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Wharton Emeritus Professor Peter Linneman explains the difference between Chapter 7 and Chapter 11 Bankruptcy.
BRUCE KIRSCH: We learn about the two types of corporate bankruptcy in the US– Chapter 7 and Chapter 11 bankruptcy. Now when most people hear that a company has gone bankrupt, the mental image that appears is a boarded-up factory and there’s empty offices. And nobody’s there. The phones are disconnected, or ringing and nobody’s there to answer them. And, in essence, the company really has no value left in it.
Now that image could be appropriate to describe Chapter 7 but not Chapter 11. How is Chapter 11 bankruptcy different?
PETER LINNEMAN: Well I think it’s important to understand that when people say “chapter,” what they’re referring to is a chapter of the US Bankruptcy Code or its equivalent. But let’s stay within the US, because that’s the context we’re talking about.
So when you sign any contract, that contract operates under the auspices of the United States and all of its laws. Included in all those laws is that you have the right to bankruptcy if things don’t work out. And the Bankruptcy Code and its various chapters say what happens if you choose to use that. And, in fact, you don’t even mention that in the original contract because it’s subsumed it’s a matter of law that that framework exists to deal with those situations.
Chapter 7 says, I am no longer a going concern. The company is not viable. The entity is not viable. And that does happen sometimes for commercial real estate, but not often. Usually the property has viability. There are tenants, or there should be tenants, and therefore the entity itself, the building, is generally a viable, going concern, so that you don’t generally see Chapter 7 used on a property.
More typical is chapter 11 where the asset is viable. It’s a question of, how do I deal with the fact that I either do not have sufficient liquidity to satisfy all my creditors at the moment, or how do I deal with the fact that there is no liquidity. And though I may have enough value to satisfy all my creditors, I cannot access that value.
That comes up frequently in real estate because it’s an illiquid asset. So I could have a situation where, yeah, my assets generating a million cash flow and even at a 10 cap it’s worth $10 million, and I have a $9 million loan due. But no one will make me a loan for $9 million and to sell the property for $10 million could take me six to 18 months because of the illiquidity of the asset. And I don’t want to do a fire sale. And so, given the illiquidity of the asset, I may have a shortfall in terms of liquidity.
Alternatively, I may have a situation where temporarily– or at least I believe temporarily– my asset is worth less than my liability. But if you give me time, I believe the asset will recover its value such that the asset’s worth more than the liability. And you just got to give me time to bridge my way to it.
That’s what Chapter 11 is about. And that’s why you’ll hear the phrase “Chapter 11 protection.” And what it’s protecting you from is under the full auspices of US law. Being fully implemented, it is protecting you in your various contractual relationships, including with your lenders, your employees, et cetera. It’s protecting you from them squeezing you out on a temporary shortfall of liquidity or a temporary impairment of value relative to liabilities. And it’s giving you time within a very prescribed framework to work out how to get liquidity or how to work out that all the creditors get paid in full. But it may take longer to repay them.
The most notable example of what happened was in the 2008-2009 crisis. There were no loans available to anybody, at any price. If your loan came due then, it almost didn’t matter what your asset value was because no one was going to make any loan to anybody for anything. Therefore, you would be in default of your loan, even though the value of the property could be way in excess of the loan, but you could never realize it in time to pay off the loan because of the illiquidity.