When Your Customer Goes Belly-Up

How to protect an unsecured creditor's interests when its customer is in financial straits.


  • BANKRUPTCY LAW HAS SOME UNPREDICTABLE consequences. If a customer has physical possession of its supplier's property, ownership may be debated. Conversely, a supplier may reclaim some goods it has already shipped. If a supplier files a formal proof of claim, it may waive other rights.

  • THE COURT MAY SET ASIDE DISTRESS SALES of assets or inflated prices for goods shipped to the bankrupt debtor as constructively fraudulent. Any such transaction at less than full value may raise questions.

  • IF A CUSTOMER LOOKS FINANCIALLY SHAKY, creditors should start keeping meticulous records, consider ways to secure payment for shipments, identify all credit exposure and discuss the possibilities for a consensual workout.

  • CHAPTER 11 BANKRUPTCY LEAVES much CONTROL with the debtor, but the creditor's recoveries may be higher than they would be in a Chapter 7 liquidation. If the debtor's management is not both competent and trustworthy, creditors should consider filing an involuntary bankruptcy petition and ensure that a trustee is appointed thereby ousting management. In bankruptcy proceedings the debtor or trustee can reject most contracts and leases from the date of the petition.

  • UNSECURED CREDITORS USUALLY BAND TOGETHER in Chapter 11 cases by forming a committee with fiduciary responsibilities. Typically, the debtor negotiates with its creditors to develop a workable reorganization plan. To become effective, the plan must be approved by the court.

  • CREDITORS SHOULD LOOK CAREFULLY at the debtor's disclosure statements and do a reality test on projections. The court will address objections to a reorganization plan, and creditors vote whether to accept or reject it. Nonetheless, the court has the final say.
STEPHEN T. BOBO, Esq., is a partner in the law firm of D'Ancona & Pflaum LLC, Chicago, and a member of the American Bar Association. His practice is concentrated on bankruptcy, corporate reorganization, creditors' rights and related litigation. His e-mail address is sbobo@dancona.com.
KENNETH J. GOODHEART, CPA, CMA is a senior manager in the transaction services practice of KPMG LLP. His e-mail address is kgoodheart@kpmg.com.

In fat times it's easy to miss the signs that a valued customer may have financially overextended itself. Alas, inevitably someone's customer does declare bankruptcy. Even such high-profile companies as Boston Chicken, Crown Books, Grand Union Co., L.A. Gear, Montgomery Ward, Pan Am Corp. and J. Peterman have stumbled in the last few years.

To protect a creditor's interests, CPAs in business and industry and those in public practice who advise business clients need to understand that bankruptcy law is full of traps. If a creditor doesn't tread carefully, it may find that its prior notion of who has a right to what claims can turn to dust. The CPA can help creditors bolster their claims.

Bankruptcy law can seem mysterious to the uninitiated. CPAs should be aware of many circumstances that can cause complications. In some cases, assets that a debtor has in its possession can end up as property of the bankruptcy estate (see glossary) even though the supplier's management believes its company owns them.

For example, depending on the circumstances, the bankruptcy court may treat

  • Consigned inventory as the debtor's property.
  • The creditor's property as an extension of unsecured credit, even if the transaction is not styled as a sale, if it is used in the debtor's manufacturing process or is entrusted to the debtor for processing and return.
  • Equipment leases as sales rather than true leases.

To recover such assets or their value, CPAs should be aware that the creditor must prove its ownership interest. In any of the situations described, a clear, written agreement will help the creditor make its case. The agreement should require the debtor's books and records to reflect the creditor's property interest. Filing a financing statement called a UCC-1 , under a provision of the Uniform Commercial Code, can put other parties on notice that such an agreement exists. Normally, a UCC-1 is filed to perfect a security interest granted in personal property; however, unsecured creditors may file a UCC-1 proclaiming an interest in specified assets even if there isn't any security interest. For example, when the owner of artwork consigns it to a gallery for sale, she can file a UCC-1 to protect herself in case the gallery's finances wobble.

