Restructuring and insolvency law is the federal framework, set out in Title 11 of the U.S. Code, that decides what happens when a business cannot pay its debts: either the company reorganizes under court supervision and keeps operating, or a trustee liquidates its assets and pays creditors in a fixed order of priority. The system runs on a few core moves. A petition gets filed. An automatic stay freezes collection. The company either confirms a reorganization plan or its assets are sold off. Creditors are paid according to a statutory ranking that rarely bends.
When a Business Is Legally Insolvent
Federal law recognizes two ways a company can be insolvent, and meeting either one is enough.
The balance sheet test compares total debts against the fair market value of everything the company owns. If debts exceed assets, the company is insolvent.1Office of the Law Revision Counsel. 11 USC 101 – Definitions Fair market value means what the property would sell for today, not what it cost originally. Equipment bought for $2 million five years ago might now be worth $400,000, and the test uses the current figure. Property the debtor transferred or hid to keep it away from creditors doesn’t count on the asset side.
The cash flow test looks at operations instead of the ledger. A company that cannot pay its bills as they come due is insolvent even if its assets, on paper, exceed its debts. A manufacturer might own millions in real estate and still fail this test if it can’t cover payroll or vendor invoices on time. Creditors often point to this kind of failure when pushing a company into bankruptcy against its will.
Involuntary Petitions
Most cases begin voluntarily, but creditors can force a company into bankruptcy. If the company has twelve or more eligible creditors, at least three must join the petition. With fewer than twelve, one creditor can file alone. The petitioning creditors’ claims must total at least $21,050 above the value of any collateral securing them, and those claims cannot be disputed or contingent.2Office of the Law Revision Counsel. 11 USC 303 – Involuntary Cases A frivolous involuntary petition can cost the filer damages, attorney fees, and even punitive damages if the court finds bad faith.
What the Automatic Stay Does
The moment a petition is filed, federal law imposes an automatic stay that freezes nearly all collection activity against the debtor. Lawsuits stop. Foreclosures halt. Creditors cannot seize equipment, drain accounts, or continue garnishing payments.3Office of the Law Revision Counsel. 11 U.S. Code 362 – Automatic Stay The stay reaches every entity, not just the most aggressive creditor.
Without it, the fastest creditor would strip whatever assets it could reach, leaving nothing for anyone else and making reorganization impossible. The stay buys the debtor time to assess its situation and pick a path forward.
The freeze is not permanent. A creditor can ask the court to lift it by showing a lack of adequate protection of its interest in specific collateral. A secured lender whose collateral is losing value quickly has a strong case for relief. The court weighs the creditor’s risk of loss against the debtor’s need for the asset.
Reorganizing Under Chapter 11
Chapter 11 is the primary route for businesses that want to restructure their debts and stay open. The company keeps running while it negotiates new terms with its creditors.
Debtor in Possession
In most Chapter 11 cases, existing management stays in place instead of being replaced by an outside administrator. The company becomes a “debtor in possession” and takes on the same rights and duties a trustee would carry.4Office of the Law Revision Counsel. 11 U.S. Code 1107 – Rights, Powers, and Duties of Debtor in Possession The people who know the business are usually better positioned to run it through restructuring than an outsider. If management committed fraud or showed gross incompetence, the court can appoint an independent trustee instead.
The Exclusivity Period
The debtor gets first crack at proposing a reorganization plan. For 120 days after the order for relief, only the debtor can file one. Once that window closes, creditors, equity holders, and other parties can propose competing plans. The court can extend exclusivity for cause, but it cannot push the filing deadline past 18 months or the acceptance deadline past 20 months after the order for relief.5Office of the Law Revision Counsel. 11 U.S. Code 1121 – Who May File a Plan
Voting and Cramdown
The plan groups creditors into classes based on the nature of their claims, and each class votes. For a class to accept, creditors holding more than half the claims in number and at least two-thirds of the total dollar amount must vote yes.6Office of the Law Revision Counsel. 11 USC 1126 – Acceptance of Plan
When one or more classes reject the plan, the debtor can still seek confirmation through a “cramdown.” The court can force a plan on dissenting classes if the plan does not unfairly discriminate and is “fair and equitable.”7Office of the Law Revision Counsel. 11 USC 1129 – Confirmation of Plan For unsecured creditors, “fair and equitable” means they either get paid in full or nobody with a lower-priority claim gets anything. That is the absolute priority rule, and it stops shareholders from keeping their equity while unsecured creditors absorb the loss.
