Bankruptcy 101

“I. Declare. BANKRUPTCY!” If you are like me, this iconic line from Michael Scott may be one of the first things that comes to mind when you think about bankruptcy. Of course, the joke is that bankruptcy does not really make “all your problems go away,” per Creed Bratton. In fact, bankruptcy is a complex mechanism and not everyone or every entity can take advantage of its benefits.

One of the first things I learned about bankruptcy is that a legal condition that arises after someone files or petitions for bankruptcy. It does not just mean someone has run out of money or are not able to pay their debts. And once you enter into the bankruptcy process, there are many additional steps to be able to address the problems and get a fresh start.

In law school, the bankruptcy class focuses on the Chapter 11 bankruptcy process, which involves the reorganization of a corporation or partnership. This is in contrast to Chapter 7, which provides for liquidation of the debtor’s assets and is usually the process most individuals pursue. Through studying Ch. 11 bankruptcies, I had the chance to learn about corporate structures, financing, and accounting, about the aims and rules under the Bankruptcy Code, as well as what the bankruptcy courts have added to the statutory regime.

Here are three main themes in Bankruptcy:

1. Bankruptcy goals

The main goal in Ch. 11 bankruptcy is to create value or save value that would otherwise be lost. Bankruptcy wants to make sure that no one is worse off, and may even cause some to be better off. To achieve this, the rules makes the company a “debtor,” and force all parties into a mandatory process so that they can negotiate and arrive at a “reorganization plan,” which is a plan to address the company’s financial and economic distress by paying out claims, distributing value, and designating new use of assets. Generally, some of these parties will have to vote for the plan in order for the company to come out of the bankruptcy as a reorganized entity.

Other bankruptcy goals include checking for and correcting financial and economic distress, creating breathing room for the debtor, creating an economically viable company, addressing collective action or debt overhang obstacles that would hinder a solution, and distributing value to people to whom the debtor owes money. Through many features in the statute and doctrine, the bankruptcy landscape tries to make the process fair, efficient, and value-maximizing.

2. Context matters

In order to carry out the goals of bankruptcy, lawyers and judges must understand the circumstances that lead to the bankruptcy filing or petition. First, they should know how the business operations of the debtor was structured and financed. If you’ve taken corporations, some of the topics like the duty of loyalty or shareholder rights may come up. Second, they need a clear understanding of the constituencies and their interests. Constituents include: trade creditors who had contracts with the debtor, banks who lent money, tort claimants from personal injury lawsuits, different classes of shareholders, and more. Since some of them would be voting for the reorganization plan, knowing their desires and motives help craft an arrangement that fulfills the bankruptcy aims.

3. Standards and discretion

While bankruptcy law is directed by Bankruptcy Code, there are many standards rather than rules in important bankruptcy issues. This leaves room for interpretation to the courts. In addition, bankruptcy courts are courts of equity. The statute empowers them to “what is necessary and appropriate,” and thus to make decisions with an eye toward fairness.

Using discretion, courts actively fill in gaps left unaddressed by the statute. Courts screen for cases that are not a good fit for bankruptcy, which can happen when, for example, a debtor goes into bankruptcy only to avoid or gain strategic advantages in a lawsuit, delay a government enforcement action, or to take advantage of bankruptcy rules at the expense of others.

Given this feature of bankruptcy law, advocates find it exciting to be able to make creative arguments and propose tailored solutions.

Taking bankruptcy in law school was an eye-opening experience involving a complex and interesting area of law. I gained a better understanding of the economics of running a company, the many parties involved and their conflicting interests and goals, the role of courts in managing the process and preventing abuse, and the developing areas in the doctrine. I started to understand what practitioners meant when they said that bankruptcy is a blend of litigation and transactional work.

So, if you are at all curious about what comes after the news headline: “Company X files for petition,” or if you are interested in clerking for a Bankruptcy court, taking a law school bankruptcy will give you a peek behind the curtain.