Commercial law does leave some wiggle room for unsecured creditors. Accordingly, CPAs should advise creditors to take full advantage of their rights.

For example, goods in transit may be recalled after a bankruptcy petition is filed. Depending on the shipping terms, it may be possible for a seller/creditor to recall shipments in transit to the purchaser/debtor. For instance, goods shipped FOB destination remain the property of the seller until delivery. In such cases, the seller should be able to direct the carrier to return the goods if it learns of the buyer's insolvency or bankruptcy filing prior to completed delivery. That would give the creditor a chance to reassess the buyer's creditworthiness before extending more unsecured credit. If the seller neglects to stop delivery, the goods will become the property of the bankruptcy estate, and the creditor may not get paid for them.

Most states have laws granting sellers the right to reclaim some goods shipped on open account even after delivery is made. This is called the right of reclamation . Only identifiable goods that the debtor has not processed or shipped qualify. Usually the seller must exercise this right on discovery of the buyer's insolvency and within 10 days of when the buyer received the goods. If bankruptcy intervenes, the period is extended. The creditor must make the demand for the specific goods it reclaims in writing.

A secured creditor's prior lien supersedes reclamation rights. However, the bankruptcy court may grant an unsecured creditor that wants to reclaim goods either a lien or a priority claim, which will enhance its chances of at least getting something.

Postpetition Credit Issues

Chapter 11 debtors continuing in business after filing for bankruptcy need continued access to goods and services and will seek credit. Some suppliers won't extend credit to any potential customer in Chapter 11. At the other extreme, some suppliers mistakenly believe or are encouraged by the debtor to believe that payments for sales to a Chapter 11 debtor are somehow guaranteed, minimizing or eliminating credit risk.

Not so. Postpetition debts incurred by a Chapter 11 debtor are entitled to priority in payment over unsecured prepetition debts. Postpetition trade debt receives the same priority as professional fees for attorneys and accountants, but it is not risk-free. A debtor could incur substantial losses while in Chapter 11 and become unable to fully pay secured claims and postpetition unsecured credit.

Postpetition creditors should carefully monitor the debtor's operations and review the monthly operating reports that a Chapter 11 debtor must file with the bankruptcy court. Unsecured postpetition creditors should also review any agreements between the debtor and its secured creditors for terms that may affect their own interests.

The Bankruptcy Code includes a provision to prevent debtors from giving preferential treatment to some creditors. It is also designed to deter creditors from racing to dismember a financially troubled company. This provision prevents creditors from keeping preference payments collected from an insolvent debtor shortly before it declared bankruptcy.

CPAs should also be aware that a court could overturn other property transfers. For example, if the creditor files a lien against the debtor's property, or the debtor cedes a security interest in its property just before it declares bankruptcy, it may not stick. Creditors may have to return any payments or other transfers received during the 90 days before a bankruptcy filing; for insiders such as the debtor company's officers, directors or controlling shareholders the rule is one year.

Bankruptcy law allows defenses that may permit creditors to keep some payments. The law is designed to encourage creditors to continue to do business with a troubled debtor, so a creditor can try to prove to the court that the payment was made in the ordinary course of business between the parties. However, a bankruptcy trustee gets a long time, generally up to two years, to claim that a creditor has received preferential treatment. A creditor caught in this limbo rarely sees it as justice, because it may have to return a payment that was already late.

CPAs should advise creditors to keep records of all transactions with the debtor handy. At minimum, creditors should keep all the records for the year preceding the filing. For example, if the creditor tries to prove to the court that a transaction was within the parties' ordinary course of business, it may have to demonstrate the business patterns between the parties. A mountain of records to back this up can help. However, if the debtor dragged its heels by taking even longer to pay than had been usual in that business relationship, the court will probably see the payment as outside the parties' ordinary course of business, and thus preferential, unless the creditor brings forward some other defense.