Financing the Case
A company in Chapter 11 usually needs new money to keep operating. The Code sets up a tiered system for post-petition credit. At the simplest level, the debtor can borrow on an unsecured basis in the ordinary course of business, with the lender receiving an administrative expense claim.8Office of the Law Revision Counsel. 11 USC 364 – Obtaining Credit
If nobody will lend on those terms, the court can authorize stronger incentives: a superpriority claim ahead of other administrative expenses, a lien on unencumbered assets, or a junior lien on already-encumbered assets. As a last resort, the court can authorize a “priming lien” that jumps ahead of existing secured creditors on the same collateral, but only if the debtor proves no other financing is available and the existing lienholders receive adequate protection. Each tier requires showing the prior, less drastic option was not enough.
Subchapter V for Smaller Businesses
Traditional Chapter 11 is expensive and slow, which puts it out of reach for many smaller companies. Subchapter V offers a streamlined version for businesses whose total debts fall below $3,024,725.9U.S. Department of Justice. Subchapter V – U.S. Trustee Program That limit covers noncontingent, liquidated debts (secured and unsecured) and excludes amounts owed to insiders or affiliates. Companies required to file reports under the Securities Exchange Act do not qualify.
The differences matter. There is no creditors’ committee, which eliminates a major cost. Only the debtor can file a plan. The absolute priority rule does not apply, so an owner can keep equity even if unsecured creditors are not paid in full, provided the plan dedicates projected disposable income over three to five years to creditor payments. The court appoints a standing trustee to help move the case along, but the debtor stays in possession and keeps running the business. Administrative expenses can also be stretched over the life of the plan rather than paid in full on the effective date, and for a cash-tight company that difference alone can decide whether reorganization is possible.
Liquidating Under Chapter 7
When a business cannot be saved, Chapter 7 shuts it down in an orderly way. The filing ends active operations. A trustee takes control of the assets, and management loses authority over the estate.10Office of the Law Revision Counsel. 11 U.S. Code 704 – Duties of Trustee
Everything the company owns at the moment of filing becomes part of the bankruptcy estate: inventory, real property, equipment, cash accounts, intellectual property, customer lists, and legal claims the debtor could bring against third parties. The trustee converts all of it into cash as efficiently as possible.
Asset Sales Under Section 363
Sales of estate property outside the ordinary course of business require court approval after notice and a hearing. The trustee can sell assets free and clear of liens or other interests if certain conditions are met, such as the sale price exceeding the total value of the liens or the lienholder consenting.11Office of the Law Revision Counsel. 11 USC 363 – Use, Sale, or Lease of Property Secured creditors can “credit bid” at these sales, using the value of their claim as currency rather than paying cash.
Leases and Contracts
One of the trustee’s early decisions concerns commercial leases. Within 120 days of the order for relief, the trustee must decide whether to assume or reject each unexpired lease of nonresidential real property, or the lease is deemed rejected and the property must be surrendered.12Office of the Law Revision Counsel. 11 U.S. Code 365 – Executory Contracts and Unexpired Leases The court can extend that deadline by up to 90 days for cause, but any further extension requires the landlord’s written consent. Valuable leases in prime locations are often among the estate’s most marketable assets.
Clawing Back Payments and Transfers
One of the trustee’s most powerful tools is the ability to recover payments and transfers the debtor made before filing. These actions undo last-minute attempts to favor certain creditors or move assets beyond reach.
A preference is a payment the debtor made shortly before bankruptcy that gave a creditor more than it would have received in a Chapter 7 liquidation. The trustee can recover payments made to ordinary creditors within 90 days before the filing. For insiders like officers, directors, or affiliated entities, the look-back period runs a full year.13Office of the Law Revision Counsel. 11 U.S. Code 547 – Preferences Creditors do have defenses, most commonly that the payment was made on terms consistent with the parties’ normal dealings.
Fraudulent transfer actions reach transactions where the debtor either intended to cheat its creditors or received less than fair value for what it gave away. The look-back period is two years before filing.14Office of the Law Revision Counsel. 11 U.S. Code 548 – Fraudulent Transfers and Obligations A company that sold a $5 million building to an insider for $500,000 eighteen months before filing would face this kind of claim. The trustee does not need to prove intent to defraud; receiving significantly less than fair value while already insolvent is enough.
Who Runs the Case
Bankruptcy cases involve layered oversight, with different officers handling different jobs.
In a Chapter 7 case, the trustee is the central figure. This person collects and liquidates estate assets, investigates the debtor’s financial affairs, and distributes proceeds to creditors.15Office of the Law Revision Counsel. 11 USC 704 – Duties of Trustee The trustee can sue anyone who owes the estate money, pursue preference and fraudulent transfer claims, and challenge exemptions. In Chapter 11, a trustee is appointed only if the court finds cause such as fraud or gross mismanagement; otherwise, the debtor in possession fills that role.
