What is bankruptcy?

Bankruptcy is a financial state that occurs when a person or business can no longer repay its debts. In the legal sense, bankruptcy begins when a court recognizes that the financial state of bankruptcy exists. The bankruptcy court takes charge of the bankrupt entity and disposes of its assets or reorganizes it to pay off as much of the debts as possible.

A bankruptcy proceeding recovers money for the creditor, but both parties benefit.

The purpose of a bankruptcy proceeding is to facilitate the maximum recovery of the money owed to the creditor. But it also benefits the debtor. After the debtor pays off what he can, his remaining debt is extinguished. This is not a “get of jail free” card; the debtor, whether a person or business, must face the damage to its reputation and a greater difficulty in obtaining credit for a long time into the future. Rather, it is an acknowledgement that the debtor simply cannot repay his debt. For both parties, bankruptcy offers timely resolution to an otherwise unsolvable dilemma. The creditor regains a portion of the money owed, and the debtor, relieved from the burden of a debt he cannot pay, can move on with his life.

Bankruptcy is economically valuable.

In economic terms, a speedy and fair process of bankruptcy allows both assets and people to resume being productive as quickly as possible. The creditor regains cash that it can redeploy as it sees fit. If it is a bank, it has regained funds that it can loan out again to more productive businesses or creditworthy individuals. The creditor can also redeploy the assets of the bankrupt entity into the hands of a more capable manager.

Take the financial malaise of General Motors as an example. Although effectively bankrupt, there has been no legal recognition of this fact (as of this writing in March 2009). As a result, its factories and workers continue to be tied up inefficiently making mediocre cars. General Motors is a drag on the American economy.

Bankruptcy would free General Motors’ factories and employees to be more productive. Once a court legally acknowledges General Motors’ bankruptcy, it could allow General Motors’ new owners, its creditors, to appoint a more competent manager. Or the creditors could sell the plants to a superior car manufacturer, such as Toyota. Either way, after reorganization under bankruptcy, the plants would be used to make cheaper, more attractive cars that customers want to buy.

The creditors may also choose to shut down some or all of the plants and sell them for scrap. But recycling the old plants into new steel that becomes the girders of modern, efficient factories is a better use for those plants if they are obsolete. No party is in a better position to make these judgments than General Motors’ creditors, who have their financial self-interest at stake.

While General Motors is just a single, albeit enormous, example, speedy and fair bankruptcies end the bleeding of money-losing operations across the economy, and re-direct inefficiently utilized assets and capital to more productive activities. In sum, bankruptcy facilitates economic recovery. A failure to permit bankruptcy prolongs stagnation.

Some fallacies about bankruptcy

Bankruptcy always means shutting down a business. This is not true. Creditors, in consultation with the bankruptcy court, decide whether to shut down and liquidate, or to operate under new management. Creditors have every incentive to make the decision that maximizes their pay-out over time, not just the amount of cash that can be had right now.

Bankruptcy is bad for employees. Considered in full context, bankruptcy is good for employees. An economy with speedy and fair bankruptcy procedures is one where healthy, growing companies predominate. Healthy companies can pay employees more because their labor is worth more to them. Therefore, employees benefit from bankruptcy, even if someone occasionally faces dislocation or the uncertainty of working for new management. But, even if employees dislike such occasional dislocation, there is no alternative to bankruptcy if their employer is not financially viable.

Bankruptcy allows deadbeats to avoid meeting honest obligations. When bankruptcy laws are properly drafted and applied, this is the exception rather than the rule. Bankruptcy laws are designed to protect the rights of all parties, not to unfairly favor debtor or creditor. Bankruptcy acknowledges a fact, that the debtor cannot repay all his debts, and it facilitates the repayment of all debts that can be repaid.

Government should stop bankruptcies. During financial panics, governments sometimes try to prevent bankruptcies by putting moratoriums on them, subsidizing bankrupt entities, or changing the laws governing bankruptcy to favor debtors. Such interventions are both unjust and impractical. They are unjust because they deny the legitimate right of the creditors to collect what they are owed. The money they are owed is their property, and they have the right to collect it, to the extent it is reasonably possible. Such interventions are unjust and impractical because they attempt to deny reality. “Stiffing” the creditors or forcing innocent third parties to bail out the bankrupt entity through subsidies does not change the fact that the bankrupt entity cannot repay its debts.

Bankruptcy is moral.

Bankruptcy is just, if resolved through a fair and speedy judicial process. A bankruptcy proceeding acknowledges the actual state of affairs that exists, that the bankrupt entity cannot repay its debts. It resolves this dilemma for the maximum benefit of the creditor, but in so doing allows both parties – debtors and creditors – to resolve this matter with finality, and move on with their lives. Bankruptcy only involves the parties to the debt obligation. It does not require that innocent, third parties be forced to subsidize or bail out creditors or debtors. In doing so, it respects the rights of all concerned.

A just process of bankruptcy is also economically practical. Bankruptcy removes assets from those who have mismanaged them, and puts them into the hands of those who are most capable of putting them to productive and financially responsible use.  The institution of bankruptcy is an essential part of a prosperous and just capitalist society.