single large creditor the right to control whether a plan is approved by the bankruptcy court. Such a creditor may be a bank with a large unsecured deficiency claim or a litigation adversary who has (or is likely to get) a large judgment. If this powerful creditor is hostile to the debtor it may become impossible for the debtor to obtain approval of a Chapter 11 plan. In that event a bankruptcy judge will likely find that cause exists to convert the Chapter 11 case to Chapter 7.

For most businesses, conversion to Chapter 7 is a death sentence. A trustee will be appointed and will be looking to quickly liquidate the debtor’s assets for cash. The debtor’s management will lose control of the business. Sometimes, if the trustee believes that the officers have been dishonest he will sue the officers for recovery of compensation or for errors and omissions. In any event, conversion to Chapter 7 will generally signal the end of a debtor’s hopes to save the company.

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