The U.S. Trustee is a different office. It is a Department of Justice division that oversees the bankruptcy system as a whole. It appoints and supervises individual case trustees, monitors filings for fraud, reviews professional fee applications in Chapter 11 cases, and can refer cases for criminal prosecution.9U.S. Department of Justice. Subchapter V – U.S. Trustee Program
A bankruptcy judge presides over the case, resolves disputes, approves sales and fees, and ultimately confirms or denies any reorganization plan. Separately, the U.S. Trustee convenes a meeting of creditors (the 341 meeting) within a reasonable time after filing. The debtor must attend and answer questions under oath, and the judge by statute cannot attend.16Office of the Law Revision Counsel. 11 U.S. Code 341 – Meetings of Creditors and Equity Security Holders Failing to appear without good cause is grounds for converting or dismissing the case.
Every officer of the estate owes a strict fiduciary duty to creditors as a whole. A trustee cannot favor one creditor over another unless the statute requires it, and a debtor in possession owes the same duty. Violations can lead to removal, denial of discharge, or personal liability.
The Order Creditors Get Paid In
When funds are available for distribution, the Bankruptcy Code sets a rigid payment order. Higher-priority claims are paid first, and lower-priority creditors receive nothing until every class above them is paid in full.
Secured creditors stand at the front because their debts are backed by specific collateral. A lender with a mortgage on a factory is paid from the proceeds of that factory’s sale before anyone else touches the money. Surplus flows to the estate; a shortfall becomes an unsecured claim.
After secured claims, the statute establishes ten levels of priority for unsecured claims:17Office of the Law Revision Counsel. 11 USC 507 – Priorities
- Domestic support obligations such as alimony and child support
- Administrative expenses, including trustee, attorney, and accountant fees, plus post-petition operating costs
- Gap-period claims arising between an involuntary petition and the order for relief
- Employee wages, salaries, commissions, and severance earned within 180 days before filing, up to a statutory cap per individual that is periodically adjusted for inflation
- Employee benefit plan contributions for services rendered before filing
- Specific protections for grain farmers against storage facilities and fishermen against fish processing facilities
- Consumer deposits for goods or services the debtor never delivered
- Government tax claims, including recent income taxes, property taxes, employment taxes, and excise taxes
- Claims based on commitments to maintain the capital of an insured depository institution
- Claims for death or personal injury from drunk driving
Trade vendors, credit card issuers, and other unsecured creditors without priority status sit at the bottom. They share whatever remains on a pro-rata basis after every higher category is fully satisfied. In practice, these creditors often recover pennies on the dollar, and in many cases receive nothing.
Discharge and Its Limits
The end goal of a Chapter 11 case for a reorganizing debtor is discharge: a court order that eliminates the debtor’s personal liability on pre-petition debts. Upon confirmation of a plan, the debtor is discharged from any debt that arose before the confirmation date, regardless of whether the creditor filed a proof of claim or voted.18Office of the Law Revision Counsel. 11 USC 1141 – Effect of Confirmation The plan terms replace the original debt agreements, and the company emerges with a restructured balance sheet.
Discharge has limits. If the plan calls for liquidating all or substantially all of the company’s assets and the debtor does not continue operating, no discharge is granted. Valid liens survive as well: a creditor whose lien was not addressed in the plan can still enforce it against the specific collateral even though the personal obligation was discharged. Confirmation also vests estate property back in the debtor, free of claims and interests except as the plan provides.
A discharge obtained through fraud can be revoked, typically within one year. Certain debts resist discharge entirely, including obligations arising from willful harm to others or their property, certain tax debts, and liabilities incurred through fraud.
When Chapter 11 Becomes Chapter 7
Not every reorganization succeeds. When a Chapter 11 case stalls or the company’s condition worsens, the case can be converted to a Chapter 7 liquidation. The debtor can convert voluntarily in most circumstances. Creditors and other parties can request conversion by showing cause, which the statute defines broadly to include continuing losses without a realistic prospect of rehabilitation, gross mismanagement, failure to file required reports, unauthorized use of cash collateral, or repeated failure to comply with court orders.19Office of the Law Revision Counsel. 11 USC 1112 – Conversion or Dismissal
The court will convert or dismiss based on whichever outcome best serves creditors and the estate. Conversion is not automatic even when cause exists: if the debtor shows unusual circumstances and a reasonable likelihood that a plan can still be confirmed within statutory timeframes, the court may decline to convert. As an alternative, the court can appoint a trustee or examiner if that would better protect creditors. Many contested Chapter 11 cases are won or lost here, in the fight over whether the company deserves more time or whether creditors are better off with a clean liquidation.