- September 7, 2014
- Posted by: Treadstone Management Partners
- Category: Corporate Finance
In 1978, the US Senate passed the Bankruptcy Reform Act. The act came to exist with the intention of helping failing businesses and individuals reorganize their assets, restructure their financing, come out of bankruptcy and continue their operations. In the meantime, creditors could not sue or pressure the debtors in possession for the debt owed because of the court’s protection of filers.
Not all countries have legislation for bankruptcy. The US Bankruptcy Reform Act has been amended several times since its inception and currently has six main types of bankruptcies listed: Chapter 7, 9, 11, 12, 13, 15. Neither of them is created equal and filers have to know under which one they qualify. Since the law is complicated, filers will require the help of qualified professionals, such as the Zulqarnain Group.
The first type of bankruptcy is Chapter 7 – Liquidation. Also known as straight bankruptcy, this is the quickest and simplest form of bankruptcy available. Described in its name, filing for liquidation results in selling all nonexempt assets of the filer (nonexempt assets are those the debtor cannot claim for protection under the law; Schedule C of the bankruptcy petition). The proceeds of the sold assets are used to pay off holders of claims.
A business can use Chapter 7 when it seeks to exit an industry in which it has heavy equipment, machinery, and other assets used in particular industries. Reasons for leaving are numerous; for example, unprofitable industry, lack of economies of scale, lack of economies of scope, change in business direction, etc. When filing under this type of bankruptcy, the business is paying creditors only with the proceeds from assets. In this way it is also able to get rid of equipment it no longer needs and begin anew in a new industry. In addition, a business with no physical assets can also sell its divisions to other companies as part of the liquidation process. This possibility leaves the door open for businesses to enter into mischievous dealings with which it has set up an agreement. In other words, it is able to sell one of its divisions to another company outside the competitive marketplace for a price that’s not negotiated by the market.
Another type of bankruptcy is called Chapter 9. This chapter deals with debt held by municipalities, which is defined in the Bankruptcy Code as “political subdivision or public agency or instrumentality of a State.” It’s easy to see that a city or school district (examples of municipalities) operate as businesses, either as a for-profit or non-profit, but in any case they can assume on debts and file for bankruptcy. The biggest municipal bankruptcy filing happened on July 18, 2013 in the city of Detroit. It had an estimated debt of $18-20 billion. Causes for this are attributed to the falling tax base due to the declining population, which is estimated at around 700,000 inhabitants. This is less than half than its peak population in the 50s. Other causes are Detroit’s budget deficits since 2008, home owners not paying their property taxes, and corruption.
The main type of bankruptcy used by corporations is Chapter 11. It allows the business debtor to reorganize its finances while keeping the business alive and set a payment plan for its creditors. With Chapter 11, the corporation retains control of its business and its assets with protection from the court. Creditors cannot enter into lawsuits with the corporation, and thus the business enters a hermetically sealed chamber from which it hopes to emerge financially stable. When a company files for bankruptcy, it means that its cash flow isn’t enough to cover its obligations. This shortfall can occur for various reasons, but part of it can be fixed while under bankruptcy. In 2002, Kmart filed for bankruptcy to gain protection from creditors. One reason they were losing money was because the chain was locked into long term leases with premium rates on its unprofitable stores. During reorganization, it was able to negotiate lower leases whilst under protection.
Businesses should consider Chapter 11 bankruptcy when it is locked into unreasonable payments. For example, past management’s negotiations can seem unfair to new management. Corruption can also be circumvented. When previous owners have entered into dealings with a given creditor for the exploitation of the business’s cash flows, new owners can use Chapter 11 to halt such payments and either prove the corrupt contract or discharge payments. Other factors to consider are economic depression such as the one in 2008. During that period, many financial institutions, companies, and businesses filed for bankruptcy. One such example is Lehman Brothers, which filed for Chapter 11 on September 15th, 2008. It is the largest bankruptcy in US history, with listed $639 billion in assets.
An economic depression, in which the business has no cash flow to pay creditors, can and will persuade the business to use strategic bankruptcy to save it from liquidation whilst continuing operations. Strategic bankruptcy can also help a business preserve its cash flows. While under protection, they use them for a strategic initiative, such as expansion of business line, acquisition, divestiture, etc. In essence, Chapter 11 bankruptcy can give the business time and protection to reorganize its finances, create a strategic roadmap for better financial health, and emerge from bankruptcy stronger. Moreover, businesses can view this type of bankruptcy as a pause on their creditors that demand their precious cash.
Besides the potential benefits strategic bankruptcy offers to businesses, it has to be viewed as a double edged sword. Bankruptcy can harm a business if not handled correctly. One way it is harmful is the damage it causes to reputation. Businesses rely on their reputation to sell their products for premium prices. In today’s competitive markets, businesses differentiate themselves on their reputation. Since Lehman Brothers filed for bankruptcy, they can no longer come back with the same name, due to the lack of customers’ confidence. Perhaps that is why they were acquired the day after their filing by Barclays, a reputable financial institution that managed to outlive the depression. Bankruptcy should not be considered an easy way out of loan repayments. Nor should it be considered without a proper action plan to increase cash flow. Once the court’s protection falls, creditors will still demand their money.
A personal bankruptcy and/or a corporate one is ideally the last resort to be undertaken. Filing for bankruptcy as a strategic initiative carries certain risks. Businesses have to be aware of what needs to be done to increase their cash flows. Restructuring their debt, reorganizing their business, and negotiating new contracts, are just a few examples. Overall, strategic bankruptcy can revive a dying business so the word “bankruptcy” should not instill fear but rather open the possibility of a new beginning.
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Michon, Kathleen. “Chapter 11 Bankruptcy: An Overview.” Alllaw.com. All Law, n.d. Web.
“Strategic Bankruptcy.” Wikipedia. Wikimedia Foundation, 21 May 2014. Web.