Before you decide whether to sell your bankruptcy claim, let’s examine what exactly a bankruptcy claim is. No matter what part of the economic cycle the world is currently experiencing, businesses and industries may suffer lapses in cash flow for myriad reasons. Companies that have less cash on hand may not be able to make timely payments on their debt and obligations to goods and service suppliers, landlords, employees and retirees. Companies claim bankruptcy to seek the protections afforded them by the largely debtor-friendly US Bankruptcy Code, the most important being the “automatic stay” which stops most collection actions against the debtor or the debtor’s property.
Can your business afford the time and expense of waiting out an “automatic stay”? Trading claims in bankruptcy offers several benefits to creditors right away. Selling your bankruptcy claim may be your best, soonest option.
Named for Chapter 11 of the Bankruptcy Code, Chapter 11 allows businesses to continue operating while they formulate a plan to restructure their debt obligations. A Chapter 11 debtor is known as a “debtor in possession.” After a complicated and lengthy legal process in bankruptcy court, there are different outcomes a debtor may achieve through bankruptcy. While creditors hope to recover their outstanding bankruptcy claims against the debtor, there is a wide variety of outcomes and timing which are all dependent on the particulars of each case. In the vast majority of cases, creditors do not receive a full recovery on their claims, particularly if they do not have a lien or security interest in particular assets. That’s why many creditors become bankruptcy sellers — liquidating their claims as soon as possible.
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What is the bankruptcy process?
The bankruptcy process can be broken into three distinct phases – pre-petition, post-petition and post-confirmation. The first two phases are separated by the petition date, which is the date that the company (or its creditors, or bankruptcy sellers, depending on whether it is a voluntary or involuntary bankruptcy) files to enter into bankruptcy.
Companies can file for either Chapter 11 or 7 bankruptcies:
Chapter 11
Chapter 11 of the Bankruptcy Code provides companies a certain period of time in which to develop a plan of reorganization and eventually exit bankruptcy as a more profitable company. This process is intended to satisfy one of the primary purposes of bankruptcy: to discharge certain debts and give the debtor a “fresh start.” That aim for a “fresh start” doesn’t help you the creditor, of course, but selling your bankruptcy claim for cash now saves you time in the long run, along with the costs of litigating a case in bankruptcy court.
Chapter 7
Chapter 7 of the Bankruptcy Code provides for a complete “liquidation,” or the sale of a debtor’s property and the distribution of the proceeds to creditors by a court appointed bankruptcy trustee. Unlike a Chapter 11 process, a Chapter 7 liquidation results in the cessation of business operations, a loss of jobs for employees and the loss of a customer for vendors.
Petition Date
The petition date is an important marker because any debts incurred before the date may have significantly different (often smaller) recoveries than debts incurred post-petition.
After the petition date, businesses declaring bankruptcy will need to:
- Submit first day motions, requesting the use of assets on hand (that may have security interest against them) to pay vendors that are critical to ongoing operations of the business (“critical vendors”), employee wages and other ongoing obligations.
- Submit schedules showing all claims against the business.
- File disclosure statements that provide “adequate information” to parties in interest to allow holders of claims against the debtor to make an informed decision when voting on a plan of reorganization.
- Submit the plan of reorganization within 120 days after the petition date – companies can request extensions, but once the debtor’s exclusivity period ends, other parties can submit alternate plans.
Reorganization
There are a few common ways businesses choose to reorganize:
Pre-planned restructuring
The debtor works with various creditors, lenders and shareholders prior to the bankruptcy filing and arrives in bankruptcy on day 1 with a plan to exit.
Sale of the business
Debtors may choose to hold auctions for the sale of their business to resolve debts in bankruptcy. There are two types of buyers: strategic buyers, who operate in the same segment as the bankrupt company; and financial buyers, also known as claims traders or bankruptcy buyers, who acquire companies in hopes of realizing some sort of investment return. Also, banks can “credit bid” for ownership of the company up to the amount that is owed and secured by collateral.
Formation of a trust
To satisfy future litigation claims – lawsuits are a common catalyst of Chapter 11 bankruptcies. For companies that may face future litigation claims (such as asbestos claims), it is in the debtor’s best interest to set up a trust with a set amount to settle these unknown liabilities.
30-Day voting window
Holders of bankruptcy claims or equity interests against the debtor will have a 30-day window to vote on the plan once it has been approved by the bankruptcy court. Only classes that have an impaired recovery as determined by the plan are allowed to vote.
Once the plan has been voted on and confirmed by the court, the bankruptcy enters the third stage: post-confirmation. On the “effective date” of the plan, the company officially reorganizes and distributions to creditors are made. Distributions can be made immediately on the effective date, or over time as the company’s future cash flow permits.
