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Debate: Chapter 11 bankruptcy provisions

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What are the pros and cons of chapter 11 style bankruptcy provisions?

Background and context

Chapter 11 of the U.S. Bankruptcy Code governs reorganisation (as opposed to liquidation). When a business decides that it is technically insolvent (i.e. cannot meet its debts) it may choose or its creditors may force it to file for bankruptcy. Under Chapter 11 provisions, the court has the option of supervising the reorganisation of the company’s debts. This can involve reducing or writing them off, so the company can re-emerge from bankruptcy as a viable entity. There have been recent high-profile examples such as United Airlines. Some other countries see Chapter 11 as a model for how to make the most of a situation where a basically sound company is crippled by its debt burden.

Argument #1


Chapter 11-style provisions allow a business to reorganise. Often a good business can be crippled by its previously incurred debts. For example, bad management, high interest rates or high research and development costs may mean that a company which otherwise produces positive cash flow ends up saddled with debt obligations which it cannot meet. It seems to be a waste to force the company to stop trading just because of the debt, especially if this does not make it much more likely that the debt will be repaid in any case. A Chapter-11 style approach would allow the company to keep on trading by releasing it from some of its historically incurred obligations.


Reorganisation serves to prop up bad businesses. When a company is approaching insolvency, it reflects the fact that it is basically a bad business or has been badly run. Reorganising it so that it can continue will in many cases simply delay the inevitable by helping the company to struggle on for a bit longer. However, this comes at the expense of creditors. It also serves unfairly to penalise well-run companies against which the firm competes, since these well-run companies need to meet their debts as they continue in solvent trading.

Argument #2


Chapter 11-style provisions encourage sensible corporate planning. Chapter 11 is discretionary and the courts will not look favourably on bad management. An “all or nothing” approach encourages corporate management to act recklessly and reinforce their previous mistakes. If they are headed towards insolvency, they have little or no disincentive from taking extreme risks even where the chance of these turning the company’s finances around is very small. However, the option of reorganisation can discipline the management into being more honest and deliberative, calling in help sooner rather than when it is already too late, and forming an approach which is based on maximising the business potential rather than simply juggling immediate debt payments. This should mean that the business is in a better position to succeed over the medium to long term.


The chance of Chapter 11 reorganisation discourages the correct level of risk aversion and creates a moral hazard. Risk taking can be important in business and it may be a worthwhile policy objective to encourage it. But there is a danger in making it too easy for businessmen to take risks if they do not have not have to shoulder the burden of so doing. Chapter 11-style provisions provide an example of this. Businessmen know that there is a chance that their businesses will be bailed out if they run into trouble and factor this fact into their decision-making. This therefore motivates them to approach their business in a more reckless fashion than they otherwise would, or than would be rewarded in the open market.

Argument #3


Reorganisation can help to protect the interests of employees and other stakeholders. Forcing a company into liquidation prioritises the interests of a company’s creditors over the interests of all other persons who may have an interest in the fortunes of the company or be affected by it (“stakeholders” such as employees, pensioners, suppliers, customers and shareholders). This is so even where the extra amount which is gained for creditors by putting the company into liquidation is very small or zero. The process of reorganisation, by contrast, allows other interests to be taken into account. It may therefore be possible, for example, to protect employees’ interests through continued employment in a restructured company.


Shareholders’ interests are poorly protected if at all in Chapter 11-style bankruptcies. Usually, such a process will substantially reduce or even wipe out altogether the shareholders’ interest in the company (in which case they typically pass to the creditors). This is a court-backed removal of their property rights. It is not fair that the interests of the creditors or other parties should be put ahead of the interests of the shareholders in this way, especially because the shareholders like the creditors perform an important role in providing the risk capital which is necessary for businesses to function and grow.

Argument #4


Bankruptcy law should protect those who cannot protect themselves. Opponents of Chapter 11-style provisions often argue that they do not provide sufficient protection to creditors, who provide important risk capital to businesses. However, this ignores the reality that creditors are often well able to protect their own interests and so do not need much if any additional protection through the bankruptcy regime. They are often sophisticated financial institutions or trade creditors, who have deep pockets and an ability to diversify their portfolio of loans easily and so reduce or hedge their risk. By contrast, other stakeholders are less sophisticated and cannot control their risk as easily through diversification. For example, a company winding up may harm an employee who earns ?10,000 annually much more than a bank which has lent the business ?100,000.


Creditors deserve protection in bankruptcy. It is untrue that creditors are necessarily better able to protect themselves than other parties. Many of them may not be sophisticated, because for example they are small trade partners (e.g. unpaid suppliers, or customers who have prepaid for goods which never arrive) with little choice to be creditors, or family or friends lending money, or else because sophistication would be unduly expensive in terms of research and monitoring costs. In addition, they may not easily be able to control their risks through diversifying their portfolio. Even if they can, the law should not discriminate against creditors just because they protect themselves better than other parties.

Argument #5


Bankruptcy is a special sort of business process and so is not as well thought through by many businesses as other processes would be. Bankruptcy effectively reflects a failure on the part of the business and therefore often on the part of the management. They are therefore less willing to spend time in advance planning for it and making the most suitable arrangements for it. This is just as many people who die unexpectedly young in accidents have not ordered their estates in effective ways. It is therefore appropriate that the law takes a more proactive approach to bankruptcy and acts to counterbalance the lack of thought which many companies have put into how they would deal with it.


Chapter 11-style provisions represent an unwelcome interference in private ordering. All of the parties involved in a company, including employees, shareholders and creditors, voluntarily opt into their involvement with the company. They have the opportunity to weigh up the risks and possible benefits, decide whether they want to be involved and take such steps as they can or desire to control risks. For the courts to intervene in an unpredictable way after the event is an unjustifiable intrusion into the private ordering which the parties have agreed between themselves. This is an intrusion upon important personal liberties and also helps to undermine the certainty and personal autonomy which underpins an environment favourable to business.

Argument #6


Chapter 11 provisions encourage risk taking by entrepreneurs, ensuring that the penalties for failure are not so terrible as to deter people from ever wanting to start up their own business. Outside America (e.g. in Europe) the legal consequences of business failure and bankruptcy are often so bad (e.g. liquidation rather than reorganisation is the norm, barring those involved from being company directors, taking all their personal assets including their home, making it hard to ever borrow money again for any purpose) that many men and women who have bright ideas are afraid to pursue them. Not coincidentally, the USA has a much more dynamic economy than other developed countries without Chapter 11-style provisions, creating many more new businesses and therefore more jobs.


The only people who really profit from Chapter 11 provisions are the lawyers. By the time a company has emerged from Chapter 11 protection, a big chunk of its remaining assets - which could have been distributed to its creditors - have been consumed in legal fees, often running into tens of millions of dollars. As for the idea that Chapter 11 promotes a dynamic economy, the way in which US airlines have moved in and out of bankruptcy protection over the past fifteen years suggests that they are being sustained artificially and therefore inefficiently.

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