Current Legal Issues Affecting Central Banks, Volume IV.

21B. An Explanation of, and Guide to, Business Reorganizations Under Chapter 11 of the U.S. Bankruptcy Code

Robert Effros
Published Date:
April 1997
  • ShareShare
Show Summary Details


An important aspect of the U.S. bankruptcy system is the emphasis and importance placed on financial rehabilitation—both for individuals and businesses. Chapter 11 of the Bankruptcy Code,1 which generally pertains to business reorganization, is a special relief chapter of the Bankruptcy Code; only persons (individuals, partnerships, or corporations) who are otherwise eligible for relief under Chapter 7 of the code (the special relief liquidation chapter of the code) may seek relief under this chapter. There is, however, no requirement that the person seeking relief under Chapter 11 be insolvent.2

Because of the cyclical nature of the business economy and the diverse types of business problems that have arisen in the past few decades, numerous businesses, ranging from small, single-asset real estate cases3 to multinational corporations, have successfully sought relief under the wide-ranging provisions of Chapter 11. Essentially, the goals of Chapter 11 are (i) to provide a statutory framework within which a debtor may formulate a plan of reorganization resulting in a broad discharge of indebtedness and other protective devices that will enable the business to continue its operations or, alternatively, (ii) to provide an organized plan of liquidation in order to maximize the going-concern value of the failed business for its creditor constituency.

In the first instance, the filing of a Chapter 11 case (primarily consisting of a petition seeking relief under Chapter 11, detailed schedules setting forth a complete and comprehensive description of assets and claims, an exhibit setting forth a summary of the financial structure of the debtor, and detailed answers dealing with various aspects of the debtor’s financial transactions) triggers the imposition of an “automatic stay,” which, subject to certain defined exceptions, creates a court-imposed moratorium on adverse actions pending or threatened against the debtor or the debtor’s property.4

An important development in many Chapter 11 cases is the appointment and role of the unsecured creditors’ committee. In addition, for partnerships or corporations, an equity security holders’ committee may also be appointed. The Office of the U.S. Trustee, acting independently of the court, will appoint a representative creditor committee, usually drawn from the 20 largest unsecured creditors and consisting of 3–5 members. This committee may retain counsel, and the expenses of the committee members incurred in connection with the performance of their duties are subject to reimbursement from the debtor’s estate. The committee possesses broad powers of inquiry and provides input during the ongoing phases of the debtor’s business operations. The committee also has legal authority to assert and pursue individual causes of action to enhance the estate if the debtor fails or refuses to pursue such actions. If the debtor’s management has engaged in fraud, gross mismanagement, or essentially any conduct constituting “cause,” the bankruptcy court may oust the “debtor in possession” (the new legal entity created by the filing of the Chapter 11 petition) and order the appointment of an independent trustee to render and investigate the debtor’s conduct. The appointment of an independent trustee will also result in recommendations concerning the debtor’s future business operations in the Chapter 11 case.5

Rights and Powers of Debtors in Possession

During every Chapter 11 case, the debtor in possession has all the rights and powers of a trustee. These rights and powers are set forth as follows:

Right to Reject or Assume Executory Contracts6 or Unexpired Leases

The right to reject or assume executory contracts or unexpired leases is an important aspect of all bankruptcy law. On the one hand, it enables the debtor in possession to rid itself of burdensome contracts or leases, subject only to the right of the nondebtor party to file a claim for damages sustained as a result of this breach; on the other hand, the debtor, in those cases in which a decision was made to derive the benefits of an advantageous executory contract, has the right to assume such a contract, even where there was an existing default, subject only to the debtor’s obligation to cure existing defaults, compensate the nondebtor party for actual damages sustained as a result of the prepetition breach, and provide assurance of future performance.

