This post is part of a series of posts entitled First Considerations for the Financially Distressed Business. For a comprehensive list of articles contained in this series, click here.

Because this publication focuses on debtors who wish to continue to operate, the main focus of the discussion on bankruptcy will center on chapter 11 reorganizations.

A. Debtor Eligibility – Chapter 11

Legally, anyone except a governmental agency, an estate, a nonbusiness trust, a stockbroker, a commodity broker, an insurance company, a bank, or an SBA-licensed small business investment company may file under chapter 11. An individual may not file under chapter 11 if he or she has had another bankruptcy case dismissed upon certain grounds within the last 180 days.

It is important to note that, unlike certain other types of bankruptcies, there are no financial or insolvency requirements for filing a voluntary chapter 11 case other than the good faith requirement that the case be filed primarily for the purposes of reorganization. A voluntary chapter 11 debtor can be solvent or insolvent and have assets that exceed its liabilities by any amount (or vice versa). The only restriction is a practical one—chapter 11 restructurings can be extremely expensive, therefore a debtor must determine whether the cost of the case is justified by the intended benefit.

B. Bankruptcy Estate

When a debtor files for bankruptcy, a bankruptcy “estate” is created. All of the debtor’s legal and equitable interests in property become property of its bankruptcy estate, including all tangible and intangible property. 11 U.S.C. § 541(a). This means that all of a business’s working capital becomes estate property as well as accounts receivables and inventory. Also part of the bankruptcy estate are all contract rights and causes of action. Estate property also includes “[p]roceeds, products, offspring, rents, or profits of or from property of the estate.” 11 U.S.C. § 541(a)(6).

C. Automatic Stay

As previously discussed, one of the primary benefits of bankruptcy is the “automatic stay.” The automatic stay in bankruptcy goes into effect the moment a bankruptcy case is filed. The automatic stay broadly protects the debtor and the bankruptcy estate from creditor actions. Among other things, it prohibits a creditor from commencing or continuing any action or proceeding to collect a pre-bankruptcy debt or attempting to exercise control over property of the estate. This includes such actions as lawsuits, foreclosures, repossessions, bank levies, wage garnishments and other collection activities (subject to certain exceptions). The automatic stay is extremely effective in protecting a debtor as any action taken in violation of it is generally considered void, regardless of where the creditor action is taken or the creditor’s intent in taking the action.