Saturday, March 14, 2009

The Case for Bankruptcy

What is bankruptcy?

Bankruptcy is the 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.


First published at The One Minute Case and Capitalism Magazine.


Burgess Laughlin said...

Thank you for this article. It is informative -- providing explanations that will always be useful, but especially at this time of popping welfare-state bubbles.

Equally important to me as a writer is the stylistic example this article sets. The article is clear, well organized, and respectful. It is devoid of the uninformative sarcasm, name-calling, and insults that undermine much of the writing on current economic events.

Galileo Blogs said...

Thank you, Burgess. It is also *enjoyable* to write this way. It forces me to *think* about what I am saying. That thinking is enjoyable and I am glad to see that others find it beneficial.

madmax said...

Excellent post. Back when I was a libertarian I wondered if bankruptcy administration was a valid part of government. I thought then that it could be done by private companies. I'm still uncertain because it seems that what bankruptcy does is renegotiate financial contracts. The government ultimately enforces all contracts but does that mean that bankruptcy proceedings are something that private industry could not handle? If only gov't can handle bankruptcies then would you say that bankruptcy law is a subset of contract law?

Galileo Blogs said...

Bankruptcy is a necessary governmental function and part of contract law. Your are correct that it is a renegotiation of financial contracts, but it still requires state action; a third party must arbitrate what is fair.

Some specific issues that must be handled by a bankruptcy court include: How do you rank the claims of the various creditors? How do you decide how much each creditor gets? How do you decide how a bankrupt estate should be managed? These issues must be decided by an entity that has the enforcement power of government behind it, if the private parties cannot reach agreement.

As an example of an issue that must be handled by the court, in the initial stage of bankruptcy a receiver must be appointed to administer the bankrupt estate. That requires a declaration that this person (and not that person) *will be* the receiver of the bankrupt estate, and will manage it until it is liquidated and/or reorganized.

A state of bankruptcy must also be legally recognized for title to transfer, contracts to be terminated, and all of the other steps to be taken to process it.

The bottom line is that a legal bankruptcy is a variation of the government's contract enforcement responsibility. In this case, the government steps in to enforce proper claims when one party has defaulted to the contract by being unable to pay its financial obligations.

madmax said...

Great response Galileo. Very clarifying. Thanks.

Doug Reich said...

Excellent post. Why do you think there is so much resistance to bankruptcy especially on part of auto makers? Is it because they think they can get free money from govt?

Galileo Blogs said...

Good question, Doug. The simple answer, as I see it, is: yes.

Both management and the union leaders do not want bankruptcy because they are both likely to lose their jobs in such case. Bankruptcy would put the creditors in charge. If I were a creditor, the first thing I would do is oust General Motors' CEO, who has done such a poor job running his company.

Then I would petition the bankruptcy court to scrap the absurd labor contract that has been the principle cause of the automakers' financial demise (because it pays the workers way above market rates in direct pay and largesse, such as the program where workers are paid even when they are not working).

If courts scrapped the labor contract, the bosses would probably be fired by their members.

So, an entrenched management and union is pitted against bondholders. Both management and the unions have government interventionist policies that back them and give them unfair power in this process. Subsidies are only the most recent of those government policies. Other policies have been in place for years giving them that power.

In the case of management, laws that make it very difficult to effect a hostile takeover leaves them entrenched, even if they are incompetent.

For the unions, labor laws passed in the 1930s and in subsequent decades give them artificial power to represent *all* workers, even those who would choose not be a member of the union.

Management and the unions will hang on and milk General Motors and the taxpayers for all they can until the taxpayers' representatives say "enough is enough" and stop subsidizing GM. When that happens, bankruptcy will ensue (unless GM turns itself around, an unlikely possibility in the near- to intermediate-term).

Galileo Blogs said...

I would also add to the government policies that favor management: antitrust and hostility to foreigners.

Antitrust prevents a stronger auto company, say Ford, from buying Chrysler. (Yes, now it may be permitted because of the emergency, but antitrust would typically block such an action.)

Legalized hostility to foreigners would, in all likelihood, have Congress directly block Toyota if they tried to buy GM or Chrysler.

Such hostility is already the law in other industries, such as airlines and the media, where foreign majority ownership is prohibited.

Realist Theorist said...

Great post!

This weekend, with AIG, we saw an example of what happens when the government refuses to recognize an actual bankruptcy.

AIG paid out a whole slew of bonuses. Some of these might make business sense. However, the new CEO, Liddy, said that some of these bonuses were paid because it was part of employee contracts.

AIG cannot unilaterally modify these contracts. Such employees -- qua creditors of AIG -- are being paid, because legally the company is not bankrupt. If reality were recognized, and the company were declared bankrupt, they might get only a portion of what is owed them under their contracts.

Galileo Blogs said...

Excellent point, Realist Theorist. The absurdity (and immorality -- see my earlier post on Wall Street bonuses) of President Obama hectoring his now-government employees over the bonuses they are paid is shocking theater.

Obama is wasting his time and Secretary of the Treasury Geithner's time clawing back this piss-ant (sorry for my unusual use of expletives) money when he blithely showers trillions of dollars of our money on a problem of the government's own making.

The only good thing that can come of this is that Obama & Geithner are distracted a little bit from their ongoing project of doing real damage to the economy.

And yes, to respond to your question, bankruptcy handles this situation perfectly. It is a *legal* way to modify contracts, not the method of Hugo Chavez-style pressure that Obama is trying to bring to bear on these executives.

The bottom line is, it should be neither his business nor the taxpayers' business, how much money in bonuses is paid. In a laissez-faire world of 100% private property, there are no government-owned "businesses." All such matters are between private individuals: the stockholders, bondholders, and the executives and employees they hire to run their businesses. Government's only involvement is in the limited instances where its enforcement and adjudication functions are required, as when contracts are disputed or there is bankruptcy.

AIG should have been settled in the bankruptcy court last year, and not in the so-called "court" of public opinion. If that is a court, it is only of the kangaroo variety.

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