What Happens to Business Leases and Contracts in Chapter 11 Bankruptcy?

Chapter 11 bankruptcy is the method most often used by businesses that seek to continue operating. Called “reorganization bankruptcy,” the focus is on trimming unnecessary expenses and developing a profitable plan for moving forward.

Businesses in Chapter 11 usually have many relationships to navigate in the process of reorganizing, including:

• Equipment contracts
• Property leases
• Intellectual property licenses
• Franchise contracts
• Bank loans
• Business lines of credit
• Maintenance contracts

What is an Executory Contract?

Many leases and contracts in business are executory: action must be taken by both sides to complete the requirements of the agreement. When a business files for Chapter 11 bankruptcy they likely interrupt the cycle of an executory contract, leaving it incomplete.

Part of the bankruptcy process involves creating a hierarchy of creditors according to whether the debt they are owed is secured or unsecured. Most contracts and leases are unsecured as there is no collateral held against them. Under the terms of bankruptcy debtors have 120 days to reject or maintain contracts.

Steps in Chapter 11 Affecting Contracts and Leases

A bankruptcy filing concerns all creditors doing business with the petitioner. The following are the approximate steps in the process of determining which contracts are maintained:

1. Automatic stay. When a business files for Chapter 11, it is issued an automatic stay by the court at the same time that creditors are notified of the bankruptcy petition. That means none of its creditors can contact the business (called the debtor) about outstanding balances for a specific period.
2. Reorganization plan. During the court’s stay, the business works out a plan for resuming viability, including maintaining critical partnerships with banks, suppliers, and others essential to a successful return to business. This includes prioritizing debts by class and determining how much will be paid to each, through negotiated settlement, discharge, or liquidation of assets. During this period the debtor business sketches out which contracts will be resumed or rejected to best execute the reorganization plan.
3. Business judgement test. The bankruptcy judge weighs the fairness and function of the plan, including activity affecting the contracts. The judge may accept or reject the plan according to its fairness, determined in part by the amount of debt paid to the creditor (it must be the same amount recoverable in a Chapter 7 liquidation), and a “business judgement” test. Each decision made in the reorganization plan is subject to scrutiny by the presiding judge.
4. Plan voting. Creditors are invited to view the reorganization plan and vote on its implementation. A majority from each class of creditors must approve the plan for it to move forward.
5. Committee of Creditors. Creditors who hold contracts and leases critical to the debtor business’s continued operation have an opportunity to join a committee that oversees the operations of the Debtor in Possession (DIP) and administration of the reorganization plan. This committee advises the bankruptcy trustee, who is principally in charge of the petitioner’s ongoing operations and must consent to any changes, hiring, major purchases, or other activities that may affect or alter the terms of the reorganization plan.
6. Rejecting contracts. Contracts and leases that are rejected by the debtor under Chapter 11 may be considered in breach as of the date of filing for bankruptcy. Certain contracts cannot be rejected by the debtor, including those that call for the debtor to make a loan or provide financing, one that prevents a third party from intervening in the contract, or those for nonresidential property that were previously terminated or completed.
7. Damaged reputation. If a company successfully completes all of the requirements of Chapter 11 bankruptcy, it may still suffer the financial effects of a damaged credit score and reputation. Creditors may decide against lending to the company or doing business with the Debtor in Possession.

Key Allies for Wisconsin Chapter 11 Challenges

Companies on both sides of a bankruptcy case may seek legal counsel when a key business partnership is interrupted by a Chapter 11 petition. Kerkman & Dunn’s experienced bankruptcy attorneys are experts on navigating complex relationships with creditors and regulations set forth in U.S. bankruptcy law.