Going Bankrupt In The World

Going Bankrupt in the World

 by: Sam Vaknin,

Ph.D.

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 is a technical or equity insolvency status.

But this is not the only way that a company can be rendered insolvent. It

could also run liabilities which will outweigh its assets. This is bankruptcy

insolvency. True, there is a debate raging as to what is the best method to

appraise the assets and the liabilities. Should these appraisals be based on

market prices - or on book value?

There is not 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. To say its lines - 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 things) selling

its assets?

The proceeds of the sale of the assets is divided (as "bankruptcy

dividend") among the creditors. It makes sense to choose this route only if the

(money) value generated by liquidation exceeds the (money) the company as a

going concern, as a living, functioning, entity.

The company can, thus, go into "straight bankruptcy". The secured

creditors will receive the value of the property which was used to secure their

debt (the "collateral", or the "mortgage, lien"). Sometimes, they will receive

the property itself - if it not easy to liquidate (=sell) it.

Once the assets of the company are sold, the first to be fully paid off

will be the secured creditors. Only then will the priority creditors be 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 there is any money left after all these payments, it will be

proportionally doled out to the unsecured creditors.

The USA had many versions of its bankruptcy laws. There was the 1938

Bankruptcy Act, which was followed by amended versions in 1978, 1984 and,

lately, in 1994.

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 small

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 writing 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 new claims received by the creditors (instead of the
  
  old, discredited, ones) equal, at least, to 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 stockholders and

stockholders in the insolvent firm will 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:

The American Law leans in favour of maintaining the company as a going

concern. A whole is larger than the sum of its parts - and a living business is

worth more than the sum of its assets, sold separately.

A more in-depth study of the bankruptcy laws shows that they allow for

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 Interim Trustee is empowered to do the following:

• liquidate property and make distribution of liquidating dividends to
  
  creditors
  
  

• make management changes
  
  

• arrange unsecured financing for the firm
  
  

• operate the debtor business to prevent further losses
  
  

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 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 ages old ABSOLUTE PRIORITY rule, that says that the claims of

creditors have categorical precedence over ownership claims. From now on, 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 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.

Despite its clarity and business orientation, many countries found it

difficult to adopt to the pragmatic, no sentiments 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 receivership. He collects rents and other income on

behalf of the firm.

So, British Law is much more in favour of the creditors. It recognizes the

supremacy of their claims over the property claims of the owners. Honouring

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.

Economies in transition were 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. It is not allowed to

swap debt for equity. Moreover, the law provides for a very short time to reach

agreement with creditors about 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 5/97.

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 3/93 - 9/93 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, always pitting horses against tanks, always

losing the war, as a result. The pre-war (1934) law declares bankruptcy when

confronted with 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 payment. There

is, indeed, 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 someone has

yet to come with 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?

Until such time as these questions are answered and as long as the

microeconomic debt crisis deepens -we will witness a flowering of versions of

bankruptcy laws all over the world.

About The Author

Sam Vaknin is the author of "Malignant Self Love - Narcissism Revisited"

and "After the Rain - How the West Lost the East". He is a columnist in "Central

Europe Review", United Press International (UPI) and ebookweb.org and the editor

of mental health and Central East Europe categories in The Open Directory,

Suite101 and searcheurope.com. Until recently, he served as the Economic Advisor

to the Government of Macedonia.