Right to Avoid or Annul Certain Prepetition Transactions

The right to avoid or annul prepetition transactions most frequently asserted pertains to certain transfers of the debtor’s property that were preferentially made to satisfy, in whole or in part, a prepetition antecedent debt within 90 days prior to the filing of the Chapter 11 case.7 The recovery of a preference will enlarge the estate for the benefit of all unsecured creditors. Other rights asserted by debtors include the right to avoid or recover property that was fraudulently transferred prior to bankruptcy, as well as property of the estate transferred subsequent to the date of bankruptcy unless authorized by the bankruptcy court; the right to avoid certain types of statutory liens that were triggered prior to bankruptcy by the debtor’s insolvency; and finally, the right to avoid any type of security interest that was not properly perfected as of the date of bankruptcy.

Right to Use, Sell, or Lease Property of the Estate

The debtor is usually free to sell property of the estate that is employed in the ordinary course of the debtor’s business (for example, inventory), as long as the sale occurs in the ordinary course of business. Sales of property outside the ordinary course may also occur, but only after notice is given and hearing held, and if certain statutory conditions are present. For example, if the debtor possesses a margin of equity in a given asset, that asset may be sold free and clear of all liens, claims, and encumbrances, with the proceeds of sale subject to any prior perfected security interest.

Right to Obtain Secured or Unsecured Credit

In the ordinary course of the debtor’s business, all extensions of unsecured credit will be allowed as an administrative expense. Through this right, the unsecured creditor is entitled to a first-priority right of payment in advance of the debtor’s other prepetition unsecured creditors. Envisaging that the debtor may otherwise be unable to obtain unsecured credit to finance its business operations, the Bankruptcy Code thus grants to the prospective creditor a super priority, or lien, on the debtor’s property.8

Right to Secure Turnover of Estate Property Seized by a Creditor Prior to the Chapter 11 Case

An important aspect of bankruptcy law—and one frequently employed in Chapter 11 cases—is the statutorily created right to seek a turnover of estate property whenever such property was lawfully seized by a creditor prior to the commencement of the case. If the seizure applies to property of the debtor’s estate and if the creditor’s security interest is not subject to avoidance in the bankruptcy case (namely, subject to one of the debtor’s avoiding powers explained previously), the debtor is entitled to a return of that property, subject only to providing “adequate protection” to the creditor.

Rights of Creditors

In order to balance the debtor’s rights available in a Chapter 11 case, the creditors also have rights and protections that are statutorily created. While unsecured creditors (namely, those creditors who lack some form of lien right, such as a consensual, judicial, or statutory lien) generally must await the confirmation of the debtor’s plan of reorganization before receiving any distribution with respect to their claims,9 secured creditors (for example, creditors asserting foreclosure rights against the debtor’s real estate) may have the right to seek relief from the broad effects of the automatic stay. In other words, secured creditors are entitled to receive adequate protection for their security interest;10 in the absence of such protection, the bankruptcy court may modify or annul the stay.11

Plan of Reorganization

The debtor in possession is required to file a plan of reorganization within the first 120 days after the Chapter 11 case has been initiated. This period of debtor exclusivity is, however, subject to either being shortened or extended, depending on the unique facts of the Chapter 11 case. In most significant cases (such as those involving large, publicly held corporations), extensions will usually be granted, within which period only the debtor enjoys the right to file a plan of reorganization. If exclusivity has expired or has been terminated by the court, any party in interest may file a plan.

As a matter of both substance and procedure, the plan of reorganization must be accompanied by a disclosure statement that sets forth “adequate information” for the benefit of a “hypothetical reasonable investor.” The plan document must also define classes of creditors and comply with specific statutory requirements. The disclosure statement represents a critical point in the progress of the Chapter 11 case because the court must approve this statement before either it or the debtor’s plan can be disseminated. In fact, neither acceptances nor rejections of the plan can be solicited prior to the bankruptcy court’s approval of such a disclosure statement.12

Confirmation of the Plan

In order to secure confirmation of the plan, the debtor must secure a simple majority in number and a two-thirds majority in dollar amount of all creditors within a given class. Assuming that the acceptance standards have been complied with, the debtor can then seek confirmation of its plan of reorganization.13

