General Motors, American Airlines, Texaco, Caesars Entertainment, all have something in common. They and hundreds of other familiar companies were once broke and on the verge of extinction but lived to fight another day thanks to the American legal framework for bankruptcy.
Roughly half of all new business ventures fail within their first 5 years, erasing the shareholders’ equity investment and often leaving the enterprise with debt it cannot repay. Even established enterprises with long histories may encounter existential challenges due to economic cycles, external events, or management mistakes. But who would willingly undertake such risk if the result of failure was a lifetime of penury or even imprisonment? Part of the genius of the American system is the recognition that risk taking must be encouraged and failure is not a death sentence.
This spirit of entrepreneurship propelled us from colonial outpost to the world’s superpower. Capitalism depends upon the competitive allocation of capital to its best and highest use, a process that Adam Smith referred to as the “invisible hand”.
Yet this phenomenal success would not have been possible had not the Framers anticipated the need for an orderly discharge of debts in circumstances where the debtor had no hope of repayment.
Article I of the Constitution grants Congress the authority to establish uniform laws governing bankruptcies, intended to replace a pastiche of disparate state statutes. Within a document so remarkable in every aspect, the doctrine of corporate bankruptcy ranks high for its salutary effect on the development of capitalism in the New World.
Congress made several early but abortive attempts to codify that authority throughout the 19th century, most of which were ultimately viewed as too lenient toward debtors. Progress was made and lessons learned (federal debtor’s prison was abolished in 1833), leading up to the Bankruptcy Act of 1898 and subsequent refinements.
Current law governing bankruptcy is contained in Title 11 of the United States Code, enacted in 1978. The title contains several chapters that address specific circumstances and procedures for individual, corporate, and municipal restructurings.
Chapter 11 of the bankruptcy code provides a route for a company with unmanageable debt to restructure its obligations sufficiently to continue as a going concern. This path is preferred if the enterprise is more valuable if it continues to exist rather than liquidating its assets to distribute to creditors. In other words, it is worth more alive than dead.
In most cases, the debtor company initiates the process by filing a petition with the U.S. bankruptcy court. The petition includes a comprehensive financial statement including assets and liabilities, leases and contracts, and income and expenses.
Typically, existing management remains in charge of day to day operations, an arrangement known as debtor in possession. The bankruptcy petition stops most collection efforts and lawsuits while the company crafts a detailed plan of reorganization that recognizes the priority of creditors given the likelihood that not all debts will be fully repaid. Some of the company’s obligations stand at the front of the line, like secured bank loans or other liens, while others may be unsecured, holding no claim on collateral and generally falling lower in the pecking order. Creditors within each class of debt must be treated fairly.
The reorganization plan is then presented to a committee comprised of creditors who are considered “impaired”, meaning they are unlikely to be made whole. If the committee approves the arrangement, it is submitted to the court for final approval. The confirmed reorganization plan specifies which debts will be cancelled or reduced and a new schedule for repayment of the remaining obligations. The firm can now emerge with a more manageable debt burden and a new lease on life.
A familiar example of a successful Chapter 11 reorganization is the mall operator CBL Properties. Faced with a collapse in retail traffic during the pandemic, the company was unable to service its debt and filed for reorganization in August of 2021. During the process, CBL continued to operate, reduced its debt by $1.7 billion, and emerged from bankruptcy in November 2021. Withing the last month, CBL announced a successful long term debt refinancing at a lower interest rate, received a rating upgrade from S&P Global, and declared a special dividend payable to shareholders. In the absence of a legal framework for restructuring, CBL would have been forced to liquidate its properties at fire sale prices or simply hand over the keys to the banks.
Sometimes, restructuring under chapter 11 is simply not feasible. In this case, the bankruptcy code provides for liquidation under chapter 7 under which the assets are sold, and the proceeds distributed to the creditors. Toys “R” Us, which once boasted a 25% share of the U.S. toy market, filed for chapter 7 liquidation in 2017 and closed all its stores the following year. The brand name has since been sold twice and its current owner, WHP Global, is attempting a comeback inside Macy’s stores but has no other connection to the defunct retailer.
Individuals are also afforded relief from unsustainable debt, perhaps due to overwhelming medical bills or job loss. Chapter 13 provides a mechanism to pause collection efforts by creditors and work out a repayment deal over up to 5 years. This form of personal bankruptcy allows the debtor to retain certain assets like a home or vehicle during the process. If all else fails and a workout is not feasible, chapter 7 liquidation is available here as well.
Chapter 9 of the code provides for municipal restructuring. Detroit Michigan and Jefferson County Alabama (Birmingham) successfully used this procedure to regain viability during the 2010s. Chapter 12 defines a similar escape route for adjustment of debts owed by family farmers and fishermen.
The dynamism of the U.S. economy depends critically upon the willingness of entrepreneurs to assume substantial risk, a much less likely prospect if failure led to debtor’s prison. The availability of an orderly do-over in the event of failure is fundamental to American success.