According to the law, the debtor gets to decide whether or not to reject ongoing leases and contracts that still obligate both sides to perform. That can leave creditors without much control over the outcome, although they may petition the bankruptcy court to compel the debtor to make up its mind. If the debtor assumes the preexisting obligation, with court approval, the decision is binding. After that, payments under the contract are an administrative expense of the estate and have priority over unsecured prepetition debts. To gain court approval to assume a prepetition lease or contract, the debtor must make good on all defaults and give adequate assurance of its future performance.

When a debtor rejects a contract, the agreement effectively ends as of the petition date. If terminating the contract damages the creditor, it can file a claim for compensation. However, the creditor has a duty to act to limit its damages if possible. Under certain types of agreements, such as shopping center leases and intellectual property licenses, creditors may have other rights as well.

Sometimes a company may think it has completed a transaction with another that is shown later to have been financially distressed. If that transaction was for less than reasonably equivalent value, a raw deal for the debtor, the court is likely to reverse it. CPAs should be aware that if the debtor paid more than the debt was actually worth, the court will probably consider the transaction at least constructively fraudulent , which is a considerably broader concept than intentional fraud since fraudulent intent doesn't enter the picture. This could happen long after the beneficiary of the lopsided deal felt secure that it had collected payment. Usually, the debtor or the trustee can level an accusation of constructive fraud for up to two years after the petition date on transfers that took place for at least the year preceding the petition. Using strong-arm powers, in most jurisdictions the trustee can reach back even further by invoking state law.

Exhibit 1: Almost Bankrupt?
Some Warning Signs

The customer:

  • Changes vendors a lot.
  • Places more, but smaller, orders.
  • Complains more frequently.
  • Requests proof of delivery more often.
  • Returns more product.
  • Keeps losing top managers.
  • Pays for each shipment progressively later.

Debtors rarely get into financial trouble overnight. Usually, 20/20 hindsight reveals warning signs of impending financial difficulty that the creditor should have been alert to. Exhibit 1, at left, lists some of these.

Of course, more complaints and fewer orders from a customer may mean that the supplier has new competition offering better service or that the customer is making excuses for not paying on time. A huge order could mean that the customer is thriving or it is stocking up on inventory in anticipation of bankruptcy. Any of the portents listed in exhibit 1 can have other, more benign explanations. But if symptoms accumulate, watch out. CPAs should advise sales, credit and customer service personnel to recognize these signals and report them to management.

Once financial distress is suspected, management can take precautionary steps before a customer files for bankruptcy. Exhibit 2, below, shows some of these.

Exhibit 2: What to Do If a Customer Shows Signs of Financial Stress

Keep impeccable records.

  • On all invoices, clearly indicate the date that goods or services were supplied.
  • If goods are released only in exchange for payment, make sure the records say so plainly.
  • Record the date of each payment received.

Tie shipments closely to payments.

  • Ensure that the customer pays current invoices on a current basis.
  • Apply any additional payments to past-due invoices.
  • Require payment in advance or C.O.D. for all new orders.
  • Require payment on outstanding invoices before shipping new orders.
  • Refuse orders.
  • Exercise reclamation rights promptly after learning the customer is insolvent or has filed for bankruptcy.

Demand collateral or other guarantees.

  • Require standby letters of credit, or deposits.
  • Demand third-party guarantees.
  • Insist on a purchase money security interest in the goods sold.

Identify all credit exposure or potential exposure.

  • Outstanding accounts receivable.
  • Contractual obligations incompletely performed by the debtor.
  • Supplier financing for sales to the debtor.
  • Supplier assets in the debtor's possession.

Seek out information on an ongoing basis.

  • Update credit reports.
  • Request financial statements.
  • Visit the debtor's premises.

    Keep impeccable records.

Although it is good business practice to keep meticulous records at all times, the creditor should also keep close tabs on how payments relate to shipments. Exhibit 2 shows ways to do this. In contrast to the usual business practice, alert creditors should ensure that payments from a financially strapped customer are applied to recent invoices on a current basis, applying any additional payment only to past-due invoices, better to let one or two invoices get later than the established pattern than to let all of them slide. Businesses often apply payments to the oldest outstanding invoices first, but if bankruptcy is imminent that is a bad idea, because too many transactions could fall behind the historical payment pattern and potentially raise preference issues. If the customer paid promptly in the past, make sure it pays promptly for shipments now.

