Legal Rules Governing Bankruptcy and Dissolution in the United States

U.S. law distinguishes between bankruptcies which are governed by Federal law and winding-up procedures (i.e., dissolution of the legal entity) which are governed by state law.

Bankruptcy

Once a company declares bankruptcy, it can undergo one of two processes. In the first process (Chapter 7 bankruptcy), the company is liquidated. In other words, the company ceases to operate, its assets are sold, and the proceeds are distributed among its debt holders and shareholders according to the priorities attached to the liabilities and to the company's equity. In this process, the proceeds are distributed according to the absolute priority rule, pursuant to which debt holders are entitled to the repayment of their debt before the shareholders. Among the debt holders, secured debt holders are paid before unsecured debt holders. Holders of debt which is unsecured by assets are paid according to the priority of their debt.

The assets are usually sold under the court's supervision by a trustee who is put in charge of the assets (or a receiver). In some cases, the trustee sells the entire company as a "going concern," and in other cases the assets, if any, are sold separately. Research indicates that the consideration received in a liquidation sale is lower than the consideration received in the sale of an active company as a "going concern."

In practice, creditors with priority often agree to waive the priority rule so as to enable a faster process and prevent various claims between the creditors.

In the second process, namely, reorganization (Chapter 11 bankruptcy), the company continues operating under the court's protection and after reaching understandings with the company's debt holders. In this alternative, the debt holders and equity holders are made new undertakings by the company in lieu of the company's undertakings to them before the bankruptcy. For instance, debt holders may become equity holders, in consideration for discharging part of their debt. After the bankruptcy petition is filed, the company has 120 days to file a reorganization plan with the court, and the debt holders can either accept or reject it. If the company does not file a reorganization plan, or if it is rejected by the debt holders, the court is authorized to extend the time frame so that an agreement on the reorganization may be reached, or to ask the debt holders to propose a plan of their own. For a rehabilitation plan to be accepted, a majority vote is required for each of the various classes of debt holders and equity holders.

The court may exempt the company from the need to obtain the approval of each class of debt and equity holders if it is convinced that the plan is fair and does not discriminate among the holders of the various classes of debt and equity. In this scenario (known as "cramdown"), in which some classes of debt or equity holders do not agree to the reorganization, the holders of such classes of shares or debt have to receive, within the reorganization, at least the amount they would have received in an ordinary dissolution (under Chapter 7).

Most bankruptcies in the United States start out as Chapter 11 bankruptcies, and only if the attempts to rehabilitate the company fail is the company dissolved under Chapter 7.

Dissolution

Following is a review of the rules governing the dissolution of companies in Delaware, in which many technology firms are organized.

The law in the State of Delaware provides a broad set of rules with respect to the dissolution of companies which are organized there. The state's dissolution procedures are designed to balance between the interests of the directors and shareholders, who want to limit their exposure to claims by the company's creditors, and the interests of creditors, who want to have their claims granted. A company which operates under the state's dissolution rules provides its directors with considerable protection against claims by the company's creditors.

Dissolution usually begins with a resolution by the company's board of directors that the dissolution is desirable for the company. After the resolution is adopted, the board of directors sends a notice to the shareholders in which it specifies the content of the dissolution decision adopted and asks the shareholders to approve it. At the general meeting convened to approve the dissolution decision, a simple majority of the holders of voting rights is required. It should be noted that a decision to dissolve a company may be taken without any action by the board of directors, by a written resolution of all persons entitled to vote.

Once the dissolution decision is approved, at the initiative of either the board of directors or the shareholders, the company must file a Certificate of Dissolution for the company with the Delaware Secretary of State. The Certificate of Dissolution must include the following details: the name of the company; the date of approval of the dissolution; an affidavit with regard to the entity which approved the dissolution decision (the board of directors and the shareholders or only the shareholders); and the names and addresses of all the company's directors and officers. The date of dissolution of the company is either the date on which the Certificate of Dissolution is filed or a later date, if the Certificate of Dissolution so provides.

The company's legal entity continues to exist for another three years after the date of dissolution in order to resolve claims against the company, settle its liabilities, and conclude its business affairs. It should be noted that if a claim is filed against the company in the three years following its dissolution decision, the company will continue to exist for this purpose alone until the final resolution of the claim. In other words, no new claims may be filed against the company after the three-year period, even if its legal entity continues to exist due to prior claims.

The legal framework in Delaware enables the company's board of directors to choose one of two ways to distribute the company's assets in the dissolution: a judicial procedure or a default procedure, which is more common among Delaware companies. In both cases, the company's directors are not exposed to legal claims by the company's creditors if they follow the provisions of the law. The default procedure is faster and more flexible than the judicial procedure. In this procedure, the company's board of directors adopts a dissolution plan according to which the company either pays or arranges for sources of payment for all of the company's debts and liabilities, including contingent claims and pending contractual undertakings, which, based on known facts, are reasonably assumed to become due before the statute of limitations expires. This act has to be taken before any dissolution dividends are distributed to the shareholders.

It may appear at first sight that the default procedure is simpler and preferable to the judicial procedure. However, a close scrutiny reveals that the compliance with the demands of this procedure, particularly the demand that a "reasonable" amount be set aside to pay for any claims and debts not yet due, prior to distributing a dissolution dividend, may be put to the test and therefore places the directors at risk. Directors therefore prefer at times to enjoy the protection afforded to them by the judicial procedure.

The judicial procedure enables directors to ensure that they fulfill the requirement of meeting the company's future liabilities and therefore provides them with legal protection against personal liability. According to this procedure, the directors are required to send official notices to the company's creditors with respect to the dissolution of the company. Subsequently, the company moves the court to determine the following two items: (1) the amount and type of collateral required to pay the company's contractual undertakings, including any future liabilities not yet due; (2) the amount and type of collateral required to pay all of the company's other liabilities (i.e., non-contractual liabilities), including pending future liabilities which are likely to mature in the future.

In the judicial procedure, no dissolution dividend can be distributed to the shareholders for 210 days from the date of dispatch of the notice to the creditors. If the board of directors chooses the default procedure, the distribution of the company's assets may be commenced immediately after setting aside assets sufficient to pay the company's liabilities, including future and pending liabilities. Either way, the shareholders' debts to the creditors are limited to the amount of the dissolution dividend they received.