What is Prepetition Liability
Prepetition liability is a term used to refer to obligations that arise before a company’s filing for bankruptcy. A company has to petition for bankruptcy protection; once this is done, liabilities fall into two categories: pre-petition, or those that arise prior to petition, and post-petition, those that arise after petition. These two types of liabilities are often shown on the balance sheets of companies in bankruptcy protection.
BREAKING DOWN Prepetition Liability
The classification of a liability as either prepetition or post-petition has significant influence on the amount the company will have to pay for the liabilities. Once a claimant (or its creditor) files Chapter 11 bankruptcy, creditors must cease collections actions designed to collect on pre-petition obligations. Examples of pre-petition liabilities include debt outstanding such as amounts owed on loans and bonds, lease payments, income taxes, pension payments and other contractual obligations. A pre-petition liability that is not secured by assets is likely to only get a fraction of its original value. In other words, it is “subject to compromise,” while a post-petition liability will likely be paid in full — assuming the company exits bankruptcy protection in good shape. However, certain pre-petition liabilities are not subject to compromise. These include taxes owed. When exiting bankruptcy, a company must distinguish on its financial statements between its pre-petition liabilities that are subject to compromise and those that are not.
In certain cases, companies in the Chapter 11 bankruptcy process may designate suppliers of key components or services with which it does business, as “critical vendors.” If the bankruptcy court approves the designation, the company can pay pre-petition claims from these vendors in full to keep important operations running. There are limitations to this practice. Companies in bankruptcy may also reject contractual and lease obligations and liabilities, and clawback payments made to creditors while technically insolvent but prior to the bankruptcy filing. It may also ask the bankruptcy judge overseeing its reorganization to discharge its pre-petition liabilities.
Other Liabilities in Bankruptcy
Another category of liabilities, or claims, can come into play during the bankruptcy process. Contingent liabilities are triggered by a future event. Contingent liabilities may or may not appear on a company’s financial statements. Often, they are instead described in the notes accompanying the statements.
Typically reorganization agreements for companies emerging from bankruptcy contain a provision forbidding any payments to shareholders “unless creditors agree” until pre-petition liabilities have been paid in full.