Why companies file for bankruptcy – and how it protects both debtors and creditors

Reports have emerged^[1] that Purdue Pharma is in settlement talks to resolve thousands of federal and state lawsuits over its role in fueling the opioid epidemic^[2]. As part of the reported settlement, the company would file for bankruptcy.

Earlier this year, Insys Therapeutics became the first opioid drugmaker^[3] to enter bankruptcy following its US$225 million settlement with the Department of Justice. In recent months, there’s been speculation^[4] that drugmakers might use bankruptcy as a way to escape accountability and avoid billions of dollars in litigation costs.

Fortunately, that’s not how bankruptcy works. Rather, as I’ve learned in my experience^[5] studying and practicing bankruptcy law, the process is designed to not only protect debtors like Insys or Purdue but also creditors such as states and other opioid litigants.

Bankruptcy is not perfect, and sometimes outcomes seem unfair. But it’s definitely not the “get out of jail free” card that many fear.

Making the best of a grim situation

To most people, bankruptcy has a negative image^[6]. And for good reason: A filing almost always means there’s not enough money to go around.

But the system makes the best of a grim situation by imposing an orderly and open process that preserves value and encourages negotiation. Bankruptcy reorganizations by well-known brands such as Delta^[7] and General Motors^[8] show that it can bring parties together and resurrect struggling companies.

At the most fundamental level, the Bankruptcy Code creates an estate to collect all of the debtor’s assets into one place, identify and categorize claims against the debtor in terms of priority and then distribute the assets accordingly.

Exactly how those three core tasks play out in a given case will vary depending on what type of bankruptcy case the debtor files and specific facts about the debtor.

Chapter 7 vs. Chapter 11

Large business debtors have two bankruptcy options: liquidation or reorganization.

Chapter 7 cases are designed^[10] to liquidate the company, meaning it will no longer exist, and any remaining value will be divided up and distributed to creditors.

In contrast, a Chapter 11 reorganization^[11] allows a debtor to sell some or all of its assets or propose a reorganization plan that aims to resolve and satisfy enough creditors to re-emerge as a going concern.

For example, airlines United, Delta and American all filed for Chapter 11^[12] protection in the mid-2000s and managed to unload enough debt to stay aloft. More recent filings seeking reorganization include those by Sears^[13], Pacific Gas and Electric Company^[14] and Toys R Us^[15].

Companies sometimes initially file under Chapter 11 to reorganize but later decide to shut down after they fail to confirm a plan or find a suitor. Recent examples of this include Bon-Ton Stores^[16], Circuit City^[17] and Borders^[18].

For companies looking to survive, the Bankruptcy Code^[19] requires either creditor support or payment in full. If even one class of impaired creditors votes against a plan, the company must go through a demanding “cramdown” process for court approval to proceed.

Once a Chapter 11 plan of reorganization is finalized and approved, a debtor emerges from bankruptcy and continues operating, usually in a stronger position than before.

Benefits of bankruptcy for debtors

Bankruptcy provides at least two valuable benefits to all debtors: time and space.

The moment a debtor files its petition, an automatic stay is imposed on creditors, which operates like a pause button on any collection efforts, litigation or similar actions. Creditors can ask the court to lift the stay under certain circumstances, but the standard for doing so is often difficult to meet.

The bankruptcy court has broad authority to control all matters involving the debtor’s estate, including claims that are distantly related to the main bankruptcy case. The debtor may ask the court to pause other lawsuits outside of the bankruptcy case if they affect the estate. By bringing together all those with a stake in the company’s assets in one place, a debtor can more efficiently deal with all claims against it.

While the stay is in place, debtors use the bankruptcy process to evaluate their problems and make the necessary changes to succeed after reorganizing. This includes deciding which contracts they want to carry forward and which to abandon.

To avoid a contested process, savvy debtors seek a global settlement with as many stakeholders as possible – which is what Purdue is likely trying to do^[20] – and include “sweeteners” to sway undecided creditors in favor of the plan.

Benefits for creditors

Clearly, bankruptcy provides debtors with significant power to rearrange their business affairs.

What many people misunderstand, however, is that this power is balanced by strong creditor protections^[21]. The Bankruptcy Code requires debtors to disclose significant information about their operations and imposes strict checks on debtor actions.

For example, the debtor must publicly file information about all of its assets and liabilities, sit for a bankruptcy deposition with creditors and seek the court’s permission before taking many actions outside of the ordinary course of business.

Under Chapter 11, the debtor is allowed to remain in possession of its estate and continue operating. Creditors that are concerned about the debtor’s ability to preserve the estate’s value may ask the court to appoint an examiner or trustee^[22] to take control. Creditors may even move to dismiss the case if they believe the debtor is abusing the bankruptcy process.

The Bankruptcy Code creates a committee of unsecured creditors – those without assets backing their claims – to advocate on behalf of claimants who are likely not involved in the case. The court may also form a special committee representing tort claimants in cases where debtors face litigation or future claimants whose injuries are not yet known. The court overseeing the bankruptcy of Imerys, for example, appointed plaintiffs^[23] to represent cancer victims with claims against the talc supplier^[24].

These and other features add a degree of fairness to an inherently unjust situation. The debtor may be sitting in the driver’s seat, but numerous other stakeholders have the power to make sure that the company follows the rules of the road.

With such protections in place, creditors and the general public need not fear the worst if bankruptcy plays a bigger role in the unfolding opioid saga.

References

1. ^{^} Reports have emerged (www.nytimes.com)
2. ^{^} opioid epidemic (theconversation.com)
3. ^{^} became the first opioid drugmaker (www.npr.org)
4. ^{^} there’s been speculation (www.commondreams.org)
5. ^{^} I’ve learned in my experience (www.law.uga.edu)
6. ^{^} has a negative image (hbswk.hbs.edu)
7. ^{^} Delta (www.reuters.com)
8. ^{^} General Motors (ssrn.com)
9. ^{^} AP Photo/Mark Lennihan (www.apimages.com)
10. ^{^} Chapter 7 cases are designed (www.uscourts.gov)
11. ^{^} Chapter 11 reorganization (www.uscourts.gov)
12. ^{^} all filed for Chapter 11 (www.vox.com)
13. ^{^} Sears (www.investopedia.com)
14. ^{^} Pacific Gas and Electric Company (www.reuters.com)
15. ^{^} Toys R Us (www.dailyrepublic.com)
16. ^{^} Bon-Ton Stores (money.cnn.com)
17. ^{^} Circuit City (www.nbcnews.com)
18. ^{^} Borders (dealbook.nytimes.com)
19. ^{^} Bankruptcy Code (uscode.house.gov)
20. ^{^} Purdue is likely trying to do (www.cnbc.com)
21. ^{^} strong creditor protections (www.uscourts.gov)
22. ^{^} trustee (www.justice.gov)
23. ^{^} appointed plaintiffs (www.law.com)
24. ^{^} claims against the talc supplier (www.bloomberg.com)