Claimholder priority
Claimholders that have higher priority according to the Bankruptcy Code typically receive a higher distribution relative to creditors with lower priorities. Holders of claims and equity interests will generally be separated into a few groups (listed in order of descending priority):
- a) administrative bankruptcy claims (professional fees, post-petition administrative claims);
- b) secured bankruptcy claims (bank debt, mechanics liens);
- c) priority bankruptcy claims (wage and tax claims);
- d) general unsecured bankruptcy claims (trade and litigation claims);
- e) equity interests (shareholders and management).
Where does your business fit in this list of priorities? Trading your bankruptcy for cash now puts you at the top of a new list — companies putting an end to this unpleasant and unreliable process for themselves and instead focusing on their core business.
What happens to employees of a bankrupt company?
In general, businesses in Chapter 11 bankruptcy are seeking to reorganize and require the efforts of some subset of their pre-existing employee base. It is common for debtors to design bonus plans to retain management when declaring bankruptcy. Employees will be paid for work performed after the petition date, but prepaid wages will not be paid until the conclusion of the bankruptcy case along with other prepetition claims. Up to $13,650 of prepetition wages is considered a priority bankruptcy claim under the Code. Wages exceeding the cap, severance, unused vacation and litigation claims are all considered non-priority, general unsecured claims.
What happens to retirement benefits in bankruptcy?
Debtors can choose to assume or reject corporate retirement benefit plans. This can lead to claims from the Pension Benefit Guaranty Corporation, a government entity that insures pension plans.
What happens to patents in bankruptcy?
Patents are considered property of the bankruptcy estate. If prepetition lenders have a lien on these assets, any value will first be used to satisfy these secured bankruptcy claims. If the patents are unencumbered by liens, they may be available to other creditors.
What happens to the stock of a company in bankruptcy?
For companies with publicly-traded equity securities, a “Q” is added to the end of the ticker symbol which indicates the company has filed for bankruptcy protection. However, the stock continues to trade even after such bankruptcy claims. Whether or not the equity will retain value post-emergence is completely dependent on the particulars of the bankruptcy case. Most often equity does not retain value and is worthless post-emergence, which results in the delisting of the stock. There have been several widely reported cases of equity retaining value but they are the exception rather than the rule in bankruptcy claims.
How much do creditors get back in a bankruptcy?
In bankruptcy, claims are grouped according to similarity (called classification). These groupings are based upon various factors, such as identity of the obligor (claims of parent vs. their subsidiaries may be separately classified), collateral interests (secured vs. unsecured), senior vs. subordinated, post-petition vs. pre-petition, claims entitled to certain priorities (such as government tax claims), and so forth. Interests are also grouped in the same manner, with preferred stock and common stock having their own classes. Generally, a plan will classify bankruptcy claim holders as secured creditors, unsecured creditors entitled to priority, general unsecured creditors, and equity security holders.
A plan of reorganization does not have to provide for the full payment of all prepetition bankruptcy debts (and usually does not). Certain classes of creditors may be deemed “impaired” (i.e., whose contractual rights are to be modified or who will be paid less than the full value of their bankruptcy claims under the plan), while other classes may be deemed “unimpaired” (i.e., whose bankruptcy claims will be paid in full in cash or otherwise reinstated on its original terms).
In theory, there is a strict hierarchy of payment among bankruptcy claims of differing priorities (called the “absolute priority rule”). This well-established bankruptcy principle states that bankruptcy claim holders with higher priority should receive 100% of their claim in full before the next (lower priority) class receives any portion of the reorganization proceeds. In practice, it is common for chapter 11 bankruptcies to violate the absolute priority rule with bankruptcy claims. For example, “give ups” or “carve-outs” by senior classes of creditors to achieve confirmation of a plan have become an increasingly common feature of the chapter 11 bankruptcy process, as stakeholders strive to avoid disputes that can prolong the bankruptcy case and drain estate assets by driving up administrative costs.
In terms of recovery rates, bank debt recovered on average of 72% of the amount owed in the 2002-2003 downturn (according to Standard & Poor’s LossStats Database). Senior unsecured bonds recovered 29% on average of the amount owed (a materially lower yield due to lack of collateral/security). Subordinated unsecured bonds recovered 21% on average of the amount owed (a lower recovery compared to senior unsecured bonds due to their lower priority). In the current environment, recovery rates across the capital structure are expected to be materially lower compared to prior distressed periods due to higher average secured debt levels in today’s corporate capital structures and materially weaker (i.e., more borrower friendly) credit agreement terms (including the proliferation of no-covenant and covenant-lite structures).
