Distressed Debt Strategy: Chapter 11 Bankruptcy Process

In a prior post, I had mentioned that, during the bankruptcy process, an investor can take control by holding 33% of the debt.  How can the investor have control with a large yet minority postion?  The answer is in the Chapter 11 process.  It gives the company breathing space for its debts and the ability to reorganize its capital structure.  This gives the company a second chance to become a profitable concern.

The company initiates the process by filing Chapter 11 petition with the court.  Upon receiving the filing, the court freezes debt and collection actions.  The company, now called the "debtor in possession" maintains its business operations and submits a reorganization plan to the court.  This plan may be "prepackaged" or may be created within 120 days of filing.  The company has to get the debt owners to accept the plan 60 days afterwards.  Obviously, if the debt holders are paid in full, the plan will be approved.  Otherwise, the plan is accepted if 50% of debt owners and if holders of 67% of the total amount of debt approve it.  This is when an investor with 33% of the debt holds a power position.  Since the investor is able to block any approval of the reorganization plan, this forces the company to negotiate with them.  After this original period has passed and no plan has been accepted, anyone can submit their own plan.  If the company agrees with the new plan, the court may approve it.  If none of the plans are acceptable to the company and debt owners, the court can force a cramdown plan.  Basically, the court tells everyone what the plan is.

Reorganization of the company usually means reimbursing debt, converting debt into equity and wiping out the current equity holders.  Within the company's bond structure, senior secured debt is paid back first.  Subordinated debt receive less than face value and other debt is converted to equity.

The source for the bankruptcy process summary is Mark Anson, The Handbook of Alternative Assets, pgs 483 - 487.  The book forms the core of the CAIA curriculum.