The basic difference between Bankruptcy (Chapter 7) and Reorganization (Chapter 11) is that in bankruptcy, the estate is liquidated, while in Chapter 11, it continues in operation. It’s not enough for an enterprise to show a profit. It must be generating cash. If you plant a grove of walnut trees, accrual accounting will show a profit every year, because the trees are worth more, but the enterprise is an alligator. You have to pay the nurseryman labor, and buy chemicals and fertilizer, and pay taxes for the century that it takes to bring those walnut trees to maturity. At the end of a century, the veneer will presumably sell for a fortune, but you have to keep sinking money into the enterprise for a longer period of time than any of us can expect to live.
Given adequate credit, it’s sufficient that one turn a profit, but unlimited credit simply doesn’t exist. On the other hand, you can keep a money-losing enterprise going as long as you’re bringing in money faster than you’re allowing it to depart. That’s the basis of a Ponzi scheme: you are losing money, but you bring in money faster than it departs.
In order for Chapter 11 to work, you need to be able to rearrange finances of the business so that you’re bringing in cash faster than it’s going out. If you are stuck in uncompetitive contracts, being able to renegotiate them might work. Kmart had a lot of stores that were losing money. When they went into reorganization, they were able to break leases, keeping the profitable stores, and closing the unprofitable ones. Instead of tying up capital in inventory to stock those unprofitable stores, they were able to invest that capital in their profitable stores and make them more profitable.
The only “appraisal” on real estate that matters is one that everyone agrees is correct. If there’s a disagreement, they put the property up for auction, and the selling price is whatever the property sells for.
If the bank holds a $18 million mortgage on the PAM building, and they think it’s worth $15 million, they will buy the building at auction if it goes for less than $15 million. If the property goes for $16 million, they’ll let it go to someone else. In either case, the bank will get the first $18 million in proceeds from the auction, and if the property sells for less than $18 million, then the PAM owes the difference. However, since the building has already been sold, this is an unsecured obligation.
At this point, you have a difference between chapter 7 bankruptcy and chapter 11 reorganization. Under chapter 7, you add up the assets and liabilities of PAM, and pay off the creditors in proportion to how much money PAM owes them. Certain debts have priority (such as taxes due the IRS, employees’ paychecks, and deposits from customers) and they get paid off first. If they are paid off in full, then the remaining money is divvied up among the unsecured nonpriority creditors, in proportion.
Under chapter 11, the trustee is allowed to play games with the finances. If it is essential that the enterprise have certain goods and services and there’s only one source, that source can insist on full payment as a condition for continuing to supply those goods and services. Someone who is less essential may end up taking a bath for the full amount owed.
If everyone would act in their enlightened self-interest, there’d be no need for filing reorganization. You can work out the same plan voluntarily, and avoid all those legal bills. That often doesn’t happen, though. People often cut off their nose to spite their face.
But if PAM is under water with their mortgage, they need to find someone who will buy the building at a value the bank considers fair, and then lease it back to PAM at a price PAM can afford. That’s true whether PAM files for reorganization or not.
Typically, schools have less than 1/3 of a year’s revenue invested in assets other than real estate, and consequently, they will have relatively few liabilities other than their mortgage. If they have their ducks in a row – that is, their other costs in line and sufficient revenue to cover them – a sale and lease-back of the building is probably all they need to work out in order to continue operation. If they have too many (or overpaid) teaching staff or a lack of students, they have to solve those problems, or nothing will save them.
