Going Bankrupt In The World

Going Bankrupt in the World

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.