It Sounds Scary, but Bankruptcy Isn't Always Bad

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It Sounds Scary, but Bankruptcy Isn't Always Bad

Recent economic turbulence has put tremendous pressure on businesses -- some of them have sought assistance by asking the government to purchase their bad assets or to extend an infusion of capital into their business through purchase of stock.  The effectiveness and appropriateness of these new approaches are now being debated.  A more traditional alternative for a struggling company is to file for bankruptcy.  Bankruptcy is a scary word to many people – it is often thought of as the end.  If the company filing for bankruptcy decides to liquidate all of its assets and distribute the proceeds among its creditors, it is the end; the company will cease operations.  However, bankruptcy law also provides an option that allows a financially troubled company to present a plan of reorganization to its creditors while continuing business operations.  Using this procedure, set forth in chapter 11 of the bankruptcy code, the bankrupt business retains possession of some or all of its property, develops a plan, and generates funds to pay its debts.

The ability of the debtor to continue to operate the business is a substantial reason to file for chapter 11. The basic premise is that the business has more value (or potential value) as an operating business than in liquidation.  A goal of chapter 11 is for the company to design a plan that will allow it to operate as a profitable organization; one that will continue to contribute to the economy by producing valuable products and employ workers.  To do this, however, the company needs to reorganize its debts, including some of its contractual obligations; a plan which requires approval by at least one class of the company’s creditors.  In large chapter 11 cases, these creditors may number in the thousands. Rather than negotiating with each creditor, committees are formed to represent the interests of the creditors while the company continues to use the business assets, borrow funds and conduct business as long as it does not cause additional damage to the creditors. The bankruptcy process is monitored by the U.S. Trustee, a division of the Department of Justice.

Many people wonder what happens to the value of publicly traded stocks of companies that have announced bankruptcy.  When a company reorganizes its debt, the holders of secured debt are the first to be paid. Typically, these are banks that issued credit to the company that was backed by collateral, assets such as a building, inventory, accounts receivable or equipment. After these debts are paid or restructured, the next in line to be paid are "unsecured creditors," e.g., priority claims for taxes, wages, lenders of non-collateralized loans, suppliers with unpaid invoices and bondholders.  The last are stockholders who often walk away with a complete loss since they have the lowest priority.  Such was the case of Delta Air Lines, whose shares in early 2006 became virtually worthless.  Shares of new stock were issued to creditors and began trading after the airline emerged from restructuring. The most notable bankruptcy turnaround story is a local one, that of Federated Department Stores (now Macy’s), which declared chapter 11 in 1990, two years after it was taken over in a highly leveraged buyout.  Just four years later, the company was strong enough financially to purchase its longtime department store rival, Macy's.

So, while bankruptcy is a scary and unpleasant word, it can be a process that leads a company to a better financial state.