In just a few weeks, COVID-19 has taken the world by storm, derailing everything from the stock market to the supply chain to healthcare, work, and family life. It has also left many companies—both large and small—to question whether filing for Chapter 7 (corporate liquidation) or Chapter 11 (debt relief and reorganization) makes sense in our new reality.
But which form of bankruptcy may make the most sense, Chapter 7 or Chapter 11?
Chapter 7 vs. Chapter 11 bankruptcy
If a company's financial future is so bleak that the decision to close its doors and wind up its affairs makes the most sense, Chapter 7 of the United States Bankruptcy Code provides that escape route. Chapter 7 involves closing the business and liquidating all of its assets. It can provide a chance to reset and start over.
Once a Chapter 7 petition is filed, a bankruptcy trustee is appointed by the Court to take over the business and attempt to sell the company's assets. Any proceeds of the sale are then distributed among creditors according to the priority rules established by the Bankruptcy Code. Though expensive, the advantage of filing for Chapter 7 bankruptcy protection is that the company rids itself of debt and stops the proverbial bleeding.
On the other hand, if a corporation or limited liability company (LLC) decides that it may be advisable to reorganize its business affairs, debts, and assets, a Chapter 11 bankruptcy proceeding is often the preferred path forward. The main difference is that the company can continue to operate, albeit without the debt on its shoulders, subject to the company's fulfillment of a court-approved reorganization plan.
The future of bankruptcy under COVID-19
Even before COVID-19 overtook America, many companies were already struggling to churn a profit—J. C. Penney, Rite Aid, and Modell's come to mind. However, when COVID-19 reared its ugly head, the landscape became even grimmer for many businesses.
In response to COVID-19, governors in nearly all 50 states took immediate action by mandating that any "non-essential" businesses close their doors until further notice. At the same time, any "essential" businesses could remain open, subject to certain social distancing policies. The truth is that no one really knows when the COVID-19 ban will be lifted or how soon the economy will bounce back.
According to the Honorable Christopher S. Sontchi, a former bankruptcy law practitioner and current Chief Judge of the U.S. Bankruptcy Court in Delaware commented that "the trend on whether there are lots of bankruptcy filings or not will probably depend on how long the [COVID-19] shut-down lasts and when businesses may be allowed to re-open."
Judge Sontchi predicts that if businesses are not permitted to re-open until late summer or early fall, there will likely be a flurry of bankruptcy filings, particularly among smaller businesses. In this regard, Judge Sontchi pointed out that the procedures offered by the Small Business Relief Act (SBRA) make filing for bankruptcy easier and less expensive under Chapter 11. And although bankruptcy filings are generally quite onerous and very expensive, Judge Sontchi believes that programs like the SBRA will contribute to a rise in Chapter 11 filings, particularly for smaller companies.
Other legal experts agree that if companies are forced to file for bankruptcy in light of the effects of COVID-19, they will more likely file under Chapter 11 versus Chapter 7. This action is anticipated to be the case because the primary issue confronting companies of all sizes is the lack of cash flow. For that reason, recent stories in the media suggest that the industries most likely to seek bankruptcy protection include retailers, hospitality, restaurant chains, and car dealerships, to name a few.
Although throwing in the towel and closing up shop under Chapter 7 is certainly an option, experts believe that the overall desire to reorganize (Chapter 11) and forge ahead, as opposed to liquidating and shutting down the business altogether (Chapter 7), will be the determining factor in the future.
Only time will tell how debtors (and creditors for that matter) will choose to address these unique issues brought on by the COVID-19 pandemic, and how swiftly either side may act, if at all. In the interim, companies in distress should consult with restructuring advisors, and look to preserve cash as much as possible.