Going Bankrupt in the World
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Close to 1.6 million Americans filed for personal bankruptcy (mostly under chapter 7) in 2004 - nine times as many (per capita) as did the denizens of the United Kingdom (with 35,898 insolvencies). The figure in the USA 25 years ago was 300,000. Bankruptcy has no doubt become a growth industry. This surge was prompted by both promiscuous legislation (in 1978) and concurrent pro-debtor (anti-usury) decisions in the Supreme Court.
Under chapter 7, for instance, cars and homes are exempt assets, untouchable by indignant creditors. Even under chapter 13, debt repayments are rescheduled and spread over 5 years to cover only a fraction of the original credit.
A new reform bill, passed in both the Senate and the House of Representatives in April 2005 seeks to reverse the trend by making going financial belly up a bit less easy. The Economist noted that:
"While consumers do carry more debt than they used to, the amount of income devoted to servicing that debt has not gone up that much, thanks to falling interest rates and longer maturities. Other factors must be at work; plausible candidates include greater income volatility, legalised gambling, bigger medical bills, increased advertising by lawyers offering to help people in debt, and a cultural shift that has destigmatised bankruptcy."
Personal bankruptcies are rare outside the United States. Besides being stigmatized, such debtors surrender most of their income and virtually all their assets to their creditors. If the money they borrowed was spent frivolously or recklessly - or if they have a tainted credit history - borrowers are unlikely to be granted bankruptcy protection to start with.
Still, personal bankruptcies are dwarfed by corporate ones. In the plutocracy that the United States is fast becoming, corporations and their directors remain largely shielded from the consequences of the profligacy and malfeasance of their management.
The new bill merely curtails bonus schemes to executives and key personnel in firms under reorganization and introduces bankruptcy trustees where the management is suspected of fraud. Compare this to Britain where managers are responsible for corporate debts they knowingly incurred while the firm was insolvent.
Moreover, debts owed by individuals to firms take precedence over all other forms of personal financial obligations. In other words, as The Economist notes: "The new treatment of secured car loans could put child-support and alimony payments behind GM’s finance arm in the queue."
It all starts by defaulting on an obligation. Money owed to creditors or to suppliers is not paid on time, interest payments due on bank loans or on corporate bonds issued to the public are withheld. It may be a temporary problem - or a permanent one.
As time goes by, the creditors gear up and litigate in a court of law or in a court of arbitration. This leads to a "technical or equity insolvency" status.
But this is not the only way a company can be rendered insolvent. It could also run liabilities which outweigh its assets. This is called "bankruptcy insolvency". True, there is a debate raging as to what is the best method to appraise the firm's assets and its liabilities. Should these appraisals be based on market prices - or on book value?
There is no one decisive answer. In most cases, there is strong reliance on the figures in the balance sheet.
If the negotiations with the creditors of the company (as to how to settle the dispute arising from the company's default) fails, the company itself can file (ask the court) for bankruptcy in a "voluntary bankruptcy filing".
Enter the court. It is only one player (albeit, the most important one) in this unfolding, complex drama. The court does not participate directly in the script.
Court officials are appointed. They work hand in hand with the representatives of the creditors (mostly lawyers) and with the management and the owners of the defunct company.
They face a tough decision: should they liquidate the company? In other words, should they terminate its business life by (among other acts) selling its assets?
The proceeds of the sale of the assets are divided (as "bankruptcy dividend") among the creditors. It makes sense to choose this route only if the (money) value yielded by liquidation exceeds the money the company, as a going concern, as a living, functioning, entity, can generate.
The company can, thus, go into "straight bankruptcy". The secured creditors then receive the value of the property which was used to secure their debt (the "collateral", or the "mortgage, lien"). Sometimes, they receive the property itself - if it is not easy to liquidate (sell) it.
Once the assets of the company are sold, the first to be fully paid off are the secured creditors. Only then are the priority creditors paid (wholly or partially).
The priority creditors include administrative debts, unpaid wages (up to a given limit per worker), uninsured pension claims, taxes, rents, etc.
And only if any money is left after all these payments it is proportionally doled out to the unsecured creditors.
The USA had many versions of bankruptcy laws. There was the 1938 Bankruptcy Act, which was followed by amended versions in 1978, 1984, 1994, and, lately, in 2005.
Each state has modified the Federal Law to fit its special, local conditions.
Still, a few things - the spirit of the law and its philosophy - are common to all the versions. Arguably, the most famous procedure is named after the chapter in the law in which it is described, Chapter 11. Following is a brief discussion of chapter 11 intended to demonstrate this spirit and this philosophy.
This chapter allows for a mechanism called "reorganization". It must be approved by two thirds of all classes of creditors and then, again, it could be voluntary (initiated by the company) or involuntary (initiated by one to three of its creditors).
The American legislator set the following goals in the bankruptcy laws:
To provide a fair and equitable treatment to the holders of various classes of securities of the firm (shares of different kinds and bonds of different types).
To eliminate burdensome debt obligations, which obstruct the proper functioning of the firm and hinder its chances to recover and ever repay its debts to its creditors.
To make sure that the new claims received by the creditors (instead of the old, discredited, ones) equal, at least, what they would have received in liquidation.
Examples of such new claims: owners of debentures of the firm can receive, instead, new, long term bonds (known as reorganization bonds, whose interest is payable only from profits).
