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Chapter 11 vs. Chapter 7 Bankruptcy

Step-by-Step Guide to Understanding Chapter 11 vs. Chapter 7 Bankruptcy

Last Updated November 15, 2023

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Chapter 11 vs. Chapter 7 Bankruptcy

Chapter 11 Bankruptcy vs. Chapter 7 Bankruptcy

Under the oversight of the Bankruptcy Court, the debtor has the opportunity to emerge from Chapter 11 as a viable business with a better-aligned capital structure.

Conversely, during Chapter 7, the assets belonging to the debtor are liquidated to pay off liabilities owed to creditors in accordance with the absolute priority rule (“APR”) and the business ultimately ceases to exist.

Regardless of whether the corporation determines if Chapter 11 or Chapter 7 is the right course of action for its circumstances, the decision by the debtor is legally required to be in the “best interests” of the impaired creditors.

If an actual turnaround of the debtor seems plausible and the catalyst for the financial distress is deemed temporary and/or one that the company could adapt to, filing for Chapter 11 could be the right choice.

But liquidations under Chapter 7 can often be an unavoidable outcome, as not every company is suited for a reorganization. Instead, an irrational attempt at a turnaround could put the debtor in a worsened state and further reduce the recovery proceeds belonging to creditors.

The decisive factor for whether to file for Chapter 11 or Chapter 7 comes down to the perceived value of the enterprise post-reorganization.

Chapter 11 Bankruptcy: In-Court Reorganization Process

Chapter 11 is designed to facilitate the rehabilitation of the debtor by giving it “room to breathe” through protective measures as it puts together a plan detailing a strategy to turn itself around.

Under Chapter 11 protection, the debtor in possession has time to put together and propose a plan of reorganization (POR) that must receive approval from the Court while sufficiently meeting the voting criterion from creditors.

If successful, the recovery rates will be higher under Chapter 11 than Chapter 7 liquidation and are normally the preferred option by the debtor and most creditors.

The financial distress catalyst will differ case by case, but in nearly all cases it is related to irresponsible or poorly timed debt financing.

Chapter 11 bankruptcies involve the debtor renegotiating the terms of its debt obligations with creditors to emerge from bankruptcy such as:

  • “Amend and Extend” Provisions
  • Cash Interest to Paid-in-Kind (“PIK”)
  • Debt-to-Equity Swap

Learn More → Chapter 11 Bankruptcy Reorganization (IRS)

Chapter 11 Bankruptcy Drawbacks: In-Court Fees

Considered to be the more complex form of bankruptcy between the two types, Chapter 11 comes with much greater costs, which is its most common criticism. For more extended processes, in particular, the costly nature of Chapter 11 can be a concerning drawback.

Unlike Chapter 7, Chapter 11 provides the debtor with a rare opportunity to reorganize its debt obligations and re-emerge as a more operationally efficient company (i.e., a second chance to redeem itself). But in return for the avoidance of liquidation, the professional fees such as legal and Court expenses can accumulate into a substantial bill, which is one of its main disadvantages.

Chapter 11 Bankruptcy: In-Court Provisions

Chapter 11 has the intention of giving the debtor that found itself in an unfortunate situation a “fresh start” to return to operating on a sustainable basis.

Also known as “rehabilitation bankruptcy”, the debtor negotiates modifications with its creditors to come to an agreeable resolution that enables the debtor to remain afloat into the future.

The pathway towards reorganization presents numerous benefits for distressed companies, including:

  • During the “Exclusivity” Period, the Debtor has the Exclusive Right to Propose a POR
  • Relief from Unsustainable Debt Burdens (i.e., Remedies to Normalize D/E Ratio)
  • Under Section 363, Debtor Can Sell Assets “Free of Existing Liens and Claims”
  • Protection from Creditor Collection Efforts through the “automatic stay” provision
  • Option to Assume Beneficial Contracts & Reject Burdensome Contracts
  • Access to Urgent Capital via Debtor in Possession Financing (DIP)

Basically, these in-court Chapter 11 provisions and the continued backing of the debtor by the Court suggest that a true turnaround can be done.

Considering the debtor in possession is required to operate in the “best interests” of its creditors, the submitted reorganization plan must be approved by the creditors.

But the Court can override a creditors’ objections and still impose the plan on the creditor(s) if the requirements are met (i.e., preventing the “holdout” problem).

In the final step of Chapter 11, assuming the debt renegotiations are satisfactory to creditors and the Court confirms the POR, the debtor emerges from bankruptcy and sets the plan into motion.

Chapter 7 Bankruptcy: Liquidation

Chapter 7 is the straight liquidation of the assets belonging to the debtor and subsequent distribution of the proceeds with senior secured debt securities holding precedence in recoveries over unsecured claims.

