Why does Bankruptcy Law Exist?
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Legal Bankruptcy Process When a company with financial obligations to outside creditors becomes insolvent, its creditors have several options. The can either negotiate directly with the company (i.e. the debtor) to turn things around or choose to pursue legal action against the company. A secured creditor, one that has a claim (i.e. obligation) that is backed by a specific asset, can move to seize the asset and sell it to fulfill the obligation owed to it by the debtor. An unsecured creditor can pursue legal action by suing the debtor to obtain a lien on an asset that it could then seize and sell to fulfill its obligation. Alternatively, instead of pursuing non-bankruptcy legal remedies, the creditors can collectively force the debtor into a bankruptcy proceeding. (The company can also voluntarily enter bankruptcy proceedings in order to seek the court’s protection from creditors). Bankruptcy law was designed to deal with insolvency by addressing the shortcomings of the legal system in this area. If a company is insolvent, then it by definition does not have enough assets to pay all of its liabilities; as such, not all creditors will be able to recover their claims in full once a debtor becomes insolvent. This creates an adverse incentive for each creditor to seize the debtor’s assets before other creditors lay claim to them first, which creates two negative outcomes. First, the assets of the debtor are seized and sold off in an inefficient “fire-sale” fashion, destroying any collective value the assets may hold. Second, each creditor expends increased amounts of resources trying to beat the other creditors in a collective “race” to the debtor’s assets. Bankruptcy law prevents this senseless destruction of value by imposing an orderly process where each creditor (or “claimant”) is given an equal opportunity to establish the priority of its claim on the debtor’s assets. It also increases the certainty that a creditor will be fairly compensated for its claim by the debtor. (Fair compensation in this case may not be the full amount of the obligation, but an amount roughly approximate to what the creditor could have expected to receive outside of bankruptcy adjusted by the weighted probabilities of getting to the assets before the other creditors). Other than preventing a detrimental impact on creditors, the bankruptcy process
also provides a major benefit to the debtor company itself; in certain instances it allows for a “fresh start”, a chance for the company to start over despite default. As such, it can be viewed as a form of insurance for all debtors against financial and economic misfortune (which must be paid for in the form of higher overall interest rates). (Adler, Baird, & Jackson, 2007) The Chapter 11 section of the Bankruptcy Code allows for the financial and economic rehabilitation of companies that – in the opinion of the relevant stakeholders and the courts – should survive and continue to operate as a going concern. Companies that become insolvent and enter bankruptcy are by definition experiencing a form of “financial distress”, which may or may not be caused by underlying “economic distress”. Financial distress is a situation that arises when the revenues generated by the company are insufficient to repay its debts in a timely manner, as originally promised to its creditors. This condition is a symptom of an inappropriate capital structure, one that is not a good fit for the company’s business model. In contrast, economic distress constitutes a fundamental flaw in the company’s business model; the products or services it provides are simply not competitive in the marketplace or it is not able to efficiently utilize its assets to produce an economic profit. The two types of distress often coexist, or are causal – it’s easy to see how continued economic distress can lead to eventual financial distress for any company that has financial debts. Financial distress can also lead to economic distress in the case where a company is forced to sell off its most profitable assets to pay down its debts. Alternatively, other companies face financial distress as a result of external shocks or temporary setbacks despite being economically viable overall. The role of bankruptcy proceedings is to separate the companies that possess a going-concern surplus from those that should be dismantled and liquidated. The reasoning is that companies that can utilize a particular set of assets in a more effective way than anyone else should be worth more as a going concern than if those assets were sold off to other companies. It is in the spirit of the Bankruptcy Code
that these companies be given an opportunity for a “fresh start”. This gives the creditors an opportunity to recoup their claims (or at least an opportunity to receive more than they would get if the debtor was liquidated, whether via repayment or an ownership stake in the new firm) and society as a whole benefits from the continued existence of an economically viable firm. Alternatively, if a company has no going concern surplus, then there is no point for it to continue to exist; it should be liquidated with the proceeds going to repay its creditors. (This is the purpose of Chapter 7 of the Bankruptcy Code, which deals with an orderly liquidation of a debtor’s assets). (Adler et al., 2007) A company that is merely suffering from financial distress is prime candidate for rehabilitation through Chapter 11 proceedings. The process allows the court to reduce its debt obligations (in a fair and equitable manner) to ensure that the new capital structure is consistent with the company’s projected future earnings. However, companies that are also facing economic distress (in addition to financial distress) can also be helped. In the latter case, the goal of the bankruptcy process is to investigate, and if possible, eliminate the sources of the economic distress through a reorganization plan. Since buy-in from creditors and approval by the court is necessary in either case, the process ensures that any restructuring or reorganization plan meet the stringent requirements of all the parties involved.
