Bankruptcy Law & Chapter 7 Explained

Corporate Chapter 7 Proceedings

Chapter 7 proceedings are the mirror image of Chapter 11 proceedings: But instead of attempting to reorganize and continue operations, the Chapter 7 debtor shuts down and liquidates all assets. Appropriately, Chapter 7 corporate debtors do not operate as debtors-in-possession; instead, the Office of the U.S. Trustee appoints a Chapter 7 Trustee to "wind-down" the business - liquidating its assets and distributing the proceeds to creditors.

More and more debtors are using the Chapter 11 process to liquidate their assets, instead of going through Chapter 7, in order to avoid the appointment of an outside Chapter 7 trustee; management would rather be in charge of the liquidation than hand over the keys to a "stranger." Nonetheless, Chapter 7 remains corporate debtors' predominant liquidation tool.

Many Chapter 7 proceedings are involuntary. In such cases, creditors initiate the bankruptcy, "forcing" the debtor into bankruptcy by filing the bankruptcy petition. Creditors often file involuntaries to protect their claims from a debtor who should, but doesn't, commence voluntary proceedings. Involuntary petitions can also be acts of aggression, aimed at disabling a rival. Fortunately, bankruptcy courts have authority to abstain from bankruptcy proceedings and dismiss inappropriately-filed involuntary petitions.

Chapter 7 proceedings follow a similar, albeit streamlined, route to Chapter 11 proceedings:

Phase 1: Shutting down the doors

As with Chapter ll, voluntary Chapter 7 liquidations begin with the debtor filing a petition, schedules of assets and liabilities, and other information. Unlike Chapter ll reorganizations, however, there is usually no DIP financing or other mechanisms to keep the business going, since the debtor typically closes shop upon commencing Chapter 7. On occasion a court authorizes a Chapter 7 debtor to continue operating for a limited period of time, but this is the exception, not the rule. The debtor typically lets go of all of its employees, other than a few members of management to help wrap up affairs.

Shortly after the commencement of Chapter 7 proceedings, the U.S. Trustee appoints a Chapter 7 Trustee, typically chosen from a panel of trustees with experience in liquidation proceedings. The Chapter 7 Trustee oversees the winding up of the debtor's enterprise, including the assessment and liquidation of the assets, and has complete authority over the business. Although the Chapter 7 Trustee is often a bankruptcy attorney, he typically functions solely as a businessperson and usually hires outside counsel (or uses other attorneys in his law firm) to perform all legal work.

Phase 2: The middle of the case

The long middle of a Chapter 7 case is usually much shorter than its Chapter 11 counterpart; there are no concerns about creating and voting for a plan of reorganization, rejecting executory contracts, or defending the estate against creditors threatening to stop doing business with the debtor. Instead, the middle of the case focuses on liquidating the estate's assets through an auction process.

The middle of the case shares several other features with Chapter 11 proceedings, including:
 

• Enhancing the assets of the estate through avoidance actions;
• Conducting a claims process, including securing proof of claim forms and resolving disputed claims; and
• Filing a variety of administrative reports with the court, including fee applications and monthly financial reports.

By the end of this phase of the case, the Chapter 7 Trustee holds a pot of cash, including the proceeds of asset sales and money brought back into the estate through avoidance actions, and has a clear sense of the pool of claims against the estate.

Phase 3: Disbursing the estate

After the assets are sold and claims reconciled, all that remains is distribution of the proceeds of the estate to creditors according to a priority system similar to that outlined for Chapter 11 proceedings. Corporate debtors don't get a discharge of old debts, but, as with liquidated Chapter 11 debtors, that's usually not a big deal - there is nothing for creditors to go after.

Not all Chapter 7 proceedings are so simple. In general, however, corporate Chapter 7 is a far more streamlined road than its Chapter 11 counterpart, thanks to the relative ease of administering a debtor which has ceased operating.
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Consumer Bankruptcies: Chapters 7, 11 and 13

Then there's the other side of the bankruptcy practice - the world of consumer bankruptcies. The lion's share of bankruptcy petitions filed every year is by individuals. These are a totally different ballgame than corporate proceedings, because you are dealing with a human being instead of a business. Appropriately, the consumer bankruptcy practice is a different world than its corporate counterpart.

Individuals filing for bankruptcy have a variety of options: Chapter 7 liquidation or a Chapter 11 or 13 reorganization or rehabilitation. An individual Chapter 7 debtor, like her corporate counterpart, liquidates all but certain exempt and post-petition property, distributing the liquidation proceeds to its creditors. Unlike her corporate counterpart, she receives a discharge of most pre-petition debts other than certain exempt debts such as - sorry, folks - education loans.

Individuals with income over a given threshold can opt for the rehabilitation procedures of Chapters 13. In a Chapter 13 proceeding, the debtor satisfies his debts through a court-approved plan providing for payments to creditors over several years. As opposed to Chapter 7 liquidations, the Chapter 13 debtor keeps his assets and funds the plan through future income. Chapter 13 is in many ways the consumer counterpart of Chapter 11 procedures, focused on retaining assets and a forward-looking plan of reorganization or rehabilitation.

The biggest question for the debtor choosing between Chapter 7 and Chapter 13 is pain now or pain later - throw your assets to the fire in Chapter 7, or dribble out your future earnings in Chapter 13. Most choose immediate pain, making Chapter 7 the most common type of consumer bankruptcy.

