What Is a Prepetition Liability?
When a company or individual files for bankruptcy, they must first list all their debts. These are called prepetition liabilities. Post-petition liability, on the other hand, is all the debt incurred after the bankruptcy case is logged. These two types of liabilities are often shown on the balance sheets of companies in bankruptcy protection and are separated to distinguish which outstanding balances are expected to be paid in full.
- When a company petitions for bankruptcy, everything it owes is categorized as either prepetition debts, incurred prior to filing, or post-petition liabilities, assumed after the bankruptcy filing.
- Classification of a liability as either prepetition or post-petition on the balance sheet has a significant influence on the amount the company will have to pay.
- Creditors are likely to collect only a fraction of the value of the prepetition liabilities they are owed, unlike post-petition liabilities, which must be paid in full.
- Not all prepetition liabilities are subject to compromise, and a company must distinguish which are not in its financial statements.
Understanding a Prepetition Liability
When a company petitions for bankruptcy, it must list in full everything it owes. These liabilities are then split into two categories: prepetition debts incurred prior to filing and post-petition liabilities taken on afterward.
This classification is important as it has a significant influence on how much the company will have to pay. Once the defaulting entity files for Chapter 11 bankruptcy, creditors will have difficulty collecting on its prepetition obligations including amounts owed on loans and bonds, lease payments, pension payments, and other contractual obligations.
Most prepetition liabilities are reduced or dismissed during bankruptcy proceedings, so creditors are likely to only get a fraction of the original value of what they are owed unless these liabilities are secured by assets. In other words, that means that clawing back payments is “subject to compromise.”
When a liability is recorded on the balance sheet prior to the bankruptcy petition, creditors can expect to retrieve only a fraction of that debt.
Liabilities registered as post-petition on the balance sheet, on the other hand, are not considered a part of the bankruptcy case and, as a result, must be honored and paid in full—assuming the company exits bankruptcy protection in good shape.
Limitations of a Prepetition Liability
Not all prepetition liabilities are unrecoverable. A secured creditor can still enforce a lien against property owned by the debtor, while some liabilities might not be subject to compromise. When exiting bankruptcy, a company must distinguish in its financial statements between its prepetition liabilities that are subject to compromise and those that are not. Obligations not open to negotiation usually include taxes owed and anything that was not listed by the debtor.
Another category of liabilities, or claims, can come into play during the bankruptcy process. Contingent liabilities are triggered by a future event and may or may not appear on a company’s financial statements—often, they are described in the footnotes accompanying the statements. Should unliquidated claims of this nature not be included in the bankruptcy petition, it might be difficult for the debtor to avoid payment.
Typically, reorganization agreements also contain a provision forbidding any payments to shareholders “unless creditors agree” until prepetition liabilities have been paid in full.
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 prepetition claims from these vendors in full to keep important operations running. There are, however, limitations to this practice.
Companies in bankruptcy might 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, or cancel, its prepetition liabilities.