CPAs can advise other measures to help protect the supplier's interests. Before a creditor ships any new orders, it may wish to seek some additional meaningful assurance of payment. The possibilities include requiring advance payment or cash on delivery. Refusing to ship new orders until a check has cleared is drastic but may be necessary. However, these actions may push a valued customer on the verge of bankruptcy over the edge. They may also mean confronting, and possibly losing, a customer. CPAs need to make such decisions in context: Know whom the debtor's other creditors are, how viable the business is once past the crisis and whether it has ready access to new capital infusions.

Demand guarantees. More radical actions a CPA might discuss with a creditor include demanding deposits, stand-by letters of credit and third-party guarantees. After a bankruptcy filing, the creditor may also consider obtaining a purchase money security interest in the goods it sells to the debtor, essentially a lien. Such a move can give the seller a senior secured interest in those goods.

As a practical matter, creditors rarely do demand collateral. They may be reluctant to act on information they see as flawed, anecdotal or too inconsequential to justify a confrontation with a valued customer.

Exhibit 3: Find The Hidden Creditor/Debtor Relationship

Your company may be vulnerable if it:

  • Provided goods or services to the debtor for later payment.
  • Returned goods purchased from the debtor and is awaiting a refund.
  • Bought goods from the debtor and has a warranty claim.
  • Paid out on a debt guaranty and is seeking reimbursement.
  • Paid a deposit, advance or down payment for goods or services to the debtor.
  • Leased real or personal property to the debtor.
  • Was awarded a judgment against the debtor that has not been paid.
  • Was held jointly or severally liable with the debtor and seeks contribution or reimbursement from it.
  • Has unfulfilled agreements with the debtor for service or supplies.

Identify all credit exposure. Initially, the creditor should systematically itemize the ways in which the debtor's financial deterioration could affect the company, for example, accounts receivable and contractual obligations incompletely performed by the debtor. Exhibit 3, left, shows a checklist of potential vulnerabilities.

Gather information on an ongoing basis. Exhibit 2 suggests some measures that might help a creditor gather better-quality information. For instance, request credit reports. Ask for copies of statements that the debtor already gives others, such as banks. If those third-party reports beg for explanation, don't be shy about asking. Paying a courtesy visit to the debtor's premises can shed light on intangibles such as morale and the activity level there, to say nothing of the condition of the hard assets. A visit can also lay the groundwork for a friendly solution without going to court.

A debtor on the brink of bankruptcy may approach its creditors to attempt a composition . The debtor meets with its creditors, admits difficulties and negotiates a payment arrangement with them. The process works much as a reorganization plan in bankruptcy except that no court supervision is involved.

CPAs should be aware that when they are successful, compositions usually take less time and cost less overall than bankruptcy proceedings. In practice, however, compositions rarely succeed. Since dissenting creditors don't have to accept a consensual plan, even a minority of the creditors can block the process by opposing it. If the dissenting creditors litigate or file an involuntary bankruptcy petition, the attempt fails. Creditors that receive payments under a failed composition plan may even have to return them later as preferential.

Two good indicators that a composition has a chance of success: the creditors view the debtor as fair, honest and open, and they attribute the debtor's financial stresses to external factors, not mismanagement.

If a composition seems unlikely, the debtor may voluntarily file a petition for bankruptcy protection. The debtor does not have to consult with its creditors before filing a petition. The bankruptcy estate, the entity holding the bankrupt company's assets in trust for the creditors, incurs most of the direct costs of the bankruptcy case, including professional fees and the trustee's fees, if one is appointed. Although that might make bankruptcy seem to be to the creditors' advantage, the benefit is usually illusory. The cost of the legal proceedings will only reduce the amount to be distributed to creditors later.