Adler, B., Baird, D., & Jackson, T. (2007). Bankruptcy: Cases, Problems and Materials (4th ed., p. 797). New York, NY: Foundation Press.
also provides a major benefit to the debtor company itself; in certain instances it allows for a “fresh start”, a chance for the company to start over despite default. As such, it can be viewed as a form of insurance for all debtors against financial and economic misfortune (which must be paid for in the form of higher overall interest rates). (Adler, Baird, & Jackson, 2007) The Chapter 11 section of the Bankruptcy Code allows for the financial and economic rehabilitation of companies that – in the opinion of the relevant stakeholders and the courts – should survive and continue to operate as a going concern. Companies that become insolvent and enter bankruptcy are by definition experiencing a form of “financial distress”, which may or may not be caused by underlying “economic distress”. Financial distress is a situation that arises when the revenues generated by the company are insufficient to repay its debts in a timely manner, as originally promised to its creditors. This condition is a symptom of an inappropriate capital structure, one that is not a good fit for the company’s business model. In contrast, economic distress constitutes a fundamental flaw in the company’s business model; the products or services it provides are simply not competitive in the marketplace or it is not able to efficiently utilize its assets to produce an economic profit. The two types of distress often coexist, or are causal – it’s easy to see how continued economic distress can lead to eventual financial distress for any company that has financial debts. Financial distress can also lead to economic distress in the case where a company is forced to sell off its most profitable assets to pay down its debts. Alternatively, other companies face financial distress as a result of external shocks or temporary setbacks despite being economically viable overall. The role of bankruptcy proceedings is to separate the companies that possess a going-concern surplus from those that should be dismantled and liquidated. The reasoning is that companies that can utilize a particular set of assets in a more effective way than anyone else should be worth more as a going concern than if those assets were sold off to other companies. It is in the spirit of the Bankruptcy Code
that these companies be given an opportunity for a “fresh start”. This gives the creditors an opportunity to recoup their claims (or at least an opportunity to receive more than they would get if the debtor was liquidated, whether via repayment or an ownership stake in the new firm) and society as a whole benefits from the continued existence of an economically viable firm. Alternatively, if a company has no going concern surplus, then there is no point for it to continue to exist; it should be liquidated with the proceeds going to repay its creditors. (This is the purpose of Chapter 7 of the Bankruptcy Code, which deals with an orderly liquidation of a debtor’s assets). (Adler et al., 2007) A company that is merely suffering from financial distress is prime candidate for rehabilitation through Chapter 11 proceedings. The process allows the court to reduce its debt obligations (in a fair and equitable manner) to ensure that the new capital structure is consistent with the company’s projected future earnings. However, companies that are also facing economic distress (in addition to financial distress) can also be helped. In the latter case, the goal of the bankruptcy process is to investigate, and if possible, eliminate the sources of the economic distress through a reorganization plan. Since buy-in from creditors and approval by the court is necessary in either case, the process ensures that any restructuring or reorganization plan meet the stringent requirements of all the parties involved.
Adler, B., Baird, D., & Jackson, T. (2007). Bankruptcy: Cases, Problems and Materials (4th ed., p. 797). New York, NY: Foundation Press.
