Chapter 11 is a chapter of the United States Bankruptcy Code which governs the process of reorganization under the bankruptcy laws of the United States (The Bankruptcy Code itself is Title 11 of the United States Code therefore reorganization under bankruptcy is covered by Chapter 11 of Title 11 of the United States Code.) In contrast, Chapter 7 governs the process of a liquidation bankruptcy.

Definition

When a troubled business decides that it is unable to service its debt or pay its creditors, it can file (or be forced by its creditors to file) with a federal bankruptcy court for bankruptcy protection under either Chapter 7 or Chapter 11. A Chapter 7 filing means that the business intends to sell all its assets, distribute the proceeds to its creditors, and then cease operations. A Chapter 11 filing, on the other hand, is an attempt to stay in business while a bankruptcy court supervises the "reorganization" of the company's contractual and debt obligations. The court can grant complete or partial relief from most of the company's debts and its contracts, so that the company can make a fresh start. Often, if the company's debts exceed its assets, then at the completion of bankruptcy the company's owners (stockholders) all end up with nothing — all their rights and interests are terminated — and the company's creditors end up with ownership of the newly reorganized company, in the hopes that it will eventually succeed financially as compensation for their losses.

Rationale

It is often the case that the value of a typical business as a going concern is higher than the value of the sum of its parts if the business's assets were to be sold off individually. It follows that it may be more economically efficient to allow a troubled company to continue running, cancel some of its debts, and give ownership of the newly reorganized company to the creditors whose debts were cancelled; in this way, jobs are saved, assets are retained, the engine of profitability which is the business is maintained rather than being dismantled, and, as a proponent of a Chapter 11 plan is required to demonstrate as a precursor to plan confirmation, the business's creditors end up with more money than they would in a Chapter 7 liquidation.

Details

All creditors who register with the court can be heard by the court, which is responsible for determining whether the plan of reorganization complies with the purposes of the bankruptcy law and provides for fair and equitable treatment of all parties in interest. Priority of claims is determined by Section 507 of the Bankruptcy Code, but as a general rule secured creditors, such as some banks and bondholders, have a higher-priority claim on the proceeds of the sale of corporate assets than unsecured creditors, such as vendors who have not been paid for products they previously delivered to the company (and who do not have any collateral for their claim). Once a business files for Chapter 11 bankruptcy, its creditors are not allowed to attempt to collect previously incurred debts except through the bankruptcy court. Under some circumstances, the creditors or the United States Trustee can ask the court either to convert the case to a liquidation under Chapter 7, or to appoint a trustee to manage the debtor's business. The court will grant a motion to convert to Chapter 7 or appoint a trustee if either of these actions is in the best interest of all creditors (appointment of a trustee also requires some wrongdoing or gross mismanagement on the part of existing management, and is relatively rare).

Typical debts and contracts cancelled in a Chapter 11 bankruptcy include unsecured loans and, if cancelling them would be financially favorable to the company, ubion contracts, supply or operating contracts (with both vendors and customers) and long-term real estate leases.

Chapter 11 is not liquidation; it is reorganization. Once Chapter 11 is filed, the company may "emerge" from bankruptcy within a few months or within several years, depending on the size and complexity of the bankruptcy. All debtors filing Chapter 11 cases are required to propose a plan of reorganization: if the debtor fails to make a proposal, the court may consider proposals from creditors. If no plan of reorganization is approved by the court (this process is called confirmation) then the court may either convert the case to a liquidation under Chapter 7 or, if in the best interests of the creditors and the estate, the case may be dismissed resulting into a return to the status quo before bankruptcy.

Stock

If the company's stock is publicly traded, a Chapter 11 filing generally causes it to be delisted from its primary stock exchange if it was listed on the New York Stock Exchange, the American Stock Exchange, or the NASDAQ. On the NASDAQ the identifying fifth letter "Q" at the end of a stock symbol indicates the company is in bankruptcy (formerly the "Q" was placed in front of the pre-existing stock symbol; a celebrated example was Penn Central, whose symbol was originally "PC" and became "QPC" after the company filed Chapter 11 in 1970). Many stocks that are de-listed quickly resume listing as over the counter (OTC) stocks. However, once a publicly traded company emerges from Chapter 11, the stock is typically nullified (by the order of the bankruptcy court) rendering the OTC shares worthless.

Individuals may also file Chapter 11, but due to the complexity and expense of the proceeding, this option is rarely chosen by debtors who are eligible for Chapter 7 or Chapter 13 relief.

Criticism

Some critics have claimed that Chapter 11 bankruptcy is excessively lenient in giving a needless "escape hatch" to the incompetent management of a failing company, damaging the efficiency of the economy as a whole and allowing poor managers to continue managing. It is unusual for the management of a company in Chapter 11 to be fired, as it is usually assumed that the present management team knows far more about the company and its customers than would a new set of management. These critics note that in Europe, bankruptcy law is far less lenient for failing companies.

Another efficiency criticism is that a company undergoing Chapter 11 bankruptcy is effectively operating under the "protection" of the court until it emerges, in some cases giving the bankrupt company a great advantage against its competitors, distorting the market and harming more competitive businesses. Where a key market participant (or more than one) goes into Chapter 11, it can also result in significant over-capacity in the industry. The most-cited current example is the airline industry in the United States; as of 2006, over half the industry's seating capacity is on airlines that are in Chapter 11 . These airlines have been able to stop making debt payments, freeing up cash to expand routes or weather a price war against competitors — all with the bankruptcy court's approval. This is especially important in the airline industry as fixed capital costs for the airplanes (and the debt on those costs) make up such a large part of the airlines' expenditures.

Others criticise the process on the basis that, by forestalling the creditors' rights to enforce their security in the event of non-payment, it reduces the economic value of collateral in the United States, and thereby increases the cost of secured lending. However, studies on the subject seem to reach different conclusions on the extent of this, or indeed whether it is in fact the case at all in practice ^[2].

Statistics

Federal vs. state bankruptcies

Chapter 11 bankruptcy cases dropped by 60% from 1991 to 2003. One 2007 study found this was because businesses were turning to proceedings under state law, rather than the federal bankruptcy proceedings which include Chapter 11 filings. Insolvency proceedings under state law, the study stated, are currently faster, less expensive, and more private, with some states not even requiring court filings. However, a 2005 study^[4] claimed the drop may have been due to an increase in the incorrect classification of many bankruptcies as "consumer cases" rather than "business cases".

Cases involving more than US$50 million in assets are almost always handled in federal bankruptcy court, and not in a state proceeding.