Some individual debtors opt for a full-fledged - and far more complex -Chapter 11 proceeding. Although Chapter 11 debtors administer their own estates and do not hand over the reins to a bankruptcy trustee as in Chapters 7 and 13, they also share the same burdens of the Chapter 11 corporate debtor, including the requirement of creditor approval of a rehabilitation plan. Appropriately, a Chapter 11 consumer process is much longer and more political than Chapter 13. Nonetheless, individuals with complex asset and liability structures more akin to a corporate debtor might find Chapter 11 an appropriate route.

Probably the most complex and publicized aspect of consumer bankruptcies involves state laws shielding certain assets from bankruptcy. Florida and Texas have the honor of having the most free-ranging asset-shielding laws, allowing an individual debtor to hang onto his or her house, including all of the house's tennis courts, swimming pools, 10-car garages, golden faucets... you get the picture. Few features of consumer bankruptcy do more to distort its image; the debtor with a mansion on Fisher's Island is the bankruptcy equivalent of President Reagan's welfare queen sitting in her Cadillac bought with AFDC payments. Bad publicity from these laws has sometimes masked the reality of consumer bankruptcy laws. Most consumer petitioners are average people who simply fell upon rough financial times.

Alternatives to Conventional Bankruptcy

Out-of-court restructurings

Many distressed companies opt for out-of-court debt restructurings, in which they negotiate with creditors to restructure the terms of their debt, instead of bankruptcy. For example, a debtor might negotiate with its creditors to exchange its short-term trade debt for long-term bonds. Debtors might also opt for a variety of other transactional solutions, such as non-bankruptcy asset sales, restructuring of their secured debt, or exchange offers, in which bondholders exchange old debt for new debt with terms more beneficial to the debtor.

While they sometimes prove to be dress rehearsals for the debtor's eventual bankruptcy, these out-of-court restructurings often alleviate short-term liquidity problems, buying the debtor sufficient time to revive its cash flow and avoid bankruptcy altogether.

If these transactions don't take place in bankruptcy court, why are they often part of the bankruptcy lawyer's practice? Think about it - bankruptcy practitioners are not only fluent in bankruptcy law, but also on the ins and outs of working with distressed companies. They understand the risks of a bank lending money to a troubled company and can explain to creditors why an out-of-court debt restructuring is preferable to an in-court bankruptcy.

They can't be fooled in negotiations by creditors who overstate the risks and downside of bankruptcy. And they can structure deals with an eye towards a future bankruptcy, adding safeguards that would protect their client in the event of a filing.

Appropriately, many large law firms don't call their insolvency departments "bankruptcy." Instead, they aim for more inclusive, and more appropriate, names like "work-out and bankruptcy litigation" or "bankruptcy and restructuring." These terms reflect the intertwined nature of corporate bankruptcy and out-of-court restructurings, both of which are simply methods of helping a distressed company, requiring very similar skill sets.

Assignments, dissolutions and other state insolvency procedures

Most states permit a wide variety of insolvency alternatives, some under court guidance and subject to statute, others out-of-court and independent of legislative command. In an assignment for the benefit of creditors, the debtor - the assignor - assigns its estate to an assignee, who liquidates the assets and distributes the proceeds to creditors. Compared to a bankruptcy proceeding, an assignment is relatively speedy and cheap, and is increasingly common in dot-com bankruptcies, where time is of the essence, thanks to intangible assets whose value quickly slips away. Many states allow common law assignments, without the oversight of courts, which many debtors (although not all creditors) find preferable.

Receivership proceedings are similar to assignments, although they are almost always conducted under the auspices of a court. Here, a receiver is nominated by the debtor or appointed by the court to oversee the winding-down of the debtor's business and distribution of proceeds to creditors. Dissolutions are another state option, where the debtor, often with the help of an agent, independently winds down its business.

All of these procedures are similar to Chapter 7 proceedings, with statutes often allowing avoidance actions and including claims procedures. A debtor's choice among these options depends on the particular contours of the case law and statutes governing these procedures in each state. In some states an assignment might be the most efficient and least cumbersome among these procedures; in others, a debtor might prefer the particular protections allowed in a receivership proceeding. All of these procedures are usually cheaper and quicker than bankruptcies; but they also don't always afford the debtor the same comprehensive protections of the Code, such as the complete discharge.

International Insolvency Proceedings

International and cross-border insolvency proceedings are becoming increasingly common for U.S. bankruptcy practitioners. In proceedings like the Federal-Mogul case, involving over 100 subsidiaries in the United States and the United Kingdom, affiliated debtors file simultaneous cases within two, three or more jurisdictions. With the growing internationalization of the corporate world, you can only expect an increase in this trend. Although a U.S. practitioner generally cannot practice in a foreign court proceeding, you can participate in the coordination of the U.S. and foreign cases, and work with foreign co-counsel in mapping out strategy.

In some cases, subsidiaries are sufficiently separate from each other that minimal coordination of each of the subsidiaries' proceedings is required. In other instances, though, strong corporate relationships between a parent and its debtor subsidiaries might render tightly integrated proceedings necessary. In such instances, cross-border insolvency protocols, setting the ground rules and coordinating foreign (and often conflicting) law, and joint hearings, simultaneously broadcast in each courtroom, are gaining use as courts break new ground in sophisticated case management.
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