Chapter 11 bankruptcy does not always work to the creditors' advantage, although it often does. In general, Chapter 11 reorganizations reduce or restructure the debtor's obligations to creditors. In a Chapter 11 case, restructuring the debt typically enhances the debtor's cash flow and credit position, potentially benefiting both debtor and creditor.

A Chapter 11 bankruptcy proceeding leaves significant control in the debtor's hands, subject to court supervision. Management remains in control of the company unless the court finds cause to order a trustee appointed to take over. Creditors, and the CPAs working for them, should also be aware that a Chapter 11 bankruptcy filing gives the debtor the exclusive right to file and seek court confirmation of a plan of reorganization for 120 days, although the bankruptcy court can extend or shorten that for cause.

Any group of three unsecured creditors holding $10,000 of undisputed claims among them can initiate an involuntary bankruptcy proceeding if the debtor is falling behind on a lot of its debts. Creditors may wish to consider filing an involuntary bankruptcy petition if any of the following apply:

  • The creditor believes that insiders or other creditors are receiving favorable treatment.
  • The creditor thinks that the debtor company is about to sell its assets for less than fair value.
  • A secured creditor forecloses on its collateral and is expected to dispose of those assets for less than their fair value.
  • The debtor appears to be engaging in fraud.
  • The managers continue to lose money or otherwise make bad business decisions.

However, if the court dismisses the creditors' involuntary petition, the debtor may hold the creditors that filed the petition liable for any damages the petition has caused. Furthermore, if the court finds that the creditors filed the petition in bad faith, they can be liable for punitive damages as well. Creditors should exercise caution in pursuing this option.

Bankruptcy cases involving large corporate debtors are filed under either Chapter 11 or Chapter 7 of the Bankruptcy Code, regardless of whether the debtor files a voluntary petition or the creditors file an involuntary petition. Exhibit 4, below, shows the salient differences between the two. The debtor has the right to convert an involuntary Chapter 7 proceeding to Chapter 11.

Exhibit 4: Chapter 7 vs. Chapter 11
Chapter 7 Chapter 11
Either involuntary or voluntary. Usually voluntary.
Goal: Liquidation. Goal: Reorganization plan.
Business is discontinued. Business continues.
Management is replaced by a trustee. Management usually stays.

The goal of a Chapter 11 case is to get court approval for a reorganization plan. Under Chapter 11, the bankruptcy court usually allows the debtor's management to continue in charge of the business. The court only directs appointment of a trustee for good cause. These features of Chapter 11 distinguish American bankruptcy law from bankruptcy law elsewhere in the world. In almost every other country, if a company is bankrupt the court removes management and the business is liquidated.

By contrast, a Chapter 7 case is solely for the purpose of liquidating a debtor's assets. In a Chapter 7 case, a trustee is appointed automatically. The Chapter 7 trustee shuts down the business, liquidates its assets and distributes the net proceeds to the creditors.

Chapter 11 proceedings may also be used to liquidate a corporation. Sometimes it is in the creditors' interest that the debtor remain a going concern until its assets can be sold. The debtor's existing management may well be adequate for this purpose.

A bankruptcy proceeding triggers the automatic stay . That prohibits creditors' collection and enforcement actions against the debtor. Unsecured creditors usually lack grounds to have the automatic stay modified or terminated.

A secured creditor can obtain a modification or termination of the automatic stay if it shows cause. For example, a real estate lender usually can get the court to lift the stay so it can foreclose on property that the debtor has no equity in and does not need for a successful reorganization.

To establish the amount of a claim with the court, creditors may file a proof of claim. However, even this apparently straightforward area has traps, so a creditor should consult experienced bankruptcy counsel before filing a proof of claim.

It is a good idea to file this form by the deadline, the claims bar date , especially if the debtor's records are inadequate. The court notifies creditors of the bar date by mail. The court may either subordinate or disallow any claims filed after the bar date regardless of merit. When possible, documentation should accompany the proof of claim form. Copies (not originals!) of invoices, statements and contracts are good backup.