The confirmation hearing is conducted by the U.S. Bankruptcy Judge, who must make a determination that all statutory requirements have been complied with by the debtor. Essentially, these statutory requirements are set forth and explained as follows:

  • The plan complies with all plan provisions set forth under the code, and the proponent of the plan has complied with all such provisions.
  • The plan is one proposed in good faith and does not involve “any means forbidden by law.”
  • Full disclosure has been made for all payments that are to be made, and all payments for services, costs, or expenses have been approved by the bankruptcy court.
  • Full disclosure has been made as to the identity and affiliations of the debtor, and the plan sets forth certain required information with regard to post-confirmation management.
  • Where necessary, and where rates are involved, government regulatory approval has been secured.
  • With respect to any impaired class of claims, each individual claimant must have accepted the plan, or there must be evidence that the claimants will receive at least what would be received in a Chapter 7 (liquidation) case.
  • Each class of claims set forth in the plan has accepted or is deemed to be unimpaired under the plan.14
  • Special payment provisions will be made for defined priority claims, which will usually require payment in full or, in the case of tax claims, deferred payments over a six-year period.
  • Where claims are impaired under the debtor’s plan, there should be at least one accepting noninsider class.
  • An express finding has been made by the bankruptcy court that the plan is feasible and is not likely to be followed by liquidation or require the need for further financial reorganization (except where the debtor’s plan is one of liquidation).
  • All required fees to the U.S. Trustee have been paid.
  • Special protective rights owed to retirees will be continued under the plan.

However, if a certain class of creditors has not accepted the debtor’s plan of reorganization,15 and as long as there is at least one accepting noninsider class of claims, the debtor may attempt to obtain a “cram down” of the plan against the dissenting creditor class. A cram down essentially requires that the bankruptcy court find the plan of reorganization to be “fair and equitable” and not unfairly discriminatory with respect to any class of creditors.

Confirmation of the plan effects a broad discharge for the debtor of all claims arising prior to the confirmation order and causes all property interests to be vested in the debtor pursuant to the provisions of the plan. Subject to statutorily created exceptions (for example, where the debtor has filed a plan of liquidation and will no longer remain in business sub-sequent to the Chapter 11 confirmation date), the legal effect of a Chapter 11 discharge is broad in scope and affects all creditors, regardless of their acceptance or claims status.


The framework of Chapter 11 of the U.S. Bankruptcy Code is based on several important legal principles, all of which stress the need for (i) a legally imposed moratorium, within which creditors are compelled to desist from any action or legal proceeding that affects the debtor or its property; (ii) full and adequate disclosure of all relevant information to creditors; and (iii) meaningful participation of creditor or equity security holders in the case through formal committees. In addition, the Bankruptcy Code establishes (i) the ability of the debtor to reject burdensome executory contracts or to assume without penalty contracts that are advantageous; (ii) the ability of the debtor to secure debtor-in-possession financing in order to continue necessary business operations; and (iii) the ability to bind dissenting creditors subject to the acceptance and cram down standards set forth under the Bankruptcy Code. At the same time, the Bankruptcy Code recognizes that creditor rights must be considered and protected; accordingly, it encourages and provides creditors with powerful statutory rights (for example, participatory rights as a committee, strict but flexible notice of hearing requirements binding on the debtor, strict disclosure requirements with respect to the formulation of a plan, and rights to recover previously transferred property in violation of certain code sections).

For most of the major national and transnational corporations that have been compelled to seek relief under Chapter 11, the rehabilitative provisions of the bankruptcy law not only have resulted in successful reorganizations but have saved countless jobs, provided a significant return to creditors, including taxing authorities, and enabled the debtors to preserve the going-concern value of their businesses. Unfortunately, because of the expense and delay inherent in the legal process, most small businesses have not fared so well.16 Nevertheless, Chapter 11 remains one of the most important economic safety nets in the U.S. legal system today.

    Other Resources Citing This Publication