Bankruptcy & Organization
This essay investigates the topic of bankruptcy as it relates to corporate organization. Bankruptcy is a proceeding that is governed by federal law; and offers protection to debtors from creditors under certain guidelines and for a certain period of time. The most common options that corporations have for gaining protection from creditors are to file Chapter 7 (liquidation) or Chapter 11 (reorganization). This article focuses on issues and topics related to Chapter 11.
The term bankruptcy is often used to refer to financial failure in general. However, in the U.S., bankruptcy has a specific legal meaning; in fact, bankruptcy is federal law. Congress has the power to enact "uniform laws on the subject of bankruptcy" and "restricts the ability of states to provide a discharge or collect assets that are not in the state. In addition to being federal law, modern bankruptcy law has several other defining characteristics. Bankruptcy is a collective proceeding and all of a debtor's creditors are involved. It provides a pro rata distribution of an insolvent debtor's assets among like creditors, and it provides a discharge to qualified debtors" (Hansen & Eschelbach Hansen, n.d.).
History of Bankruptcy Law
Prior to the 20th Century, bankruptcy laws generally favored the creditor rather than the debtor; debtors were often considered criminals and might be punished with imprisonment or death as a result of the inability to re-pay their debt. U.S. Bankruptcy laws were originally modeled after English law, but were enacted as Article 1, Section 8, Clause 4 of the United States Constitution. Article 1, section 8 became known as Uniform Laws on the subject of Bankruptcies throughout the United States. Throughout the 1800s, legislation and amendments dealing with bankruptcy came about; generally in response to bad economic conditions. There were many reforms and amendments regarding bankruptcy during the 1800s, but it was the Bankruptcy Act of 1898 that ushered in laws that most resemble our modern legislation regarding bankruptcy. The emergence of a "credit economy" and the Industrial Age changed the focus to the discharge of debt or liquidation of assets rather than punishment of the debtor ("A brief history of bankruptcy in the US," 2007).
1898 Bankruptcy Act
Today's modern bankruptcy law has its roots in the 1898 Bankruptcy Act. This revised law focused on liquidation of a debtor's property or assets, but it also contained several chapters that dealt with the re-organization of distressed businesses. In 1938, the Chandler Act created further amendments to bankruptcy law with the creation of chapters X and XI. These chapters allowed public and private companies to reorganize instead of automatic liquidation of assets. The Chandler Act also introduced the role of the "bankruptcy referee" who had "quasi-judicial powers" ("A brief history of bankruptcy law," 2002) and served as an appointed representative to act as an intermediary in the proceedings.
Bankruptcy Reform Act of 1978
Bankruptcy law had been part of federal legislation from the beginning of the 19th Century but it was not until the Bankruptcy Reform Act of 1978 and the introduction of Chapter 11, that the practice of bankruptcy was "legitimized" as a viable option for businesses in distress to re-organize. Prior to the revision of Chapter 11, bankruptcy had been avoided by businesses as a "ghetto" and not a viable business tool for re-organization and restructuring. The 1978 Bankruptcy Reform Act introduced a reorganization tool for corporate debtors ("A brief history of bankruptcy in US," 2007).
The Bankruptcy Code has been amended several times since 1978, most recently in extensive amendments in 2005 through the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 or BAPCPA.
The U.S. Bankruptcy Court handles all bankruptcy cases through the U.S. district court system. Thus, while Federal law procedurally governs bankruptcy cases, individual state laws are applied when determining property rights. State law therefore plays a major role in most bankruptcy cases.
Filing for Bankruptcy
When a public company is unable to maintain operation because of "crippling debt," the organization may seek protection under federal bankruptcy laws. Bankruptcy laws provide guidance about the course of action that a business may take-whether it is to go out of business or to re-organize. When a public company (corporation) files for bankruptcy protection it is generally under one of the following two chapters of the Bankruptcy Code:
- Chapter 11 of the Bankruptcy Code to "reorganize its business and try to become profitable again. Management continues to run the day-to-day business operations but all significant business decisions must be approved by a bankruptcy court."
- Chapter 7, the company "stops all operations and goes completely out of business. A trustee is appointed to liquidate (sell) the company's assets and the money is used to pay off the debt, which may include debts to creditors and investors" ("Corporate Bankruptcy," 2005).
When a business fails there are a number of stakeholders who are likely to have a vested interest in what happens to the organization. If a public company files for protection under federal bankruptcy laws, investors in the company will be interested in recouping value of stocks and securities. Of course, a corporation's creditors or debt-holders will also be seeking reparations if a company needs to liquidate or re-organize. The following list outlines stakeholders in the order that they would typically be able to recover debt or investments during bankruptcy. Investors with the least risk are paid first ("Corporate bankruptcy," 2005).
- Secured Creditors: Typically a bank is paid first. Debt is secured by assets or collateral.
- Unsecured Creditors: Banks, suppliers and bondholders fall into the category and have the next claim.
- Stockholder: Owners of the company (stocks) may not receive anything. Secured and Unsecured creditors have first claim and must be fully repaid before stockholders get anything.
Securities Trading for Companies under Bankruptcy Protection
Most companies that are under bankruptcy protection do not meet minimum trading standards to trade on major market indexes. There is no federal law that prohibits the trading of securities of companies in bankruptcy ("Corporate bankruptcy," 2005). There are several alternatives for the trading of securities, and even an index that trades shares from companies in financial trouble.
According to the Securities
"The reorganization plan will spell out your rights as an investor, and what you can expect to receive, if anything, from the company. The bankruptcy court may determine that stockholders don't get anything because the debtor is insolvent. (A debtor's solvency is determined by the difference between the value of its assets and its liabilities.) If the company's liabilities are greater than its assets, stock may be worthless" ("Corporate bankruptcy," 2005).
The Bankruptcy Abuse Prevention and Consumer Protection Act
The implementation of the Bankruptcy Abuse Prevention and Consumer Protection Act (also known as the "Act") in October of 2005, signaled the largest change in bankruptcy code in 20 years (Cecil, 2005). The "Act," welcomed by proponents and vilified by its detractors, has shifted the focus of the code to the rights of the creditor and away from debtors. The Act's "creditor-friendly" provisions, in contrast to the old law's "debtor-friendly" provisions, make it much more important for prospective chapter 11 filers to think and plan ahead and significantly easier for creditors to collect on certain types of debt ("Chapter 11 then and now," 2006).
The Act came about as a result of much lobbying by creditor banks, credit card companies and other's who wanted to curb alleged abuse of the bankruptcy system. There's no doubt that changes to the code will make it more difficult for companies to restructure and many predict that there will be more filings for Chapter 7 (liquidation) as a result of the code changes. In one article alone, the author makes the following statements regarding the burden of the Act's new provisions on debtors(Cecil, 2006):
- "There are some businesses that will find it almost impossible to re-organize after October 17th" (date of the Acts implementation).
- "New laws make re-organization more difficult."
- "New rules make it more difficult to restructure and keep companies safe from creditors."
Prior to October of 2005, the U.S. Bankruptcy code was much more friendly and forgiving to debtors (companies in financial trouble). Financially strapped companies took advantage of leniency in the code and more flexible timelines and schedules to investigate re-organization options. According the Securities and Exchange Comission, the following statement applies in many cases ("Corporate bankruptcy," 2005):
"Most publicly-held companies will file under Chapter 11 rather than Chapter 7 because they can still run their business and control the bankruptcy process. Chapter 11 provides a...
(The entire section is 4117 words.)