Standard Chapter 7 Procedure
  1. A trustee is assigned to become responsible for the collection and liquidation of all assets
  2. Once the debtor’s assets are liquidated by the trustee, the proceeds are distributed among the debtor’s creditors
  3. Post-petition and Court confirmation, the debtor goes out of business and operations immediately cease
  4. The main responsibility of the trustee is the proper allocation of proceeds to creditors holding allowed claims on a pro-rata basis while abiding by the priority of claims waterfall (i.e., the absolute priority rule, or APR)

Liquidation Recovery Rates: Collateral Value

Simply put, Chapter 7 bankruptcies are known as “liquidation bankruptcies” as the estate of the debtor is sold and the proceeds from the sale are distributed to creditors.

Chapter 7 is a liquidation of the debtor’s assets, as the management and impaired creditors are in consensus that a reorganization attempt would only further diminish the residual value.

Implied in the decision to proceed with Chapter 7, the debtor is deemed to be past the opportunity for reorganization, whereby the chance of a turnaround is too small to justify taking on the risk and putting in the effort.

For the voting process among creditors to occur, the POR must pass several tests – most relevant to the topic covered in this article, the Court must confirm that the recoveries are higher under the POR than a straight liquidation (i.e., the “best interests” test).

Said differently, the Chapter 7 liquidation recoveries serve as a “floor” that the recoveries under the proposed POR must exceed – otherwise, the plan will fail to receive Court approval.

Chapter 7 Trustee

In liquidations, the process is handled and overseen by the Chapter 7 Trustee. Chapter 11 also appoints a U.S. Trustee, but their responsibilities are quite different. In Ch. 11, the Trustee’s tasks are more related to oversight of the bankruptcy proceedings to confirm compliance.

Because it was determined that a liquidation would be in the “best interests” of creditors, the Trustee liquidates the assets of the debtor as part of the Chapter 7 bankruptcy.

Here, a Chapter 7 Trustee acts as the representative of the bankruptcy estate, NOT the debtor. The appointed Trustee is responsible for ensuring creditors are paid off in the proper order, following the APR –  proceeds were distributed to creditors based on priority.

Since the Trustee has no previous relations with neither the debtor nor the creditors, accusations of wrongdoing are lessened (e.g., preferential treatment to lower-priority claim holders).

But a distinct downside to creditors is that the Chapter 7 Trustee tends to prioritize the quick liquidation and distribution of proceeds in line with the priority of claims waterfall, rather than maximization of the creditors’ recovery.

Chapter 7 Bankruptcy Timeline: Time Span Before Closure

Chapter 7 liquidations can be completed in a matter of months. In contrast, Chapter 11 cases have historically taken around one year to two years.

But the gap between the two has gradually become narrowed as the duration required for Chapter 11 has been reduced over the past decade in part due to “pre-packs,” which have allowed certain Chapter 11 bankruptcies to close in less than a couple of months.

Nevertheless, Chapter 7 bankruptcies are regarded for closing faster because of there being less work required and proceeds are distributed to creditors sooner (and fewer fees are incurred).

Senior Creditors: Indifference to Chapter 11 or Chapter 7

Generally speaking, recoveries are higher under Chapter 11 than Chapter 7 and are the preferred option by the debtor and creditors, the exception being senior secured creditors that are close to being guaranteed full recovery either way.

In either filing type, the recovery rates to senior secured creditors are likely 100% or near full recovery, but Chapter 7 suggests repayment on an earlier date.

During Chapter 11 RX, the debtor tries to reorganize and re-emerge as a better-run company meaning that creditors do not get paid right away and instead receive different terms on their debt holdings (e.g., interest rates, the dollar value of debt, debt-to-equity conversion).

The longer duration and the uncertainty of the RX outcome can therefore influence senior secured lenders to prefer Chapter 7.

Chapter 11 → Chapter 7 Conversion: Liquidation Flow Chart

Contrary to misconception, liquidations can occur in Chapter 11 as well.

The notable difference is that the management team oversees the process – therefore, even if Chapter 11 ends in liquidation, creditors still tend to prefer Chapter 11 because of management’s active role.

  • Chapter 7 liquidation has more of a “fire sale” aspect to it, in which liquidating the assets as quickly as possible is prioritized over maximizing the recovery rates
  • Chapter 11 can be a lengthy, drawn-out process – but if it ends in liquidation – to some creditors it could have still been worth the risk even if it meant fewer recovery proceeds now

If Chapter 11 fails, it can be converted into a Chapter 7 liquidation, as shown below:

Chapter 11 Bankruptcy to Chapter 7 Liquidation Conversion

Despite the provisions and list of potential remedies granted by the Court in financial restructuring procedures to improve the odds of the debtor achieving its goal – such plans can easily fall apart and end up in liquidation.

Chapter 11 processes can start off optimistically, but prolonged negotiations that seemingly progress nowhere can frustrate creditors, especially if the value of the estate has continued to decline noticeably.

Usually, such circumstances coincide with vocal creditors that have become disappointed from the lack of improvement shown by the debtor, which will often cause the Court to acknowledge a liquidation might be best for all parties involved.

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