The Fundamentals of Business Bankruptcy (Reorganization and Liquidation)

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I. INTRODUCTION

Contracts govern countless commercial transactions entered each day by businesses throughout the United States. In connection with the need to promote and regulate commerce, Congress has exercised its power to establish uniform laws on the subject of bankruptcies by enacting the Bankruptcy Code (the "Code"). The Code embodies the power to alter contractual rights and is an implicit part of every contract.

In general, once a bankruptcy case has been commenced by a party to a contract, state law (and/or applicable non-bankruptcy federal law) continues to define a party's rights under the contract and federal bankruptcy law determines how those rights are enforced in a bankruptcy case. For example, damages may be calculated under state law, but they are paid out according to bankruptcy priorities and principles. Additionally, the Code contains provisions designed to promote the equal treatment of creditors with claims of the same priority.

The Code has provisions providing for reorganization and liquidation of eligible entities and is divided into different Chapters. Cases are commenced under the Code by filing a bankruptcy petition with the bankruptcy court under one of five operative Chapters: 7 (liquidation); 9 (municipal debt adjustment); 11 (reorganization); 12 (adjustment of debts of a family farmer with a regular annual income); or 13 (adjustment of debts of individuals with regular income). As far as business entities are concerned, the operative Chapters discussed in this article are Chapters 11 and 7. Chapter 11 of the Code governs reorganization cases (although Chapter 11 can be used for liquidation). Chapter 7 solely applies to liquidation cases.

The provisions in Chapters 1, 3 and 5 of the Code apply to both Chapter 11 (reorganization) and Chapter 7 (liquidation) cases. In some instances, it is feasible for entities to reorganize (e.g., through an out-of-court debt restructuring or workout) or liquidate (e.g., through an assignment for the benefit of creditors) without resorting to the jurisdiction of the bankruptcy court.

II. REORGANIZATION VERSUS LIQUIDATION

A. Chapter 11

Chapter 11 of the Code provides a framework for business reorganization (Chapter 11 may also be used for liquidation). In contrast, Chapter 7 solely involves liquidation. Upon the filing of a voluntary Chapter 11 petition, a reorganization case is commenced. Contemporaneously with the commencement of the case, the debtor (the entity filing the voluntary petition) becomes a debtor-in-possession. The filing of a bankruptcy petition creates a bankruptcy estate which includes all legal and equitable interests of the debtor in property as of the commencement of the case. The debtor-in-possession continues to control and possess property of the estate and is authorized to manage and operate its business unless and until otherwise ordered by the Bankruptcy Court. The primary goals of Chapter 11 are rehabilitation of the debtor, equality of treatment of creditors holding claims of the same priority, and maximization of the value of the bankruptcy estate.

B. Chapter 7

Chapter 7 provides a formal, judicial procedure for the orderly liquidation of the assets of the debtor and the ultimate payment of creditors in the order of priority set forth in the Code. Under Chapter 7, an independent bankruptcy trustee is appointed to conduct the liquidation and is charged with the responsibility of marshalling the debtor's assets, liquidating them, and ultimately distributing the net proceeds to creditors. The trustee is armed with powers that include the ability to avoid and recover preferential and fraudulent transfers made by the debtor and the trustee may assert claims and initiate actions on behalf of the bankruptcy estate.

C. Out-of-Court Alternatives

1. In General

In some situations, an out-of-court debt restructuring or workout involving secured and/or unsecured creditors may be a viable option for a distressed enterprise. …