Owners of subordinated debentures will, probably, become shareholders and shareholders in the insolvent firm usually receive no new claims.
The chapter dealing with reorganization (the famous "Chapter 11") allows for "arrangements" to be made between debtor and creditors: an extension or reduction of the debts.
If the company is traded in a stock exchange, the Securities and Exchange Commission (SEC) of the USA advises the court as to the best procedure to adopt in case of reorganization.
What chapter 11 teaches us is that:
American Law leans in favor of maintaining the company as an ongoing concern. A whole is larger than the sum of its parts - and a living business is sometimes worth more than the sum of its assets, sold separately.
A more in-depth study of the bankruptcy laws shows that they prescribe three ways to tackle a state of malignant insolvency which threatens the well being and the continued functioning of the firm:
Chapter 7 (1978 Act) - Liquidation
A District court appoints an "interim trustee" with broad powers. Such a trustee can also be appointed at the request of the creditors and by them. The debtor is required to file detailed documentation and budget projections.
The Interim Trustee is empowered to do the following:
By filing a bond, the debtor (really, the owners of the debtor) is able to regain possession of the business from the trustee.
Chapter 11 - Reorganization
Unless the court rules otherwise, the debtor remains in possession and in control of the business and the debtor and the creditors are allowed to work together flexibly. They are encouraged to reach a settlement by compromise and agreement rather than by court adjudication.
Maybe the biggest legal revolution embedded in chapter 11 is the relaxation of the age old ABSOLUTE PRIORITY rule, that says that the claims of creditors have categorical precedence over ownership claims. Rather, under chapter 11, the interests of the creditors have to be balanced with the interests of the owners and even with the larger good of the community and society at large.
And so, chapter 11 allows the debtor and creditors to be in direct touch, to negotiate payment schedules, the restructuring of old debts, even the granting of new loans by the same disaffected creditors to the same irresponsible debtor.
Chapter 10
Is sort of a legal hybrid, the offspring of chapters 7 and 11:
It allows for reorganization under a court appointed independent manager (trustee) who is responsible mainly for the filing of reorganization plans with the court - and for verifying strict adherence to them by both debtor and creditors.
Chapter 15
Adopts the United Nations model code on cross-border bankruptcy of multinationals.
Despite its clarity and business orientation, many countries found it difficult to adapt to the pragmatic, non sentimental approach which led to the virtual elimination of the absolute priority rule.
In England, for instance, the court appoints an official "receiver" to manage the business and to realize the debtor's assets on behalf of the creditors (and also of the owners). His main task is to maximize the proceeds of the liquidation and he continues to function until a court settlement is decreed (or a creditor settlement is reached, prior to adjudication). When this happens, the receivership ends and the receiver loses his status.
The receiver takes possession (but not title) of the assets and the affairs of a business in a receivership. He collects rents and other income on behalf of the firm.
So, British Law is much more in favor of the creditors. It recognizes the supremacy of their claims over the property claims of the owners. Honoring obligations - in the eyes of the British legislator and their courts - is the cornerstone of efficient, thriving markets. The courts are entrusted with the protection of this moral pillar of the economy.
And what about developing countries and economies in transition (themselves often heavily indebted to the rest of the world)?
Economies in transition are in transition not only economically - but also legally. Thus, each one adopted its own version of the bankruptcy laws.
In Hungary, Bankruptcy is automatically triggered. Debt for equity swaps are disallowed. Moreover, the law provides for a very short time to reach agreement with creditors about a reorganization of the debtor. These features led to 4000 bankruptcies in the wake of the new law - a number which mushroomed to 30,000 by May 1997.
In the Czech Republic, the insolvency law comprises special cases (over-indebtedness, for instance). It delineates two rescue programs:
A debt to equity swap (an alternative to bankruptcy) supervised by the Ministry of Privatization.
The Consolidation Bank (founded by the State) can buy a firm's obligations, if it went bankrupt, at 60% of par.
But the law itself is toothless and lackadaisically applied by the incestuous web of institutions in the country. Between March 1993 and September 1993 there were 1000 filings for insolvency, which resulted in only 30 commenced bankruptcy procedures. There hasn't been a single major bankruptcy in the Czech Republic since then - and not for lack of candidates.
Poland is a special case. The pre-war (1934) law declares bankruptcy in a state of lasting illiquidity and excessive indebtedness. Each creditor can apply to declare a company bankrupt. An insolvent company is obliged to file a maximum of 2 weeks following cessation of debt payments. There is a separate liquidation law which allows for voluntary procedures.
Bad debts are transferred to base portfolios and have one of three fates:
Reorganization, debt-consolidation (a reduction of the debts, new terms, debt for equity swaps) and a program of rehabilitation.
Sale of the corporate liabilities in auctions.
Classic bankruptcy (happens in 23% of the cases of insolvency).
No one is certain what is the best model. The reason is that no one knows the answers to the questions: are the rights of the creditors superior to the rights of the owners? Is it better to rehabilitate than to liquidate?
The effects of strict, liquidation-prone laws are not wholly pernicious or wholly beneficial. Consumers borrow less and interest rates fall - but entrepreneurs are deterred and firms become more risk-averse.
Until such time as these questions are settled and as long as the corporate debt crisis deepens - we will witness a flowering of disparate versions of bankruptcy laws all over the world.
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