If the creditor has any reason to be concerned about being sued by the bankruptcy estate, however, it should consider carefully whether to file a proof of claim. When a creditor does file one, it forfeits its right to a jury trial. Bankruptcy proceedings can get complicated. If the debtor decides to sue the creditor for some reason, for example, breach of contract, the creditor might want a jury to hear its case because juries are more inclined to rely on their overall sense of justice while some judges may focus more on technicalities. The creditor should decide which route to take after consulting with counsel about the particular facts and circumstances of the case. This creates a real dilemma for creditors.

Exhibit 5: Mail Me a Check

Distributions to creditors might not be made until long after the case starts. If and when claims are paid, they may be funded from:

  • Cash generated from ongoing business operations.
  • New infusions of capital.
  • Sale of some or all of the debtor's assets.
  • Proceeds from lawsuits brought by the debtor.

However, when distributions are ready, a surprising number of creditors can't be found. Creditors hoping to get paid must make sure that the bankruptcy court and the debtor or trustee has the creditor's current address.

In many Chapter 11 cases, the office of the U.S. Trustee organizes volunteers from the unsecured creditors into an official committee. The committee can serve as a check on how the debtor operates its business. It can also somewhat counterbalance the power that secured creditors typically wield.

Committee members are volunteers with fiduciary responsibilities to the other unsecured creditors. To qualify for the committee, a creditor is usually among the top 20 claimants. The bankruptcy estate is responsible for paying lawyers and accountants the committee hires, with prior court approval. Creditors with a conflict of interest with the estate, such as a significant competitor or a potential purchaser of the debtor's assets, often choose not to serve and may hire their own counsel.

Although serving on a creditors' committee may eat up a lot of time, the committee can often increase the value of the estate, time well spent. However, such effort is wasted if the bankruptcy estate isn't worth enough to satisfy even secured creditors.

The first official meeting between the creditors and the bankrupt party is called the 341 meeting . Conducted within a month or two of the bankruptcy filing, the meeting gives creditors a chance to question a sworn representative of the debtor. The debtor's counsel often makes the first presentation. A representative of the U.S. Trustee's office initiates the questioning, beginning with routine queries. Professionals for the creditors' committee usually have their turn at the plate as well.

A creditor should come away from the 341 meeting with a fuller picture of the debtor's financial condition and past transactions and, in Chapter 11 cases, the debtor's future prospects. Creditors should do their homework before the meeting because each may be limited to a few questions. When the debtor plans to continue operations, creditors should challenge the debtor's projections by comparing them to historical results. For instance, they could ask, What is your break-even volume? If the debtor's management doesn't know the answers to such questions, its projections are likely to be unreliable. A creditor that needs to ask numerous and detailed questions, beyond what it learned at the 341 meeting, should ask to conduct a Rule 2004 examination of the debtor, similar to a deposition.

Bankruptcy Glossary

automatic stay An injunction, a legal prohibition, preventing creditors from enforcing claims against the debtor originating before the bankruptcy petition was filed. It also prevents creditors from grabbing control over property of the bankruptcy estate. The stay goes into effect automatically on the bankruptcy filing.

bankruptcy estate All the debtor's property, of all types, including legal or equitable interests, as of the commencement of the bankruptcy case. After filing, the estate property is held in trust for the creditors.

bankruptcy trustee (private) An experienced attorney, accountant, or business professional appointed by the U.S. Trustee to administer the bankruptcy estate in place of the debtor's management.

claims bar date The date by which proofs of claim must be filed.

composition plan An out-of-court reorganization proposal outlining the ways that the debtor intends to restructure, including reducing or deferring payments to creditors.

constructive fraud A raw deal for the debtor at a time when the debtor is economically vulnerable because it is insolvent or lacks sufficient capital. When a financially strapped debtor's property is transferred for less than reasonably equivalent value (for example, a Rolex for a dollar), the deal is constructively fraudulent.

effective date The date when the provisions of the plan of reorganization go into effect. A provision of the plan fixes the effective date.

