Chapters 7 and 11 Can Negatively Affect Creditors and Shareholders, Daniel Kamensky Says

Although business bankruptcies have declined in the United States since 2009, more than 13,000 businesses filed for bankruptcy in 2022, according to Statista. These bankruptcies significantly impact the corporation’s stakeholders, says Daniel Kamensky, founder and member of the Advisory Board of The Creditor Rights Coalition and founder and managing partner of Kingston Valley Enterprises.

The impact can vary depending on whether the company files for bankruptcy under Chapter 7 or Chapter 11 of the federal bankruptcy code.

Chapter 7

Under Chapter 7, the business ceases operations, and a court-appointed trustee liquidates its assets. The trustee then divides the proceeds among stakeholders based on their order of priority with the remaining stakeholders receiving nothing.

Priority claims (including certain wage and tax claims) are paid first, after which secured debt and then unsecured debt, like trade claims and unsecured bondholders, are paid. To the extent value remains, it is then paid to shareholders, with preferred stockholders receiving payment before common stockholders.

In a Chapter 7 liquidation, the value of their assets is often too little to cover all the debts, leaving nothing for shareholders, says Kamensky.

Chapter 11

Chapter 11, in contrast, is used to reorganize and reorganize a business. When a company files for Chapter 11 bankruptcy, the company is given a “breathing spell” to reorganize while still operating. The US Trustee appoints a committee of the largest creditors to work with the company to restructure its debt. The company, as the debtor in possession, controls the restructuring process and usually prepares a business plan and proposes a plan to reorganize the company to stakeholders. For a plan to be confirmed, it must be proposed in good faith and each class of impaired creditors must receive a higher recovery than they would receive under a Chapter 7 liquidation. In addition, at least one class of impaired creditors must have accepted the Plan. The court is given discretion to approve the Plan over the objections of other classes of creditors if it is fair and equitable. Once the company complies with the terms of the restructuring, the court will discharge the rest of its debt.

In a chapter 11 case, a liquidating plan is permissible. Such a plan often allows the debtor in possession to liquidate the business under more economically advantageous circumstances than a chapter 7 liquidation. It also permits the creditors to take a more active role in fashioning the liquidation of the assets and the distribution of the proceeds than in a chapter 7 case

Creditors generally receive some recovery during a chapter 11 bankruptcy while shareholders are generally (though not always) wiped out.Creditors are impacted because they often make concessions such as lowering interest rates, agreeing to longer payment terms, or forgiving part of the debt. Daniel Kamensky says the impact could be devastating for trade creditors who have depended heavily on the company.

Also, filing for Chapter 11 protection may sometimes result in a sale of a company under Section 363 of the Bankruptcy Code. Creditors, especially those with secured claims, have more input in a Section 363 sale than they do under a Chapter 7 sale. They can also credit-bid the amount of their secured debt at the sale auction, allowing them to obtain it without providing cash. However, a sale doesn’t guarantee secured creditors will receive all they are owed and generally leaves other stakeholders with nothing, Kamensky says.