plan of reorganization A detailed outline for restructuring the assets, liabilities and equity interests of the debtor which must be proposed and approved pursuant to the requirements of Chapter 11 of the Bankruptcy Code.

preference payment An atypical payment made by an insolvent debtor to discharge preexisting unsecured debts that the creditor must return to the bankruptcy estate. The court might consider almost any payment made within the 90 day period before the filing of a bankruptcy petition preferential unless the creditor can prove it was not.

purchase money security interest A security interest granted by the debtor to the seller in the specific goods that it is purchasing which, if properly documented, takes precedence over any preexisting security interests granted by the debtor in those goods.

right of reclamation The right of a seller of goods to make a written demand for the return of those specific goods on discovering that the buyer is insolvent. The seller has this right throughout the 10-day period after the debtor receives the goods. In the event of an intervening bankruptcy, the seller has an additional 10 days to send the reclamation demand.

Rule 2004 examination A broad-ranging examination of any party in a bankruptcy case relating to the acts, property and financial condition of the debtor, including topics related to a plan of reorganization. Such examinations are usually conducted at the request of a trustee, a debtor retaining control of its affairs, or a creditors' committee.

secured creditor A creditor that holds a valid lien on or a security interest in property of the debtor as collateral for payment of the debt.

341 meeting (Also known as the first meeting of creditors.) A meeting, provided for in Section 341 of the Bankruptcy Code, at which a representative of the debtor is examined before the creditors and their representatives. It is usually scheduled within a month or two after the bankruptcy filing.

UCC-1 A financing statement filed with state authorities as provided for under Article 9 of the Uniform Commercial Code ( in effect in all states except Louisiana) giving public notice of the filer's interest in specific property of the debtor.

United States Trustee A U.S. Department of Justice official appointed to oversee the administration of bankruptcy cases in a particular geographic area.

unsecured creditor A creditor with a claim against the debtor that is not backed by any collateral from the debtor such as a mortgage on the debtor's real estate.

A reorganization plan is a legal document that classifies the claims, and describes how the claims will be treated, for instance, that unsecured creditors will get fifty cents on the dollar over three years. To provide creditors with an adequate basis for evaluating the proposed plan, the debtor must file a disclosure statement with it. The disclosure statement describes the debtor's financial troubles, how those problems will be resolved and how the reorganized company will treat claims. If a creditor, rather than the debtor, proposes a reorganization plan, it has to send a full disclosure statement as well.

Together, the plan of reorganization and the disclosure statement contain information similar to that in a business plan or a prospectus. In addition to historical financial statements, most disclosure statements include future projections for the reorganized business. The court must approve the disclosure statement before it can be sent out to creditors.

After the reorganization plan and the disclosure statement are filed, interested parties can raise objections. Often, the plan proponent modifies the plan and disclosure statement at least once to accommodate objections before they are sent to the creditors to vote on.

Each creditor can either accept or reject the plan. Each class of claimants, there might be three or four or there might be over a dozen, votes as a group. For a class to accept the plan, two conditions must be fulfilled: (1) a majority of the claimants, regardless of claim size, must approve it, and (2) a two-thirds majority of those claimants participating, weighted by the dollar value of their claims, must approve it.

The court can confirm a plan even if some creditor classes reject it; this is called the cram-down provision. A cram-down is usually vigorously contested in court. The issues usually revolve around either the value of the debtor's business or how to divide the pie between classes of creditors. As long as the court believes the plan is fair to all creditors and meets all other Chapter 11 requirements, it will confirm it, especially if it thinks a class of creditors is objecting irrationally rather than acting in its economic interest.

When the court confirms the plan, implementation gets under way on the effective date fixed by the plan. Once the plan has been substantially consummated, the debtor can ask the court to close the case. Unfortunately for the creditors, however, if a debtor defaults on a confirmed reorganization plan, the Bankruptcy Code provides few other legal remedies. In most cases, the only alternative is to liquidate the estate. The sad fact is that most smaller companies that file for a Chapter 11 reorganization ultimately end up in a Chapter 7 liquidation.

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